Rerating Russia

By bne IntelliNews April 8, 2010

Ben Aris in Moscow -

Russia is about to return to the international debt markets with a sovereign bond issue, its first since the government defaulted on its debt in 1998. Rather than shun the sale, investors are champing at the bit for a piece of the action.

Russia observers will be watching the issue of up to $17.8bn closely, expected to be completed towards the end of April, as the price of the bond is likely to make a mockery of Russia's rating by the three big international rating agencies.

Russia's credit rating is way too low, as it boasts some of the strongest fundamentals in the world, but it's still tarred by its increasingly irrelevant "emerging market" moniker, argue Russia watchers. While beleaguered EU member Greece is falling over backwards to try to convince investors to buy its bonds, Russia's roadshow, which kicks off on April 21, will be a walk in the park by comparison.

The world has been turned upside down by the global financial crisis. Nowhere is this clearer than in the two countries' bond offerings. While Greece is sagging under a heavy public debt burden, Russia not only has almost no debt to speak off (Capital Economics predicts 9.5% of GDP by the end of this year), but also has well over $400bn in hard currency reserves. That's five times more than either the US or UK, making it the third-richest country in the world in terms of cash. While Greece will struggle to pay off its bonds as it staggers under a 12% budget deficit, Russia has $24 in cash to cover each dollar the government plans to borrow.

Russia is enjoying a mirror image of the problems its more developed peers are facing up to. For example, the UK is one of the most indebted countries in Europe now after it borrowed a massive €257bn last year, ratcheting up its leverage to borrow about €2.80 for every €1 that the Bank of England is holding in its vaults as a reserve. The US is in similar dire straits.

Nevertheless, Russia's pubic finances are still under some pressure. It needs to finance a budget deficit that will come in at between 3% and 8% (depending on the price of oil), and needs to raise some funds to get it through this lean patch.

On tour

Russia's finance officials are planning a tour of Asia, Europe and North America to promote Russia's first Eurobond issue since 1998 - 12 years after it defaulted on its bonds during its last big crisis - but are confident that they will be able to tap the markets for relatively cheap money. "Borrowing terms will likely be very advantageous," Finance Minister Alexei Kudrin told reporters earlier in April, adding that the market understands Russia can borrow domestically if the terms aren't "extremely favourable."

Liam Halligan, chief economist with Prosperity Capital Management, says Kudrin can afford to be confident. "Since taking office in May 2000, he has built Russia's massive reserve base and paid off almost all sovereign debts. Russia is launching this Eurobond as one of the world's most fiscally secure nations - a reality likely to surprise mainstream western investors, causing them to reassess a range of Russian assets."

The government has already given Kudrin the authority to borrow up to $17.8bn if he wants to, but as oil prices breached the $85 per barrel level at the start of April, money is starting to pour into the country and most experts expect Russia to borrow half or even a quarter of this amount.

The price of the bond will highlight the overly cautious stance of most rating agencies on Russia. Currently, Russian sovereign debt has a 'BBB' rating, which is only two notches above junk bond status. At the same time the US and UK have (so far) kept their 'AAA' ratings despite their worsening finances. Most economists are predicting Europe's external debt to rise from 100% of GDP to 130% over the next five years, while that of Russia is expected to continue falling. Indeed, analysts say that the ratings of developed countries' have disconnected with reality, while countries like Russia are being penalised. "On the basis of our model, the [best possible] 'AAA' rating for the US and the United Kingdom cannot be explained, as these two countries are rated two to three rating notches better than countries with comparable fundamental data," Ingo Jungwirth, an analyst with Raiffeisen International, wrote in a study in March.

His study found that based solely on the country's finances, both the US and UK should be downgraded three notches to a 'AA'. However, if the ratings agency actually went through with a downgrade, the cost of borrowing to both countries would spike and spark a financial global crisis, which would probably wreck the global economy for decades. Jungwirth suggests that these two countries earn a "bonus" for being too big to fail.

On the flip side, Russia is underrated given the strength of its financial position. Consider that on the day Iceland defaulted on its debt at the start of this crisis, it enjoyed higher ratings than Russia. Today Russia's 'Baa1' rating from Moody's Investors Service is still the same as bailout-dependent Iceland's. Fitch Ratings and Standard & Poor's currently class Russian debt as 'BBB' - even lower than Moody's. "These ratings seriously understate Russia ability to service and repay its debts. Some say they reflect the risk that Russia might 'choose to default'. Yet Russia's political elite was traumatized by 1998. Kudrin, with the blessing of successive premiers, has spent the last 10 years trying to rebuild his country's fiscal reputation. The idea of a deliberate default is absurd," says Halligan.

There are already some signs that investors are cottoning on to the strength of the Russian bond offering. After US investment bank Lehman Brothers collapsed, the spreads on UK credit defaults swaps (CDS) - a kind of insurance against bond defaults by the issuer - have soared by 281 basis points (bps). At the same time, Russia's CDS have actually contracted by 17 bps over the same period, making it one of the few countries in the world deemed by investors to be a safer place to invest than it was before the start of the crisis. "The government isn't issuing the bond to raise money. It has plenty of money," says Halligan. "The main reason they are issuing the bond is to draw attention to the Russian economy, force the government to explain its reform agenda better and help 'decontaminate' Russia as a place to do business."

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