Barely five years after Russia defaulted on its debt and triggered a global financial crisis, the country’s regulators have a fresh problem on their hands. This time the issue isn’t failure -- it’s success. Too much success.
Awash in oil revenue and a return of flight capital, Russia is experiencing an unprecedented bond market boom. The flood of money has sent interest rates plummeting and driven the ruble up against the dollar. Russian corporate bonds returned 29 percent in dollar terms last year, according to Moscow investment bank Nikoil, beating the 25.7 percent return for the J.P. Morgan emerging-markets bond index.
The rally has spawned a vibrant local corporate bond market where one scarcely existed two years ago. A raft of companies, from state-owned giants like Gazprom to ambitious young growth companies like Joint Fruit Co., the country’s leading fruit importer, have raised about $3 billion over the past year, sometimes at rates well below the level of inflation. Bankers anticipate an additional $5 billion in issuance this year, including the first-ever ruble-denominated bond by the European Bank for Reconstruction and Development.
The fast-growing ruble bond market is the latest, and arguably the most important, measure of Russia’s robust economic health as President Vladimir Putin, reelected by a landslide last month, starts his second term. By recycling windfall oil revenues and oligarch wealth into cheap financing for corporate Russia, the market promises to transform the nation’s economy, fostering businesses outside the natural-
resource sectors.
Ruble bonds also have Moscow bankers licking their chops. “Domestic fixed-income markets are a huge medium-term growth opportunity,” says Stephen Jennings, chief executive of Renaissance Capital, which has been one of the leading underwriters of ruble bonds. “The market we have now is a total infant compared to what we will have in ten years’ time.”
Fulfilling that promise is far from guaranteed, however, as anyone who lived through the boom and bust in Russian government bonds, or GKOs, in the late 1990s can attest. The combination of strong capital inflows and surging oil receipts has led the Central Bank of Russia to consider imposing capital controls later this year in an attempt to prevent either an upsurge in inflation or an uncontrolled rise of the ruble. It’s an unfamiliar challenge for the central bank, which typically has dealt with currency crises of a different sort. It remains to be seen whether the authorities -- with Putin’s second administration headed by a virtually unknown prime minister, Mikhail Fradkov -- can contain the market’s excesses without crippling it.
“We have our own onshore money in Russia,” says Jerome Booth, chief of research for Ashmore Investment Management in London. “But as far as ruble bonds are concerned, we’re waiting and seeing what kind of mechanism the central bank is going to come up with to sterilize capital inflows.”
Poor accounting standards, a lack of reliable credit ratings and complicated corporate holding structures also pose hazards for investors and could quickly turn today’s shining success into a disaster. “The general story of Russia is still quite attractive, but it’s difficult to put money into something when you don’t know who or what it is,’' says a cautious Alexander Branis, a director at Moscow-based Prosperity Capital Management, which runs some $300 million in Russian equities.
An even bigger concern is the narrow investor base that’s fueling the bond market’s growth. The same handful of Moscow banks that are underwriting the recent spate of bond issues are also the biggest buyers. Russian analysts estimate that domestic banks hold a little more than half of the bond market, a potentially worrying echo of the 1990s, when banks funneled cash into government bonds. Hundreds of them went bankrupt when the market collapsed, taking most of Russia’s private savings deposits with them. For banks enjoying an upsurge in deposits but limited lending opportunities, buying bonds makes sense, maybe even at negative real yields, but it leaves Russia’s financial system vulnerable to corporate defaults or a sudden drop in the bond market.
“If the downward trend in interest rates reverses -- and you have to think we’re pretty close to the bottom now, given the substantial negative real yields -- investors and intermediaries in fixed-rate bonds are going to be burned,” says Isabelle Laurent, head of funding for the EBRD in London.
Despite all the potential pitfalls, however, the market shows few signs of slowing down any time soon. “Compared with the mid-1990s, there’s a much greater development of financial institutions in Russia,” says Dmitri Vasiliev, who watched the pre-1998 boom up close as director of Russia’s securities commission and is now head of strategy at Moscow utility Mosenergo. “We have unit trusts and asset management companies, which didn’t exist before. That, and the huge oil money, creates a good opportunity for companies to diversify financing.”
For Russia, such optimism represents a welcome change. After all, it was only five and a half years ago that the Treasury defaulted on $70 billion in GKOs, kicking off a global panic that brought down U.S. hedge fund Long-Term Capital Management and sparked fears of a meltdown in the world financial system.
The country’s financial rehabilitation has been no less dramatic. A combination of geopolitical instability, restraint by OPEC and, in the past year, global economic recovery has kept oil prices firm -- recently rising above $35 a barrel, the highest in more than a decade -- and swelled the country’s coffers. The state budget has been in continuous surplus since 2000, running 1.7 percent ahead of expenditures last year and a projected 1.5 percent in 2004, according to forecasts by Moscow bank Troika Dialog. Foreign debt has shrunk to about 25 percent of gross domestic product from 82 percent in 1999. The economy grew more than 7 percent last year, compared with 4.3 percent in 2002, and is expected to expand by more than 6 percent this year, according to brokers’ projections. Inflation, which ran at 37 percent in 1999, was down to 12 percent last year and is forecast at about the same for 2004.
Potentially more important, but much less quantifiable, is the apparent improvement in business climate. There is a rising expectation that owners will try to make their fortunes by growing, rather than stripping, their enterprises and will observe contractual law in dealing with creditors, investors and customers. BP, which put up $6.75 billion last year for half of Siberia-based Tyumen Oil Co., has led a parade of natural-resource multinationals taking an urgent second look at Russia. Putin’s virtually unopposed reelection, meanwhile, suggests four more years (at least) of stability and gradual reform.
The greatly improved economic climate at home, along with a falling dollar and extremely low interest rates abroad, have combined to reverse capital flight for the first time in post-Soviet history. Some $3.2 billion in Russian money came home last year, according to Moscow investment bank United Financial Group, and that was icing on the cake of a $39 billion current-account surplus. The trend remains intact despite a brief panic after last October’s arrest of Yukos chief executive Mikhail Khodorkovsky. In 1999, the year before Putin was elected president, close to $40 billion -- 10 percent of Russia’s GDP -- fled the country.
As Russian capital looks for productive investments at home, companies and their bond underwriters are only too happy to oblige. The market, which was launched with a 50 million-ruble ($1.75 million) offering for Magnitogorsk Iron & Steel Works at more than 20 percent interest in 2000, has now spread to include some 100 companies, with a total outstanding volume of about $5 billion. Gazprom hit the market with a record 10 billion-ruble, three-year issue in January. Other blue chips, whose only previous option for bond finance was the Eurobond market, are jumping on the bandwagon. Transneft, the state-owned oil pipeline operator, plans to set a new record with a 12 billion-ruble offering later this year. Big hard-currency earners like diamond monopoly Alrosa Co. and steelmaker Severstal are already in the market for about 3 billion rubles each.
“The domestic bond market has become a real source of corporate financing this past year or two,” says Pavel Gourine, chief of investment banking at the Russian office of Austria-based Raiffeisen Bank, which has underwritten $1 billion worth of issues for companies like cell phone operator VimpelCom and Aeroflot Russian Airlines. “Big issuers can use them along with Eurobonds to match their ruble exposure. For smaller companies, the ruble bonds are a door that can lead them toward Eurobonds or foreign syndicated loans.”
Russia’s top exporters still use more foreign than domestic financing, placing $12.5 billion worth of Eurobonds last year alone. “Ruble bonds are often not appropriate for exporters,” says Alan Bigman, chief financial officer at metals producer SUAL Group. “A strengthening ruble hurts profitability of export-oriented companies anyway, and taking out debt in rubles exacerbates this currency exposure.” But the domestic market offers funding to companies whose main revenues are in rubles.
Consider the example of Joint Fruit Co. Like so many of Russia’s young businesses, the ten-year-old St. Petersburg produce dealer had reached the limits of a banking system that offers, at best, one-year loans on onerous terms. “The bank always wants collateral,” says Joint Fruit financial director Julia Zakharova. “And once everything you have is collateralized already, then what?”
So Joint Fruit made its bond market debut last year with a 750 million-ruble offering of two-year bonds bearing 17 percent interest. It is using the proceeds to modernize its warehouse in the southern agribusiness hub of Krasnodar and install a mechanized line for wrapping Ecuadorian bananas and Spanish avocados. Zakharova acknowledges that the bond finance was expensive but says it was important to establish the company in the market. Joint Fruit plans to issue a further 1 billion rubles in three-year bonds at 12 percent this year to finance information technology investments and purchase a fleet of trucks.
Uralsvyazinform, a fixed-line phone monopoly based in the Urals region, issued 3 billion rubles in three-year bonds at 14.5 percent last year; the company is looking to issue an additional 3 billion this year at still lower rates to finance the build-out of its cellular and data networks. The ability to borrow at attractive rates in rubles is vital for Uralsvyazinform’s growth, says Elena Neverova, head of investor relations. “We almost issued a Eurobond before the 1998 crisis, and thank God we didn’t,” she says. “Hard-currency borrowing makes sense for hard-currency earners like oil companies. We get all our revenue in rubles.”
Uralsvyazinform, for example, is given a lowly single-B rating by Standard & Poor’s, yet the company expects to pay only about 12 percent -- equal to Russia’s inflation rate -- on its bond issue this year. Better still, blue-chip Gazprom, which S&P gives a sub-investment-grade rating of double-B-minus, achieved an 8 percent rate on its bond issue. Comparable credits couldn’t dream of raising funds at such relatively low levels in Western markets. In Russia, however, excess liquidity and expectations of further rises in the ruble, which has risen 13 percent against the dollar since the start of 2003, have driven yields down to extraordinarily low levels.
For foreign investors, that means the easy pickings are probably gone. “Yields are low now, so what you’re really talking about is buying into some of the ruble movement,” contends Ashmore Investments’ Booth.
William Browder, the dean of Moscow asset managers who runs $1.5 billion at Hermitage Capital Management, is scathingly critical of Russia’s corporate bond market. “I don’t see how it makes sense to buy 8 percent bonds in a country with 12 percent inflation,” he snaps. “This is just a bet on the ruble by Russians fleeing the dollar and a few foreigners fleeing 1 percent deposit rates in the West. "
Foreign investors aren’t as all-important as they used to be in Russia, though. The buzz phrase in financial Moscow these days is the “de-dollarization” of the economy. To see the potential of this trend, just consider how much money flowed out of Russia in the recent past.
Oligarchs may have stashed as much as $200 billion abroad during the first post-Soviet decade, while ordinary citizens kept another $35 billion in their jam jars, according to investment bank United Financial. Major purchases, from washing machines to apartments, were priced in dollars, or “green” money, while the ruble was disdained as “wooden” in the local slang. That’s hardly surprising, given that post-Soviet hyperinflation reduced the ruble to a low of 6,000 to the dollar. Currency reform in 1996 slashed that rate to six, but the 1998 market default knocked the ruble back down near 30 to the dollar. The West, and particularly the U.S. stock market, seemed a much safer bet at the time.
The bursting of the global technology bubble, which coincided with Putin’s rise to power and a rebound in oil prices, appears to have changed the perceptions of Russia’s monied elite. Capital flight shrank precipitously throughout Putin’s first term before finally reversing last year. “The Nasdaq crash was a great wake-up call for capital flight out of Russia,” says James Fenkner, head of research at Troika Dialog. “I talk to clients every day who tell me, ‘I had my money in Nasdaq, and now I want it back here.’” Troika Dialog currently gets some 60 percent of its order flow from Russian investors, compared with just 10 percent in 1997.
The dollar’s slide in 2003 turned a cautious reconsideration of the ruble into something of a stampede. Not only did capital flight reverse, but even deposits in Russian commercial banks grew by 28 percent last year -- evidence that the general public shares some of the elite’s confidence in the local financial system.
Now the problem is what to do with this newfound liquidity. The ruble’s advance has been kept in check only by the Central Bank of Russia, which, taking a page from the Chinese economic policy handbook, has been aggressively buying dollars to safeguard the country’s competitiveness. Russia’s foreign currency reserves grew by 60 percent last year, to $76.9 billion; the central bank bought up an estimated $8.8 billion in December alone, according to UFG. But those purchases swelled the domestic money supply by a whopping 50 percent in 2003 and threaten to ignite an upsurge of inflation.
Seeking a way out of this dilemma, the central bank is considering imposing controls on foreign portfolio investment. A new law passed by the Duma in December gives the bank power to erect barriers as of this June. “The dynamics of capital flows that we saw in December and January may make implementation of our 2004 monetary policy goals difficult,” Konstantin Korischenko, the central bank’s deputy chairman, said recently. “I am talking about problems that could arise and tools provided by legislation to deal with them.” Meanwhile, Economy Minister German Gref, a key reappointment to Putin’s new cabinet, also has hinted that there will be some form of capital controls.
Many bankers predict that the authorities will impose a requirement that 20 percent of capital inflows from abroad be put on interest-free deposit at the central bank. Such a prospect is chilling what little foreign interest there was in Russian domestic bonds. “The biggest problem for global investors in these instruments is already lack of full convertibility of the ruble,” says Ian Hague, a principal at Firebird Management in New York, which holds Russian equities exclusively through American depositary receipts.
But global players make up less than 5 percent of the ruble bond market, according to Raiffeisen, and Russians who want to repatriate cash are skilled at outsmarting their state’s regulations. So most bankers believe that demand for ruble investments will push the currency up further, whatever the central bank does. “For the first time in all of Russian history, the expectation of devaluation has turned into an expectation of appreciation,” asserts Boris Ginzburg, head of fixed-income research at Nikoil, a Moscow investment bank.
If the central bank doesn’t crimp the bond market boom, a lack of corporate transparency might. Except for the top tier of Russian blue chips that have received ratings from Western agencies, assessing credit risk at the country’s companies is more art than science. “We’re hoping to see some local ratings from S&P this year, but for now investors use their own staff analysis,” says Raiffeisen Bank’s Gourine. The bank claims to be the second-ranked bond underwriter in Russia after Trust Investment Bank (an affiliate of Khodorkovsky’s Yukos), having brought issues from such companies as Aeroflot and VimpelCom.
A recent investor presentation by Nikoil for Inteco, a Moscow construction company looking to raise 1.2 billion rubles for a new cement plant, shows how informal Russian credit assessment can be. Moscow being what it is, the Russian investors understood full well that Inteco’s political connections were probably its most important economic asset. The question was, which connections? “The room was sort of divided into two camps,” recalls Nikoil’s Ginzburg. “One thought the company would be fine as long as [Moscow Mayor Yuri] Luzhkov stayed in office. The other was afraid they’d get caught in the antioligarch climate after Yukos and the rest of it.” In the end, the first camp won out, and Inteco got its money for three years at 10.95 percent.
“Right now we’ve just got liquidity chasing yield,” says Troika Dialog’s Fenkner. “There’s no concern about credit quality.” This point is underscored with unusual candor by Uralsvyazinform’s Neverova. “I hate to be unpatriotic, but I have to say, Russian investors are less professional than foreigners so far. There are fewer demands for information and less analysis.”
Even when politics aren’t an issue, Russian bookkeeping can be. Depreciation schedules, for instance, can be manipulated to alter the bottom line. “Russian accounting statements were designed for reporting to the state planning committee in the old days, and later the tax authority,” Ginzburg says. “They are based on legal form rather than economic essence.”
Accounting is just one of the governance question marks facing investors in Russia’s domestic bond market. The regional phone companies and utilities that are aggressively coming to market are all part of state-controlled holding structures -- Svyazinvest for the telecoms, Unified Energy System for the power generators. These big holding companies are slated for privatization during the next few years. By the time their subsidiaries’ three-year bonds come to maturity, many will likely be controlled by oligarchs. Well-connected financial holdings like Base Element and MDM Financial Group have taken strategic positions in preprivatization utilities, while Alfa Group is the leading contender to buy Svyazinvest. The companies also will remain subject to tariff regulation, so profits could be erased in a stroke if the Kremlin’s mood tacks toward the populist.
The risks of poor transparency are compounded by the bond market’s relatively narrow investor base. By Raiffeisen’s reckoning, a little more than half of the paper is held by domestic banks scrambling to direct their sudden glut of deposits. That fact threatens to magnify the financial impact of any corporate defaults, as banks find their liabilities to depositors matched by worthless or illiquid assets.
But the domestic investor base is growing. Pension funds, insurance companies, asset managers and the big state banks own about 30 percent of the bond market, Raiffeisen estimates, and that share should rise as the institutions gather mass. Top insurer Gosstrakh predicts that it will rake in $1 billion in premiums this year as mandatory coverage kicks in for Russia’s accident-prone drivers, and the company needs to invest this money somewhere. State-owned savings bank Sberbank is also viewed as a potential bond market anchor.
“If the defaults came this year, when Russia’s commercial banks still hold most of the paper, it would be a real crisis,” says Alexander Kudrin, the fixed-income analyst at Troika Dialog. “But that’s unlikely with all the liquidity out there. If we can last until 2006, when Sberbank, Russian institutions and some foreigners are in the market, it won’t be so much of a problem.”
And there are tentative signs that investor demands are forcing companies to improve transparency. Joint Fruit drew 200 investors to its bond presentation in Moscow last year, and the company holds monthly chat-room sessions with investors. “Investors need to know what our goals are and how we are going to repay them,” CFO Zakharova says. “Working on the answers for them also improves the quality of our own management.”
Although some of the 100-plus ruble bond issuers are sure to default and current yields may be taking that risk too lightly, Russian capitalism now has enough of a track record to assume that most borrowers will repay, with enormous potential benefit for the country as a whole. Some of Russia’s wealth may at last be lured into enterprises that create Russian jobs and Russian prosperity rather than evaporate into foreign vaults and villas. Companies that have struggled for a decade or more on the corporate equivalent of mattress money have a shot at funds for expansion at a time when they are mature and stable enough to use them rationally. Reviving Russian banks and nascent financial institutions have the chance for reliable returns in their own backyard.
“The Russian economy is fundamentally underleveraged and underinvested,” says Renaissance Capital bond analyst Pavel Mamai. “The banking system can’t reallocate capital. That’s why we’re very bullish on this bond market.”
Putin’s Russia has earned the chance, anyway, to brave this next step away from Communism and toward normalcy. Best of all, it is not asking for anyone else’s money. And who would have guessed that four years ago?
Benchmarks and red tape The European Bank for Reconstruction and Development has been an active issuer in the fledgling domestic bond markets of Central and Eastern Europe, lending them credibility and establishing benchmarks for other borrowers. The bank is itching to play a similar role in Russia, and given that it invests about $1 billion a year there, it’s ideally placed to do so. Fulfilling that ambition, however, is proving more difficult than the bank expected.
EBRD officials have been wrestling with the Kremlin bureaucracy since 2001, when they first approached the Federal Securities Commission about issuing ruble-denominated bonds. The commission decided that foreign-domiciled issuers needed their own enabling law, which the Duma finally passed in January 2003. Regulations took an additional six months to write, and since last summer the bank has been trying to nail down fuzzy details, such as whether state pension funds will be allowed to buy the EBRD paper.
The bank is determined to come to market later this year with a 1 billion-ruble ($42 million) bond issue, says Isabelle Laurent, chief of funding at EBRD headquarters in London. “Our need for funding may override the need to secure all the optimum attributes for our bond,” she says. The size represents a scaling down of ambitions: Earlier this year bank president Jean Lemierre set a goal of issuing $50 million to $100 million worth of ruble bonds.
The EBRD has issued six promissory notes in rubles during the past three years, but these are unwieldy instruments that under Russian law require physical certificates to be transferred. The bank has never had more than 400 million rubles outstanding.
Laurent hopes to issue a floating-rate bond, aiming to establish a much-needed rate benchmark for the market and fill out Russia’s primitive yield curve. “Ninety-nine percent of the liquidity is in the overnight markets or for a week, and then you have banks buying two- and three-year paper,” she explains. “But since nobody lends for one month or three months, no one knows what the true equivalent of LIBOR is.”
The lack of a proper yield curve leaves the market potentially vulnerable to instability, Laurent contends. Overnight interest rates currently stand at about 2 percent, thanks to central bank dollar purchases that have created a flood of ruble liquidity. That has encouraged banks to load up on corporate bonds and pushed yields down as low as 8 percent. But the short rates are volatile, rising to 7 percent around the time of Yukos CEO Mikhail Khodorkovsky’s arrest last October and spiking to 20 percent at the end of the third quarter, when corporate depositors withdrew funds to pay taxes. A more sustained shock at the short end, such as falling oil prices or the imposition of further capital controls by the central bank, could turn today’s bond market boom into a bust. “If rates reverse, the credibility of the local market itself is at risk,” Laurent warns.
Market participants are hoping that Laurent succeeds. “It’s difficult to overestimate the significance of the EBRD coming into the market,” says Pavel Gourine, chief of investment banking at Raiffeisen Bank in Moscow. “This would not only provide the market with a benchmark but also attract new investors and issuers.”
The EBRD still faces difficulties, though -- among them, figuring out whom to talk to at the Federal Financial Markets Service, which Putin abruptly created last month to replace the Federal Securities Commission.
“I think in principle the Russians do want us to be in this market,” Laurent says.
They just don’t seem to want to make it easy. -- C.M.
