MOSCOW BLOG: Looking into the abyss

By bne IntelliNews October 22, 2008

bne -

Russia is looking into the abyss. It's not clear if it will fall in, but the much-cited massive hard currency reserves won't be enough to save Russia if things continue like this. We are in the middle of an extremely fragile time and unless confidence is restored in the next six weeks or so, the crisis could snowball to reach cataclysmic dimensions.

The first thing to note is that this crisis, in Russia anyway, remains concentrated in investment banks and the capital markets. There are three tiers of fear, with the banks at the top and terrorised. Next comes the companies who are hurting, but in many sectors they have yet to feel any impact from the crisis. At the bottom are the normal people who so far have remained largely unconcerned (partly because the Kremlin has banned reporting of the Russian angle on telly).

Equity traders are bearing the brunt of the sell-offs and remain stuck in the "vortex of despair," as Julian Rimmer of Uralsib in London describes it. The stock market is down 75% from its May peak compared with the 95% fall during the 1998 financial crisis. Last week, Raiffeisen International analysts said we have already reached the bottom and the Russian banks on Tuesday, October 21 said there were signs of bargain hunting in the market as some investors agree. However, Finance Minister Alexei Kudrin also said mid-October that there is further to go. Confusion reigns.

The US clearly still has further to go with consequences for everyone else. The reporting season there has just finished, but these reports contain earning projections for the next quarter, when there is a good chance many US companies simply won't have any. There is probably going to be a wave of bankruptcies and more panic that will infect the international markets again early next year.

In the meantime, big Russian companies haven't yet been hurt. The September macro figures just came out and paint a deceptively rosy picture. The overall performance of the Russian economy remained stable. Industrial production increased by 6.3% year-on-year, while agricultural is actually doing exceptionally well, with growth at a four-year high of 11.1% year-on-year.

Even more encouragingly, the two key components of growth - consumer demand and investment - also remained robust in September. These are Russia's saving graces and what gives confidence that even if the rest of the world goes into a deep recession, the Russian economy will become an island of growth amongst the global economic devastation: retail sales grew by 14.2% year-on-year and, even better, fixed investment had recovered from a slump to a bit more than 7% in August to rise by 11.8% year-on-year.

If the crisis stops here, Russia would quickly bounce back with little lasting damage.

Small complaints

I was at the East Capital annual awards ceremony on October 17 to celebrate the awards for best growth, IPO and discovery of the year. Russia was represented by VimpelCom CEO Alexander Izosimov, who said he has seen no impact from the crisis and the company will retain its 30% year-on-year on growth. (The other two winners - a well-capitalised Croatian bank and a Serbian juice company - were also pretty sanguine about their ability to get through next year).

The impact of this crisis won't hit big companies, especially in the retail sector, for months or maybe not until the middle of next year. Just how hard a blow they receive depends on how fast confidence can be restored. But the complaints of Russia's smaller companies have gone up the scale rapidly and are approaching a scream.

I also met with Simon Dunlop, managing partner of Kinoplex, which is building large cinema/entertainment complexes in the Russian regions, each one costing about $5m a piece. "There is no money in the market at all for investment. We were planning to open six new complexes next year, now we had to work hard to find the money to finish one that is half completed. We have iced plans for all the others for the moment," says Dunlop.

This story is being repeated across the board. The irony of the Russian banking crisis is that the system is actually awash with money. The sector normally needs between $25bn and $35bn to function, but after the state injections of capital, there is two to three times this amount in bank vaults. The problem is the banks are so scared that not even Sberbank is lending.

According to the president of another medium-sized business I talked to, he already had a pre-approved loan for investment from a well-known midsized bank. But when he met with the bank's CEO, he was told that from the 1,000 pre-approved loans in August, the bank had actually only paid out on 10 - and two of those were to power companies that needed working capital to fund the start of the heating system, which they couldn't refuse for political reasons.

As retained earnings account for about three-quarters of most companies' investment capital, most companies have money to keep going. But this won't last long and as the use of credit has rapidly expanded in the last years, if the deep freeze on money markets isn't lifted within in the next one or two months, small and medium-sized enterprises will start failing - not because they are not profitable (most are wildly profitable), but simply from the lack of cashflow.

Immediate action

Things are moving very fast now and it's a time for decisive action. Currently, it seems that every month that passes without finding a bottom to this crisis is wiping about 0.6% off GDP growth for 2009 and reducing the state's hard currency reserves by some $30bn a month. From the worst-case scenario for growth of 5.5% in 2009 that both the government and investment banks were predicting only two weeks ago, now the figure of 3.5% is being bandied about.

In theory, the $590bn of hard currency reserves that Russia started this crisis with - that's 23 months of import cover against the 3-4 months most countries have - would be enough to last a year and a half, but the current rate of spending is already affecting the value of the ruble. And this is where it the scenarios start to get terrifying.

The talk about a possible devaluation that started this week represents a significant scaling up of the danger. Until last week, the main fear was a run on banks. However, the government and the Central Bank of Russia have acted decisively (and, in fact, at least a week to 10 days faster than the western world; having an virtual dictatorship is an advantage in times of crisis).

The hike in the minimum guaranteed by the deposit insurance agency (DIA) to RUB700,000 is, on a proportional basis, even more generous than anything in the West and covers the bulk of private deposits. It should be enough to prevent bank runs. Moreover, the extra RUB200bn capital the DIA got this week means it could cover the collapse of all of Russia's 1,000 smaller banks. However, it doesn't have anywhere near enough money to cover the failure of the top 200 banks.

So far, withdrawals are up between 2% and 6%, which banks can easily cope with. The biggest was at Rosbank, which saw its capital fall by 15% in September, but analysts say that was simply oligarch Mikhail Prokhorov moving his money about. Still, companies have been moving their money from commercial banks to state-owned banks, which is putting the smaller banks under more pressure. Small bank takeovers by state-owned banks are now almost a daily occurrence.

However, if confidence in the ruble fails, then we would see massive capital flight from banks. The CBR said Wednesday, October 22 that it will support the ruble and has spent $2bn this week already. But not even Russia's reserves would be enough to protect the ruble if there is a wide spread failure of confidence in the national currency.

Russia is currently experiencing a "virtual bank crisis" that would be solved almost overnight by the return of confidence and the free flow of money. But the longer this goes on, the more real that crisis becomes.

For example, there have been no bond defaults at all in Russia since the inception of the ruble bond market in 2001. In August there were 10, and numbers out Tuesday say there were 28 defaults worth RUB45bn ($1.7bn) in September. If this carries on, the quality of bank sector assets will decay, starting a downward spiral of defaults, bankruptcies and runs.

The government has stepped up to the plate with $50bn for state-owned debt agency VEB to effectively nationalize Russia's corporate external debt. On Tuesday, VEB said companies have applied for twice as much. Again the longer the crisis goes on, the bigger this figure will get. Add to this all the money the government has been pledging to support a growing list of struggling sectors, like automotive, real estate, oil and so on and the $530bn the state has left starts to look like a lot less than it did in August.

Analysts say that November will be a key month. If the government can stabilise the situation so that money starts flowing again, then the worst will be passed, barring some more external shocks like oil prices falling to $30 a barrel. They point to Kazakhstan, which went though all this last September at the very start of the US' sub-prime debacle. In Almaty, the banks have cut assets and given up 200% growth in single digits. But no one is worried about a collapse of the Kazakh bank sector; what really concerns people is what is going to happen to their house prices (Residential prices in Moscow just dipped by under 1%, but pundits are predicting a 20-30% fall next year).

If the damage stops here, in the post-Apocalyptic world Russia will actually look pretty good. With best-case US growth predictions of zero next year and 0.5% for the EU, Russia's 3.5-5.5% will look very attractive. Indeed, many of the conditions that fuelled the last boom will be back: no growth prospects in the western world, low interest rates, a huge under developed consumer market, and massive upside for mis-priced stocks.

Equity valuations at the moment are simply silly. Russia's average price/earnings ratio is about 3.5 now, against an emerging market average of 8%. Gazprom's market capitalisation has fallen to under $100bn, which is less than the company is predicting as income next year. This means the company's share price values its gas reserves, a quarter of the world's total, at nothing. And you can buy banks with price to book values of less than one - in other words you can buy cash in the bank at a discount.

To make these spectacular returns from Russia, all you need is confidence in the Russian story - but confidence is in very short supply at the moment.

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MOSCOW BLOG: Looking into the abyss

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