Ben Aris says that, although the economy is growing and sovereign ratings are improving, the last push towards investment grade will be hard going.

After a decade of decline, Russia is on track for its fifth year of strong growth. Thanks to the blistering pace of growth, the international ratings agencies have upgraded Russia half a dozen times in the last four years and analysts are speculating that as soon as the presidential elections are over next March, the country will reach the sought after “investment grade” that could open the flood gates for foreign investment. However, the ratings agencies say that the last stretch will be the most difficult.

The headline economic results are impressive. Economic growth exceeded 7% in the first six months of the year, Russia is running a $28.3bn trade surplus and the central bank has built up hard currency reserves of about $65bn. All the agencies concur that there is little chance of another Russian debt default.

Investments won

Rising domestic consumption, driven by growing incomes and a revolution in corporate governance, have encouraged a few big foreign companies to commit and make some multi-billion dollar investments since the start of the year. The sense of optimism is palpable and has infected the equity market, driving up the leading RTS index to within a whisker of its all-time high of 571 by September.

As Russia begins to bloom, the ratings agencies have repeatedly upgraded the sovereign ratings from SD (selective default) in the wake of the 1998 financial crisis to one or two notches below the sought after investment grade ratings.

Both Moody’s and Standard & Poor’s (S&P) have Russia at two notches below investment grade at Baa3 and BBB- respectively and, after a double upgrade in May, Fitch has Russia at only one notch below with BBB-.

Having come so far so fast, analysts have been speculating that Russia will bound over the last hurdle after the political uncertainties of a parliamentary election in December and the presidential elections in March 2004 have passed. The ratings agencies are not so sure.

“All the recent speculation on an imminent upgrade has been a little premature,” says David Riley, senior Russia analyst at Fitch. “The Duma elections will probably produce a Duma that continues to support the Kremlin and [president Vladimir] Putin is likely to be re-elected. But these two events on their own are not enough to justify an upgrade. We need to see more progress than this to justify another upgrade.”

Russia’s economy remains top heavy and its over-dependence on raw materials leaves it exposed to external shocks. The macroeconomic numbers may sparkle but economists say that much of this good fortune is due to sustained high oil prices on the world markets – something over which Russia has no control.

Over-dependent on oil

In a recent report, the World Bank said that Russia would struggle to meet Mr Putin’s goal of doubling GDP by 2010 and the economy was becoming more, not less, dependent on oil production.

While manufacturing and services have been growing strongly in recent years, they are both being outpaced by the export-orientated sectors. Manufacturing was up an impressive 6.1% during the first six months of this year but the natural resources sector was up 8.5%.

“By this measure alone, Russia’s dependence on natural resource exports has increased, not diminished,” says Christof Ruhl, the World Bank’s senior Russia economist. “Since the [1998 financial] crisis, growth rates over 5% have only been achieved in conjunction with an increasing oil price. The goal of doubling GDP in 10 years or less can only be achieved if either the oil price continues to rise or if total factor productivity in Russia’s economy increases significantly.”

A third of the government’s revenues and half of Russia’s export revenue are from the oil sector. A sharp downturn in oil prices would hit the government’s finances hard and ratings agencies say it is still not clear how the economy would weather the ensuing storm.

“Russia needs better macro numbers than the average investment grade country to get an investment grade,” says Mr Riley. “A question mark still hangs over Russia’s fate if oil falls to $13 a barrel and stays there for any length of time. Russia may have a very low debt-to-GDP ratio but it still earns half its revenues from oil exports and government still receives a third of its revenues from oil production.”

The World Bank worries that neither domestic consumption nor domestic investments have reached a point at which they can guarantee Russia’s sustained recovery. If the country is going to keep up the pace, it needs either unrealistically high oil prices, says Mr Ruhl, or an acceleration of structural reforms – reforms that have largely stalled in the run-up to the elections season.

Both the World Bank and the ratings agencies have highlighted the disappointing pace of structural reform, while acknowledging that there have been improvements. The lack of banking reform in particular has been a disappointment; the worry is that, despite the growing lake of petrodollars, without a functioning banking sector it is hard to turn this cash into growth and this leaves the economy vulnerable to the vagaries of the global commodity markets.

Healthy upgrades

So far the upgrades have reflected Russia’s return to economic health but there is still much to do before the country can step up to the next level. To be awarded an investment grade, not only does the economy need to be on a sound footing, but also the political and judicial systems should be reliable, which is not yet the case, as the recent Yukos affair has shown (see article on page 64).

“Things like the banking sector are still weak. The risks that always were there are still there but there has been significant progress both through economic growth and with the institutions,” says Elena Anankina, an analyst at S&P. “They are still not perfect but they are also not as wild as they were four years ago.”

In need of reform

Far ranging structural reform has yet to begin. Both Fitch and S&P have Russia’s ratings outlook as “stable”, which means neither agency is expecting to raise their rating in the near future.

“Tinkering with the tax system is all very well but the problem is that so much depends on just one person,” says Ms Anankina. “Bankers are trying to reduce the risks – they are almost there but for us this is not enough. The outlook on the sovereign rating is stable. The key risks are all long term by nature.”

All the agencies are holding off to see what happens after the elections, when the country will start on what some have argued is its second phase of restructuring. If the first phase is characterised as “removing the obstacles to growth” then the second should be “implementation”.

“If Mr Putin wins a fresh mandate [in the March elections] and uses it to broaden the reforms beyond the tax system and takes on the banking sector, for example, then the prospects for an upgrade would look strong,” says Mr Riley.


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