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#15 - JRL 7221
From: Ben Aris <benaris@online.ru>
Date: Fri, 13 Jun 2003 11:16:28 +0400
Subject: [RusBizList] RBL624 -- June 13

Russia Business List
Friday, June 13, 2003

Eric Kraus
"History does not repeat itself historians repeat themselves!"
A.J.P. Taylor

A cat was recently let loose amongst the pigeons by the head of one well-known Russian investment bank who provocatively evoked the bubble-phase of Russian capitalism, suggesting that we could be in for a repeat of the boom-bust. Bollocks! we say T&B is, secretly, delighted. Having had little choice but to agree with the boringly bullish consensus of late, at last we have another windmill to tilt at! Not that we would argue the fact that valuations on a fair number of local assets have become, to put it mildly, challenging. What we disagree on are the implications: T&B would like to reassure our readers that the current Russian economic context is no more a repeat of the 97 boom/bust cycle than it is of the 16th Century sack of Novgorod!

Asset prices have a way of overshooting; Russia is certainly not unique in this respect. We currently see a great deal of liquidity chasing a rather limited pool of assets; as always, this engenders some rather fanciful expectations about potential returns.

Some of these prices will thus correct, a few quite painfully.

Similarly, the only justification for some of the recent ruble debt issuance has been the strongly negative real rates, and some rather dubious banks are now lining up to issue Eurobonds.

Inevitably, there will be some defaults. None of this, however, suggests another crisis waiting in the wings. When people refer to a growing Russian bubble, they are referring to the run up to the great crash of 98, a period fundamentally different from the present bull-market. Examining it in detail:

First, the parallels:

They are obvious: the RTS is currently seeing a major bull run, whilst debt prices have gone ballistic; the bond originators are staking out every substantial Russian company (as well as some rather dodgy banks), and Russia is, once again, becoming the darling of international investors and of those ultimate lagging indicators, the ratings agencies.

Between these superficial similarities, of course, there yawns a gaping chasm: the huge shift in Russian fundamentals.

Then the divergences:

- In the run-up to the crash, largely based upon misapplication of famously bad advice from the IMF, Russian macros were totally unsustainable.

Taxes simply could not be collected, while the resultant government deficits required refinancing at increasingly ruinous rates; massive flight capital outflows greatly outran the relatively modest trade surplus.

Russia is currently alone among its G8 peers in running both (huge) primary and (large) headline budget surpluses. Furthermore, flight capital is rushing home.

- In 1997, GDP had been steadily shrinking for 10 years. Russia essentially produced nothing all (save promissory notes) Russian GDP is seeing its forth year of rude growth, looking to exceed 6% this year, 5 times the growth rate of any other G8 country. Go into any corner store, and the vast majority of products on display are of domestic origin.

- In 1997, huge ruble overvaluation totally distorted the economy. Foreign indebtedness ratios seemed acceptable only due to GDP being hugely overstated by currency overvaluation. Although headline Forex reserve figures seemed adequate, real net reserves may well have been negative.

While the ruble is gradually strengthening, it is still relatively cheap in PPP terms. This revaluation is market-driven, not imposed. The weakening of the dollar against the Euro has maintained competitiveness for import substitution, evinced by the relatively slow growth in imports. By current trends, Russian reserves will soon be adequate to repurchase the entire foreign debt stock!

-The whole wretched edifice was finally brought down by the GKO bubble; any sane person not employed by the IMF should understand that 150% annual real rates were not long sustainable.

Mark Twain remarked that a cat who sat once upon a hot stove would never sit on a hot stove againnor, for that matter, on a cold stove! Burnt once, the Russian finance ministry steadfastly refuses to issue enough debt even to mop up the excess local liquidity, while real ruble rates are strongly negative. The government has sought to avoid accumulating contingent liabilities by prohibiting further Eurobond issuance by stateowned entities (Transneft, etc). Russian companies are hugely underleveraged. A sovereign debt bubble is less likely than snow in June (which, admittedly, Moscow just saw) -In the late 90s. currency overvaluation and the GKO bubble drained the economy of every last ruble; much like the situation in Argentina in the run up to its collapse, barter and countertrade became vital coping mechanisms.

The Russian economy is now run on a cash-cash basis; The Virtual Economy is a creature of the past. Companies are making, showing (and paying dividends upon) real profits.

-In 1997, the run up in asset prices was purely a case of foreigners buying and selling back and forth from each other. The Russians were out of the game.

Much like in the Moscow nightclub scene, we foreigners have become marginal players, welcome to participate, but no longer the rainmakers. Russians now overwhelmingly own their own market.


Is T&B offering a free put on Russian assets? Has Russia come under the direct protection of the Holy Spirit, so that nothing further could go wrong?

Has T&B gone soft in the head?

Nyet! Russia is still Russia, and Russia has a way of surprising even the wariest amongst us. T&B sees no credible disaster scenario, but there are several potential scenarios which could lead to a sharp deceleration in growth, along with a sharp correction in asset prices.

We mention three of them, in the order of the most serious first.

- Putin risk

Much of the spectacular improvement in Russia can be attributed to one man, President Vladimir Putin. Were he to leave the scene for any reason, there would be a sharp increase in political and economic uncertainty. Although there is no obvious successor, we would note that of the various people who could be called to succeed the President, all have a vested interest in the continuation of the current politico-economic framework. Although none has shown evidence of having the political skills of Mr. Putin, none would be likely to upset the apple-cart.

Magnitude: Moderate / Severe Likelihood: Very low, but not readily measurable

- Banking crisis / Credit Crunch

Negative real interest rates are showing their classical effect: misallocation of credit to projects with dubious return. In particular, Russian enterprises are borrowing 3-year rubles via the bond market for projects with a 7+ year payback.

Furthermore, a few of the bond issues strike us as economically irrational, and servicing this debt depends upon the issuer being able to roll it at maturity.

Sooner or later one of the bonds will default. This in itself is no tragedy, indeed, not a week goes by without a couple of bond defaults in America and the EU; risk/reward curves are built upon this. The danger is that, if the default and ensuing bankruptcy is handled badly, this could cause buyers to pull away from the market, leading to a credit crunch and a wave of bond defaults.

Although we have no experience with post-98 bond failures, the historical record for proper workouts of Russian bankruptcies is NOT encouraging.

T&B hopes that it will happen sooner rather than later; this would lead to proper credit differentiation and diminish liquidity-driven borrowing; anyone doubting the danger of excessively low rates need merely look at the current unwind of the American credit bubble. In any event, the absolute magnitude of the Russian bond market is still tiny by comparison with GDP, and thus poses no risk to the entire edifice. Finally, a widening of bond spreads could lead to an upsurge in equity IPOs, currently starved out by very cheap debt finance.

Magnitude: Mild / Moderate Likelihood: Substantial

- Oil at $10

This old scarecrow has been waved at us for the past 4 years; there is little more we can say. Oil is a commodity with a very tightly balanced market and some politically highly unstable producers; it is a fair bet that at least one will be perpetually in crisis. Oil is still historically cheap in real terms.

Asian growth is sucking in increasing amounts of energy, while existing global reserves are being depleted. Furthermore, there is an implicit put option at $15, since with oil much below that price, Saudi Arabia would blow up, seriously disrupting markets. Finally, given the 6-month lag in gas prices, oil would have to fall to some absurdly low valuation, and then remain there for a good 18 months for Russia to feel a serious hit.

Magnitude: Moderate Likelihood: Very low

In summary, T&B sees no suggestion of a repetition of 1996/1998. Many Russian assets are indeed becoming fully valued; before the end of this cycle, many will become substantially more so. This is in the nature of markets. Much as the Internet bubble in America was not itself responsible for the current dire economic situation (it was a symptom of the credit bubble, not the cause), the crash of 1998 was not caused by the overvaluation of assets in 96-97, but rather, by the insane macroeconomic policy subtending it. The system is healthy; caveat emptor for the individual stocks

Goodness what a difference a millennium makes!

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