Flaws in Russia’s banking system have been exposed by a mini-crisis in May, which forced several retail banks to fold and bond prices on the sector to nosedive. But will banking reforms be enough to rebuild investor confidence? Simon Pirani reports
While investors tend to have short collective memories and emerging market investors have perhaps the shortest, no one has forgotten that six years ago last month, Russia defaulted on $44 billion worth of rouble-denominated bonds. So the recent sight of queues of customers waiting patiently to withdraw their savings from some of Russia’s largest privately owned retail banks understandably caused some concern among investors. In the space of a week – July 12 to 19 – spreads on privately owned bank bonds widened by between 70bp and 200bp; spreads on Russian corporate bonds also widened, but by much less – 30bp to 60bp.
The banking sector’s mini-crisis began in May, when the Central Bank withdrew the licence of Sodbiznesbank (about the hundredth-largest Russian bank by total assets) on the grounds of suspected money laundering. A spate of rumours, including tales of a bank blacklist, emerged. This prompted a run on deposits at some banks, including Credittrustbank, which has shared ownership with Sodbiznesbank. Three more banks, including Dialog-Optim (fifty-fourth largest), went under. Banks’ confidence in other banks evaporated and, for several days in June, so did interbank lending.
The crisis reached its peak in early July as lines of depositors wanting to withdraw their savings formed outside banks. Alfa Bank, the country’s fourth largest bank and the largest privately owned, came out fighting, blaming business enemies for circulating false rumours and underlining that it had sufficient assets to cover all retail withdrawals. Its owners injected several hundred million dollars of their own cash.
On July 7, Central Bank chairman Sergei Ignatiev acted to ease the liquidity problems by cutting the amount of deposits retail banks are required to keep as reserves from 7% to 3.5%, injecting an estimated $5 billion into the banking system. He also announced a Central Bank-supported takeover of a failing bank, Guta Bank (twenty-second largest) by Vneshtorgbank and made it clear that the authorities had no issues with Alfa, MDM or Rosbank.
The market welcomed Ignatiev’s firm action and by the end of July the dip in private banks’ bond prices had been reversed. Commentators were unanimous that this was a crisis of confidence and liquidity, but not a repeat of the August 1998 crash. Then, Russia was still mired in the biggest peace-time slump anywhere, ever; now its economy is growing steadily. Then, it had minimal foreign exchange reserves of $7.8 billion; now it has $88.3 billion. Then, it had a seriously mispriced currency and a bloated speculative market in Treasury bonds and currency forwards; now it is praised by international institutions for good fiscal management.
Marat Djafarov, emerging markets corporate strategy at Dresdner Kleinwort Wasserstein, says: “This was not a typical banking crisis caused by a serious economic downturn or a movement in forex rates. This was a crisis of confidence.”
But the shudder revealed the depth of underlying, and still unresolved, problems within the banking sector, such as the heavy reliance of small and medium-sized banks on the interbank market, the maturity mismatch of assets and liabilities, and the fact that many of the 1,300 institutions remain little more than ‘pocket banks’ for industrial groups.
The fact that a mini-crisis could happen when macroeconomic factors are so positive was perceived as a sign that reforms are overdue – not only the introduction of deposit insurance, which is due to start from March next year, but also stronger banking supervision, a reduction in the number of banks and greater competition to help end the near-monopoly domination of the retail market by Sberbank.
Most investors have confidence in Ignatiev’s reformist team at the Central Bank, but change is painfully slow: standards for owners remain low and loopholes in the law allow ownership to be concealed; minimum capital requirements of €5 million are only being imposed on new banks this year, and on existing banks only by 2010; likewise the move to international accounting standards is under way, but slowly; and there are no clear legal mechanisms for dealing with failed banks.
The banking sector problems have also revealed the conflicting interests and approaches from different sections of government that are part of the Russian dilemma. Djafarov at Dresdner points out: “The government has emphasised economic growth as the main goal. For its part, the Central Bank is committed to reform, but you cannot consolidate the banks and take on the powerful business interests involved without detracting from the aim of growing the economy. We now expect the banking reform to be deprioritised.”
Further delay there is worrying, say analysts at Fitch. They cite banking sector problems including weak regulation, connected lending, conflicts of interest over state-owned banks, transparency and dollarisation as “a significant sovereign rating weakness”.
Most observers believe that change will take years rather than months, and that further banking crises are therefore possible, although they will certainly not result in a systemic crisis involving government finances, as they did in 1998. The state-owned banks, which actually benefited from this year’s shudder, as depositors shifted funds to them, are in no significant danger. As for the private banks, the pugnacious response by the largest, Alfa – whose bonds as of early August were trading in the same range as they were before the mini-crisis – shows that they too are far more resilient than those that dominated in 1998. Peter Botoucharov, head of emerging markets strategy at Commerzbank in London, says: “The events in the banking sector can ultimately be seen as a positive mid-term trend, as they will lead to banking sector consolidation.” Investor sentiment towards both banking and corporate bonds is cautious due to the Yukos affair, but remains strong, he points out.
Yukos in the firing line
And as if a mini-banking crisis weren’t enough to dampen investors’ enthusiasm for Russia, at the same time the Russian government has demanded Yukos, an oil company that is Russia’s largest company, pay $6.78 billion (€5.63 billion) in unpaid taxes, which could force the firm into bankruptcy.
The combination of anti-Yukos government policies and uncertainty over the domestic banking sector has as yet not produced a major upset in Russian capital markets but there have been subtle reactions. A survey by the Ministry for Economic Development published last month registered a net outflow in private-sector capital of $5.5 billion in the first half of this year: in the second half of last year there was a $3.8 billion inflow. Last year was the first time Russia had experienced a net inflow of capital since communism fell in 1991 – the trend has quickly returned to large-scale capital flight.
That is perhaps the most important negative impact of the attack on Yukos, which has put a question mark over property rights and damaged the most successful oil producer. But it also means that Russia’s confirmation by Fitch and S&P as an investment-grade borrower is unlikely any time soon. Moody’s upgraded Russia to its lowest investment grade, Baa3, just before Yukos chief Mikhail Khodorkovsky’s dramatic arrest in October last year, but S&P and Fitch, who have been increasingly critical of the government’s handling of the Yukos affair, are not expected to follow until the middle of 2005 at the earliest. Ingrid Iversen, who runs Insight Investment’s emerging market portfolio, says: “In that sense Russia’s performance is capped a bit.”
Even so, buyers of Russia’s bonds do not yet seem excessively concerned. Even those more conservative-minded investors such as Joe Biernat, head of research at European Capital Management, are not completely avoiding Russia. “We approach Russia with caution, and basically only involve ourselves with sovereign and quasi-sovereign investments,” he says. “We would see other Russian paper only as a trading play, not as a ‘buy and hold’.”
This mentality was reflected in the fact that bonds from state-owned banks such as Sberbank and Vneshtorgbank suffered very little from the mini-crisis. In the critical week when bank bond prices fell by between 2% and 4.5%, Sberbank bond prices fell by 0.6% and Vneshtorgbank bond prices by 0.42%; their spreads widened by 37bp and 14bp respectively, compared with widening of between 70bp and 200bp across the sector as a whole. And as the scare receded, Vneshtorgbank was able to launch a $300 million three-year bond, with a spread of 266bp over US Treasuries.
Other bondholders are even more upbeat. According to Insight’s Iversen: “The market is in good shape technically and sovereign paper is robust.” And Anton Simon, head of high yield at Putnam Investments in London, whose career included a spell on the board of Alfa Bank, says: “Russia is only going one way: forward, making use of its incomparable natural and intellectual resources. That’s a reason to hang on to the sovereign debt. In the medium and long run, the government needs Russian entrepreneurs of all kinds, but in the short term it will obsess about showing them who’s boss. That’s reality; that’s something the market has to live with.”
Impact on bond issuance
Nevertheless, investors’ caution has had a negative effect on corporate bond issues: base metals producer Norilsk Nickel has been postponing plans for a debut bond all year. In July, steel-maker Evrazholding scaled back its Eurobond issue to $150 million from $200-300 million. And in June, telecoms operator Vimpelcom reduced the size of its bond to $250 million from $500 million.
Successful corporate bonds have been getting done but they show investors’ tendency to prefer state-owned companies and deals with some kind of collateral. This was epitomised by a $1.25 billion 2020 bond from Gazprom, a state-owned gas monopoly. The sinking fund bond, arranged by Morgan Stanley and ABN Amro, was actually a securitisation of export receivables. An offshore repayment structure made it possible for the rating to pierce the sovereign ceiling – BBB- ratings from both Standard & Poor’s and Fitch Ratings. In mid-August Gazprom’s new bond was yielding slightly less than the comparable Russian bond maturing in 2018: 7.42% compared with 7.66%. And though the bond fell to slightly less than par in the secondary market – 98.75 in mid-August – traders believe that was due to short-term liquidity issues.
In addition, on July 1 the market was flooded with €5 billion of what amounts to Russian bonds when Germany used a credit-linked note (CLN) structure to offload some of the money it is owed by the Russian government under its Paris Club obligations. The Russian authorities were less than ecstatic about the move given that it may inhibit a sovereign issue planned for next year. What’s more the issue, named Aries, was priced wider than Russia’s existing debt: the $2.44 billion 10-year tranche was priced to yield 9.6%. In comparison, Russia’s 2011 yields 7.7% and the benchmark Russia 30-year bond yields 8%.
As a result, according to Paul Timmons, economist at Moscow Narodny Bank, the deal initially “spooked the market”. The spread between Aries 2014 and Russia 2030 was 180bp at issue but due to a combination of tightening in the CLN and widening in the ordinary sovereign bonds the difference quickly fell to nearly half that level, 92, and has traded in a range of 85 to 105 since.
As Iversen at Insight points out: “The Aries issue was a substantial extra supply that very few countries’ debt could have withstood.” Although she adds that Russia has proved more resilient to the extra supply than other emerging markets would have been “because its paper is perceived as superior”. But there is concern that Russia’s ability to issue its own debt could be hampered if Germany, to which Russia owes $18.5 billion, returns to the market after a six-month lock-in, or if other bilateral creditors follow Germany’s lead. According to analysts the most likely would be France, given that its budget deficit is close to the limits allowed by the European Union and that it is owed €3 billion by Russia.
Long-term, the Yukos factor casts a shadow over the Russian economy: JPMorgan forecasts that underlying GDP growth will fall from the current 7.5% to about half that level as both local entrepreneurs and foreign investors grow nervous. On the other hand, Russia’s superb economic and financial fundamentals – far outstripping anything that could have been dreamed of in the aftermath of the 1998 crisis – means that its sovereign bonds especially are good value.
Strategists and traders believe that the benchmark Russia 2030 sovereign, which has been trading at spreads of 330-350bp over US Treasuries, could justifiably tighten to below the 300 mark. Timmons at Moscow Narodny says: “Some of the crossover funds that came into Russian debt last year from Latin American and Turkish bonds have gone back into Turkey on positive news from there. But I see no reason why they shouldn’t come back.”
A trader on the EM desk of a major bank agrees: “In emerging market, hard-currency debt, Russia remains the best. It has withstood the rush of extra supply from Aries, the banking sector crisis, Yukos, and S&P’s comments that it will not upgrade this year. The market has priced out the prospect of further investment-grade ratings this year, and the Russia 30 should tighten from its present level.”
Sovereign and quasi-sovereign Russian bonds, then, remain among the best that emerging markets can offer. Corporate and bank bonds are most affected by the banking sector crisis and the Yukos affair – although both are probably priced in by now. And the breakthrough to investment grade by the Gazprom securitisation bond is a reminder that Russia may soon have much to offer wider classes of investors.
This article appeared in Credit magazine, September 2004.
Posted November 2004; © 2004 Simon Pirani