Ben Aris in Moscow -
bne: this report is in three parts. See the end of the page for links to the rest. END
Russia has fallen into the middle-income trap and the only way out is to push through deep structural reforms. Happily the government seems to be well aware of this fact and in 2013 started implementing many of these changes, which are already delivering results.
Russia improved its standing in the World Bank's "Doing Business" ranking for the second year in a row to become the easiest BRIC country for doing business, rising to 92nd spot from 112, overtaking China (96) in the process.
Raising Russia from its previous 120th place into the top 20 has been a key reform since Putin set it in 2011 and while this process is ongoing, more progress can be expected in 2014. As the chart below shows, on several scores, like contract enforcement and paying taxes, Russia already does pretty well, but in a few, like connecting a factory to the power grid or issuing construction permits, Russia is close to the very bottom of the list.
On this last point, in December Putin set up a new ministry, the Ministry of Construction, Housing and Utilities, which is presumably specifically charged with dealing with the multifarious problems in the construction sector. And more problem-specific reforms like this can be expected in 2014.
That said, the general approach of the government remains to deal with these problems top-down. This is a permanent feature of Putin's administration. Against this he continues to listen to advice from his more liberal ministers and does compromise. The case in point was a Putin bill to allow any investigator to open a criminal case into anyone he is investigating. The general outcry this idea caused forced Putin to backtrack and water the bill down.
Despite all the criticisms of the Kremlin, policy debates are real and the liberal reform camp retains a strong, if not dominant, voice.
Russia's banking sector had a terrible year in 2013, although the outlook for 2014 is better.
The economic slowdown plus the lack of access to international capital markets resulted in the capital of banks being squeezed, which forced the lenders to fall back on their own resources to fund lending.
This has led to a deterioration in capital adequacy ratios: the mandatory minimum CAR in Russia is 10%, but for most of the last decade, thanks to the volatility of the economy, most banks have kept their CAR at about 20%. However, over the last two years they have been eating into their own resources to fund retail lending, as the only real source of profits and the sector's CAR had fallen to about 13% as of the end of December.
This is a dangerous situation, as the whole banking sector has become less stable as a result. And this is only the average; bankers say that many of the smaller banks may be in trouble, which has lead the CBR to start closing smaller banks (see section below).
To battle these problems the CBR has imposed much stricter prudential rules under the Basel III regime, which will improve the stability of the sector, but for 2014 will reduce the profitability of the sector. Capital growth for the sector has dropped to around 20%, but all of Russia's major banks were reporting by the end of 2013 that they had managed to incorporate the new prudential norms without too much difficulty.
The new rules were specifically designed to curb white-hot consumer lending - the only really profitable business for banks at the moment - which has also hurt profits. But this was probably a wise decision, because a bubble was developing in consumer loans and as 2013 wore on the level of non-performing consumer loans (NPLs) was starting to rise.
• CBR crackdown on small banks
There are about 900 banks in Russia, but of that 550 have less than RUB1bn ($31m) of capital, which is equivalent to a market share of not more than 2.5%. The CBR has decided it is time to clear out this deadwood cluttering up the sector.
The policy has undermined confidence and unsettled the larger and more legitimate banks. At the time of writing, the CBR had closed 30 banks over the course of 2013 and it is expected to close more in 2014.
This has had an impact on the interbank market, where small banks go to get most of their funds. The danger is that the larger banks will simply stop lending to the interbank market, which could precipitate a banking crisis if too many small banks, cut off from funds, go bust all at once.
The CBR has to find a fine balance between the speed it chooses to go to clean up the sector and keeping the whole sector liquid and functioning.
As with the other sectors a lot of this pressure will be removed if the economy picks up and investment restarts, as at the moment the banking deposit and loan books are heavily and unusually weighted toward the consumer, not corporates.
• CBR introduces systemic bank list
On the flip side to closing small banks, the CBR beefed up support for the big banks by creating a list of "too big to fail" systemically important banks, which should bolster confidence.
These banks are considered the backbone of the system. The list will be updated each year and all will be closely watched. Together, they account for 73% of the assets of the Russian banking system, the same share of total deposits, and more than two-thirds of the interbank lending market.
In effect, the CBR has extended the de facto state guarantee for the state-owned giants Sberbank and VTB Bank to include the biggest of the private banks, above and beyond the coverage from the banking deposit insurance scheme.
• Deposit Insurance Agency (DIA) helps confidence
Russia's Deposit Insurance Agency (DIA) guarantees the first RUB700,000 ($21,900) of deposits and is a mainstay of creating confidence in the banking system.
However, it is still not quite big enough to cover the real risks. The government delayed a plan to increase the amount covered to RUB1m until next year.
Currently the DIA has enough funds to cover the collapse of one big top-10 bank or four medium-sized ones in the next tier down.
The fund currently holds a total of RUB185bn ($5.8bn), but the cost of bailing out the depositors of Master Bank will be RUB31bn alone and the DIA also has to compensate depositors at Pushkino Bank to the tune of RUB20bn, both of which were to be shuttered in December.
In all, the DIA's funds cover 4.1% of total deposits, below the 5% that the government believes is the minimum comfort level, although this will be increased in 2014 to improve stability.
• Consumer lending & NPLs
Retail loans were pretty much the only profitable banking business out there in 2013 and banks of all colours have been piling in. However, personal indebtedness has risen to the point where loans were starting to go bad, so the CBR has moved aggressively to curb lending.
Consumer loans (including credit cards and cash loans) account for 78% of loan arrears, auto loans for 14%, and mortgage loans for 3%, according to Sequoia Credit Consolidation, a leading debt collection agency.
Overdue debt on credit cards was the fastest growing problem, but overall credit card penetration remains very low.
In all, the level of personal debt as a share of disposable income has risen fastest in Russia out of the countries of the region and topped 10% in 2013. However, Russians have little other debt and debt from mortgages in Russia is by far the lowest in the region.
The highest level of default is typical of unsecured loans, while mortgage and auto loans only rarely go bad.
However, the levels of debt have been increasing. In 2011, an average borrower had one or two loans, but by 2013 the same borrower has three to five loans. The share of debt servicing from the monthly expenditures has risen to 45% of monthly income for these borrowers.
Late payments on retail loans rose to RUB435bn ($13.6bn) as of the end of December, although this level is expected to fall again in 2014, thanks to the tighter regulations and provision requirements introduced in 2013.
On March 1, the CBR doubled minimum provisions for unsecured retail loans and thereby withdrew large amounts from banks' turnover.
On July 1, ratios for loans at high interest rates were increased, which will also slow lending.
In September 2014 the CBR plans to increase risk ratios for unsecured consumer loans used for the calculation of capital adequacy by up to three-times in respect of loans at high interest rates.
Read Russian OUTLOOK 2014 Part 1: Russia's growth model runs out of steam
Read Russian OUTLOOK 2014 Part 2: Turning more bullish on Russia markets
Read Russian OUTLOOK 2014 Part 3: Change afoot in Russian business and banking
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