Myth Busters
A number of our peers have recently taken to deflating urban myths, also a favourite pastime of T&B. Furthermore, and perhaps more to the point, it is far
less demanding of time and effort to simply enumerate one’s major points, rather than trying to spin them into a coherent and compelling narrative…and it
is, after all, summer-time!
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-“Decorrelation is Dead”
• Whilst “decorrelation” did not function in precisely the fashion that many observers – T&B included – had expected, i.e. sheltering the emerging
financial markets from global volatility, in fairness, no one had expected that the world’s largest economy would come close to outright collapse, creating
unprecedented economic disruption. Nevertheless, the current crisis confirms the decorrelation hypothesis, rather than debunking it. As the G7 slumps into
recession, the differential between growth rates of the largest emerging economies and the developed world is widening – not shrinking. In particular,
China is gaining ground by the day…
-The United States economy is twice the size of the four BRICs put together (and/or this has some conceivable
relevance)
• Expressed in volume terms, i.e. PPP, their combined GDPs are not far from that of the US; more importantly, as G7 output shrinks, the share of the BRICs
in global growth is a now large multiple of that of the developed economies. Taken together, the “developing” economies now account for more than 50% of
global GDP.
-The burgeoning US budget deficit is the fault of Obama/of generous social spending/is going to be brought under control
• For shame! It is estimated that the Iraq war alone will ultimately cost some $3 trillion dollars (including interest on the debt, lifelong care for blast
victims, etc.); add a few trillion more for Afghanistan, missile systems, fighter planes which will never fire a shot in anger, and pretty soon the recent
bailouts aimed at attenuating the massive social dislocation arising from a deep recession begin to look like a rounding error. And, as for the budget
deficit…
-The increase in US domestic savings will allow the budget deficit to be safely financed by domestic savings
• The increase in US consumer savings is simply the mirror-image of the increase in government dis-savings -it will not begin to restore balance, even
before taking into account the huge increases in spending which will be required to rebuild the bankrupt social insurance system.
-Economic growth will rebalance the US budget
• For the past two decades at least, economic growth has been driven by increasing credit creation; as this credit is now being withdrawn, the state has
employed massive deficit spending as a substitute. This may provide a temporary fix, but it certainly does nothing to rebalance the budget – a feat which
would likely require a decade of austerity to accomplish. It should be intuitively obvious that deficit-fuelled growth cannot yield taxable profits
sufficient to balance the very deficit spending which sustains said growth!
-The commodity super-cycle is dead
• It’s not even sleeping – if globalization has done one thing, it has been to draw billions of new consumers into the global economy. These new consumers
crave cars and coolers and washing machines – not internet protocols and nursing care. Industrial output will thus resume its secular rise, inexorably
increasing the demand of commodities. As for oil, the story is even simpler: they aren’t making any more of it – quite the opposite; and despite all of the
warnings, we see no signs of it going out of fashion. © Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 01 July 2009
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-There is no substitute for the dollar
• Perhaps there isn’t – yet – but as day follows night, one (or several) partial solutions shall soon enough present themselves. The ball is in the
Chinese’ court, and suddenly, they are being uncharacteristically aggressive in this matter; as the owners of the world’s largest reserves, their views are
to be taken seriously. At every crucial turning point in history, pundits will reliably be found to assure us that things will never change – meanwhile,
the very earth is moving under their feet.
-Oil is dead – prices will never again revisit their recent peaks
• A choice bit of idiocy, most recently retailed in a cover story in Newsweek magazine. In fact, with energy-intensive growth in the emergings, the
depletion of existing hydrocarbon reserves, the sharp cutbacks in exploration budgets and rig counts, and the increasingly vulnerable dollar, it is only a
matter of time before oil prices once again spiral out of control. Our best guess for the timing of the next run is late-2010, but it is only that – a
guess.
-The Chinese do not/cannot/will not consume
• Anyone who has visited Hong Kong or Macao (or, for that matter, Bangkok or Jakarta) may beg to differ. Mainland Chinese consumption has been growing by
about 10% per annum however the even faster increase in Chinese exports has masked this phenomenon in the GDP accounts. Simple logic suggests that there are few tasks easier for a government than to convince desperately undersupplied consumers to purchase more tangible goods – provided, of course, that the goods and the income/credit are made available.
-The entire planet yearns for European/American style liberal democracy
• The perceived failure of global capitalism, the rise of militant Islam, as well as the success of states using a more nationalistic model (China, Russia)
suggest that the West would do well to stop flattering itself that its model is universally admired. Multipolarity extends to political systems…a very competitive market.
-As Correlation proves Causation -Superposition proves Analogy
• We have seen numerous charts purporting to demonstrate that the current economic crisis is analogous to – or even worse than – the Great Depression.
Quite frankly, this is nonsensical. At some point, the charts for any two economic downturns will likely look similar, and, ugly though it may be, the current global context is utterly dissimilar to events of 80 years ago. Whatever happens – a replay of the 1929 depression is no more to be feared than a return to the Great Spanish inflation of the seventeenth century! Full of sound and fury – but signifying nothing…
http://nikitskyfund.com/files/tnb/A_Good_Joke_01July2009.pdf
Showing posts with label russia. Show all posts
Showing posts with label russia. Show all posts
17 June 2009
Appointment in Yekaterinburg ~ Hudson
The Ending of America's Financial-Military Empire
By MICHAEL HUDSON
The city of Yekaterinburg, Russia’s largest east of the Urals, may become known not only as the end of the road for the tsars but of American hegemony too; as the place not only where US U-2 pilot Gary Powers was shot down in 1960, but where the US-centered international financial order was brought to ground.
Challenging America is the prime focus of extended meetings in Yekaterinburg, Russia (formerly Sverdlovsk) today and tomorrow (June 15-16) for Chinese President Hu Jintao, Russian President Dmitry Medvedev and other top officials of the six-nation Shanghai Cooperation Organization (SCO). The alliance is comprised of Russia, China, Kazakhstan, Tajikistan, Kyrghyzstan and Uzbekistan, with observer status for Iran, India, Pakistan and Mongolia. It will be joined on Tuesday by Brazil for trade discussions among the so-called BRIC nations --Brazil, Russia, India and China.
The attendees have assured American diplomats that it is not their aim to dismantle the financial and military empire of the United States. They simply want to discuss mutual aid – but in a way that has no role for the United States, for NATO or for the US dollar as a vehicle for trade. US diplomats may well ask what this really means, if not a move to make US hegemony obsolete. After all, that is what a multipolar world means. For starters, in 2005 the SCO asked Washington to set a timeline to withdraw from its military bases in Central Asia. Two years later the SCO countries formally aligned themselves with the former CIS republics belonging to the Collective Security Treaty Organization (CSTO), established in 2002 as a counterweight to NATO.
Yet the Yekaterinburg meeting has elicited only a collective yawn from the US and even European press despite its agenda -- nothing less than the replacement of the global dollar standard with a new financial and military defense system. A Council on Foreign Relations spokesman has said he hardly can imagine that Russia and China can overcome their geopolitical rivalry, suggesting that America can use the divide-and-conquer that Britain used so deftly for many centuries in fragmenting foreign opposition to its own empire. But George W. Bush (“I’m a uniter, not a divider”) built on the Clinton administration’s legacy in driving Russia, China and their neighbors to find a common ground when it comes to finding an alternative to the dollar and hence to the US ability to run balance-of-payments deficits ad infinitum.
What may prove to be the last rites of American hegemony began already in April at the G-20 conference, and became even more explicit at the St. Petersburg International Economic Forum on June 5, when Mr. Medvedev called for China, Russia and India to “build an increasingly multipolar world order.” What this means in plain English is: We have reached our limit in subsidizing the United States’ military encirclement of Eurasia while also allowing the US to appropriate our exports, companies, stocks and real estate in exchange for paper money of questionable worth.
The artificially maintained unipolar system,” Mr. Medvedev spelled out, is based on “one big center of consumption, financed by a growing deficit, and thus growing debts, one formerly strong reserve currency, and one dominant system of assessing assets and risks.” At the root of the global financial crisis, he concluded, is the fact that the United States makes too little and spends too much, particularly its vast military outlays, such as the stepped-up US military aid to Georgia announced just last week, the NATO missile shield in Eastern Europe and the US buildup in the oil-rich Middle East and Central Asia.
The sticking point for all these countries is the ability of the United States to print unlimited amounts of dollars. Overspending by U.S. consumers on imports in excess of exports, U.S. buy-outs of foreign companies and real estate, and the dollars that the Pentagon spends abroad all end up in foreign central banks. These banks then face a hard choice: either to recycle these dollars back to the United States by purchasing US Treasury bills, or to let the “free market” force up their currency relative to the dollar – thereby pricing their exports out of world markets and hence creating domestic unemployment and business insolvency.
When China and other countries recycle their dollar inflows by buying US Treasury bills to “invest” in the United States, this buildup is not really voluntary. It does not reflect faith in the ability of the U.S. economy to enrich foreign central banks for their savings. Nor does it represent any calculated investment preference. It is simply a matter of a lack of alternatives. U.S.-style “free markets” hook countries into a system that forces them to accept dollars without limit. Now they want out.
This means creating a new alternative. Rather than making merely “cosmetic changes as some countries and perhaps the international financial organisations themselves might want,” said Mr. Medvedev at the end of his St. Petersburg speech, “what we need are financial institutions of a completely new type, where particular political issues and motives, and particular countries will not dominate.”
When foreign military spending forced the US balance of payments into deficit and drove the United States off gold in 1971, central banks were left without the traditional asset used to settle payments imbalances. The alternative was to invest their subsequent inflows of US dollars in US Treasury bonds, as if these still were “as good as gold.” Central banks now hold $4 trillion of these bonds in their international reserves. These loans have financed most of the US Government’s domestic budget deficits for over three decades now! Given the fact that about half of US Government discretionary spending is for military operations – including more than 750 foreign military bases and increasingly expensive operations in the oil-producing and transporting countries – the international financial system is organized in a way that finances the Pentagonand also US buyouts of foreign assets expected to yield much more than the Treasury bonds that foreign central banks hold.
The main political issue confronting the world’s central banks is therefore how to avoid adding yet more dollars to their reserves and thereby financing yet further US deficit spending – including military spending on their borders.
For starters, the six SCO countries and BRIC countries intend to trade in their own currencies so as to get the benefit of mutual credit that the United States until now has monopolized for itself. Toward this end, China has struck bilateral deals with Argentina and Brazil to denominate their trade in renminbi rather than the dollar, sterling or euros, and two weeks ago China reached an agreement with Malaysia to denominate trade between the two countries in renminbi. Former Prime Minister Tun Dr. Mahathir Mohamad explained to me in January that as a Muslim country, Malaysia wants to avoid doing anything that would facilitate US military action against Islamic countries, including Palestine. The nation has too many dollar assets as it is, his colleagues explained. Central bank governor Zhou Xiaochuan of the People's Bank of China put an official statement on the bank’s website, explaining that the goal is now to create a reserve currency “that is disconnected from individual nations.” This is the aim of the discussions in Yekaterinburg.
Aside from no longer financing the U.S. buyout of their own industries and the U.S. military encirclement of the globe, China, Russia and other countries would no doubt like to enjoy the same kind of free ride that America has been getting. As matters stand now, they see the United States as a lawless nation, financially as well as militarily. How else to characterize a nation that proclaims a set of laws for others – on war, debt repayment and treatment of prisoners – but flouts them itself? The United States is now the world’s largest debtor yet has avoided the pain of “structural adjustments” imposed on other debtor economies. U.S. interest-rate and tax reductions in the face of exploding trade and budget deficits are seen as the height of hypocrisy in view of the austerity programs that Washington forces on other countries via the IMF and other Washington vehicles.
The United States tells debtor economies to sell off their public utilities and natural resources, raise their interest rates and increase taxes while gutting their social safety nets to squeeze out money to pay creditors. And at home, Congress blocked, on grounds of national security, China’s CNOOK from buying Unocal, much as it blocked Dubai from buying US ports and blocked other sovereign wealth funds from buying into key infrastructure. Foreigners are invited to emulate the Japanese purchase of white elephant trophies such as Rockefeller Center, on which investors quickly lost a billion dollars and ended up walking away.
In this respect the US has given China and other payments-surplus nations no alternative but to find a way to avoid further dollar buildups. To date, China’s attempts to diversify its dollar holdings beyond Treasury bonds have not proved very successful. For starters, Hank Paulson of Goldman Sachs steered its central bank into higher-yielding Fannie Mae and Freddie Mac securities, explaining that these were de facto public obligations. They collapsed in 2008, but at least the U.S. Government took over these two mortgage-lending agencies, formally adding their $5.2 trillion in obligations to the national debt. In fact, it was largely foreign official investment that prompted the bailout. Imposing a loss for foreign official agencies would have broken the Treasury-bill standard then and there, not only by utterly destroying US credibility but because there simply are too few Government bonds to absorb the dollars being flooded into the world economy by the soaring US balance-of-payments deficits.
in late 2007, seeking more of an equity position to protect the value of their dollar holdings as the Federal Reserve’s credit bubble drove interest rates down, China’s sovereign wealth funds sought to diversify. China bought stakes in the well-connected Blackstone equity fund and Morgan Stanley on Wall Street, Barclays in Britain, South Africa’s Standard Bank (once affiliated with Chase Manhattan back in the apartheid 1960s) and in the soon-to-collapse Belgian financial conglomerate Fortis. But the US financial sector was collapsing under the weight of its debt pyramiding, and prices for shares plunged for banks and investment firms across the globe.
Foreigners see the IMF, World Bank and World Trade Organization as Washington surrogates in a financial system backed by American military bases and aircraft carriers encircling the globe. But this military domination is a vestige of an American empire no longer able to rule by economic strength. US military power is muscle-bound, based more on atomic weaponry and long-distance air strikes than on ground operations, which have become too politically unpopular to mount on any large scale.
On the economic front there is no foreseeable way in which the United States can work off the $4 trillion it owes foreign governments, their central banks and the sovereign wealth funds set up to dispose of the global dollar glut. America has become a deadbeat –a militarily aggressive one -- as it sruggles to hold onto the immense power it once earned by economic means. The problem for the rest of the world is how to constrain its behavior. Yu Yongding, a former Chinese central bank advisor now with China’s Academy of Sciences, suggested that US Treasury Secretary Tim Geithner be advised that the United States should “save” first and foremost by cutting back its military budget. “U.S. tax revenue,” he said, “is not likely to increase in the short term because of low economic growth, inflexible expenditures and the cost of ‘fighting two wars.’”
At present foreign savings are what finance the US budget deficit by buying most Treasury bonds. The consequence is taxation without representation for foreign voters as to how the US Government uses their forced savings. It therefore is necessary for the financial diplomats to broaden the scope of their policy-making beyond the private-sector marketplace. Exchange rates are determined by many factors besides “consumers wielding credit cards,” the usual euphemism that the US media cite for America’s balance-of-payments deficit. Since the 13th century, war has been a dominating factor in the balance of payments of leading nations – and of their national debts. Government bond financing consists mainly of war debts, as normal peacetime budgets tend to be balanced. This links the war budget directly to the balance of payments and exchange rates.
Foreign nations see themselves stuck with unpayable IOUs under conditions where, if they move to stop the US free lunch, the dollar will plunge and their dollar holdings will fall in value relative to their own domestic currencies and other currencies. If China’s currency rises by 10 per cent against the dollar, its central bank will show the equivalent of a $200 million loss on its $2 trillion of dollar holdings as denominated in yuan. This explains why, when bond ratings agencies talk of the US Treasury securities losing their AAA rating, they don’t mean that the government cannot simply print the paper dollars to “make good” on these bonds. They mean that dollars will depreciate in international value. And that is just what is now occurring. When U.S. Treasury Secretary Geithner assumed an earnest mien and told an audience at Peking University in early June that he believed in a “strong dollar” and China’s US investments therefore were safe and sound, he was greeted with derisive laughter.
Anticipation of a rise in China’s exchange rate provides an incentive for speculators to seek to borrow in dollars to buy renminbi and benefit from the appreciation. For China, the problem is that this speculative inflow would become a self-fulfilling prophecy by forcing up its currency. So the problem of international reserves is inherently linked to that of capital controls. Why should China see its profitable companies sold for yet more freely-created US dollars, which the central bank must use to buy low-yielding US Treasury bills or lose yet further money on Wall Street?
To steer round this quandary it is necessary to reverse the philosophy of open capital markets that the world has held ever since Bretton Woods in 1944. On the occasion of Mr. Geithner’s visit to China, Zhou Xiaochuan, minister of the Peoples Bank of China, the country’s central bank, said pointedly that this was the first time since the semiannual talks began in 2006 that “China needed to learn from American mistakes as well as its successes” when it came to deregulating capital markets and dismantling controls.
So an era is winding to its end. In the face of continued US overspending, de-dollarization threatens to force countries to return to the kind of dual exchange rates common between World Wars I and II: one exchange rate for commodity trade, another for capital movements and investments, at least from dollar-area economies.
Even without capital controls, the nations meeting at Yekaterinburg are taking steps to avoid being the unwilling recipients of yet more dollars. Seeing that U.S. global hegemony cannot continue without the spending power that they themselves supply, governments are attempting to hasten what Chalmers Johnson has called “the sorrows of empire” in his book by that name – the bankruptcy of the US financial-military world order. If China, Russia and their non-aligned allies have their way, the United States will no longer live off the savings of others in the form of its own recycled dollars, nor have the money for unlimited military expenditures and adventures.
US officials wanted to attend the Yekaterinburg meeting as observers. They were told No. It is a word that Americans will hear much more in the future.
Michael Hudson is a former Wall Street economist. A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002) He can be reached via his website, mh@michael-hudson.com
30 March 2009
Russia Supports Gold as Part of IMF SDR
MOSCOW, March 28 (Reuters) - Russia supports expanding the IMF's Special Drawing Rights (SDR) to include the rouble, the yuan and gold, but sees no chance of the G20 Summit accepting a new reserve currency, a Kremlin aide said on Saturday, agencies reported.
"It would be logical for the set of currencies (that make up the SDR) to be expanded, and it could include other currencies, including the rouble, the yuan and perhaps others," state RIA news agency reported the Kremlin's senior economic aide Arkady Dvorkovich as saying.
China this week caused a stir ahead of the April 2 Group of 20 meeting of rich and emerging economies when it suggested the world move towards greater use of the International Monetary Fund's Special Drawing Rights, created by the IMF in 1969 as an international reserve asset.
G20 leaders have made clear that for now the dollar's status as the dominant reserve unit remains, but the idea of creating a new reserve currency system based on SDRs has not entirely been knocked down.
Dvorkovich said he sees no chance of the G20 accepting a new reserve currency next month, but his comments suggest the issue will be in the spotlight at the meeting, where world leaders will discuss ways to combat the global economic crisis.
"We could also think about more effective use of gold and gold and forex reserves in this system," Dvorkovich said, RIA reported. For its part, he added, Russia would support the broad use of the rouble and the yuan as reserve currencies, Itar-Tass reported. (Reporting by Simon Shuster; editing by Sue Thomas)
http://www.reuters.com/article/marketsNews/idAFLS37648120090328?rpc=44
"It would be logical for the set of currencies (that make up the SDR) to be expanded, and it could include other currencies, including the rouble, the yuan and perhaps others," state RIA news agency reported the Kremlin's senior economic aide Arkady Dvorkovich as saying.
China this week caused a stir ahead of the April 2 Group of 20 meeting of rich and emerging economies when it suggested the world move towards greater use of the International Monetary Fund's Special Drawing Rights, created by the IMF in 1969 as an international reserve asset.
G20 leaders have made clear that for now the dollar's status as the dominant reserve unit remains, but the idea of creating a new reserve currency system based on SDRs has not entirely been knocked down.
Dvorkovich said he sees no chance of the G20 accepting a new reserve currency next month, but his comments suggest the issue will be in the spotlight at the meeting, where world leaders will discuss ways to combat the global economic crisis.
"We could also think about more effective use of gold and gold and forex reserves in this system," Dvorkovich said, RIA reported. For its part, he added, Russia would support the broad use of the rouble and the yuan as reserve currencies, Itar-Tass reported. (Reporting by Simon Shuster; editing by Sue Thomas)
http://www.reuters.com/article/marketsNews/idAFLS37648120090328?rpc=44
8 March 2009
Truth Beauty and Russian Finance ~ (Yet another) Year of Living Dangerously Russia in the Global Crisis
Recently, we were asked to contribute a paper on the impact of the global economic crisis upon Russia. Whilst T&B sees a number of signs of stabilization in Russia – a phenomenon painfully missing virtually anywhere else – both the speed and the severity of the global meltdown is simply breathtaking. Russia is climbing back up the rock-face, but it is climbing up through an avalanche…
It is thus a risky business issuing bullish calls for any economy – we see growing evidence for a gradual stabilization in Russia – most recently, at 40.6 the VTB Purchasing Manager Index (PMI) while still clearly recessionary, has improved for the second month running – from 33 in December to 35 in January; inventories of finished goods have declined quite substantially, one of the conditions for a resumption in manufacturing activity. As of this writing, the rouble has stabilized, and after the spectacular recovery in the Eurobond market, the rouble bond market is now steadily improving, with bids for first and second tier assets at yields around 20%.
Life lacks spice if not spent far out upon a limb, so we will risk making fools of ourselves with a series of predictions: the S&P will hit our target of 650 (now just 50 points away) sooner rather than later – but will then stabilize (hope, not evidence). Oil prices have probably bottomed. Chinese resource demand is coming back. The RTS equity market bottomed around 500 last October and
© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -1 -
does not want to go any lower (current quote: 540) but we would expect it to trade within a reasonably narrow range for the immediate future. The best near term investment opportunities now include Russian Eurobonds, and for the adventurous, selected rouble bonds.
In brief – we have seen a fair number of swallows – we begin to suspect that they may a springtime make. That said, the downside risks are obvious: if we are faced with a true meltdown of the global economic, financial and trading systems, then any predictions regarding Russia in isolation should not be relied upon. If the disaster scenario were to eventuate, we suspect that our readership would have other, more immediate preoccupations – the procurement of food, water, and a dry cave in which to sleep – rather than blaming us for a missed call or two.
(Another) Year of Living Dangerously – Russia and the Global Crisis
Whilst the economic impact upon Russia of the initial phases of the global economic crisis exceeded rational expectations formulated based upon the secular shift in economic activity towards the emerging markets, in fairness, the sheer havoc triggered by the collapse of the serial US asset bubbles is unprecedented; in retrospect, the current crisis will be seen to have represented the fundamental inflection point in secular shift in the global balance of economic power away from the old economies of the West.
For now, innocent bystanders need beware. As in every financial crisis, the initial disruption was both panicked and non-selective; both babies and bathwater were pitched out of windows as financial entities went into survival mode. Then, as the crisis matures, markets begin to increasingly differentiate between those companies or countries faced with the threat of imminent demise, as opposed to those which have become oversold beyond any rational valuation, and thus, offer compelling opportunities for the adventurous. We think that the contagion effect in Russia was front-loaded, i.e. that the worst effects were felt in late 2008, and that a period of stabilization is now at hand.
The Three Horsemen of the Apocalypse – and the Missing Stallions
Three principal mechanisms account for the transmission of the global economic crisis to the Russian economy; in order of decreasing importance, these are the global credit contraction, the collapse in commodities prices, and the reversal of investment flows. These shocks have been of a magnitude unprecedented in modern economic history, and especially, occurred with extraordinary rapidity, with in particular credit going from bounteous to almost non-existent virtually overnight.
For structural reasons, the emerging markets – not excluding Russia – were highly exposed to a sudden failure of global capital markets. Since conditions will almost certainly continue worsening during the course of 2009-2010, legitimate questions can be asked regarding the economic survivability of several emerging countries, in particular of Eastern Europe. As regards Russia, on the other hand, it appears that most of the damage has already been felt, and absent a complete collapse in the global trading system or commodities markets, we would expect to see stabilization not far from the current levels.
We will first consider the three essential factors driving the crisis, as well as the near-term outlook for each, before turning to the mitigating factors, i.e. those areas where Russia is relatively immune to contagion effects.
1. Credit While Russia was initially able to shrug off the first phases of the global crisis, the disastrous decision to allow a disorderly failure of Lehman Bros sent global financial markets spiralling into crisis mode. The desperate rush by banks to repatriate capital led to the sudden withdrawal of all credit – regardless of the ultimate creditworthiness of the borrower. The Russian corporate sector, largely funded in the international capital markets, proved to be dangerously exposed.
© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -2 -
This fragility was a direct consequence of the “Kudrin System” whereby, so as to forestall the development of “Dutch Disease” and hyperinflation driven by massive commodity export revenues, under FM Kudrin Russia moved to capture the windfall profits of the oil producers, accumulating massive Forex reserves while reducing the sovereign debt load to trivial levels. Given the perceived limits to the ability of the Russian financial system to absorb and allocate investment capital, the government invested oil export revenues into G7 assets, essentially leaving it to the global investment banks to intermediate these reserves back into the Russian economy.
Deprived of domestic options for financing business expansion, working capital or Capex, the Russian corporate sector by necessity turned to the global banks and capital markets for funding. Given that until October 2008 the international banks were both highly liquid and increasingly desperate for credit-worthy borrowers, they willingly provided increasing volumes of finance; the counterpart to burgeoning sovereign Forex reserves was thus the rapidly-growing indebtedness of the Russian corporate sector.
Had the onset of the global crisis been delayed by a further 24 months, it is likely that the Russian private sector would have found itself disastrously over-indebted. In the event, whilst the gross indebtedness of the Russian corporate sector has been rather alarmingly estimated at some $500 billion, this ignores the huge offsetting foreign assets held by the corporate sector. Estimated debt service and redemptions for 2009 are approximately $110bn, the vast majority of which have already been funded by issuers purchasing USD on the local market; indeed, many of the obligors, in particular the banks, have been actively buying back their outstanding Eurobonds, which have performed very strongly over the past few months.
The Washington Consensus Strikes Again…
We would argue that the crisis was exacerbated by the premature, politically-motivated decision to fully integrate Russia into global financial markets, embracing total liberalisation just as the Western system spiralled into an asymptotic bubble trajectory, asserting Russia’s newfound economic stability by dismantling all capital controls. Unfortunately, whilst controls are relatively ineffective in preventing outflows, at the time outflows were not the problem; the problem was an excess of hot money looking for short term trading opportunities and where controls had been relatively effective was in discouraging the inflow of foreign hot money.
In the event, with the capital account thrown open, the “global carry trade” got underway in earnest; hedge funds piled into short-term rouble assets, given the perceived one-way rouble exchange rate risk, as well as local interest rates which, while negative in real terms, were well above the dollar cost of funding. These inflows, coupled with a strongly positive trade account, obliged the Russian Central Bank to run an inappropriately easy monetary policy so as to slow rouble appreciation; along with torrential capital inflows, this pushed domestic real interest rates into deeply negative territory – resulting in inflation, excessive currency valuation, and a serious misallocation of resources. Furthermore, since virtually all of the currency inflows were short term, they made no useful contribution to much-needed infrastructure investment or Capex; of course, when global risk tolerance collapsed, there was a violent reversal of capital flows, leaving the CBR to a desperate and ultimately unsuccessful attempt to preserve popular confidence in the currency and banking system by seeking to hold the rouble at an unsustainable level.
Perspectives –
Despite the occasional public calls for capital controls by hardliners in the Russian government, the Central Bank is fully aware that the time for currency controls is when the money is pouring in – when the cash pours out, controls prove extremely porous. Indeed, by triggering precautionary capital flight, they generally prove counterproductive, especially in a country as skilled as is Russia in the evasion of administrative controls. As recently affirmed by Mr. Putin himself, for now, the game will continue to be played by the old rules.
Perhaps the most successful aspect of the anti-crisis package has been the shoring up of the Russian banking system. There have been no disorderly bank failures; the level of popular and corporate bank deposits has been broadly maintained; and while NPLs are rising (and recent
© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -3 -
changes in CBR bank reporting regulations certainly have not enhanced clarity), their absolute levels do not threaten Russian macroeconomic stability.
At present, global credit markets have begun to recover, and indeed, a few top-rated Russian entities have managed to raise substantial new finance, while a larger number have successfully negotiated roll-overs of their existing credit lines.
By cutting back on the systematic official (non-bank) support for Russian companies faced with foreign debt maturities, the government is encouraging these to continue to seek negotiated arrangements with their foreign creditors – who may find it in their own best interests to maintain a cooperative relationship with their solvent but illiquid borrowers. Given that those companies able to do so took advantage of the stepwise rouble devaluation to purchase foreign currency sufficient to meet their 2009/2010 obligations, any defaults on foreign bonded debt will likely be confined to a couple of very minor issuers. On the other hand, we would not expect Russian corporates to gain meaningful access to global capital markets in the foreseeable future.
2. Commodities Although the Russian government has long been cognizant of the risk posed by excessive dependency upon the global commodity cycle, in practice, this dependency has proved exceedingly difficult to break. Russia is by nature a major exporter of energy, minerals, as well as an increasingly important force in the global agricultural commodities market. Thus, during the commodity up-cycle, cash pours in, driving currency appreciation, inflation, and crowding out non-commodity economic activity. The down-cycle of course is marked by rapid economic deceleration, credit squeeze, and deflation.
To date, the most successful attempts at industrial diversification have involved Russian exporters moving up the commodity value-added chain, e.g. from export of iron ore and slab steel to high- value added speciality steels; from natural gas to fine chemicals; from pulp and lumber to coated paper and furniture.
Tacit the occasional nanotechnology fantasy, the development of domestic manufacture has been most successful as regards import substitution – including food products, building supplies, and especially, the domestic manufacture of foreign automobile marques. For the latter sector, Russia’s politically-motivated exclusion from the WTO has proved a blessing in disguise, sheltering the domestic market for foreign car manufacturers established in Russia.
Perspectives -
For the foreseeable future, Russia’s relative correlation with the commodity cycle should be taken a given. There is no clear consensus as regards medium-term price trends in global commodity markets, although we suspect that market participants may have swung from excessive bullishness to unjustified pessimism. While economic activity in the West will almost certainly continue to decline, this will be at least partially offset by resource-intensive government mandated infrastructure spending.
Nevertheless, the continuation of the Chinese growth miracle now constitutes the sole realistic hope for avoiding a prolonged recession/depression. Quite fortunately, one would do well to discount much of the pessimism in the press as regards the ability of China to reflate. Whilst China is faced with the daunting task of reorienting export-driven manufacturing activity towards a huge and deeply undersupplied domestic market, it benefits from a high degree of political centralization and is thus able to rapidly implement radical policy directives; after a decade of contracyclical fiscal and monetary policy, China has a huge stock of ammunition – a combination of a deep budget surplus and the world’s largest currency reserves.
The first, encouraging signs of resumed Chinese demand include a modest rebound in global iron ore, coke and steel prices. Similarly, having collapsed by an unprecedented 90% last year, the Baltic Dry Index, the primary index for global bulk shipping costs, has more than doubled on growing Chinese demand. With agricultural production having collapsed in numerous geographical locales
© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -4 -
due to accelerating climate change as well as the drying up of agricultural credit, export grain prices should rebound within the next 18 months.
The key question is, of course, the oil price. It seems likely that a bottom was found in late 2008, with Brent repeatedly bouncing off of the $40 level on Brent since last December. Whilst the market has focused on demand destruction, destruction of supply has been neglected – at current prices, numerous marginal oil sources, from Canadian oil sands to deep-water offshore drilling, US stripper wells, much Kazakh production, and most alternatives including biofuels become economically unsustainable. OPEC is showing remarkable discipline, and there are modest signs of cooperation among some non-OPEC oil producers.
Meanwhile, the great oil fields are declining at variable rates – Indonesia is now a net importer, Mexican production is collapsing, and whilst the terminal phase in North Sea production has been delayed, the final slope of this decline will be extremely sharp. Although new oil sources will continue to be found, the easy oil has already been drilled, and marginal production will be feasible only at prices closer to the 65-85$ range where we see oil prices ending the year.
As regards the demand side, although it is a fair bet that the United States will never again import as much oil as it did in 2007, the US is no longer the top source of incremental demand. Amazingly, in January – for the first time in history – Chinese consumers bought more cars than did Americans (and it should be noted that American automobile sales are net-net replacement purchases, while Chinese sales represent new cars on new roads).
3. Capital flows Foreign investment capital has flowed out of all emerging markets, with global capital markets closed to Russian (indeed, to all EMEA) equity offerings since October 2008; they look to remain so for the foreseeable future. As regards debt markets, only the top-rated borrowers can raise new money – and this is considerably more expensive than in the past.
While some very alarming numbers have been reported for Russian capital flight, in fact, much of this has simply been Russian entities purchasing dollars/Euros, either to fund upcoming debt maturities and bond buy-backs, or simply for wealth preservation. Correspondent accounts with the Central Bank of Russia have surged as the Russian corporate sector has switched reserves into foreign currencies; despite the currency shift, these reserves remain available to their Russian owners.
As regards FDI, at least until recently, the vast majority of foreign companies doing business in Russia have been highly profitable – when polled, a majority confirmed their intention to maintain or increase their investments in what remains a secular growth market. We would contrast this with the situation in China, where despite a more charitable treatment in the press, one would be hard- pressed to name 5 Western companies making money on their domestic operations.
Perspectives –
The best news here is that the situation cannot further deteriorate – capital raising simply cannot fall below zero! Indeed, it could be argued that, unlike long-term foreign direct investment which has clearly been beneficial, the opening of the Russian market to speculative foreign capital flows has reliably proved disastrous; Russia may well do best when forced to rely primarily upon her own internal resources.
And the Missing Horsemen:
Unlike many of its emerging market peers, Russia is relatively immune to miscellaneous scourges facing the developing economies, and which threaten a number of Latin American (Mexico, Argentina), EMEA (Ukraine, Georgia, the Baltics, Hungary) and Asian (Indonesia, Thailand, Philippines, Korea) countries with economic collapse:
• Plunging global demand for manufactured goods © Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -5 -
Russian exports are primarily in the commodities sector – and the main driver here is likely to be Chinese industrial activity. Manufactured exports are limited to military (a growth sector in troubled times), nuclear power generation, and relatively cost-effective heavy industrial machinery (turbines, power generation, etc.) suitable for the needs of the developing countries – where at least some infrastructure spending is likely to be maintained.
• Inability to fund the current account deficit due to collapse in remittances/bond markets/exports Russia has no indispensible import requirements, being self-sufficient in all major commodities and basic foodstuffs. In a worst-case scenario, Russia could survive without Mercedes motorcars and French cheese for an unlimited period. Remittances are a negative item on the balance sheet, and the Federal government has virtually no foreign debt to refinance.
• Political instability With due respects, reports of Russian political unrest are laughable. Whilst a number of EMEA governments are breaking under the stress, Russia remains remarkably quiet. We would note that the Western press, always desperate for bad news as regards Russia, has been recycling a single demonstration by Vladivostok used car dealer for nearly three months now… Those of us who lived through the 1998 crisis were stuck by the total absence of popular protest – as the crisis worsened, people returned to their dachas to plant potatoes. Perhaps the experience of seventy years of collectivist rule durably chilled the popular enthusiasm for revolution.
As regards the international context, the crisis has diminished any Western ardour for confrontational politics, the opening of new military fronts, or expensive missile systems; a substantial improvement in US-Russian relations is thus to be expected. Similarly, some of Russia’s neighbours, previously fixated upon comprehensible but perhaps outmoded historical grievances, will now have far more important matters to attend to – in the current climate, even modest Russian investment capital flows will likely receive a warm welcome.
• Economic fragility Despite claims by the western kommentariat that the Russian politico-economic system lacks flexibility, in fact, it is far more flexible than that of most developed economies. Downward adjustment of wages and staffing levels can occur virtually overnight, with production simply halted until inventories are reduced to the desired level – as indeed happened during the January 2009 period (resulting in industrial production numbers which were dramatic but quite misleading).
In summary, while our readers are undoubtedly familiar with the inefficiencies of the Russian economy, this does have a silver lining: no manufacturer in his right mind would attempt to set up a just-in-time supply chain in Russia. After 20 very eventful years, like an old Lada automobile, much of the local industrial fabric is relatively inefficient, but at least, admirably fault-tolerant.
© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -6 -
Although we would expect to see further discouraging numbers through the first half of 2009, the period of maximal stress was apparently reached in October-November 2008; after a sharp rouble devaluation, successful support for the banking sector, and the recycling of official Forex reserves into the corporate sector, the increase in non-payments which mushroomed out in Q4 2008 has been almost entirely reabsorbed.
Although our view is temporarily unfashionable, we continue to expect a gradual differentiation between the potentially high-growth BRICs countries and the old economies of the West. Those wishing to predict the timing of a Russian rebound would do well to keep a close eye on Chinese growth trends. Whilst the financial disruption in Russia has been severe, the financial system has survived the stress test, and policy of both the Central Bank and the finance ministry are broadly appropriate. Over the next couple of years the opportunities in financial markets will likely match those enjoyed by investors in the 1998 post-crisis period.
This message is provided for informational purposes and neither the information nor any opinion expressed herein constitutes an offer, or an invitation to make an offer, to buy or sell any investment funds, securities or any options, futures or other derivatives related to such securities.
Investment in emerging markets bears a high degree of risk, and is not suitable for all investors. This report is based upon information we believe to be reliable, however it is provided solely as an intellectual exercise, and no investment decisions whatsoever should be based upon it, in full or in part. In particular, investing in securities, including Emerging Markets securities involves a great deal of risk and investors should perform their own due diligence before investing.
It is thus a risky business issuing bullish calls for any economy – we see growing evidence for a gradual stabilization in Russia – most recently, at 40.6 the VTB Purchasing Manager Index (PMI) while still clearly recessionary, has improved for the second month running – from 33 in December to 35 in January; inventories of finished goods have declined quite substantially, one of the conditions for a resumption in manufacturing activity. As of this writing, the rouble has stabilized, and after the spectacular recovery in the Eurobond market, the rouble bond market is now steadily improving, with bids for first and second tier assets at yields around 20%.
Life lacks spice if not spent far out upon a limb, so we will risk making fools of ourselves with a series of predictions: the S&P will hit our target of 650 (now just 50 points away) sooner rather than later – but will then stabilize (hope, not evidence). Oil prices have probably bottomed. Chinese resource demand is coming back. The RTS equity market bottomed around 500 last October and
© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -1 -
does not want to go any lower (current quote: 540) but we would expect it to trade within a reasonably narrow range for the immediate future. The best near term investment opportunities now include Russian Eurobonds, and for the adventurous, selected rouble bonds.
In brief – we have seen a fair number of swallows – we begin to suspect that they may a springtime make. That said, the downside risks are obvious: if we are faced with a true meltdown of the global economic, financial and trading systems, then any predictions regarding Russia in isolation should not be relied upon. If the disaster scenario were to eventuate, we suspect that our readership would have other, more immediate preoccupations – the procurement of food, water, and a dry cave in which to sleep – rather than blaming us for a missed call or two.
(Another) Year of Living Dangerously – Russia and the Global Crisis
Whilst the economic impact upon Russia of the initial phases of the global economic crisis exceeded rational expectations formulated based upon the secular shift in economic activity towards the emerging markets, in fairness, the sheer havoc triggered by the collapse of the serial US asset bubbles is unprecedented; in retrospect, the current crisis will be seen to have represented the fundamental inflection point in secular shift in the global balance of economic power away from the old economies of the West.
For now, innocent bystanders need beware. As in every financial crisis, the initial disruption was both panicked and non-selective; both babies and bathwater were pitched out of windows as financial entities went into survival mode. Then, as the crisis matures, markets begin to increasingly differentiate between those companies or countries faced with the threat of imminent demise, as opposed to those which have become oversold beyond any rational valuation, and thus, offer compelling opportunities for the adventurous. We think that the contagion effect in Russia was front-loaded, i.e. that the worst effects were felt in late 2008, and that a period of stabilization is now at hand.
The Three Horsemen of the Apocalypse – and the Missing Stallions
Three principal mechanisms account for the transmission of the global economic crisis to the Russian economy; in order of decreasing importance, these are the global credit contraction, the collapse in commodities prices, and the reversal of investment flows. These shocks have been of a magnitude unprecedented in modern economic history, and especially, occurred with extraordinary rapidity, with in particular credit going from bounteous to almost non-existent virtually overnight.
For structural reasons, the emerging markets – not excluding Russia – were highly exposed to a sudden failure of global capital markets. Since conditions will almost certainly continue worsening during the course of 2009-2010, legitimate questions can be asked regarding the economic survivability of several emerging countries, in particular of Eastern Europe. As regards Russia, on the other hand, it appears that most of the damage has already been felt, and absent a complete collapse in the global trading system or commodities markets, we would expect to see stabilization not far from the current levels.
We will first consider the three essential factors driving the crisis, as well as the near-term outlook for each, before turning to the mitigating factors, i.e. those areas where Russia is relatively immune to contagion effects.
1. Credit While Russia was initially able to shrug off the first phases of the global crisis, the disastrous decision to allow a disorderly failure of Lehman Bros sent global financial markets spiralling into crisis mode. The desperate rush by banks to repatriate capital led to the sudden withdrawal of all credit – regardless of the ultimate creditworthiness of the borrower. The Russian corporate sector, largely funded in the international capital markets, proved to be dangerously exposed.
© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -2 -
This fragility was a direct consequence of the “Kudrin System” whereby, so as to forestall the development of “Dutch Disease” and hyperinflation driven by massive commodity export revenues, under FM Kudrin Russia moved to capture the windfall profits of the oil producers, accumulating massive Forex reserves while reducing the sovereign debt load to trivial levels. Given the perceived limits to the ability of the Russian financial system to absorb and allocate investment capital, the government invested oil export revenues into G7 assets, essentially leaving it to the global investment banks to intermediate these reserves back into the Russian economy.
Deprived of domestic options for financing business expansion, working capital or Capex, the Russian corporate sector by necessity turned to the global banks and capital markets for funding. Given that until October 2008 the international banks were both highly liquid and increasingly desperate for credit-worthy borrowers, they willingly provided increasing volumes of finance; the counterpart to burgeoning sovereign Forex reserves was thus the rapidly-growing indebtedness of the Russian corporate sector.
Had the onset of the global crisis been delayed by a further 24 months, it is likely that the Russian private sector would have found itself disastrously over-indebted. In the event, whilst the gross indebtedness of the Russian corporate sector has been rather alarmingly estimated at some $500 billion, this ignores the huge offsetting foreign assets held by the corporate sector. Estimated debt service and redemptions for 2009 are approximately $110bn, the vast majority of which have already been funded by issuers purchasing USD on the local market; indeed, many of the obligors, in particular the banks, have been actively buying back their outstanding Eurobonds, which have performed very strongly over the past few months.
The Washington Consensus Strikes Again…
We would argue that the crisis was exacerbated by the premature, politically-motivated decision to fully integrate Russia into global financial markets, embracing total liberalisation just as the Western system spiralled into an asymptotic bubble trajectory, asserting Russia’s newfound economic stability by dismantling all capital controls. Unfortunately, whilst controls are relatively ineffective in preventing outflows, at the time outflows were not the problem; the problem was an excess of hot money looking for short term trading opportunities and where controls had been relatively effective was in discouraging the inflow of foreign hot money.
In the event, with the capital account thrown open, the “global carry trade” got underway in earnest; hedge funds piled into short-term rouble assets, given the perceived one-way rouble exchange rate risk, as well as local interest rates which, while negative in real terms, were well above the dollar cost of funding. These inflows, coupled with a strongly positive trade account, obliged the Russian Central Bank to run an inappropriately easy monetary policy so as to slow rouble appreciation; along with torrential capital inflows, this pushed domestic real interest rates into deeply negative territory – resulting in inflation, excessive currency valuation, and a serious misallocation of resources. Furthermore, since virtually all of the currency inflows were short term, they made no useful contribution to much-needed infrastructure investment or Capex; of course, when global risk tolerance collapsed, there was a violent reversal of capital flows, leaving the CBR to a desperate and ultimately unsuccessful attempt to preserve popular confidence in the currency and banking system by seeking to hold the rouble at an unsustainable level.
Perspectives –
Despite the occasional public calls for capital controls by hardliners in the Russian government, the Central Bank is fully aware that the time for currency controls is when the money is pouring in – when the cash pours out, controls prove extremely porous. Indeed, by triggering precautionary capital flight, they generally prove counterproductive, especially in a country as skilled as is Russia in the evasion of administrative controls. As recently affirmed by Mr. Putin himself, for now, the game will continue to be played by the old rules.
Perhaps the most successful aspect of the anti-crisis package has been the shoring up of the Russian banking system. There have been no disorderly bank failures; the level of popular and corporate bank deposits has been broadly maintained; and while NPLs are rising (and recent
© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -3 -
changes in CBR bank reporting regulations certainly have not enhanced clarity), their absolute levels do not threaten Russian macroeconomic stability.
At present, global credit markets have begun to recover, and indeed, a few top-rated Russian entities have managed to raise substantial new finance, while a larger number have successfully negotiated roll-overs of their existing credit lines.
By cutting back on the systematic official (non-bank) support for Russian companies faced with foreign debt maturities, the government is encouraging these to continue to seek negotiated arrangements with their foreign creditors – who may find it in their own best interests to maintain a cooperative relationship with their solvent but illiquid borrowers. Given that those companies able to do so took advantage of the stepwise rouble devaluation to purchase foreign currency sufficient to meet their 2009/2010 obligations, any defaults on foreign bonded debt will likely be confined to a couple of very minor issuers. On the other hand, we would not expect Russian corporates to gain meaningful access to global capital markets in the foreseeable future.
2. Commodities Although the Russian government has long been cognizant of the risk posed by excessive dependency upon the global commodity cycle, in practice, this dependency has proved exceedingly difficult to break. Russia is by nature a major exporter of energy, minerals, as well as an increasingly important force in the global agricultural commodities market. Thus, during the commodity up-cycle, cash pours in, driving currency appreciation, inflation, and crowding out non-commodity economic activity. The down-cycle of course is marked by rapid economic deceleration, credit squeeze, and deflation.
To date, the most successful attempts at industrial diversification have involved Russian exporters moving up the commodity value-added chain, e.g. from export of iron ore and slab steel to high- value added speciality steels; from natural gas to fine chemicals; from pulp and lumber to coated paper and furniture.
Tacit the occasional nanotechnology fantasy, the development of domestic manufacture has been most successful as regards import substitution – including food products, building supplies, and especially, the domestic manufacture of foreign automobile marques. For the latter sector, Russia’s politically-motivated exclusion from the WTO has proved a blessing in disguise, sheltering the domestic market for foreign car manufacturers established in Russia.
Perspectives -
For the foreseeable future, Russia’s relative correlation with the commodity cycle should be taken a given. There is no clear consensus as regards medium-term price trends in global commodity markets, although we suspect that market participants may have swung from excessive bullishness to unjustified pessimism. While economic activity in the West will almost certainly continue to decline, this will be at least partially offset by resource-intensive government mandated infrastructure spending.
Nevertheless, the continuation of the Chinese growth miracle now constitutes the sole realistic hope for avoiding a prolonged recession/depression. Quite fortunately, one would do well to discount much of the pessimism in the press as regards the ability of China to reflate. Whilst China is faced with the daunting task of reorienting export-driven manufacturing activity towards a huge and deeply undersupplied domestic market, it benefits from a high degree of political centralization and is thus able to rapidly implement radical policy directives; after a decade of contracyclical fiscal and monetary policy, China has a huge stock of ammunition – a combination of a deep budget surplus and the world’s largest currency reserves.
The first, encouraging signs of resumed Chinese demand include a modest rebound in global iron ore, coke and steel prices. Similarly, having collapsed by an unprecedented 90% last year, the Baltic Dry Index, the primary index for global bulk shipping costs, has more than doubled on growing Chinese demand. With agricultural production having collapsed in numerous geographical locales
© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -4 -
due to accelerating climate change as well as the drying up of agricultural credit, export grain prices should rebound within the next 18 months.
The key question is, of course, the oil price. It seems likely that a bottom was found in late 2008, with Brent repeatedly bouncing off of the $40 level on Brent since last December. Whilst the market has focused on demand destruction, destruction of supply has been neglected – at current prices, numerous marginal oil sources, from Canadian oil sands to deep-water offshore drilling, US stripper wells, much Kazakh production, and most alternatives including biofuels become economically unsustainable. OPEC is showing remarkable discipline, and there are modest signs of cooperation among some non-OPEC oil producers.
Meanwhile, the great oil fields are declining at variable rates – Indonesia is now a net importer, Mexican production is collapsing, and whilst the terminal phase in North Sea production has been delayed, the final slope of this decline will be extremely sharp. Although new oil sources will continue to be found, the easy oil has already been drilled, and marginal production will be feasible only at prices closer to the 65-85$ range where we see oil prices ending the year.
As regards the demand side, although it is a fair bet that the United States will never again import as much oil as it did in 2007, the US is no longer the top source of incremental demand. Amazingly, in January – for the first time in history – Chinese consumers bought more cars than did Americans (and it should be noted that American automobile sales are net-net replacement purchases, while Chinese sales represent new cars on new roads).
3. Capital flows Foreign investment capital has flowed out of all emerging markets, with global capital markets closed to Russian (indeed, to all EMEA) equity offerings since October 2008; they look to remain so for the foreseeable future. As regards debt markets, only the top-rated borrowers can raise new money – and this is considerably more expensive than in the past.
While some very alarming numbers have been reported for Russian capital flight, in fact, much of this has simply been Russian entities purchasing dollars/Euros, either to fund upcoming debt maturities and bond buy-backs, or simply for wealth preservation. Correspondent accounts with the Central Bank of Russia have surged as the Russian corporate sector has switched reserves into foreign currencies; despite the currency shift, these reserves remain available to their Russian owners.
As regards FDI, at least until recently, the vast majority of foreign companies doing business in Russia have been highly profitable – when polled, a majority confirmed their intention to maintain or increase their investments in what remains a secular growth market. We would contrast this with the situation in China, where despite a more charitable treatment in the press, one would be hard- pressed to name 5 Western companies making money on their domestic operations.
Perspectives –
The best news here is that the situation cannot further deteriorate – capital raising simply cannot fall below zero! Indeed, it could be argued that, unlike long-term foreign direct investment which has clearly been beneficial, the opening of the Russian market to speculative foreign capital flows has reliably proved disastrous; Russia may well do best when forced to rely primarily upon her own internal resources.
And the Missing Horsemen:
Unlike many of its emerging market peers, Russia is relatively immune to miscellaneous scourges facing the developing economies, and which threaten a number of Latin American (Mexico, Argentina), EMEA (Ukraine, Georgia, the Baltics, Hungary) and Asian (Indonesia, Thailand, Philippines, Korea) countries with economic collapse:
• Plunging global demand for manufactured goods © Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -5 -
Russian exports are primarily in the commodities sector – and the main driver here is likely to be Chinese industrial activity. Manufactured exports are limited to military (a growth sector in troubled times), nuclear power generation, and relatively cost-effective heavy industrial machinery (turbines, power generation, etc.) suitable for the needs of the developing countries – where at least some infrastructure spending is likely to be maintained.
• Inability to fund the current account deficit due to collapse in remittances/bond markets/exports Russia has no indispensible import requirements, being self-sufficient in all major commodities and basic foodstuffs. In a worst-case scenario, Russia could survive without Mercedes motorcars and French cheese for an unlimited period. Remittances are a negative item on the balance sheet, and the Federal government has virtually no foreign debt to refinance.
• Political instability With due respects, reports of Russian political unrest are laughable. Whilst a number of EMEA governments are breaking under the stress, Russia remains remarkably quiet. We would note that the Western press, always desperate for bad news as regards Russia, has been recycling a single demonstration by Vladivostok used car dealer for nearly three months now… Those of us who lived through the 1998 crisis were stuck by the total absence of popular protest – as the crisis worsened, people returned to their dachas to plant potatoes. Perhaps the experience of seventy years of collectivist rule durably chilled the popular enthusiasm for revolution.
As regards the international context, the crisis has diminished any Western ardour for confrontational politics, the opening of new military fronts, or expensive missile systems; a substantial improvement in US-Russian relations is thus to be expected. Similarly, some of Russia’s neighbours, previously fixated upon comprehensible but perhaps outmoded historical grievances, will now have far more important matters to attend to – in the current climate, even modest Russian investment capital flows will likely receive a warm welcome.
• Economic fragility Despite claims by the western kommentariat that the Russian politico-economic system lacks flexibility, in fact, it is far more flexible than that of most developed economies. Downward adjustment of wages and staffing levels can occur virtually overnight, with production simply halted until inventories are reduced to the desired level – as indeed happened during the January 2009 period (resulting in industrial production numbers which were dramatic but quite misleading).
In summary, while our readers are undoubtedly familiar with the inefficiencies of the Russian economy, this does have a silver lining: no manufacturer in his right mind would attempt to set up a just-in-time supply chain in Russia. After 20 very eventful years, like an old Lada automobile, much of the local industrial fabric is relatively inefficient, but at least, admirably fault-tolerant.
© Eric Kraus krausmoscow@yahoo.com & OTKRITIE Financial Corporation www.open.ru 3 March 2009 -6 -
Although we would expect to see further discouraging numbers through the first half of 2009, the period of maximal stress was apparently reached in October-November 2008; after a sharp rouble devaluation, successful support for the banking sector, and the recycling of official Forex reserves into the corporate sector, the increase in non-payments which mushroomed out in Q4 2008 has been almost entirely reabsorbed.
Although our view is temporarily unfashionable, we continue to expect a gradual differentiation between the potentially high-growth BRICs countries and the old economies of the West. Those wishing to predict the timing of a Russian rebound would do well to keep a close eye on Chinese growth trends. Whilst the financial disruption in Russia has been severe, the financial system has survived the stress test, and policy of both the Central Bank and the finance ministry are broadly appropriate. Over the next couple of years the opportunities in financial markets will likely match those enjoyed by investors in the 1998 post-crisis period.
This message is provided for informational purposes and neither the information nor any opinion expressed herein constitutes an offer, or an invitation to make an offer, to buy or sell any investment funds, securities or any options, futures or other derivatives related to such securities.
Investment in emerging markets bears a high degree of risk, and is not suitable for all investors. This report is based upon information we believe to be reliable, however it is provided solely as an intellectual exercise, and no investment decisions whatsoever should be based upon it, in full or in part. In particular, investing in securities, including Emerging Markets securities involves a great deal of risk and investors should perform their own due diligence before investing.
24 February 2009
China loan turns Russian oil east
MOSCOW - Officials involved in the Russian oil industry, and the country's state treasury, breathed a sigh of relief as the Chinese and Russian governments announced agreement on a revolutionary shift in future Russian crude oil flows.
According to the announcement from Beijing last Tuesday, where Deputy Prime Ministers Wang Qishan and Igor Sechin were meeting, China and Russia have finally agreed on terms for a China Development Bank loan of US$25 billion to Russian state oil exporter Rosneft and pipeline company Transneft to finance crude oil shipments over a 20-year period of not less than 241,000
barrels per day (15 million tonnes per annum).
The fine-print of the financing and oil-supply deals have not been released. However, the availability of $15 billion in 10-year finance for Rosneft and $10 billion to Transneft at a sub-market interest rate of around 6% will guarantee China's priority for East Siberian crude oil deliveries for the foreseeable future.
The loan and oil-supply agreements implement the inter-government memorandum of understanding signed more than three months ago, on October 29, 2008. They are the second major initiative between Beijing and Moscow, following the Chinese financing in 2004 for Rosneft's acquisition of Yuganskneftegaz in exchange for delivery of 48.4 million tonnes (194,000 barrels per day) between 2005 and 2010.
For China in the medium to long term, according to one Russian bank, the new deal will "provide an impetus to massive development of Eastern Siberia" from which China is best placed to benefit. "We believe that two options are possible: greater [Chinese] access to the East Siberian fields (currently two upstream projects via a joint venture with Rosneft) and the potential transformation of East Siberian Pacific Ocean pipeline network into a joint stock company, with China getting 49% or 50% control in it."
If the latter materializes, that would give Beijing a control stake in an oil port to be built at Kozmino Bay, near Nakhodka, on the Sea of Japan.
Reporting the loan as one of the largest in Russian credit history, a Moscow newspaper speculated that in financing the new Russian oil source, "China will reduce its dependence on deliveries of oil from the Persian Gulf, which currently comprise about 80% of China's oil imports."
The enormous size of the loan also adds to the strategic influence Beijing will have on the development of the Russian economy in the short term. According to Victor Mishnyakov, oil analyst at Uralsib Bank in Moscow, "We think that the development should offer support for the rouble and underlines our expectations that the devaluation of the rouble is over if crude prices remain at their current level throughout the year."
Troika Dialog Bank analyst Yevgeny Gavrilenkov reported, "For the balance of payments, this is really positive news," while Mikhail Galkin of MDM Bank commented that it was "a super-favorable loan for Russia".
At least $9 billion of Rosneft’s debt, due to be refinanced or settled this year, can now be covered.
Transneft will use part of the money to complete the first stage of its East Siberian Pacific Ocean (ESPO) pipeline for overland oil shipments to China, via Skorovodino to Daqing, due to start next year; and to extend the second stage of the ESPO pipeline to Kozmino Bay with additional capacity to ship up to 1 million barrels per day (50 million tonnes per annum). Transneft was saying last month that lack of finance would force postponement of commissioning of this new Asian oil outlet until 2013.
China's undertaking means that new Russian oilfields, such as Rosneft's Vankor field in central Siberia, will move oil eastwards to Asian markets, rather than westwards to Europe. This geostrategic shift of Russian energy flow has been a Chinese objective for years. Last week's signing defeats a similar objective pursued by the Japanese government, which has also been lobbying the Kremlin with promises of financing for the ESPO pipeline to the sea.
John Helmer has been a Moscow-based correspondent since 1989, specializing in the coverage of Russian business.
According to the announcement from Beijing last Tuesday, where Deputy Prime Ministers Wang Qishan and Igor Sechin were meeting, China and Russia have finally agreed on terms for a China Development Bank loan of US$25 billion to Russian state oil exporter Rosneft and pipeline company Transneft to finance crude oil shipments over a 20-year period of not less than 241,000
barrels per day (15 million tonnes per annum).
The fine-print of the financing and oil-supply deals have not been released. However, the availability of $15 billion in 10-year finance for Rosneft and $10 billion to Transneft at a sub-market interest rate of around 6% will guarantee China's priority for East Siberian crude oil deliveries for the foreseeable future.
The loan and oil-supply agreements implement the inter-government memorandum of understanding signed more than three months ago, on October 29, 2008. They are the second major initiative between Beijing and Moscow, following the Chinese financing in 2004 for Rosneft's acquisition of Yuganskneftegaz in exchange for delivery of 48.4 million tonnes (194,000 barrels per day) between 2005 and 2010.
For China in the medium to long term, according to one Russian bank, the new deal will "provide an impetus to massive development of Eastern Siberia" from which China is best placed to benefit. "We believe that two options are possible: greater [Chinese] access to the East Siberian fields (currently two upstream projects via a joint venture with Rosneft) and the potential transformation of East Siberian Pacific Ocean pipeline network into a joint stock company, with China getting 49% or 50% control in it."
If the latter materializes, that would give Beijing a control stake in an oil port to be built at Kozmino Bay, near Nakhodka, on the Sea of Japan.
Reporting the loan as one of the largest in Russian credit history, a Moscow newspaper speculated that in financing the new Russian oil source, "China will reduce its dependence on deliveries of oil from the Persian Gulf, which currently comprise about 80% of China's oil imports."
The enormous size of the loan also adds to the strategic influence Beijing will have on the development of the Russian economy in the short term. According to Victor Mishnyakov, oil analyst at Uralsib Bank in Moscow, "We think that the development should offer support for the rouble and underlines our expectations that the devaluation of the rouble is over if crude prices remain at their current level throughout the year."
Troika Dialog Bank analyst Yevgeny Gavrilenkov reported, "For the balance of payments, this is really positive news," while Mikhail Galkin of MDM Bank commented that it was "a super-favorable loan for Russia".
At least $9 billion of Rosneft’s debt, due to be refinanced or settled this year, can now be covered.
Transneft will use part of the money to complete the first stage of its East Siberian Pacific Ocean (ESPO) pipeline for overland oil shipments to China, via Skorovodino to Daqing, due to start next year; and to extend the second stage of the ESPO pipeline to Kozmino Bay with additional capacity to ship up to 1 million barrels per day (50 million tonnes per annum). Transneft was saying last month that lack of finance would force postponement of commissioning of this new Asian oil outlet until 2013.
China's undertaking means that new Russian oilfields, such as Rosneft's Vankor field in central Siberia, will move oil eastwards to Asian markets, rather than westwards to Europe. This geostrategic shift of Russian energy flow has been a Chinese objective for years. Last week's signing defeats a similar objective pursued by the Japanese government, which has also been lobbying the Kremlin with promises of financing for the ESPO pipeline to the sea.
John Helmer has been a Moscow-based correspondent since 1989, specializing in the coverage of Russian business.
3 February 2009
Russia in outer darkness
By John Helmer
MOSCOW - In outer space, as everyone knows, the absence of the force of gravity produces the appearance of weightlessness. Everything floats away.
The markets have decided that Russia is now without gravity; its equities are without weight, and at risk of floating away. Late last year, the RTS, the principal stock market index, starting decoupling from the price of the principal Russian export, oil, as the latter started to plummet. The emerging market investment funds, which have also moved with oil and Russia's other exportable commodities, also decoupled from commodity prices and the RTS.
Since the start of January, the RTS and the oil marker have been
in negative correlation. That means that even if the oil price goes up, Russian share prices go down. This is the equivalent of outer space.
It is no surprise, therefore, that everyone in the Russian market is gasping for an oxygen mask and a safety belt.
President Dmitry Medvedev and Prime Minister Vladimir Putin believe they are the constitutionally elected heads of government and imagine their government is the air supply and safety-belt of the state. Those officials aligned with them - Deputy Prime Minister Igor Shuvalov with Medvedev, Deputy Prime Minister Igor Sechin with Putin - like to think that, although elected by no one to nothing, they too are the safety belts, and pilots, of the state. Watch them closely - the more carefully Shuvalov brushes at his coiffure and Sechin draws his face into a scowl, the more you can be certain they think they are in charge of Russia's mass, motion, weight, air supply.
Without a banking and state audit system accountable to parliament, without a parliament accountable to the voters, and with regional governors and mayors appointed, not elected, where else can the force of gravity be located? If not with them, then all of Russia has indeed decoupled, and equity is in danger of valuelessness.
That is what these oscillating lines on the dials of the national control-panel mean:
In fact, once decoupling commences, there is no telling what the control-panel indicates for Russia's pilot enterprises - the dominant exporters and producers of value, such as Gazprom (gas and oil), Rosneft (oil), Norilsk Nickel (nickel, copper platinum group metals), Rusal (aluminum), Evraz (steel), Metalloinvest (iron ore), Polyus (gold), Uralkali (potash). That is because their public reports do not reveal the full extent of their debt; their shareholder stakes, pledges, and obligations; their margins; cashflow, and free cash; the ownership of their assets; their future.
Brokerage analysts, who try to measure these indicators, and issue buy/sell recommendations to the investment market, are now, more than ever, navigating by their own book - and shooting in the dark.
So are the principal enterprise owners and stakeholders, the so-called oligarchs. Each of them has now proposed to each of the senior government officials a plan calculated to cancel or refinance his debts with state money but leave him in just as much control as before. This is the reason the market has been confused by as many state takeover or consolidation plans as there are oligarchs with billion-dollar obligations they can't meet.
The evidence available from documents and inside sources close to the oligarchs themselves raises the following questions, and also answers them.
Why did Vladimir Potanin, controlling shareholder of Norilsk Nickel, place in a Monday morning newspaper on January 12 a scheme for merging Norilsk Nickel with steelmakers Evraz and Mechel, iron-ore miner Metalloinvest, and potash miner Uralkali, and vesting the lot in a new state company, in which Russian Technologies, the arms export-based state holding, would hold a 25% stake?
There can be no claim of stakeholder and management coordination, or raw material supply and production cost synergies, because Potanin didn't consult the others, or come up with an integrated value scheme. The simple driver of Potanin's plan was to create so much debt for the state to absorb, that he and the Norilsk Nickel group would be left to retain control of itself, and reduce the state shareholding in the scheme to 25%. The controlling stakeholders of the companies Potanin proposed to merge into the new state company have subsequently issued their refusals to go along. Each has his own plan.
Why did Oleg Deripaska, in a letter to Medvedev on January 20, invite the Kremlin to accept a US$45 billion valuation for Rusal, and issue $6 billion in state loans to cover part of Rusal's debt, in return for an issue of 15% non-voting shares in Rusal, and a promise to pay the state dividends - if and when aluminum prices rise enough for Rusal to declare a profit? Again, the answer is that Deripaska wants a bailout with minimum loss of control for himself.
Asked why the Norilsk Nickel consolidation plan didn't have room for Deripaska's Rusal, Norilsk Nickel's chief executive, Vladimir Strzhalkovsky, has responded that he isn't seeking a merger with Rusal because the aluminum company has too much debt. As it stands, the proposal from Potanin would pool $28 billion of debt to $60 billion in sales, according to Interros, Potanin's holding company.
Just a little memory is required to see this as a reprise of the very first state bailout, which made Potanin and the other oligarchs what they became and what they are today. In 1995-96 that was called loans-for-shares. It was the scheme by which the state treasury loaned the oligarchs money for cut-price privatization of the control stakes of the natural resource assets they incorporated as their own. Having leveraged these shareholdings in the dozen years that followed, in order to create even larger conglomerates inside Russia and parallel asset empires in safe-havens abroad, and having squirreled away billions of dollars in personal dividends, they have come back to the government with a request to play the same game all over again.
According to one oligarch, he is disappointed to find there is no government where he expects to find it, only bitter rivals at each others' throats. What he means is that it was much easier, and also cheaper, when he had to deal with president Boris Yeltsin.
A lesser known, but oligarch-sized figure, Vyacheslav Kantor, controlling shareholder of Acron, a fertilizer producer and exporter, submitted his plan to Putin and Sechin just before they appeared for an inspection of his Novgorod factory on January 25. Kantor's scheme puts himself in control of a state-financed company that would take over mining licenses Kantor has borrowed to buy and develop, but which he cannot afford any longer. He is asking for a bailout of $700 million of debt, and a credit line from a state bank of up to $2 billion for his mining undertakings. In this Acron scheme, the state equity stake in exchange would be a non-controlling one.
Other schemes that have been tabled at Sechin's office in the mineral fertilizer sector indicate the creation of a state company to consolidate existing state stakes in phosphate and potash companies, and impose a fine on Uralkali, owned by Dmitry Rybolovlev, which would oblige him to give up his stake in his company.
Alisher Usmanov, the controlling shareholder of the Metalloinvest group, said he is opposed to the mega-merger of Potanin, because it under-values his own assets, and dilutes his control. Usmanov said on January 28 that one option he prefers is a scheme of merger between Norilsk Nickel and Metalloinvest without a significant stake stake. Alternatively, to absorb his own debts, he offers a scheme incorporating Metalloinvest, Norilsk Nickel, and steelmaker and coal-miner Mechel, plus diamond-miner Alrosa. Announcing the obvious, Usmanov has said: "If the Russian government would participate in this merger and restructure the debts of the companies everybody would win from it."
A frank admission from one oligarch headquarters: "This global [state] company would be impossible to manage, it is true. But the reasoning here is that this is a measure only for the crisis period. Later, each of the companies would be able to buy back their shares from the state, and separate again."
The presumption of all these plans is that, if and when global demand recovers, commodity prices revive, export revenues grow, share prices pick up, and the international capital markets can accommodate Russian debt financing needs again, the oligarchs would borrow abroad to buy out the state - and resume the same unconstrained control of their enterprises as they enjoyed before all the trouble began. That's a big if; the when may be a long time coming.
Putin has responded ambiguously in a lengthy interview on January 25: "First, there are no final decisions here. Second, what you're speaking about was suggested by the owners of these companies. But you know that if you get two poor people together, it won't be a richer family. So it all depends on the specifics. Where there can be any positive synergy from consolidation - say, when one party has mineral resources, the second has financial possibilities, and the third has access to the markets - it will be in demand. You don't need a lot of brains to combine debts with debts, and it won't bring any results. That's why we'll keep a balanced, careful approach to this problem. Once again, the main goal here is to increase competitiveness."
But the same day Putin also said he favored Kantor and his plan: "The owners of this enterprise [Kantor's Acron] not only keep jobs in quite difficult conditions, they also develop the social sphere. Owners of the enterprise are not poor people. If those who deal with real production also have a feeling of social responsibility, we will support such people."
Then in Davos, on January 28, Putin declared: "Excessive intervention in economic activity and blind faith in the state's omnipotence is another possible mistake. True, the state's increased role in times of crisis is a natural reaction to market regulation setbacks. Instead of streamlining market mechanisms, some are tempted to expand state economic intervention to the greatest possible extent."
"The concentration of surplus assets in the hands of the state is a negative aspect of anti-crisis measures in virtually every nation. In the 20th century, the Soviet Union made the state's role absolute. In the long run, this made the Soviet economy totally uncompetitive. This lesson cost us dearly, and I am sure nobody wants to see it repeated. Nor should we turn a blind eye to the fact that the spirit of free enterprise, including the principle of personal responsibility of businesspeople, investors and shareholders for their decisions, has been eroded in the last few months. There is no reason to believe that we can achieve better results by shifting responsibility onto the state."
As clear as this looks, its application is anything but. Hence, the dislocation between what Russians say, and what the market does.
Sechin has been quoted by Interfax as saying that the decision on the consolidation plans is up to the shareholders. If that were believable, Rybolovlev of Uralkali would be relieved that he will be deciding the future of the potash miner, not Sechin. But at Uralkali headquarters in Moscow, and in Geneva where Rybolovlev is based, it is the state shareholder, and Sechin's fiat, which are expected to decide. This is why Uralkali's share price is at a substantial discount to its peers, at home and abroad; and why its downward trajectory is disconnected from the potash commodity price.
Deputy Prime Minister Shuvalov has said: "We see that many enterprises that we work with, and their shareholders, have started to feel that the state will save them no matter what. Against this background, they have begun to think ... that the state will help them no matter, help them to refinance their foreign debts and give them special programs to buy their production. We have nothing like this in our plans. Just because the enterprise is important and has several tens of thousands of workers, we do not simply intend to give out resources and wait for them to come for more later. The shareholders and heads of these enterprises must for themselves look at their own personal responsibility."
Those oligarchs who are uncomfortable with state takeover risk, and think they can refinance from the same international banks, to which they are already mortgaged, are now trying to escape.
One of them, Igor Zyuzin, owner of Mechel, is well aware that he's on others' hit-lists. He and Alexei Mordashov, controlling shareholder of steelmaker Severstal, are reported by bank analysts and industry sources as having decided to pull back last month's applications for state bank loans. Since they don't admit to lodging their application; the state bank won't say if applications have been lodged; and no one will acknowledge whether the state bank said yes or no to Zyuzin and Mordashov, there is no way of gauging whether Zyuzin and Mordashov are today more or less desperate. The international markets are in two minds - Severstal's share price is up 10% over the past four weeks; Mechel's is down 21%.
If Putin means what he was saying in Davos, this is exactly what should be happening for the greater benefit of all. "The constant temptation of nestling close to the sources of state well-being is perfectly understandable," the prime minister told the Davos audience. "But at the same time, these sources are not inexhaustible, nor are they cure-alls."
But Putin will not return to Moscow to tell parliament which of the oligarch enterprises will be saved by state financial guarantees, budget funds, or state bank cash. Nor will state auditors and valuers be allowed to testify to parliament on the terms of the new round of loans-for-shares. These are state secrets. And the funny thing about state secrets is that in the marketplace, outside the state, they perform like heavily discounted promissory notes.
In due course, the market will get Putin's message from the enterprise shareholders. It will discount the value of what they say.
In the meantime, the market will apply the outer-space discount. That deals with the risk of not being able to anticipate anything at all. Uncertainty and fear are now making Russian assets worth less than they were during the last two national crises - in 1991, when the Soviet system collapsed; and in 1998, when the Treasury and the banking system defaulted.
John Helmer has been a Moscow-based correspondent since 1989, specializing in the coverage of Russian business.
MOSCOW - In outer space, as everyone knows, the absence of the force of gravity produces the appearance of weightlessness. Everything floats away.
The markets have decided that Russia is now without gravity; its equities are without weight, and at risk of floating away. Late last year, the RTS, the principal stock market index, starting decoupling from the price of the principal Russian export, oil, as the latter started to plummet. The emerging market investment funds, which have also moved with oil and Russia's other exportable commodities, also decoupled from commodity prices and the RTS.
Since the start of January, the RTS and the oil marker have been
in negative correlation. That means that even if the oil price goes up, Russian share prices go down. This is the equivalent of outer space.
It is no surprise, therefore, that everyone in the Russian market is gasping for an oxygen mask and a safety belt.
President Dmitry Medvedev and Prime Minister Vladimir Putin believe they are the constitutionally elected heads of government and imagine their government is the air supply and safety-belt of the state. Those officials aligned with them - Deputy Prime Minister Igor Shuvalov with Medvedev, Deputy Prime Minister Igor Sechin with Putin - like to think that, although elected by no one to nothing, they too are the safety belts, and pilots, of the state. Watch them closely - the more carefully Shuvalov brushes at his coiffure and Sechin draws his face into a scowl, the more you can be certain they think they are in charge of Russia's mass, motion, weight, air supply.
Without a banking and state audit system accountable to parliament, without a parliament accountable to the voters, and with regional governors and mayors appointed, not elected, where else can the force of gravity be located? If not with them, then all of Russia has indeed decoupled, and equity is in danger of valuelessness.
That is what these oscillating lines on the dials of the national control-panel mean:
In fact, once decoupling commences, there is no telling what the control-panel indicates for Russia's pilot enterprises - the dominant exporters and producers of value, such as Gazprom (gas and oil), Rosneft (oil), Norilsk Nickel (nickel, copper platinum group metals), Rusal (aluminum), Evraz (steel), Metalloinvest (iron ore), Polyus (gold), Uralkali (potash). That is because their public reports do not reveal the full extent of their debt; their shareholder stakes, pledges, and obligations; their margins; cashflow, and free cash; the ownership of their assets; their future.
Brokerage analysts, who try to measure these indicators, and issue buy/sell recommendations to the investment market, are now, more than ever, navigating by their own book - and shooting in the dark.
So are the principal enterprise owners and stakeholders, the so-called oligarchs. Each of them has now proposed to each of the senior government officials a plan calculated to cancel or refinance his debts with state money but leave him in just as much control as before. This is the reason the market has been confused by as many state takeover or consolidation plans as there are oligarchs with billion-dollar obligations they can't meet.
The evidence available from documents and inside sources close to the oligarchs themselves raises the following questions, and also answers them.
Why did Vladimir Potanin, controlling shareholder of Norilsk Nickel, place in a Monday morning newspaper on January 12 a scheme for merging Norilsk Nickel with steelmakers Evraz and Mechel, iron-ore miner Metalloinvest, and potash miner Uralkali, and vesting the lot in a new state company, in which Russian Technologies, the arms export-based state holding, would hold a 25% stake?
There can be no claim of stakeholder and management coordination, or raw material supply and production cost synergies, because Potanin didn't consult the others, or come up with an integrated value scheme. The simple driver of Potanin's plan was to create so much debt for the state to absorb, that he and the Norilsk Nickel group would be left to retain control of itself, and reduce the state shareholding in the scheme to 25%. The controlling stakeholders of the companies Potanin proposed to merge into the new state company have subsequently issued their refusals to go along. Each has his own plan.
Why did Oleg Deripaska, in a letter to Medvedev on January 20, invite the Kremlin to accept a US$45 billion valuation for Rusal, and issue $6 billion in state loans to cover part of Rusal's debt, in return for an issue of 15% non-voting shares in Rusal, and a promise to pay the state dividends - if and when aluminum prices rise enough for Rusal to declare a profit? Again, the answer is that Deripaska wants a bailout with minimum loss of control for himself.
Asked why the Norilsk Nickel consolidation plan didn't have room for Deripaska's Rusal, Norilsk Nickel's chief executive, Vladimir Strzhalkovsky, has responded that he isn't seeking a merger with Rusal because the aluminum company has too much debt. As it stands, the proposal from Potanin would pool $28 billion of debt to $60 billion in sales, according to Interros, Potanin's holding company.
Just a little memory is required to see this as a reprise of the very first state bailout, which made Potanin and the other oligarchs what they became and what they are today. In 1995-96 that was called loans-for-shares. It was the scheme by which the state treasury loaned the oligarchs money for cut-price privatization of the control stakes of the natural resource assets they incorporated as their own. Having leveraged these shareholdings in the dozen years that followed, in order to create even larger conglomerates inside Russia and parallel asset empires in safe-havens abroad, and having squirreled away billions of dollars in personal dividends, they have come back to the government with a request to play the same game all over again.
According to one oligarch, he is disappointed to find there is no government where he expects to find it, only bitter rivals at each others' throats. What he means is that it was much easier, and also cheaper, when he had to deal with president Boris Yeltsin.
A lesser known, but oligarch-sized figure, Vyacheslav Kantor, controlling shareholder of Acron, a fertilizer producer and exporter, submitted his plan to Putin and Sechin just before they appeared for an inspection of his Novgorod factory on January 25. Kantor's scheme puts himself in control of a state-financed company that would take over mining licenses Kantor has borrowed to buy and develop, but which he cannot afford any longer. He is asking for a bailout of $700 million of debt, and a credit line from a state bank of up to $2 billion for his mining undertakings. In this Acron scheme, the state equity stake in exchange would be a non-controlling one.
Other schemes that have been tabled at Sechin's office in the mineral fertilizer sector indicate the creation of a state company to consolidate existing state stakes in phosphate and potash companies, and impose a fine on Uralkali, owned by Dmitry Rybolovlev, which would oblige him to give up his stake in his company.
Alisher Usmanov, the controlling shareholder of the Metalloinvest group, said he is opposed to the mega-merger of Potanin, because it under-values his own assets, and dilutes his control. Usmanov said on January 28 that one option he prefers is a scheme of merger between Norilsk Nickel and Metalloinvest without a significant stake stake. Alternatively, to absorb his own debts, he offers a scheme incorporating Metalloinvest, Norilsk Nickel, and steelmaker and coal-miner Mechel, plus diamond-miner Alrosa. Announcing the obvious, Usmanov has said: "If the Russian government would participate in this merger and restructure the debts of the companies everybody would win from it."
A frank admission from one oligarch headquarters: "This global [state] company would be impossible to manage, it is true. But the reasoning here is that this is a measure only for the crisis period. Later, each of the companies would be able to buy back their shares from the state, and separate again."
The presumption of all these plans is that, if and when global demand recovers, commodity prices revive, export revenues grow, share prices pick up, and the international capital markets can accommodate Russian debt financing needs again, the oligarchs would borrow abroad to buy out the state - and resume the same unconstrained control of their enterprises as they enjoyed before all the trouble began. That's a big if; the when may be a long time coming.
Putin has responded ambiguously in a lengthy interview on January 25: "First, there are no final decisions here. Second, what you're speaking about was suggested by the owners of these companies. But you know that if you get two poor people together, it won't be a richer family. So it all depends on the specifics. Where there can be any positive synergy from consolidation - say, when one party has mineral resources, the second has financial possibilities, and the third has access to the markets - it will be in demand. You don't need a lot of brains to combine debts with debts, and it won't bring any results. That's why we'll keep a balanced, careful approach to this problem. Once again, the main goal here is to increase competitiveness."
But the same day Putin also said he favored Kantor and his plan: "The owners of this enterprise [Kantor's Acron] not only keep jobs in quite difficult conditions, they also develop the social sphere. Owners of the enterprise are not poor people. If those who deal with real production also have a feeling of social responsibility, we will support such people."
Then in Davos, on January 28, Putin declared: "Excessive intervention in economic activity and blind faith in the state's omnipotence is another possible mistake. True, the state's increased role in times of crisis is a natural reaction to market regulation setbacks. Instead of streamlining market mechanisms, some are tempted to expand state economic intervention to the greatest possible extent."
"The concentration of surplus assets in the hands of the state is a negative aspect of anti-crisis measures in virtually every nation. In the 20th century, the Soviet Union made the state's role absolute. In the long run, this made the Soviet economy totally uncompetitive. This lesson cost us dearly, and I am sure nobody wants to see it repeated. Nor should we turn a blind eye to the fact that the spirit of free enterprise, including the principle of personal responsibility of businesspeople, investors and shareholders for their decisions, has been eroded in the last few months. There is no reason to believe that we can achieve better results by shifting responsibility onto the state."
As clear as this looks, its application is anything but. Hence, the dislocation between what Russians say, and what the market does.
Sechin has been quoted by Interfax as saying that the decision on the consolidation plans is up to the shareholders. If that were believable, Rybolovlev of Uralkali would be relieved that he will be deciding the future of the potash miner, not Sechin. But at Uralkali headquarters in Moscow, and in Geneva where Rybolovlev is based, it is the state shareholder, and Sechin's fiat, which are expected to decide. This is why Uralkali's share price is at a substantial discount to its peers, at home and abroad; and why its downward trajectory is disconnected from the potash commodity price.
Deputy Prime Minister Shuvalov has said: "We see that many enterprises that we work with, and their shareholders, have started to feel that the state will save them no matter what. Against this background, they have begun to think ... that the state will help them no matter, help them to refinance their foreign debts and give them special programs to buy their production. We have nothing like this in our plans. Just because the enterprise is important and has several tens of thousands of workers, we do not simply intend to give out resources and wait for them to come for more later. The shareholders and heads of these enterprises must for themselves look at their own personal responsibility."
Those oligarchs who are uncomfortable with state takeover risk, and think they can refinance from the same international banks, to which they are already mortgaged, are now trying to escape.
One of them, Igor Zyuzin, owner of Mechel, is well aware that he's on others' hit-lists. He and Alexei Mordashov, controlling shareholder of steelmaker Severstal, are reported by bank analysts and industry sources as having decided to pull back last month's applications for state bank loans. Since they don't admit to lodging their application; the state bank won't say if applications have been lodged; and no one will acknowledge whether the state bank said yes or no to Zyuzin and Mordashov, there is no way of gauging whether Zyuzin and Mordashov are today more or less desperate. The international markets are in two minds - Severstal's share price is up 10% over the past four weeks; Mechel's is down 21%.
If Putin means what he was saying in Davos, this is exactly what should be happening for the greater benefit of all. "The constant temptation of nestling close to the sources of state well-being is perfectly understandable," the prime minister told the Davos audience. "But at the same time, these sources are not inexhaustible, nor are they cure-alls."
But Putin will not return to Moscow to tell parliament which of the oligarch enterprises will be saved by state financial guarantees, budget funds, or state bank cash. Nor will state auditors and valuers be allowed to testify to parliament on the terms of the new round of loans-for-shares. These are state secrets. And the funny thing about state secrets is that in the marketplace, outside the state, they perform like heavily discounted promissory notes.
In due course, the market will get Putin's message from the enterprise shareholders. It will discount the value of what they say.
In the meantime, the market will apply the outer-space discount. That deals with the risk of not being able to anticipate anything at all. Uncertainty and fear are now making Russian assets worth less than they were during the last two national crises - in 1991, when the Soviet system collapsed; and in 1998, when the Treasury and the banking system defaulted.
John Helmer has been a Moscow-based correspondent since 1989, specializing in the coverage of Russian business.
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