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A better footing for the markets

Russia’s investment rating upgrade is good news for the bond market as Vladimir Putin faces the first real opposition to his government since his election to the presidency five years ago. Ben Aris reports.
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The Russian bond market suffered last year from the same news-driven volatility that affected the stock market but bounced back after Russia scored a hat trick of investment grades, when Standard & Poor’s (S&P) decided to upgrade the country in February – the last of the three big ratings agencies to do so. Concern about growing political risks remains but Russia’s sparkling public finances forced the agency’s hand. Provided there are no more politically motivated attacks on big companies, bond investors are looking forward to a bumper year.

After last year’s appalling press generated by the de facto nationalisation of oil major Yukos, president Vladimir Putin must have been blessing S&P for starting 2005 on a better footing. Bond markets had already reacted well to the news that Lehman Brothers had included Russia in its US credit index, and S&P added to the good news by marking Russia up to BBB shortly afterwards. Moody’s awarded Russia an investment grade in 2003 (and was roundly criticised for jumping the gun) and Fitch followed suit in November 2004.

Bond spreads tighten

Spreads on Russia’s longest bonds, which mature in 2030, tightened modestly over US treasuries, as traders had been expecting the news for sometime. Russia’s Eurobonds already trade close to the Mexican yield curve, which received investment grade several years ago.

S&P seemed reluctant to hand out top marks, however, leaving the impression that it felt its hand was forced by Russia’s stunning public finances. The agency went out of its way to point out that political risks remain significant.

“The upgrade reflects recent, crucial improvements in the government’s debt level and external liquidity,” S&P credit analyst Helena Hessel said in the press release announcing the upgrade. But she went on to qualify the award, saying that the improvements in Russia’s financial position were so strong “that they now outweigh the serious and growing political risk that continues to be a key ratings constraint on Russia”.

Hard currency reserves rose a record $9.6bn in a single week at the start of February, bringing the total to a new all-time record of $128.3bn, almost $20bn more than Russia’s total external debt. Russia is so flush with cash these days that it has started bailing out countries like Germany, which intends to pay its €500m pledge for the victims of December’s tsunami disaster with Russian debt redemptions.

However, the apparent rise in political risks has worried investors, who are plagued by the questions: was the Yukos affair a one-off and is the Kremlin trying to reintroduce an updated version of central planning?

Political risks 

Mr Putin is facing the first real opposition to his government since he took over five years ago. A botched reform on the way that benefits are paid to the poor and pensioners brought thousands of people onto the streets in January, in what Roland Nash, managing director and co-head of equity product group at Renaissance Capital, dubbed the “babushka revolution”. By February, the protests had widened to transport workers as sharp tariff hikes introduced at the start of the year came into force.

Analysts say that the vertical power structure that Mr Putin has created is partly to blame for his problems – his usual sky high popularity had plunged from more than 80% to about 45% by the beginning of last month.

“Mr Putin is boxed in behind a very strong institutional apparatus he has created. This is the first time we have seen him look weak as he faced down his first real opposition from the babushkas and businessmen. The latter have realised that if they want any real say in how the country is run then the time to speak up is now,” says Mr Nash.

The Kremlin’s policy towards reform does seem to have veered off in a new direction in the past year. The liberals in the government, such as economic development and trade minister German Gref, have become uncharacteristically outspoken in their public criticism of government policy, and the hard Kremlin faction, the so-called siloviki (power men), are clearly playing a more important role.

“There are now three groups vying for control in Russia. The liberals are still there in the shape of [finance minister Alexei] Kudrin and Mr Gref,” says Chris Weafer, head of strategy at Alfa Bank. “Then there are the ‘core idealists’ who want to make Russia respectable again. This includes Mr Putin and his right-hand man Igor Sechin. These men created the siloviki. Both the liberals and the siloviki have been sidelined with the core idealists in the middle.”

Mr Weafer argues that Mr Putin is still committed to his core goals of improving the life of the average Russian and reducing poverty (now less than 25% of the population). It is generally accepted that the pragmatic president realises the need for market reforms, but Russia-watchers are concerned about a new nationalism that is visible in the Kremlin’s policy.

 Different visions

“The core idealists have a different vision of Russia from the liberals. They want national champions and an industrial policy. The liberals hate these ideas but, ironically, over the medium term they are practical and pragmatic,” says Mr Weafer. “The problem with the Gref plan is that it will fail because there is no government infrastructure to make it work. National champions will be successful and come with the added benefit of being powerful foreign policy tools as Mr Putin tries to re-establish Russia’s role on the international stage.”

The international press leapt on the fact that foreigners will be barred from taking controlling interests in auctions for exploration and exploitation of a score of eastern Siberian oil fields this year. But the Kremlin went out of its way to say that foreigners are welcome partners in these projects.

Eric Kraus, managing director and chief strategist at Russian investment boutique Sovlink, dismisses the nay-saying by pointing out that, despite the rhetoric, the Kremlin is pushing ahead with some of its (politically) most difficult reforms. No-one in Russia complained when Mr Putin cut taxes after becoming president in May 2000, but four years on and the Kremlin is imposing badly-needed reforms that will for the first time hit the average Russian in the pocket.

“Russian commentators are cataclysm junkies and the lowest gradation on their Richter scale is ‘catastrophe’,” says Mr Kraus. “The common wisdom at the moment has it that reform has stopped, stalled or is going backwards, when what we are seeing is the Kremlin attempting to impose the vitally necessary, yet hugely unpopular, increases in public tariffs and changes to how benefits are paid. It was badly handled but it is still going ahead full steam. Sanity will return eventually.”

The Kremlin clearly fudged the implementation of the benefits reform and was unprepared for the strength of the reaction. Normally, such a reform would be tested with pilot trials in a few regions before being foisted onto the nation. Those that worry about the increasingly authoritarian nature of the Kremlin should be encouraged by its speed in backing down on a number of fronts in the face of popular protest. Mr Kudrin has been ordered to bail out pensioners, who complain that half of their monthly stipend is eaten up in paying for their once-free bus passes. Mr Putin also caved in to businesspeople’s bitter protests against what they claim is “persecution” by the tax authorities and he ordered their powers to be curbed.

Power problems

January’s fracas highlights the short-comings of Mr Putin’s vertical power structure. The Yukos affair has unleashed the dogs and, as all power ends with the president, he has made himself ultimately responsible for everything. Bringing all the strings of power into his office means that the small group he relies on has a limited ability to deal with the ‘bush fires’ that have broken out.

The Yukos affair took up a lot of Mr Putin’s time last year and meant that 2004 was largely lost to reforms. They remain on the agenda, however, and Mr Putin began this year by resuscitating many of the buzzwords that were bandied about at the end of 2003, such as “economic diversification” and “special economic zones”. Reforms have not been abandoned but the Kremlin has found its plate is full.

“Russia presents a schizophrenic face at the moment. There are no problems with public finance at all. The budget will be fulfilled regardless of what happens on the oil or commodity markets. It is completely insulated by the stabilisation fund,” says Anton Shruchenevsky, an economist at Troika Dialog in Moscow. “However, without reform, the economy is still operating far below its potential and stagnated between December and January because of the pessimism.”

The consensus among analysts is that this year is also going to be a confused one because the Kremlin has its hands full extinguishing ‘bush fires’. The Kremlin underestimated the problems that jailed Yukos owner Mikhail Khodorkovsky could cause in the courts; the merger between Gazprom and state-owned oil major Rosneft has been delayed; and the proposed privatisation of a majority in state-owned telecoms holding company Svyazinvest is now also in doubt. Many of these troubles have been started by vested interests in the administration, others by the Kremlin itself as part of taking a tighter grip on key sectors, say analysts.

Bright spots 

The areas where policy will leave Russia in a stronger position are the drive to pay down debt early and the ongoing effort to improve the macroeconomic fundamentals. At the start of February, Russia paid off the last of its $3.3bn debts to the World Bank, saving about $250m a year in interest payments, and says it plans to do the same with the $1bn-$2bn it still owes the IMF. Negotiations are ongoing with the Paris Club to pay off $44bn of commercial debt, but were bogged down in February over Russia’s discount for early redemption. The Russian press reports Moscow is holding out for a 10% discount while the cash-strapped Paris Club members (such as German and France) are holding out for less.

Using Russia’s oil windfall sensibly by siphoning billions into a stabilisation fund has put the government in an enviable position, with macroeconomic indicators that most Western leaders can only dream about. But problems with inflation and rouble appreciation remain. The Central Bank of Russia (CBR) received a painful lesson in market economics last year when it tried – and failed – both to hold down inflation and to prevent rouble appreciation. “It was like being faced with two roads and choosing both,” quipped one CBR official.

The CBR missed its key inflation target of 10% in 2004, which came in at 11.7% (and producers index is running at less than 30%) and this year’s 8.5% target already looks in danger after January’s month-on-month inflation reached 2.6%.

Monetary guidelines

However, the bond market was cheered after the CBR said that it would take the bull by the horns in its Monetary Policy Guidelines for 2005, which unambiguously says that inflation targeting will take precedence over holding back rouble appreciation this year. Because most domestic rouble bonds are issued at below-inflation yields, bond traders make their money on the rouble’s appreciation against the dollar and clearly the rouble will appreciate strongly this year. The CBR’s guideline says that it is hoping to hold inflation to 7.5%-8.5% whereas the exchange rate is only mentioned in passing in the context of “taking into account its possible impact on the economy”.

The dollar’s dominance of exchange rate calculation and a currency basket biased towards euros has already been introduced – nearly all Russia’s exports are denominated in dollars whereas more than half its imports come from Europe and must be paid for in euros. Traders are watching the currency exchange rate dynamics carefully but are expecting rouble appreciation to lead to a boom of rouble bond issues.

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Read more about:  Central & Eastern Europe , Russia