Nicholas Watson in Prague -

The global credit crisis has undoubtedly taken the shine off Russia's consumer finance business, but with the country poised by some estimates to become Europe's largest consumer market, the sector is still expected to perform well in 2008.

Certainly, Russia's consumer finance institutions took a battering from the fallout during from the US sub-prime loan mess. When the crisis hit mid-summer, the bonds of consumer finance institutions such as Russian Standard, Home Credit and Finance Bank, Renaissance Credit Bank and URSA Bank widened by 500-600 basis points.

The main reason is that consumer finance banks couldn't escape the general rise in borrowing costs that have rippled out across the region. The Russian banking sector, along with those in Kazakhstan and Latvia, are believed by many investors to be the most vulnerable to funding and liquidity problems, because the volumes of deposits are not deemed sufficient to fund the ongoing lending boom.

This refinancing risk is especially acute for Russia's consumer banks because their business model has always relied on external wholesale funding, which they constantly need in order to redeem previous borrowings. With global credit markets remaining tight, there are concerns that these consumer finance banks will face problems refinancing this debt. "Wholesale financing was not previously seen as a crime, but now it is apparently," says Brian Coulton, managing director of Fitch Ratings.

Deutsche Bank Research already notes that many of Russia's mid-sized and smaller banks have shown liquidity gaps in their end-2006 IFRS accounting statements and many of those banks have indicated significant repayments in 2008 and 2009; any difficulty in refinancing those debts could lead to distress and a loss of confidence in the system overall.

Comments from Russian officials haven't helped ease these worries, says Maxim Raskosnov, a fixed-income analyst with Moscow-based investment bank Renaissance Capital. Central bank officials stated in August that banks with more than 30% of liabilities in the form of external borrowing were in a very risky financial condition, as they were running the risk of sharp and unexpected devaluation in the ruble - something that has notably failed to materialise.

Perhaps a sign of this refinancing risk can be seen in the recent decision by several of the major consumer finance banks to diversify funding sources, switching their focus to collecting retail deposits. However, analysts believe this is a long-term plan, estimating that retail deposit funding won't exceed 25% of banks' liabilities before 2010.

As well as the global credit concerns, local factors such as a consumer backlash against high repayment rates are also weighing on the sector. Since 2006, a growing number of Russian officials have expressed concern that the large consumer finance banks were violating consumer rights with hidden fees and commissions that brought the effective cost of loans to 50-70%, up from a declared level of 20-30%. Not one to ignore a bandwagon when they see it, the Prosecutors' General Office launched several investigations against the banks. A fall in effective interest rates to 30-40% could be a result of this pressure.

The concerns about the sector stemming from these regulatory problems and the global credit crunch, which is still far from over by most accounts, are very real. However, a closer examination of the consumer finance business in Russia and the institutions that serve it suggest those fears could be overdone.

Lending stability

With the oil price heading toward an unprecedented $100 and Russia's economy still expected to grow 7.2% this year and 6.4% in 2008, there is little to suggest that the phenomenal growth of Russia's retail lending market will judder to a halt anytime soon.

Over the last four years, consumer finance has undoubtedly been the fastest-growing business line in the Russian banking system, with total lending volumes rising by more than 12 times during the period to $60-65bn excluding mortgages. And with consumer finance loans as a percentage of GDP standing at only 3.5%, there are still many more of Russia's growing middle-class who will want to borrow money to buy cars and other goods.

According to the calculations of Kingsmill Bond, chief strategist at Troika Dialog, the growth in that middle-class means Russia is set to become Europe's largest consumer market by as early as 2008. "We calculate that 60% of the Russian population will have monthly [purchasing power parity] disposable income per capita after household costs of over $350 in 2008, giving them access to a range of consumer goods," says Bond. "This implies that in 2008, we will see 85m Russian consumers, more than Germany's population, and therefore the largest in Europe."

While many expect that in the next few years total market volumes will grow more slowly than they did in 2002-2006, Renaissance Capital's forecast for the average consumer finance market growth rates for 2008-2010 is still 30-40% a year.

The global credit crunch may also not be as big a problem for Russian consumer finance banks as it may first appear. According to analysts, the refinancing needs of the major consumer finance banks over the next three to six months are quite modest - as a percentage of assets, they don't exceed 15% for any of the major banks such as Russian Standard, Home Credit and Finance Bank and Renaissance Credit Bank. And even if they fail to get the funding, the banks still have the option to significantly reduce the growth of loans.

"Obviously, [these banks] will face at least a temporary increase in funding costs, but it isn't a problem, as high interest margins in the consumer finance business still make it affordable for the banks to pay 200-300 basis point premiums and remain profitable at the same time," says Renaissance's Raskosnov, who adds that these banks are expected to return to the international bond markets soon.

James Watson, senior director of Fitch Ratings, describes Russian Standard as being in a reasonable position despite his agency's recent downgrading of the bank to 'BB-' from 'BB' due to the liquidity crunch. "Its refinancing is moderate and manageable in the medium term," Watson says.

The profitability of Russia's consumer finance banks is sure to be affected by greater competition to get rid of hidden fees and commissions, the subsequent tightening margins, higher funding rates and slower market growth. But the growth potential of the market, the current profitability of it plus the expected increase in M&A as more multinational lenders seize the opportunities in the Russian market mean the sector should remain a good investment in 2008 and beyond.

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