Streetwise Professor

June 30, 2009

King Canute Putin Commands the Financial Tides

Filed under: Financial crisis,Politics,Russia — The Professor @ 9:29 pm

About That Indigenous Financial Market Thing.  It ain’t doing so well.

Fitch and Alfa Bank have issued very harrowing accounts of the financial straits of Russian banks, and the burdens this will place on the government’s finances:

Russian banks need $20 billion to $80 billion in extra capital this year, a senior executive at ratings agency Fitch said, although the head of Russia’s top private bank said the need could be as high as $130 billion.

The forecasts follow a recent assessments by ratings agency Moody’s, which put the need at around $40 billion, and the central bank, which said the need for extra capital would not exceed 500 billion roubles ($16.07 billion) this year.

“We expect loans quality deterioration to be serious enough. We think the banks will need additional capital one way or another on a one-year horizon,” Alexander Danilov, senior director at Fitch’s Russian office, told a conference on Tuesday.

Danilov said the agency’s own stress test had shown that, in an optimistic scenario, non-performing loans (NPL) would reach 15 percent of banks’ loan portfolio by year-end. In the base scenario it would rise to 25 percent, and in a pessimistic scenario 40 percent.

Speaking at a separate conference, Pyotr Aven, president of Alfa Bank, Russia’s largest private bank, said the government must boost its bank recapitalisation plans 10-fold to 10 percent of gross domestic product as defaults may hit $130 billion in the next 12 months.

Aven, known for his bearish views of the impact of the crisis on the banking sector, told a conference the government’s current measures to support the banking sector were not enough.

“The banking sector needs up to 10 percent of GDP, otherwise we won’t restart,” Aven told a conference.

“We are now going down the Japanese path when problems are simply masked… We need to begin from scratch… We are not talking about liquidity, we are talking about capital, about long-term money,” he said.

Earlier, Standard and Poor’s said problem loans could soar to 35-50 percent of total lending in Russia, Ukraine and Kazakhstan, though actual loan losses would not be more than half that level in Russia [ID:nLJ957879].

Twenty-five to forty percent to fifty percent problem loans?  That’s apocalyptic.  

But don’t worry!  Putin has it all under control.  He’s ordering banks to invest $16 billion dollars in struggling Russian companies, and telling bankers not to take any holidays until they have implemented his orders:

Russian Prime Minister  Vladimir Putin  told state-run banks to expedite loans to companies to help stem a financial crisis that will force the government to run deficits for at least three years.

Putin called on banks such as  OAO Sberbank  and VTB Group to boost lending by as much as 500 billion rubles ($16 billion) by October. The government will guarantee 300 billion rubles of the total, he said.

“The government expects that banks will consistently expand lending for the priority industries and reduce borrowing costs,” Putin said today on state television.

What idiocy.  Politicized lending will only weaken further the already shaky banks, as some recognize:

Russia’s plan to use state guarantees to boost lending may exacerbate liquidity risks as state banks expand their portfolios through business loans to unsustainable projects,  Trust Investment Bank  said.

Lenders may require additional support from Russia’s  central bank  after Prime Minister  Vladimir Putin  yesterday instructed banks such as  OAO Sberbank  and VTB Group to boost lending by as much as 500 billion rubles ($16 billion) in the next three months, Moscow-based Trust said in a report today.

The program, which allocates 300 billion rubles in state guarantees on corporate loans, also runs the risk of “dragging out the lives of ineffective companies,” according to the report.

“Banks should be extremely cautious in extending credit, providing it only to those enterprises which have significant potential for development and improving their effectiveness in the future,” Trust said in the report.

And regardless, this Hail Mary is unlikely to make a material difference in an cratering economy.  Russia’s own Economic Development Ministry just posted the low bid in the Dutch auction of forecasts of Russian economic performance in 2009, undercutting the World Bank’s 7.9 percent decline projection:

The Economic Development Ministry has revised its forecast for gross domestic product growth, predicting that the economy will shrink 8.5 percent this year, compared with 6 percent to 8 percent as forecast before, Prime-Tass cited a source in the ministry as saying.

Last week, the World Bank put the contraction at 7.9 percent, compared with 4.5 percent that it forecast earlier, while the Organization for Economic Cooperation and Development estimated a 6.8 percent drop, which is greater than the 5.6 percent it estimated earlier.

The ministry was more optimistic in its inflation forecast. It downgraded the inflation estimate for the year to 12 percent to 12.5 percent, down from 13 percent.

It will be interesting to see how well and how long all the machismo Putin theatrics involving everything from pork chop prices to wage arrears in monotowns to banks will wear in the face of these grim realities.  All of these little plays are intended to demonstrate his control and power.  If, as is likely, the economy continues to implode, they will only demonstrate his impotence.  


Lucy Putin Tees It Up

Filed under: Commodities,Economics,Energy,Financial crisis,Politics,Russia — The Professor @ 8:59 pm

A couple of interesting stories about investment and Russia: one about investment in Russia, the other about Russia as an investor.

The investment in Russia story involves Putin’s invitation to Shell to participate in the Sakhalin III and IV projects.  Shell, if you recall, was browbeaten into giving up a stake in the Sakhalin II project at a bargain basement price to Gazprom.  The new offer (along with deals with German Eon and French Total) is widely considered a symptom of Russian desperation for cash as a result of the financial crisis, and its technological backwardness, combined with the desperation of the supermajors to replenish reserves.  

To me, reserves or no, it is the height of folly for Shell to rush back in.  Russia has proven time and again that it has myriad ways to separate oil majors foreign and domestic from their oil investments.  Environmental regulations, taxes, labor law, you name it.  Although some have suggested that Shell will only invest if it receives “international bank guarantees”  I don’t find this credible.  What bank would take this risk?  How could you write a contract that would specify the relevant contingencies, given the imagination of the Russians in finding ways of exerting pressure to extort wealth?

Russia may be desperate.  Today.  They were desperate in the late-90s when they entered the PSAs with Exxon and Shell and others.  They took the terms offered, then undid some of the deals when prices turned around and they felt that they didn’t need the supermajors’ money.  

Indeed, Russia used the fact that it agreed to the PSAs due to its economic exigencies to justify its subsequent attacks on Shell and others; it had been taken advantage of, Russia whined, and was taking back what had been taken from it due to its weakness.  

It is eminently predictable that it will do the same again when the market turns around at some future date. Indeed, if Shell and others rush back in now, it will reassure Putin and future Russian leaders that they pay no price for expropriation.  Steal from them today, and they’ll be back tomorrow.  

So, it appears that Shell is ready to play Charlie Brown yet again.  Good luck with that.

The other story relates to GM’s second thoughts about selling Opel to Magna, Sberbank, and Russian automaker GAZ.  GM is seeking other potential buyers, and demanding Sberbank pay 14 times more than it originally offered (perhaps reflecting a perception that the economy has firmed and the value of Opel is higher as a result).  

Another sticking point is concern about technology:

However, the Magna talks have run into difficulty over access to the Detroit group’s global technology, which Magna wants to secure on behalf of Russian partners. If the sale proceeds, Magna and Sberbank plan to build Opel-based cars in Russia with Gaz, billionaire Oleg Deripaska’s car company.

This is wise.  Property rights in Russia are weak, and this is especially the case with respect to intellectual property.  It will be very difficult for Opel and GM from keeping GAZ from circumventing any contractual protections on its IP.  

In short, whether you are thinking of investing in Russia, or having Russians invest in you . . . be VERY careful.

June 29, 2009

Fat, Drunk, and Stupid is No Way to Go Through Life, Son

Filed under: Economics,Politics,Russia — The Professor @ 8:49 pm

Reuters carries this horrific report on a study of alcohol related death, published in the Lancet:

Cheap and illicit alcohol kills more than half Russian men and women in their most productive years and the government must act urgently to reverse the trend, a study to be published in The Lancet at the weekend said.

“Excessive alcohol consumption in Russia, particularly by men, has in several recent years caused more than half of all the deaths at ages of 15-54 years,” the Lancet article said. The research conducted in three industrial cities — Tomsk, Barnaul and Biysk — said “excess mortality from liver cancer, throat cancer, liver disease, and pancreatic disease is largely or wholly because alcohol caused the disease that caused death”.

High mortality from tuberculosis and pneumonia may be partly a result of increased exposure to infection, weak immunity, or decreased likelihood of cure, the research found.

Russia’s mortality rate in people aged 15-54 years was more than five times higher for men and three times higher for women than in Western Europe, the study showed.

Alcohol is responsible for about three quarters of the deaths of all Russian men aged 15-54 and about half of all deaths of Russian women of the same age, the data showed.

. . . .

He estimated Russia had some 2.5 million registered alcoholics and about the same number of unregistered ones.

“Drunkards, not alcoholics, are the main threat to demography,” Nemtsov told Reuters. “Heavy drinkers make up 40 percent of Russian males, but this figure may be bigger.” The proportion of male and female drinkers is 4 to 1, he said.  [The distinction between drunkards and alcoholics is a new one on me, but I think I understand the difference in this context.]

Thirty-thousand people — twice the number the Soviet Union lost during its 10-year war in Afghanistan — die from alcohol poisoning in Russia each year.

To put the last statistic in context, in the United States, the total number of accidental poisoning deaths from all causes in 2004 was  20,950.    And that in a nation with more than twice the population as Russia.  In 1996-1998, there was an average of 317 deaths attributed primarily to alcohol poisoning, with another 1,076 deaths where alcohol poisoning was a contributing cause.  So, roughly speaking, there are at least 25 times more deaths from alcohol poisoning in Russia, with a population of less than half that of the US–making a 50 fold difference in the rate of such deaths between the two countries.  

I know there are those who deny that this is germane to Russia’s demographic prospects, since from a purely biological perspective it is the female population that is the constraint on the number of births.  However, the article notes that although Russian male death rates are an appalling 5 times greater than Western European rates, Russian female death rates are still 3 times greater, which is a demographic drag.  Moreover, moving beyond the purely biological, it must be remembered that there is a choice component to fertility, and fertility choices depend in part on economic prospects.   Women will be far more reluctant to have children when there is a substantial risk of the premature death or incapacitation of their spouse, not to mention the fact that the earning potential of alcoholics (and drunkards!) is impaired (no pun intended) even if they survive, not to mention that the prospect of living with a drunk and the associated pathologies hardly encourages thoughts of children.  (And what of the torment of the children that these men do father?)  

I know there will be some readers that think otherwise, but I don’t write this out of a desire to point out Russian failings.  I find the whole thing truly horrifying and sickening and tragic.  I can only wonder at what leads so many people to destroy their lives in this way.  It really is beyond my comprehension.  But it cannot say anything good about the spiritual health (again no pun intended) of Russia.  Instead, it suggests a profound unhappiness and widespread despair.  How can people brag about “Russia getting off its knees” when a good portion of the population–more than 40 percent of the men–are face first in the gutter in a drunken stupor?   And what drives them there in the first place?

But what is even more incomprehensible to me is that this appears to be a low priority for the government–if it is a priority at all.  The problem is sometimes recognized, but there seems to be little effort to address it.  Putin has admitted the problem, but he merely recommends that “Russians should drink less.”    I guess he has more important things to do, like lowering the price of pork chops. You cannot make this stuff up.  

So, out of genuine curiosity and concern (believe it or not), I ask all self-styled Russophiles: What explains this social catastrophe? What should be done about it? And why isn’t the government doing it?

Self Inflicted Wounds

Filed under: Military,Politics,Russia — The Professor @ 6:34 am

Apropos the ongoing discussion of giving proper acknowledgement to Soviet accomplishments in the Second World War, consider this quotation from American historian David M. Glantz:

Who, then, is at fault for promoting this unbalanced view of the war?  Certainly, Western historians who wrote about the war from only the German perspective share part of the blame.   They argue with considerable jutification, however, tht they did so because only German sources were available to them. . . . [T]he most important factor in the creation of the existing perverted view is the collective failure of Soviet historians to provide Western (and Russian) readers and scholars with a credible account of the war.   Ideology, political motivation, and shibboleths born of the Cold War have combined to inhibit the work and warp the perspectives of many Soviet historians

. . . .

Unfortunately, the most general works and those most accessible to Western audiences tend to be the most biased, most highly politicized, and least accurate.   Until quite recently, official State organs routinely vetted even the most scholarly of these books for political and ideological correctness.   Even now, eleven years after the fall of the Soviet Union, political pressure and limited archival access prevents historians from researching or revealing many events subject to censorship in the past.

These sad realities have undercut the credibility of Soviet (Russian) historical works (fairly or unfairly); permitted German historiography and interpretation to prevail; and, coincidentally, damaged the credibility of those few Western writers who have incorporated Soviet historical materials into their accounts of the war.   These stark historical realities also explain why today sensational, unfair, and wildly inaccurate accounts of certain aspects of the war [e.g., the Suvorov hypothesis] so attract eh Western reading public and why debates still rage concerning the war’s direction and conduct.

Today, several formidable barriers continue to inhibit the exploitation of Soviet (Russian) sources and make a fundamental reassessment of the the war on the Eastern Front more difficult. . . .

The third barrier, that of credibility, is far more formidable, and, hence, more difficult to overcome.   To do so will require combined efforts of both Western and Russian historians accompanied by an unfettering of the binds on Russian archival materials, a process that has only just begun.   In short, the blinders and restrictions that inhibited the work of Soviet and Russian military scholars must be recognized and eliminated.   Only then can historians produce credible and sound histories of the war that accord the Soviet Union and the Soviet Army the credit they so richly deserve. [Emphasis added.   From the introduction of “Slaughterhouse: The Handbook of the Eastern Front”   (2005).]

In brief, Glantz argues that Soviet, and latterly Russian, authorities bear considerable culpability for Western ignorance about the war.

Alas, the Russian government has moved in the opposite direction since Glantz wrote these words in 2002.   It has been increasing restrictions on access to historical records, and moving towards the re-establishment of an official view of history, with the threat of sanctions formal or informal for those who challenge the official orthodoxy looming in the background.

Thus, as is so often the case, Russian means and Russian ends are at odds.   Officialdom complains of the distortion of historical depictions the Soviet war effort, and its essential contribution to victory over Hitler, but at the same time adopts policies calculated to interfere with the achievement of a more accurate understanding of the historical record.   The fetish for control ultimately undermines the achievement of the hoped-for ends.

Glantz is right.   However imperfectly, scholarly understanding is best achieved by competition and open access to relevant records.   The example of the response to the Suvorov hypothesis (that Barbarossa merely preempted Stalin’s plan to attack Germany) is an excellent example of this process in action.   “Official history” and highly restrictive–and preferential–access to historical records is an anathema to the scholarly historical enterprise.

The last sentence in the quoted section demonstrates quite clearly that Glantz is a firm believer that the Soviet Union was primarily responsible for vanquishing Hitler.   He has written numerous books setting out this view.   He cannot be dismissed, therefore, as a Russophobe, or a neocon Soviet basher.   His verdict on Soviet and latterly Russian culpability for the historical misconceptions that they lament so bitterly is not biased.   It is harsh, but just.   And as surely as night follows day, the course he recommends will not be followed, so the laments will continue.   Just another in a long line of self-inflicted wounds that will only further diminish the prospect for any improvement of understanding of Russia by the West.

June 26, 2009

Equilibrium Responses

Filed under: Derivatives,Economics,Exchanges,Financial crisis — The Professor @ 4:56 pm

Soon after posting my piece on the Treasury White Paper where I repeated my argument about the failure of most regulators and commentors to think through the equilibrium responses that would likely occur as a result of regulatory changes, I came across this Seeking Alpha post by David Enke that makes the point nicely:

Gensler believes that “central clearing will further lower risk,” but will it? While this is probably true initially, the long-run benefits could disappear. How so? Given that dealers will need to abide by stricter capital and margin requirements, the capital requirements will no doubt continue to grow as the added liquidity risk of less actively traded contracts is accounted for. While again this seems sensible, the extra cost will force even more contracts to move on to the exchanges. This will in turn reduce the amount of OTC contracts that are likely to be offered. Once again, all good, right? Not necessarily.

One of the benefits of OTC contracts is that you can develop a specialized contract that better matches the risk you are trying to hedge. Standardized contracts do not offer the same flexibility, causing a company to enter into less than perfect hedges, thereby making the company more risky over the long-run. This has the effect of causing risk management to be more expensive and less efficient for companies, just at the time when additional risk management is being encouraged.

Once again, raising capital requirements on risky assets has some obvious benefits, but hopefully the added burden is not so much as to eliminate the efficient use of the OTC market. If this happens, regulators may find themselves dealing with yet another problem.  

Just so.  Couldn’t have said it better myself.  

The statement about “eliminat[ing] the efficient use of the OTC market” gets to the nub of the issue.  The Geithners, Genslers, and legislators looking to clamp down on the OTC market seem to believe that “efficient use of the OTC market” is an oxymoron.  I think that they are they are wrong, and in their misguided distrust of these markets, they will make things worse, not better.

So much for an “indigenous financial system independent of the West”

Filed under: Economics,Financial crisis,Politics,Russia — The Professor @ 4:36 pm

The Russian banking system has been teetering since the beginning of the crisis.  The government intervened relatively effectively at the beginning of the crisis to address the severe liquidity problems in the banking system; this was one of the most salutary aspects of the government’s performance during the crisis.  But if the liquidity crisis has abated, a solvency crisis is looming due to the havoc wreaked by the near collapse of the real Russian economy, and the concomitant spike in non-performing commercial,industrial, retail, and construction loans.  The government appears to be planning to respond to this impending catastrophe by nationalizing the banks, and using funds built up during the seven fat years to recapitalize them:

Russia is looking at a bail-out of its banks that would go further than the emergency action taken by the US, amid growing fears that  bad loans  could paralyse the country’s economy.

Igor Shuvalov, deputy prime minister, will consider taking stakes in troubled banks when a group of experts on the financial crisis meets on Friday to discuss ways to recapitalise Russia’s banking system, according to a draft proposal seen by the Financial Times.

The proposal, one of several under consideration, would see the government issue OFZ treasury bills, a type of bond, to boost the balance sheets of the biggest banks. In return, the state would receive preferred shares.

Unlike the US  bank bail-out, the Russian scheme would see the government take board seats and have veto rights.

Analysts said such a plan would allow banks to declare the true level of their bad loans and, once their balance sheets were cleaned up, enable them to start lending again in 2010.

About $100bn in domestic loans fall due by the end of the year and the central bank has said bank profits would be wiped out if non-performing loans reached 10-12 per cent of the total.

With high interest rates and a dearth of new credit, bankers say they fear non-performing loans could hit as much as 20 per cent of overall credit portfolios by the end of the year.

Ratings agencies Standard & Poor’s and Moody’s have warned that Russia could need to spend $40bn recapitalising the banking system.

The recapitalisation funds would be limited to the top 55 banks in Russia’s 1,100-strong banking system, analysts said. The draft bill says only banks with a minimum of Rbs50bn ($1.6bn) in assets would be eligible.

. . . .

If the government continues to delay, “this means that many banks will just stop operations. They will continue to exist but they won’t be able to provide new loans,” Ms Orlova said.

The government fears it could spend its entire Rbs4,000bn reserve fund and more, once it begins to recapitalise the private banking sector, she added.

The demands on Russia’s “rainy day” funds escalate by the minute.  It is almost certain that they are insufficient to fill all the holes in the Russian dike: financial aid to regional governments to pay workers at idled factories; social expenditures; bank bailouts.  

Steel and coal company Mechel’s SEC filing provides a chilling, and relatively objective, take on the kinds of problems that afflict Russian companies–and hence the banks who have lent to them:

Going Concern
Russian business environment
The Russian economy is vulnerable to market downturns and economic slowdowns elsewhere in the world. The ongoing global financial crisis has resulted in capital markets instability, significant deterioration of liquidity in the banking sector, and tighter credit conditions within Russia. While the Russian government has introduced a range of stabilization measures aimed at providing liquidity and supporting debt refinancing for Russian banks and companies, there continues to be uncertainty regarding the access to capital and cost of capital for the group and its counterparties, which could affect our group’s financial position, results of operations and business prospects. These considerations similarly apply to other jurisdictions where our group operates.
Our group’s activities in all our operating segments have been adversely affected by the uncertainty and instability in international financial, currency and commodity markets resulting from the global financial crisis. The recession is affecting most economic regions, forcing us to reduce production, cut costs, manage increased risk factors and strengthen our competitiveness, including curtailing production, halting non-critical capital expenditures, accelerating new strategies for raw materials, initiating headcount reductions, suspending major investment programs, and making other liquidity enhancements.
We believe we are taking appropriate measures to support the sustainability of our business in the current circumstances. We believes our operational cash flow in 2009 will be sufficient to fund proprietary capital expenditure projects and permit us to operate the business in a profitable fashion during 2009. However, further market deterioration could negatively affect our consolidated results, financial position and cash flow in a manner not currently determinable.
Going concern
The current economic environment is challenging and we believe that the outlook for the next several years presents significant challenges in terms of sales volume and pricing as well as input costs. Specifically, the current economic conditions create uncertainty about (1)  the level of demand for our products; (2)  the pricing of major commodities mined or manufactured by us; (3)  the exchange rate between the Russian ruble and U.S.  dollar and its impact on the cost of our inventories; and (4)  the availability of bank financing in the foreseeable future.
We believe we have taken measures to deal with the uncertainties in our operating environment and that our operating cash flows in 2009 will be sufficient to allow us continue to operate in the normal course of business including routine working capital and priority capital projects, assuming the successful restructuring of our debt as described below.
As of December  31, 2008, we breached a number of financial and non-financial covenants (as discussed in “—  Liquidity and Capital Resources  â€” Covenant breaches” below)  and as a result, the lenders can request accelerated repayment of a substantial portion of our long-term debt. As of December  31, 2008, we had $5.149  million of loans repayable during 2009, including $1.564  million of long-term debt that was classified as short-term liabilities as of that date because of the covenant violations. We do not have the resources to enable us to repay the total of these loans if repayment were called.
Our group has commenced discussions with our bankers about additional facilities to be provided on a  long-term  basis. Our group is also seeking to refinance  and/or  restructure the terms and conditions of our existing debt to extend  maturities beyond 2009 and provide greater working capital flexibility. Our group is currently in negotiations with the consortium of banks, but it is likely that the terms and agreement on the conditions of these borrowing arrangements will not be completed until the second half of 2009. Based on negotiations conducted to-date, we believe that we will successfully refinance or restructure the terms and conditions of (1)  $1,000.0  million out of the $1,500.0  million “Oriel” credit facility and (2)  its $1,781.0  million “Yakutugol” syndicated loan. To repay the remaining $500.0  million of the “Oriel” credit facility, we plan to use half of the credit line obtained from Gazprombank referred to below.
We have succeeded in obtaining additional financing by reaching the following credit line agreements:
  •   Gazprombank  â€” $1,000.0  million U.S.  dollar-denominated credit facility repayable in quarterly installments in  2010-2012  for a partial repayment of its “Oriel” and “Yakutugol” credit facilities. As a security for these credit facilities the group pledged 35% of the shares in Yakutugol and Southern Kuzbass Coal Company;
  •   VTB  â€” 15  billion rubles ($510.1  million) credit facility expiring in November 2009 under the guarantees issued by Mechel and pledges of Southern Kuzbass Coal Company and Chelyabinsk Metallurgical Plant production assets;
  •   Sberbank  â€” 3.3  billion rubles ($112.3  million) credit facility due in 2010.
We are also pursuing alternative sources of funding in the event the above mentioned negotiations do not result in adequate funding. Specifically, in February 2009, our group registered one-year ruble-denominated bonds in an aggregate principal amount of 30  billion rubles ($824.6  million) with the Moscow Interbank Currency Exchange (MICEX). Subsequently, in May 2009, the group registered another ruble-denominated bond issue of 45  billion rubles ($1,406.9  million) with the FFMS. Issuance of these bonds would be subject to market conditions at the time, and while we have not formally decided to proceed with the issuance of these bonds, if issued, these bonds would provide us with additional financing flexibility.
Furthermore, our group has been included in the Russian Government’s list of strategic businesses that are eligible for state financial support in the current economic environment. Subsequently, in January 2009 our group received an approval from the state-owned Vneshekonombank (“VEB”) for a one-year $1,500.0  million facility to refinance the “Oriel” credit facility, which to-date we have elected not to use. There is no assurance, however, as to how much further state financial support, if any, may be received by us.
We have concluded that the uncertainty about our refinancing and restructuring of our outstanding debt described above represents a material uncertainty that casts significant doubt upon our ability to continue as a going concern. However, based on our plans as noted herein, we believe that we have, or will secure, adequate capital resources and liquidity to continue in operational existence for the foreseeable future and have presented our consolidated financial statements on a going concern basis of accounting.

Need I say more?  

I’ll let the World Bank take it from here:

The Russian economy will shrink by 7.9 percent in 2009 despite a recent rise in commodity prices, the World Bank said on Wednesday, a much sharper contraction than the 4.5 percent it forecast earlier.

Russia’s economy contracted by 10.2 percent in January-May 2009, according to Economy Ministry estimates, and First Deputy Prime Minister Igor Shuvalov told Reuters on Tuesday the annual contraction may reach 9 percent. [ID:LN305314]

“Given a much larger gross domestic product contraction in the first quarter of 2009 than anticipated, Russia’s economy is likely to contract by 7.9 percent in 2009, despite higher oil prices assumed in the current forecast,” the World Bank said in its quarterly country report.

Russia, the world’s largest energy producer, has been hit hard by the plunge in global demand for commodities, while its banks and many businesses that had borrowed heavily abroad have been squeezed by the global credit crunch.

The World Bank’s lead economist for Russia Zeljko Bogetic told a news conference there was a “natural lag” before the recent upturn in commodity prices would have an impact on Russian growth, “provided that it holds, of course, which is not entirely clear.”

The World Bank forecast Russia’s jobless rate to rise to 13 percent by the end of this year, from its 9.9 percent May level, and said single factory towns will be the hardest hit by rising unemployment and wage arrears.

“Some stabilisation (in the jobless rate) is related to seasonal factors and job shedding is not over,” Bogetic said.

The World Bank projected Russia would return to moderate growth of 2.5 percent in 2010 and 3.5 percent in both 2011 and 2012 in a “gradual and prolonged” recovery.

“The speed of the subsequent recovery in Russia will to a great extent depend on the revival of global demand and the global financial system,” the report said, adding that Russia will reach pre-crisis growth rates only at the end of the third quarter of 2012.


FISCAL DEFICIT High oil prices may keep Russia’s fiscal deficit lower than initially forecast but the report noted spending risks linked to recapitalising the banking sector and extra social costs.

The report saw the fiscal deficit at 7.2 percent this year, and at 6.0 percent in 2010. The World Bank based its forecasts on average Russian Urals crude prices URL-E URL-NWE-E of between $56 per barrel this year and $63 per barrel in 2010.

Bogetic said Russia needed to reduce the amount of aid going to people who do not really need it, and boost the budget’s revenue base through raising liquor and tobacco excise duties.

The World Bank said a delay in Russia’s accession to the World Trade Organisation caused by a decision to form a customs union with Belarus and Kazakhstan could undermine benefits from a rules based trading regime.

The report said lower inflation has created room for more official interest rate cuts, which should help investment in the second half of 2009. But it also warned that overvaluation of the rouble could hurt the recovery.

It expects inflation to reach 11-13 percent this year. The nation’s current account surplus is forecast at $32 billion in 2009 and $36 billion in 2010.

The World Bank said capital outflows will total $60 billion this year and decline to $30 billion in 2010.

Non-performing loans could reach 10 percent of the total in banks’ portfolios, the report said, adding that consolidation in the sector should be accelerated.

The nationalization of Russian banks, will hardly facilitate the development of a robust financial system.  It will more likely result in an inefficient, politicized system that directs resources to the politically favored, rather than the economically viable.  This was the gravamen of my criticism of nationalization proposals in the US, and goes in spades in natural state Russia.  With sharply diminished ability to tap international capital markets, and a nationalized domestic banking system, Russia will have difficult times indeed financing a transition to a modern progressive economy.  


A Question

Filed under: Military,Politics,Russia — The Professor @ 3:59 pm

Brace yourself, people:  I can sympathize with Russia taking umbrage at Brown’s and Sarkozy’s omitting mention of the contribution of the USSR to the defeat of Nazi Germany during the recent 65th anniversary commemoration of the D-Day landings.  That omission is extremely ahistorical, and slights the sacrifice of millions of Soviet soldiers and civilians.  

I do have one question though.  I am genuinely curious to know what Russian leaders have said at Victory Day celebrations about the contribution of the United States, United Kingdom, Canada, Australia, New Zealand, the Free Poles (especially), the Free French, and other Allied nations to the vanquishing of Hitler.  Are they as evenhanded and objective in their assignment of credit for contributions to victory as they demand others to be?  If so, bully for them.  If not . . .  Russia’s recent complaints would lose a considerable amount of their force.  

Can anybody out there help me out, and provide translations of/links to remarks of Putin, or Medvedev, at recent Victory Day celebrations (or other WWII-related commemorations)?

SWP in the Economist

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 3:01 pm

I was quoted in this week’s Economist in an article raising doubts about whether OTC clearing is all that it is cracked up to be.  It is good to see good reporters at reputable publications chipping away at the happy talk conventional wisdom surrounding clearing.  The last sentence in the piece is especially important, and poses a question I’ve often asked here at SWP: “If the benefits of CCPs in OTC markets are so overwhelming, why did they not emerge on their own?”  Kudos to Adam Creighton and the Economist.

Regulatory Bait-and-Switch

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 12:57 pm

Finally had a chance to look over the much anticipated Treasury White Paper on “reforming” financial regulation.   It’s a long document, addressing many issues with which I am not that conversant, so I will focus my attention on the Paper’s recommendations for OTC derivatives.

The Paper begins its analysis with an extended discussion of what it asserts was a “lax regulatory regime for OTC derivatives–and, in particular, for credit default swaps” (p. 44):

In the years prior to the crisis, many institutions and investors had substantial positions in CDS–particlarly CDS that were tied to asset backed securites (ABS), complex instruments whose risk characteristics proved to be poorly understood even by the most sophisticated market participants.   At the same time, excessive risk taking by AIG and certain monoline insurance companies that provided protection against the decelines in the value of such ABS, as well as poor counterparty risk management by many banks, saddled our financial system with an enormous–and largely unrecognized–level of risk.   When the value of the ABS fell, the danger became clear. . . . Lacking authority to regulate the OTC derivatives amrket, regulators were unable to identify or mitigate the enormous systemic threat that had developed (pp. 44-45).

Based on this rather tendentious reading of the history of highly non-standardized, illiquid instruments, and on this reading alone, the Treasury makes the following policy recommendation:

To contain systemic risks, the Commodity Exchange Act (CEA) and the securities laws should be amended to require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).

This has to be one of the most collossal non-sequiturs on record.   Highly non-standardized financial derivatives allegedly led to a systemic crisis–so we should mandate clearing for standardized products.   As an exercise in logic, by comparison to this the “Burn the Witch” scene in Monty Python in the Holy Grail is a model of precise reasoning.

Thus, as has been true all along, the case for clearing of standardized OTC derivatives levitates, with no evident means of logical or empirical support.   This could be a great Vegas magic act.

In retailing, this is known as the “bait-and-switch.”   Regulators often punish stores that engange in such conduct.   Here, we’re out of luck–because the regulators are the ones perpetrating the bait-and-switch.

A coherent case for mandating clearing would require a demonstration that OTC derivatives suitable for clearing pose a systemic threat, at least illustrated by anecdotes analogous to the now tired arguendo ad AIG.   (The absence of any such anecdotes is very, very telling–not to mention that argument-by-anecdote is a very de minimus standard because “data” is not the plural of “anecdote.”)   What’s more, the argument would require a rigorous comparative analysis of the systemic risks posed by alternative mechanisms–bilateral and centrally cleared.   Instead, we are repeatedly entertained by next part of the magic act: assertions that clearing makes these risks disappear!

Even the arguendo ad AIG has its defects.   To wit:

  • If “the most sophisticated market participants” failed to recognize the risk characteristics of the CDS on ABS, how possibly could one expect a CCP to do any better?   Yet another magic trick: the CCP as deus ex machina, that magically appears to solve all of the difficulties that had stumped the most sophisticated.   Indeed, if anything, the CCP is likely to be a less sophisticated evaluator of risks.   So wouldn’t forcing things onto clearinghouses potentially make things worse?
  • “Excessive risk taking by AIG and the monolines . . . saddled our financial system with an enormous . . . level of risk.”   This betrays a serious misunderstanding of the role of derivatives.   As I argued in It’s a Wonderful Life, AIG Edition, AIG et al took on existing risks associated with existing ABS.   If AIG et al hadn’t taken on the risk, it would have remained somewhere else in the financial system.   And it’s almost certain that it would have remained with Goldman, SocGen, DB, etc.   So, if the decline in ABS prices was so big to threaten the existence of those firms unless AIG paid off on its CDS, their existence would have been even more threatned without AIG’s equity absorbing a portion of the loss.   The bailout would have been bigger, not smaller.   The only substantive difference is that it would have gone to these firms directly, rather than being laundered through AIG.
  • More generally, this points to a continuing defect with the Treasury analysis, and most other analyses of regulatory changes: the equilibrium responses to these changes.   It is clear that Treasury, and Washignton generally, now views OTC derivatives as the financial equivalent of Satan, and wants to crack down on them.   Let’s say this happens, and OTC derivatives shrink, or even disappear.   How will market participants respond?   Will there be less hedging because an instrument that revealed preference suggests is superior to available alternatives is constrained?   If so, will the system become more susceptible to disruption, not less?   By focusing on the seen, and failing to inquire at all about the endogenous, equilibrium effects of changes in regulation that are largely unseen, regulators are likely to make things worse, not better.
  • As I’ve noted before, “standardization” is a red herring in many respects.   Standardized instruments may be unsuitable for clearing due to serious information problems.

Other policy recommendations also float in the air, untethered by logic or evidence.   For instance, the White Paper asserts in a decidedly conclusory way that “[m]arket efficiency and price transparency should be improved in derivatives markets by requiring the clearing of standardized products . . . and by moving the standardized part of these markets onto regulated exchanges and regulated transparent electronic execution systems . . . . Furthermore, regulated financial institutions should be encouraged to make greater use of regulated exchange traded derivatives.”

Note the implicit assumption that incumbent arrangements are inefficient, and result in an inefficient level of price transparency.   Why should inefficient market arrangements persist?   Surely, they can.   And if they do, it should be possible to present argument and evidence demonstrating this.   No luck if you are looking for anything about that in the White Paper, or virtually any government discussion of this issue.

Another lighter-than-air argument relates to “market integrity”: “Market integrity concerns should be addressed by making whatever amendments to the CEA and the securities laws that are necessary to ensure that the CFTC and the SEC . . . have clear, unimpeded authority to police and prevent fraud, market manipulation, and other market abuses involving all OTC derivatives” (p. 46).   What the necessary laws might be, the Paper doesn’t bother to say: I guess that’s the mind reading portion of the act.   Again, you would think that if there are demonstrable gaps in the existing authorities to punish manipulation, etc., it would be possible to cite chapter and verse to support the claim.   No such citations here.

I can only hope–and I am sure that it is just that–that the level of analysis is superior in the remainder of the White Paper.   All I can say is that the case laid out regarding the dangers of OTC derivatives, and the improvements that would result from the policy recommendations, is completely lacking.   Completely.   Like I said above, the policy recommendations regarding OTC derivatives levitate, unsupported by any serious analysis or evidence.   Out of such sloppy group-think legislative and regulatory disasters are made.   So get ready for an explosion when the spark of reality ignites the gas holding aloft this regulatory Hindenberg.

June 24, 2009

High Beta + Predatory Government = Precarious Economic Future

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 7:05 pm

I’m back!  And glad to be here.  Italy was great, but it nothing beats the US in my book.  Going away for awhile helps make that very clear.

And now, back to our regularly scheduled blogging . . .  

Earlier in the year I argued (mainly with BFC) that Russia was a high beta economy, meaning that the fluctuations in Russian economic performance, and the performance of its financial markets, would be more extreme than those in the rest of the world. This original diagnosis was predicated on Russia’s extreme dependence on hydrocarbon exports, and the dependence of hydrocarbon prices on worldwide economic conditions.   One corollary of this is that Russia’s economic fate is tied to that of the broader world economy: As goes the world economy, goes the price of oil, goes Russia.

Recent news provides some confirmation of this analysis, but also suggests quite strongly that other aspects of Russia’s economic fate are unique to it—and that those don’t, don’t bode well for Russia’s near and medium term future.   (It’s long term future is pretty bleak, given its demographic difficulties.)   That said, Russia is not hopeless; its prospects depend on foreign investors failing to learn their lessons about the dangers of putting capital in Putinist Russia, and past experience suggests that these investors are capable of just that.  

The confirmation of the high beta hypothesis: the fact that Russian stock prices fell far more than world prices during the height of the crisis 4Q 2008; the recent boom in Russian stock prices, up around 140 percent off their lows, coincident with a strong but substantially smaller (around 33 percent) increase in stock prices in the US and Europe, and the rally in oil—up around 120 percent off its lows; the more recent drop in Russian equities—around 20 percent—coincident with a 5 percent or so drop in developed market prices, and a 10 percent or so drop in emerging markets, and a modest drop in oil prices; and increased pessimism about the prospects for recovery in Russia, coincident with a diminution of hopes for an imminent, and robust, world economic recovery.  

Virtually all of the economic news emanating from Russia is quite bleak.    To wit:

A stunning drop in investment spending:  

Russia’s biggest contraction in capital investment since December 1998 shows that the government’s stimulus package is “not working,” Alfa Bank said.

Last month’s 23.1 percent annual drop means “the fiscal stimulus funds are not finding their way into the real economy,” Natalia Orlova, Moscow-based chief economist at Alfa, Russia’s largest privately owned bank, wrote in a note e-mailed today.

“The general conclusion is that the state’s fiscal policy is focused on the social sphere rather than investment and that the Finance Ministry is trying to offset the decline in budget revenues with lower spending,” Orlova wrote.

The economy of the world’s biggest energy producer shrank an annual 9.8 percent in the first quarter, the most in 15 years, and may contract 8 percent this year, the government estimates. The stimulus package earmarks 2.51 billion rubles ($80 million) to battle the slump, including funding designated for the auto industry, agriculture and construction.

The budget deficit widening to 511 billion rubles through the end of May was the result of increasing transfers to regional budgets, rather than funneling money to the economy, the report said.

The source of the widening budget deficit—transfers to regional budgets—is of particular interest.   It suggests that the center feels compelled to prop up the regional governments, likely out of fear of social discontent and popular unrest.  

EDM provides further detail on the desperate straits of the regional governments, and the central government’s pulling out all the stops to keep them afloat while demanding that they in turn support employment in their regions:

Kudrin’s main headache, however, is the need to bail out an increasing number of regions that face insolvency while the income from the state budget has fallen by more than one third (Vedomosti, June 19). Putin is inspecting the regions demanding from the governors not to close the plants that cannot find any demand for their products and to pay salaries to idle workers, but that requires more transfer of funds from the federal coffers – a policy that goes directly against Kudrin’s course on reducing inflation (Kommersant, June 19).

Moreover, the decline in investment reflects a very bearish view on the economic future.   Given that Russia’s recent investment levels are quite modest compared to other emerging markets, and to the past example of the Asian Tigers, this drop in investment bodes ill for future growth.

A widespread recognition that government policy is ineffectual at best, and more likely extremely counterproductive:

Russia’s “anti-crisis” program, signed by Prime Minister Vladimir Putin on June 19, probably won’t return the country to sustained growth before 2012 and risks increasing state intervention, Capital Economics said.

“At its core there remains a fixation with micro-managing the economy, characterized by a plethora of targets, an over- reliance on state intervention and a hint of economic nationalism,” Capital’s London-based emerging-Europe economist analyst Neil Shearing wrote in a note e-mailed late yesterday.

The economy of the world’s biggest oil producer shrank an annual 9.8 percent in the first quarter, the most in 15 years, and may contract 8 percent this year, the government estimates. The stimulus package earmarks 2.51 billion rubles ($80 billion to battle the slump, including funding designated for the auto industry, agriculture and construction.

The government’s intent to “pick winners” among industries and check the growth of food prices may distort market and curb the supply of products, the Shearing said.

Carmakers are set to receive 90 billion rubles, farmers 63.1 billion rubles for agriculture and construction companies 247.2 billion rubles, according to calculations by Trust Investment Bank.

The total amount in the final draft is less than the 2.98 trillion rubles pledged by the government earlier after it reduced support for the banking industry by 500 billion rubles.  

Declining retail sales:

Russia’s economy is shrinking more than expected, sending “damaging waves” throughout the former Soviet Union, the World Bank said.

Collapsing industrial production, rising unemployment and capital flight will reduce Russia’s gross domestic product by 7.5 percent this year and restrain “intraregional trade flows and transfers,” the World Bank said in a report posted on its Web site today.

. . . .

Retail sales fell the most in almost a decade in May, sliding an annual 5.6 percent, the fourth consecutive decline and the biggest since September 1999. The average monthly wage decreased an annual 3.3 percent in May, while real disposable incomes dropped 1.3 percent.

And perhaps most ominously, the prospect that rising energy prices—themselves dependent on the extremely uncertain prospects for a global recovery, and the policy of the Fed—will not be Russia’s (or should I say Putin’s?) salvation when (or should I say if?) they come to stay:

Russia’s economic slump may deepen in the second quarter to an annual contraction of 10.9 percent because rising oil prices won’t spur growth without a recovery in lending, according to Goldman Sachs Group Inc.

“Russia’s deep output decline, in our view, is less the direct impact of lower commodity prices and more the effect of the sudden stop in capital inflows that the country suffered beginning in the third quarter of 2008,” Rory MacFarquhar, Moscow-based economist at Goldman, said in a report today.

The world’s biggest energy supplier is falling into its first recession in a decade after the global decline sapped demand for commodities while capital flows to riskier markets dried up. A stimulus package has failed to spur lending even as the central bank cut interest rates three times since April.

Capital investment in May fell an annual 23.1 percent, the biggest drop since December 1998, as industrial output declined a record 17.1 percent last month. Russian retail sales slid an annual 5.6 percent in May, the fourth consecutive decline and the biggest since September 1999.

. . . .

Lending to households and companies declined in the fourth quarter of last year by the equivalent of 5 percent of gross domestic product and fell 6 percent of GDP during the first three months of 2009 from a year earlier, according to Goldman.

Urals crude oil, Russia’s chief export earner, traded at more than $71 a barrel this month after falling to a low of $32.34 in December. The higher oil prices won’t spur growth because the profits are largely collected by the government in taxes, MacFarquhar wrote.

In previous years, the non-financial sector expanded borrowing by over 20 percent of GDP annually and Russia’s external debt grew by 30 percent every year, the report said.

The rise in oil prices will result in a stronger ruble and increase nominal GDP, leading to a budget shortfall of 6.2 percent this year, compared with an official forecast for a deficit of more than 10 percent, according to Goldman.

The collapse in capital inflows is another manifestation of the widespread pessimism about Russian economic prospects, and parallels the decline in investment.   The disparity between the dizzying growth rate in household and business lending in recent years, and the decline in 4Q 2008-1Q 2009 is particularly illuminating.

Investment is not robust anywhere, but the Russian fall is precipitous and nearly unique: notably the BIC countries have not experienced the collapse observed in Russia.   (Although lumping these countries together has never made much sense given their great differences on virtually every economically and politically relevant dimension—and including the Russian “R” to make BIC into BRIC was especially non-sensical).   This is the factor that seems on the one hand to confirm the high beta hypothesis, but which instead more likely reflects something distinctive to Russia other than its dependence on raw material exports.   Instead, it plausibly reflects the fundamental defects of the country’s natural state political and economic system.  

This is a natural implication of Putinism, as Shearing puts it: “At its core there remains a fixation with micro-managing the economy, characterized by a plethora of targets, an over- reliance on state intervention and a hint of economic nationalism.”   Add to this the Telenor fiasco, coming as it did on the top of numerous expropriations of investors both foreign and domestic; the ongoing farce of the Khodorkovsky trial, with its chilling implications for any Russian who falls afoul of the system, and its demonstration of the complete absence of an independent legal system and protection of individual rights; the trial of a different sort of being a foreign investor in Russia (cf. Ikea’s decision to suspend expansion in the country in large part due to the abuses it has suffered at the hands of Russian officialdom, petty and elevated); the WTO decision; the rows with everyone from Belarus to the US over food imports; the lack of credible commitment by the government to protect property or to adhere to contracts; the political risks epitomized by the Georgian War and its lawless, rogue aftermath (with the recent veto of the UN mission in South Ossetia and Abkhazia just the most recent example); and on and on.   Given this litany, it is no surprise that foreign investment has deserted Russia, and is unlikely to come back any time soon.

Here’s a way of summarizing this: high raw material prices are a necessary, but not sufficient condition, for Russian economic growth.   Booming resource prices in the earlier years of this decade created the possibility that Russia could be a lucrative investment market—if those investments were secure from predation.     And that proved to be a big if.   The capital outflows started before the world economic crisis—with the Georgian War, in fact, which put an exclamation point on the political risks in Russia.   The crisis, and the resulting collapse in materials prices, accelerated that decline.   The question is whether a reversal of the decline will lure foreign investors back.

There is room for doubt because there is no doubt that the government’s behavior both during the boom and the collapse made it abundantly clear that a fool is soon separated from his money in Russia—and that anyone who invests in Russia is very likely a fool.   If the high beta nature of the Russian economy doesn’t get you, the government is likely to.   Even companies and countries that assiduously courted the Putinite elite—BP and Norway come to mind—found themselves the victims of a predatory system.   (Is it a coincidence that Victor Fridman is deeply involved in both situations a coincidence?   Methinks not.)

Once burned, twice shy?   One would think so, and in the event, Russia’s future prospects would certainly be quite bleak.   For world economic prospects remain troubled, with pronouncements of the “green shoots” (gag) of an economic spring appearing decidedly premature, and Russia ill positioned to benefit from any world rebound due to its sinister reputation as a very dangerous place to invest.   For a country that experienced growth largely due to foreign investment attracted in large part by a boom in commodity prices, this is a very dangerous position to occupy.

But not all is lost for Putinism.   World economic recovery; a wildly expansive and inflationary US monetary policy; and the slashing of investment programs in oil and metals during the crisis; could lay the groundwork for another spike in commodity prices.   And past experience suggests that investors sometimes have short memories, and tend to let their wishes override the lessons of experience, and an understanding of the nature of Putinism.   Another commodity boom may induce foreign investors to throw caution—and common sense—to the wind, and invest in Russia again.  

So, in a nutshell, the positive case for Russian economic prospects: (a) another spike in commodity prices, and (b) foreign investors continuing to play Charlie Brown to Putin’s Lucy (tempting them with the financial football).   I put the probability of (a) in the 30-40 percent range in the 2010-2011 period, especially given the difficulties that the Fed will face when attempting to extricate itself from the extraordinary measures it has taken in recent years, difficulties exacerbated by the fiscal pressures emanating from Obamaism.   I put the probability of (b) somewhat lower than that—but not at zero, which is where it should be.   So, Russia should have no economic future due to the deformities of its politico-economic system, but it just might in spite of itself due to the prospects for policy errors in the US (and the West more generally), and (most importantly) to the cognitive and mnemonic deficiencies of Western investors.


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