What next?

By bne IntelliNews December 2, 2008

Ben Aris in Berlin -

Central banks around the world are trying to reboot the global financial system but keep getting, "Error! Total system crash." What happens now? Who will be the winners and losers? How long will it take for growth to return? What will happen to commodity prices? How is the nature of the banking system going to change with all these governments taking stakes in private banks? Are emerging markets going to lead the recovery or be the laggards?

The papers are full of commentary and analysis, and the international financial institutions (IFIs) are busy issuing research notes and forecasts, but the depth of the confusion is clear from the fact the numbers keep changing on a weekly basis. In mid-November, the International Monetary Fund was confidently predicting Russian growth would be 3.3% in 2009, but only eight weeks earlier it was confidently predicting it would be 6.5%. No one has a clear idea of what is happening at the moment and that in itself is making the current crisis all the worse.

Unlike the crises that swept emerging markets in 1997 and 1998, this crisis is not a banking crisis per se, but a crisis of "questions" concerning the future of the global financial system to which no one can seemingly answer with any confidence. Although the meltdown began in the US where the crisis has developed into a full-blown banking crisis, in emerging markets a systemic collapse of the financial sector has largely been avoided.

Almost all the countries of Eastern Europe and Central Asia (with the notable exception of Ukraine) have prudently used the boom years to build up huge reserves that they have used to contain the damage. While the last two months have been extremely expensive - Russia alone spent $150bn of the $600bn it had in reserves in August - so far only half a dozen mid-sized banks have collapsed in Russia and Kazakhstan, whereas a dozen in Ukraine have gone to the wall. But importantly, all of these banks have been bailed out or taken over. Even in Ukraine, the financial sector is still standing, has money and is ready to work.

However, all business is on hold until some of the questions can be answered with any confidence. The pause in commerce is causing a massive amount of damage and the longer it goes on, the longer it will take for the recovery to start. However, none of the countries in the region are fundamentally "broken" in the same way the bankruptcies and defaults at the end of the 1990s smashed the fragile system that was emerging from the chaos of transformation.

The make-up of the global economy has been radically altered. Equity markets in even supposedly "healthy" countries have collapsed in a crisis of confidence. Nominally, they should not have been affected by the US' problem, as few banks in emerging markets had any exposure at all to the "toxic" US sub-prime assets. But it has been the speed of the change rather than the massive destruction of wealth that has wreaked the most damage on emerging markets. In the fast-growing economies of New Europe, companies were borrowing heavily to finance rapid growth in the race to grab market share. The problem was not that they had, on aggregate, borrowed too much - in Russia the state has no debt and total corporate debt is about 30% of GDP equivalent - but the slowdown came so fast that companies had no chance to restructure their debts to cope with the changes. Russian companies had used their shares to back loans with margin calls that kick in when the shares fall 60-70% - a seeming impossibility when the deals were signed. But they were left gasping on the pier when share prices tanked this amount in only a few weeks.

How much has the crisis cost?

The first question to ask is how much this crisis has cost. New Europe's countries were growing fast by tapping global capital markets for cheap and long-term money, which has all but disappeared now.

Russia has been amongst the worst hit and the government was spending about $3bn a day in September and October to prevent a wholesale collapse of the banking system. The government has since said it will spend another $200bn to replace the borrowing that companies had been assuming they could raise from banks next year.

In all, the World Bank estimates that $1 trillion worth of Russian wealth has been destroyed between the stock market peak in May and the start of November, equivalent to 87% of GDP in 2007. Of this amount, state-owned oil and gas companies make up $700bn and Russia's leading businessmen lost another $300bn. This will take its toll on the entire region, as over the last five years or so Russia, Kazakhstan and Ukraine have emerged as the three investment "nodes" in the region: despite the ballooning levels of foreign direct investment into Russia, it has been a net export of capital for most of the last decade.

How deep will the recession be?

The amount of damage can be seen in the falling GDP estimates for this year and next. Before the crisis hit, Russia was expecting to end this year with 6.8% growth and next year with 6.2%. In light of the crisis, these numbers have fallen to 6% and 3% respectively, says the World Bank - or put another way, each week that passed during the worst of the sell-off between September 16 and the end of November saw 0.1% per day shaved off the growth forecast for next year.

"The world economy is entering a severe recession. Output is falling in the US, Japan, Germany, France and the UK, and prospects are for this contraction in activity to intensify over the next 12 months. For the major advanced economies in aggregate, Fitch Ratings is forecasting the steepest decline in GDP since the Second World War at -0.8%, in part reflecting the unusually synchronised downturn expected next year," Fitch said in a report in November, adding that world GDP would grow by just 1% next year – the lowest rate since the early 1990s and compared with an average of 3.5% over the last five years.

Ukraine and Kazakhstan have also stumbled. Kazakhstan was the first CIS country to be hit by the crisis last September. Growth has already slowed from 5.7% in the first half of this year to 3.9% in the third quarter, and is on course to end the year at 3.1%. The IMF is now predicting that growth in 2009 will be a low, but still respectable, 5.3%. However, the bank said medium-term expectations remain positive and anticipates a return to form by the end of next year.

Ukraine is having a much harder time of it. From a growth rate of over 10% in the middle of this year, growth is expected to end this year at 4.5-4.8% and economic growth will fall to 2% next year, according to First Deputy Presidential Secretariat Chief Oleksandr Shlapak.

Further afield and the damage is probably even worse. The Baltics were already facing severe macroeconomic problems before the crisis hit, while Central Europe's countries are much more closely tied to the economies of Western Europe where growth is expected to be about 0.5% next year. "[The effect of the global crisis on] countries in the region is very different," says an Organisation for Economic Co-operation and Development (OECD) economist, who asked not to be named, as he isn't authorised to speculate on the future of the region. "They are more or less vulnerable, with Russia being among the more protected ones. It is no secret to anybody that Ukraine is not only in a total political, but also a total economic, mess. I am not sure that the currency boards in the Baltics will hold, and if they didn't, that may be really nasty (think Argentina). Also, if the first goes, they would probably all go - including Bulgaria's currency board. All this probably doesn't bode well for the CEE growth investment story. But that said, given current prices there's probably a lot of value in many things if one takes a medium-term perspective and avoids the countries that are heading for a full fledged crash. Most things in Russia are a screaming buy at current valuations."

How long will the recession last?

Everyone knows next year is going to be bad, but of greater interest is when the recovery will start? In 1998, it took only two years before Russia's economy started to grow quickly again, but that was driven by a rebound in oil prices from $10 to $25. This time round, commodity prices will play a key role again. While economists all agree that long-term commodity prices will continue to climb, driven by the transformation of the emerging markets, the prospects for a rebound in the short term are dubious.

The growth forecasts of the banks and IFIs are all based on a variety of guesswork about the future of commodity prices, as well as domestic consumption and the availability of cost of credit - all of which are extremely uncertain at the moment. Indeed, IFIs have a very poor forecasting record in times of crisis: the World Bank said Russia was facing hyperinflation and years of low growth in the autumn of 1998 and completely miscalculated the beneficial effects of devaluation that fuelled a boom. The IFIs have a predilection towards pessimistic forecasts as a way to keep the pressure on reforming governments.

And there is some chance that the bounce back could come sooner than later. Fitch says the fast and coordinated action by central banks around the world and massive liquidity injections will, "head off the worst case scenario of widespread deflation."

The consensus view is currently that growth will resume in 2010, but at rates well below those seen over the last five years. Troika Dialog's Kingsmill Bond outlines the three dominant scenarios:

The IMF view: The IMF argument is that government action will be able to forestall the worst impacts of debt deflation, and that growth will therefore bounce back in the third quarter of 2009. The problem, however, is that the IMF seems to downgrade its forecasts each month, so it's too soon to say if it will be right. If the market really believed this argument, then valuations would not be at current levels, or we would be on the verge of a huge rally as in 1974.

The Roubini view: Nouriel Roubini, the foremost economist to predict the crash, believes that growth won't return until at least 2010, as the years of excess expansion on the back of a debt bubble will take time to unwind. This would put back a global market bottom to mid-2009.

The depression view: There remains a chance that global growth will follow the Japanese debt deflation route, meaning that we don't see a return to global growth for several years. Thanks to policy action, this seems a tail risk, but can't be ruled out.

What will happen to commodity prices?

Where commodity prices will settle will be a key determining factor for all three of the big economies in New Europe; Ukraine, Russia and Kazakhstan are all heavily dependant on commodity prices - either oil or steel prices or both - which have crashed in recent months.

The good news is that the IMF predicts commodity prices should settle early next year, which answers one of the most important questions facing investors, although prices will remain under pressure for most of 2009.

Macquarie, an Australian commodity and infrastructure financial group, said on November 17 that it had cut its 2009 forecasts for base metals, coal and iron ore by up to 60% to reflect the deteriorating global economic outlook. Those numbers include a cut to the 2009 contract prices of copper and zinc by 43% and 40%, respectively. For the coal sector, the thermal coal price forecast was lowered by 38%, while the bank slashed prices for the hard coking coal used in steel production by a huge 60%, citing drastic output reduction plans by global steel giants such as ArcelorMittal. Under its most pessimistic scenario, the Moscow-based investment bank Troika Dialog expects global consumption of steel to decline in 2009 by as much as 10%, bringing steel prices down by 25-45%."Clearly we are in the midst of a global slowdown and have seen some major steelmakers warning about reducing output next year - we just don't have any clarity on prices for next year at this point in time," Marek Jelinek, the CFO of Central Europe's largest coal mining group New World Resources, tells bne.

Oil prices will set the tone for the Russian and Kazakh economies, and at the time of writing had dipped below the $50-a-barrel mark, down from a high of just under $150 a barrel just a few months previously. The International Energy Agency (IEA) on November 13 slashed its 2009 oil price forecast to $80 from its previous forecast of $110, and the Russian government cut its forecast almost in half in November to $50 a barrel.

However, while $50 oil is bad news for the Russian government, it's not actually a crisis unless the price stays at $50 for several years, thanks to the huge reserves in the stabilisation fund that were specifically built up to cover budget payments in case oil prices did slump. At the end of November, Russia's Finance Minister Alexei Kudrin said there is enough money in the reserve fund to finance the budgetary shortfall at $50 for another five to 15 years, depending on the rates of growth.

One school of thought believes that the Organization of the Petroleum Exporting Countries will cut production to maintain the oil price at around $68 a barrel, as the Middle Eastern countries need this price to balance their own budgets. An expected fall of 2-5% in Russian oil production in 2009 will also support prices.

If oil does stay at $50, clearly Russia's ruble and the Kazakh tenge will have to devalue further. The ruble has already lost 20% against the dollar in the last two months despite the Kremlin spending $57bn to support the currency. The threat of a sharp devaluation remains on the cards, and the fate of the currency remains pinned to what happens to the oil price.

What will happen to the financial sector?

The biggest changes in the global economy will be to the financial sector. Lower oil prices and a weaker currency will increase debt/GDP ratios and reduce the desire of foreigners to lend money and the capacity of Russian companies to pay it back. This will keep the domestic cost of money high. The foreign debt/GDP ratio would rise from around 30% to over 40%, which would take it up toward the higher end of the emerging market universe, say analysts at Troika.

In the short term, the willy-nilly lending that most banks had indulged in will come back to bite them: the ratio of non-performing loans was already rising by the start of November. "2009 will be a tough year for the sector, as banks will have to create a significant amount of new provisions for their loan books (which have demonstrated fast growth in the past)," say analysts at VTB Capital. "We doubt the sector will see any significant recovery in the next two or three quarters: a high degree of uncertainty over asset quality will remain while negative earnings surprises start to appear."

The key to the health of the bank sector will depend on how fast credit quality deteriorates: estimates for the rising NPLs range from 3.5% to 16.3%.

Cut off from an emaciated global credit market, banks will have to look for new sources of capital, which will have a number of effects. First stop will be the state, which has stepped up to the plate not just in New Europe, but in the West as well. The Russian state is already heavily involved in its banking sector, while the Kazakh government bought blocking stakes in its leading banks in November to bolster their capitalization. State-directed lending is on the cards in both countries. "Following this crisis, it may well turn out the Belarusian bank model is the one that the rest of the world follows going forward," Peter Donnelly, a former partner at Lehman Brothers and now a director of Banco Finantia that is a big investor in Eastern Europe, said at the first Belarus Investment conference in London in November.

Next, banks will turn to the surviving (but still reduced) pools of capital in Asia and the Middle East. By the end of November, the Kremlin had already hit the Chinese up for billions in loans for its biggest state-owned oil company Rosneft, and has been pushing its oligarchs and corporates to find money in places like Hong Kong and Singapore.

However, the biggest source of capital will be a switch to domestic resources. In Ukraine, leading consumer finance bank Delta Bank presciently saw the crisis coming and has replaced $450m of international wholesale financing by collecting domestic deposits. Russia is also well placed in this regard, as it enjoys the highest level of domestic saving in the world after China. The 30% of GDP equivalent is more than enough to cover its domestic investment needs and the Kremlin's $1-trillion infrastructure investment plans.

At the same time, banks in the CIS will turn inward and borrow more from each other. As the bne Eurasia bank ranking shows (see PX), Russian banks no longer dominate in the region and between them the top 100 regional banks had assets of $891bn as of the end of the third quarter of this year. "But this will take time," says Ian Hague, manager and founder of Firebird Capital, which has a large exposure to banks across the region. "They will have to introduce more transparency and get to the point where they trust each other more than they do now. It will take several years to develop this business, but it is the obvious way to go."

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