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Investors into Russian equities were starting to breath again by the start of March as the fear of a complete meltdown began to recede. The news in general wasn't good, but at least it wasn't appalling either. Russia's economy is stabilising, but the banking sector could still buckle and bring the economy to its knees.

Russia has bled some $130bn in capital since September, with $30bn leaving in January alone. But by February the haemorrhaging had slowed to $4bn of flight capital - a term that has not been used in Russia since the 1990s - and central bank reserves even increased by $1bn in the last week of February, partly thanks to plunging imports, which have been falling faster than oil prices.

More importantly, the devaluation of the currency has slowed: the ruble has lost about 35% of its value since September when it was trading at around RUB26 to the dollar. However, by the start of March the currency was closer to RUB36 per dollar and the Central Bank of Russia's (CBR) upper limit for the new band of RUB41 seemed to be holding. Currency traders report that in the first weeks of March, the CBR had stopped intervening in the foreign exchange market.

As the currency settled into a new level, the first green shoots of confidence had begun appearing by the middle of March. A few businessmen who had been hording cash were starting to use their piles to snap up some of the plethora of bargains on offer, although most were still husbanding their resources as the global crisis clearly still has some way left to run.

The average Russian is also faring better. Contrary to investor fears, the Russian consumer is still shopping, with real consumption up by 2% year on year in January. Retail sales continue to rise and domestic producers are benefiting from import substitution. For consumers, the weight of the global crisis won't be as heavy as that being borne by their western peers. "Russian household debt, at 9% of GDP, averages $850 per person, with less than 15% of this in foreign debt. This contrasts mightily with European household debt levels at over 50% of GDP and 25% in [Central European countries]," investment bank Troika Dialog said in a recent report.

Taking stock

This emerging optimism is also reflected in the equity markets. Russian stocks are always either amongst the best or worst performing in the world. After falling from 2500 points to 500 between September and January, the RTS Index was definitely in the "worst" category. But in February, the Russian stock market flipped into its "best" mode again and outperformed all the leading global markets, albeit by falling less than anyone else.

"Year-to-date, the RTS Index is still in negative territory, with absolute returns of minus 14%. Nevertheless, the performance should be viewed in the global context: year-to-date, global markets, the S&P 500, and the MSCI EM have posted respective minus 23%, minus 23%, and minus 16% returns. Furthermore, in February, the Russian market became Europe's best performing, rising 7%; this came against a very negative backdrop as all of its neighbouring markets crumbled. The Turkish market fell 10.4%, markets in Eastern Europe declined 9.8% on average, and Brazil declined 5.0%."

Everyone agrees that Russian shares are ridiculously cheap - amongst the cheapest in the world on a price/earnings basis - but that hasn't been enough to start a stampede to buy them. Still, a few brave investors (presumably those who made money in the previous booms) are starting to bottom fish. "While the RTS could clearly fall further, and the global environment is highly uncertain, it is striking that some of the biggest corporate names in the world's eighth-largest economy are trading well below their book value - and some at less than the value of their cash holdings," says Liam Halligan, chief economist at Prosperity Capital Management, Russia's largest dedicated fund, which took in its largest single investment ever in January. "The RTS as a whole is now trading at a P/E of 2.4 times - the lowest of any stock market in the world. Yet this is an economy awash with relatively debt-free, fast-developing companies, to say nothing of Russia's vast reserves of tangible, unimpaired assets - not just oil and gas, but metals, minerals, timber, water and arable land. Faced with these fundamentals, investors are now slowly returning to the Russian market."

Don't bank on it

Still, green shoots are not about to give way to bluebells yet. The fragile and shallow bank sector remains vulnerable and could yet collapse unless domestic money starts flowing again soon.

After earning $16bn in profits in 2008, the bank sector could easily cover the extra $15bn needed to cover the growing amount of bad loans at the end of last year. However, the stationary economy means that the number of bad loans is continuing to rise and the big unknown is how bad it will get.

In previous emerging market crises, non-performing loans (NPL) have reached 35% of the sector's total outstanding debt. The result is bankruptcy on a massive scale that can take years - even decades (think Japan) - to overcome. If NPLs rise to 5.5%, banks would need to find twice as much money as in 2008 for provisions, but as they can take this from earnings, their capital adequacy levels (the money banks need to meet depositor demand at any time for cash) will remain at a comfortable 15%, reckon analysts at Troika.

The CBR is predicting the bad debt level will hit 10% this year, which is bad news as banks will have to come up with about $45bn of provisions. This will eat into their capital and so destabilise even well-run banks. At this level of NPLs, a wave of bankruptcies is almost inevitable. Despite the state's large reserves (the third biggest in the world), even the Kremlin can't afford to recapitalise the entire banking sector and will have to let a lot of banks go. Happily these will mostly be small banks, but the trick will be to manage the process so no one panics and kicks off system-destroying bank runs.

NPLs would have to rise to over 14% (requiring $60bn in provisions) to drive the capital adequacy ratio down below the danger level of 12%, which would put the entire bank system in real danger of a systemic meltdown. "In this case, bad debt charges would need to hit $60bn - four times the 2008 level - which we believe is unlikely," say analysts at Troika.

This is all assuming that there are no more external shocks, which is far from certain. If banks like Morgan Stanley are right and oil prices do fall to $25 or below, then a second round of ruble devaluation would be devastating. If NPLs then rose closer to the full-blown emerging market crisis levels of say 20%, the entire capital of the banking sector would be wiped out, as banks would need to find some $104bn for provisions - almost as much as the entire sector's capital base of $109bn.

Even though the numbers in the milder scenarios should be manageable, there is plenty of room to trip up even here. Currently, NPLs are an average of 2.5%, but once they get over 5.0%, some banks will inevitably go bust; as the mini-banking crisis of 2004 showed, it only takes one small bank for people to lose confidence in all banks and start runs on even the strongest.

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