Streetwise Professor

I went to the World Bank website to see if their November report on the Russian economy was up.   It wasn’t, so I took another look at the report issued in June.   It looks prescient in some ways, although I doubt that the WB folks thought that this danger would be realized so soon:

Issue 1: Oil revenues, booming today, could become a drag on economic
performance.

The strong recovery of oil prices since 2000 increased Russia’s dependence on oil and gas revenue, making it more vulnerable to price declines.

The share of oil revenue in total fiscal revenue increased substantially—from 10 percent of GDP to about 30 percent. Instead of diversifying, Russia has specialized in oil, which now accounts for about 60 percent of exports (figures 2.1 and 2.2). Higher oil revenues create more room for spending, but they also complicate macroeconomic management and foster dependence on a volatile, uncertain source of income. This has not been a problem in the face of high oil prices, but it could become a major vulnerability if oil prices begin a rapid descent.

The report also notes:

External debt stock and external vulnerability remain within a comfortable range, but Russia’s private corporate and banking debt is growing fast (figure 1.13). A rapid buildup of corporate and banking debt partly financed the massive consumption and investment spree of recent years. With general government external debt modest and declining, this banking and corporate debt—public and private—explains almost all the buildup of external debt (figure 1.13, left panel). External private debt almost tripled, from $106 billion at the end of 2005 to $275 billion at the end of 2007. External public debt, which includes the general government and public financial and nonfinancial organizations, has also grown thanks to borrowing in large state companies—but not nearly as fast as private sector debt. Although overall debt appears low compared with the economy’s size and its massive international reserves, it has become a concern at the central bank. That exuberant private borrowing, if continuing at the same pace during a prolonged global credit crunch, could undermine corporate liquidity and repayments, spilling over into the banking system, which faces its own risks.

The report mentions the real estate financing issue too:

Russian banking has weathered global financial turbulence, but credit, liquidity,
and market risks require monitoring.
The credit portfolio may face strains from the rapid credit expansion over the last decade, the entry of new and inexperienced borrowers, and banks’ uncertain ability to manage the risks. The brisk growth in mortgage lending could become a concern. Mortgage loans increased fivefold during 2000-06 and by at least 70 percent in 2007, though the consumer segment remains small (13 percent). The following issues are worth noting.

• The retail deposit base is concentrated in Sberbank, forcing large and medium-size banks to rely more on international funding.
• Household deposits represent 30 percent of bank liabilities on average, but they are concentrated in the state-owned banks, which hold more than 40 percent of bank assets (Sberbank, VTB, Gazprombank, Bank of Moscow, and the Russian AgriculturalBank).
• The concentration of corporate deposits • remains a concern for smaller banks. Withdrawals by a few large customers could reduceliquidity. For some smaller banks, the 20 largest depositors account for more than half of customer funding.
• Banks relying on external funding risk a   contraction in global credit. Benefiting from abundant global liquidity, banks operating in Russia have borrowed significantly from abroad over the last few years. This may pose refinancing risks for some banks.
• Banks’ exposure to market risk has grown with deeper capital markets and banks’ greater sophistication. Securities portfolios, about 20 percent of assets at the end of 2007, are dominated by corporate bonds, though equity holdings are also significant for some banks. These securities expose banks to potential equity or bond prices.losses from adverse movements in equity or bond prices. sustained strong earnings, but profits are coming under pressure.

The continuing global credit crunch is straining banks’ funding model. If the global credit crunch is prolonged, the system could face funding problems. With Russia’s thin domestic capital markets and its retail deposits concentrated in the largest state banks, some banks must depend on foreign funding. Sustained, restricted access to foreign borrowing could increase funding costs, slow credit growth, reduce profitability and capital, and expose banks to refinancing difficulties. Rapid credit growth has so far sustained strong earnings, but profits are coming under pressure.

In sum, most of the major vulnerabilities that the World Bank identified are being tested, and far sooner and far more severely than pretty much anybody had anticipated at the time the report was written.

The report also details Russia’s investment-led growth, and notes that this investment was heavily-oriented to the resource extraction sector, and largely ignored manufacturing.   These investments are not looking to good now, with resource prices down hard across the board.   The report further notes that although Russia’s investment rate (investment/GDP) has ticked up in recent years, it is still far below (barely half) the rate in other rapid growth emerging economies (21 percent vs. 38-42 percent.)     The report’s data shows that growth has been heavily driven by non-tradeables, notably construction.   So much for that.

In other words, the WB painted a picture of a nation with its private economy and government finances highly dependent on natural resource prices, largely funded by hot money, and dependent on a fragile banking system.   Oil prices (and the prices of other natural resources) are the lynchpins of such an economic system.   It is pretty clear what the implications of a collapse in these prices are.   And we are seeing them unfold before our very eyes.

The WB mentions the outstanding institutional issues facing the country, but doesn’t place tremendous emphasis on them.   The problem is that the very institutional weakenesses that the Bank acknowledges will exacerbate these problems, and make it very difficult for Russia to surmount them.

That’s the price of Urals Med (per the online WSJ).   Interestingly, the basis between Urals and Brent widened dramatically today.   It was about $.70 yesterday, and earlier in the week.   Today it blew out to $2.60 (i.e., Urals was quoted for $2.60 less than Brent.)   I don’t know why the basis moved so strongly today, but it is another ill omen.

Putin has threated to halt construction of Nord Stream unless the Europeans pony up more Euros:

Putin said ”we cannot do it alone, and we won’t,” the ITAR-Tass news agency reported.

In other words, more chutzpah.   “Pay for the gun we will hold to your head.”

This also has obvious implications for South Stream.   If there’s no money for Nord Stream, where is the money for its southern twin?

Oh, and by the way: Where is the gas that is supposed to fill Nord Stream (and South Stream, for that matter) going to come from?

From America’s financial problems, to Russia’s. Hard as it is to believe, given the depth of our miseries, that is not an improvement. To the contrary.

Where to begin?

How about the Ruble. It is widely recognized that Ignatyev’s waffling on the Ruble was a blunder. Not that statements that Russia was preparing to defend the Ruble to the last ditch would have been credible, but the attempt to be a little bit pregnant won’t have any effect on the course of the currency, and calls into serious question the competence of the central bank, and the government. Hopes that the currency will decline gradually are pipe dreams. If speculators are convinced that (a) Russia will not put its reserves behind a defense of the Ruble, and (b) the government is reconciled to a decline in the Ruble in the future, they will make the future now and mount an attack on the Ruble. If the central bank tries to stem a speculative attack and slow the rate of decline by selling dollars and euros and buying Rubles, it will burn through reserves, and for nothing–because sooner or later the fundamentals of capital flight and a current account deficit will prevail and drive the currency lower.

What’s more, if those dollars and euros are spent attempting to slow–but not stop–a Ruble decline, that’s fewer dollars available to pay back dollar and euro denominated debt. Now this is primarily private debt secured by equity in Russian firms, but as has been discussed often on SWP by me and Michel, Putin et al are loath to let the collateral fall into Western hands. But if the reserves are frittered away in a futile attempt to defend the currency against registering the reality of bad fundamentals, they won’t have a choice, and there will be widespread defaults. One can only imagine the extralegal means and judicial legendermain that the oligarchs and the government will use to keep their paws on the collateral. This would turn into a diplomatic and political catastrophe, rather than merely an economic one. And who knows what hard, desperate men will do when their backs are against the wall?

The market is sending signals that the worsening situation has substantially increased the prospect of default by the government and big corporations. From Bloomberg (article linked above):

Credit-default swaps on Russian government bonds jumped to 7.82 percent of the amount insured from 6.14 percent yesterday, according to CMA Datavision prices. The yield on its 30-year dollar bonds increased to 10.47 percent from 9.1 percent, according to Bloomberg prices.

. . . .

The cost of protecting against a default by OAO Sberbank, Russia’s largest lender, surged to 8 percent from 5.65 percent, while credit-default swaps on OAO Gazprom, the largest company, increased to 11.5 percent from 9 percent.

Credit-default swaps, conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. An increase indicates deterioration in the perception of credit quality.

Sberbank bonds plunged, sending the yield on five-year notes due 2013 up 210 basis points to 16.69 percent, Bloomberg prices show.

Sberbank’s stock fell 8.5 percent on the RTS today, and closed at $.92–not at its recent low, but damned close. And remember Sberbank is one of the banks that the government has favored, and pumped full of money. Another favored bank, VTB, was down over 22 percent.

The only other tool available to fight the Ruble decline is a sharp rise in interest rates. And the central bank pulled that tool out of the shed today. The problem is that it is a very costly tool to use. It will make it costlier for Russian firms and individuals to borrow, and cause a slowdown in the economy.

The stock market continued its slide, with the RTS down 13 percent today, 15 percent on the week. It was worse on the RIOB index of Russian stocks in London (which is not affected by the now-we’re-open-now-we’re-not shenanigans of the Moscow markets). This index was down 17.5 percent today, and 36.51 percent since 11/6/08.

And oil? Urals Med was down to $51.28/bbl. Kudrin is reconciled to oil $60/bbl or below for 2009-2011 ($50/bbl for 2009, $55/bbl for 2010, $60 for 2011.) That prospect, of course, is a major driver of all of the bleak news discussed earlier.

Whichever way Medvedev or Putin or Kudrin or Ignatyev turn, they face stark choices. Protect the Ruble–burn through the reserves or throw an already wobbly economy into a tailspin by jacking interest rates. Let the Ruble fall–serious potential for political unrest and the almost certain destruction of Putin’s credibility and reputation as the man who restored Russia from its last default. Bail out the oligarchs–say goodbye to dollars and euros. Let the oligarchs default–say goodbye to Russian control over the “crown jewels” of Russian industry, or keep control of them by repudiating foreign commitments and forget about foreign capital for a long time to come.

I think that the likely outcome is that Russia will not try to fight fundamentals, and will let the currency drop. Even if it drops like a stone. That would be the smart thing to do. As painful as the devaluation of 1998 was, it was a necessary condition for the economy to recover, and it did so in the 2000s.

But this will put tremendous domestic pressure on Putin and Medvedev. It will make them liars in the eyes of Russians across 11 time zones. But the problem they face is that attempting to defend the currency will only delay the day of reckoning, and leave them in a weaker position to deal with the fury.

And that is the danger of demanding and obtaining near absolute power, and depriving the citizenry of any meaningful political safety valve. When things go bad, everybody knows exactly whom to blame. That’s what makes a political system brittle.   And that is why there is a much greater potential for a political explosion in Russia than in the US or Europe.

I wrote an extended reply to DR’s comment regarding sovereign debt credit spreads, but (a) I had been planning on writing something regarding the price of risk more generally, and (b) the subject is of broad importance, so I’ll expand upon those thoughts in this post.

Credit spreads are essentially a price. Given a set of promised cash flows, the higher the credit spread, the lower the market price of those cash flows. Thus, if you had Russian and Brazilian debt with the same promised cash flows, a higher spread for Russia implies that the Russian debt sells for less.

This can occur for two reasons, the first of which gets the most attention, the second of which is the focus of this post.

The first reason relates to the size of cash flows. On debt instruments, realized cash flows differ from promised cash flows due to defaults. Therefore, the lower price of Russian debt could arise because market participants estimate that Russia is more likely to default than Brazil, and/or, in the event of a default, bond holders will receive fewer cents on the promised dollar from Russian bonds than Brazilian bonds.

The second reason, which is somewhat harder to grasp, is that market participants can apply different discount rates to different securities. In particular, finance theory tells us that you should discount riskier cash flows more heavily than less risky ones. All else equal, greater risk leads to greater discounting to lower price, which leads to higher spreads. Thus, Russian spreads could exceed Brazilian spreads because market participants discount Russian cash flows more heavily due to greater risk.

This raises the question: What is risk? Finance theory tells us that risks that are diversifiable should not be priced, that is, they should not affect the discount rate. This is because if the risk is diversifiable (also known as “idiosyncratic”) investors can eliminate it by holding highly diversified portfolios.

A diversifiable risk is one that affects one investment and that investment alone, and which is uncorrelated with the risks on other investments. For instance, the possibility that a particular company achieves a technical breakthrough is diversifiable, as is the risk that a particular company is hit by a product liability suit, or has a particularly good or bad management. Diversification eliminates these risks because in large portfolios, the law of large numbers means that the bad luck in one company is likely to be offset by good luck in others.

A systematic risk is one that cannot be diversified away. Typically, it is a risk that is driven by overall economic activity, that is, by the state of the overall economy. The overall economy affects all investments to some degree or another, and can’t be diversified away. We have many companies and countries, but only one economy.

Different assets have different sensitivities to overall economic activity. “Cyclicals” is an investment buzzword for companies that perform very well when the economy does well, but do very poorly when the economy is in recession. Some stocks (e.g., healthcare) are often considered to be non-cyclical because the demand for the services of these companies is not as sensitive to overall economic activity as are industries more dependent on discretionary income, such as automobiles and housing.

In brief, investments with performance that is highly dependent on overall economic activity tend to be discounted more heavily. People want investments that pay off when times are bad, and are willing to give up payoffs when times are good. Investments that are highly dependent on the overall economy are sunshine friends–they do well when you don’t need them as much (as your other investments are also paying off), but do poorly when you really do need them to pay (because all your other investments are doing poorly then too.)

Oil provides a very interesting illustration, and a link to the discussion of Russian credit spreads.

Historically, oil has had negative systematic risk. That is, oil prices tended to go up when the economy was doing badly, and go down when the economy was doing well. That meant that if you bought oil, it would pay off handsomely when you really need good payoffs–when your other investments are doing badly.

One explanation for this negative systematic risk is as follows. Supply shocks have historically been an important source of major oil price movements (think of the 1973 and 1979 oil shocks, the supply glut of 1986, and Gulf War I). Unexpected reductions (increases) in oil output raised oil prices and hurt the overall economy. The decline in the overall economy led to stock price declines. Thus, if supply shocks are major drivers of oil prices, you would expect a negative association between stock price and oil price movements.

Things are different now. At present, demand shocks are the major drivers of oil prices. Anticipations of a recession, and likely a severe, worldwide recession, have led to reductions in the expected demand for oil. This is why oil prices have declined of late. Moreover, the anticipation of a recession has caused stock prices to tank too.

Nowdays, the prices of oil and stocks tend to move in the same direction, and exhibit a relatively high correlation. You tell me what happens to the price of oil, and I can tell you (at least directionally, and with some precision as to magnitude) what has happened to the S&P or the FTSE. The price of oil is now a hostage to overall economic activity, as is the stock market. As a result, oil has gone from exhibiting low or negative systematic risk, to exhibiting high and positive systematic risk.

This can help explain Russia’s particularly high credit spreads relative to other BRIC countries, and why Russia has a higher credit spread that Iceland, even (though not as high as basket cases Pakistan, Argentina, and Ukraine.) It also contributes to the oft-noted fact that Russian stocks appear very “cheap” (as measured by price/earnings ratios, for instance) compared to other stocks.

The Russian economy is highly dependent on oil. In particular, government revenues are highly dependent on oil prices. Since oil has significant systematic risk, this means that securities (debt and equity) that are tied to the Russian economy have high systematic risk.

Moreover, the political factor risk factor plays here. It is becoming increasingly clear that the government is willing to spend a lot of money to cover the foreign currency borrowings of Russian companies. The largest borrowers, moreover, are energy companies. Their need for help will be greater, the lower the price of oil. Hence, the lower the price of oil, the faster Russia will burn through its reserves, the weaker its financial position will be, and the higher the likelihood of a default (de jure or de facto, a la 1998).

In essence, due to the close tie between oil prices and its economic fortunes, it makes sense that Russian spreads are very high. The country faces a triple-whammy. (That’s the technical finance term for it.)

First, default is more likely, and recovery rates are lower, the lower the price of oil. If oil prices remain low, Russia is more likely to blow through its reserves bailing out favored firms and defending the ruble. Furthermore, with low oil prices, government finances erode. All of these factors raise the likelihood of default on government debt. Thus, the probability of default is higher, and the recovery conditional on a default lower, the lower the price of oil.

Second, due to the high systematic risk associated with oil prices, cash flows highly dependent on oil prices are discounted more heavily. This includes government debt, private debt, and the equity of Russian companies, especially those in the energy sector, but not limited to that sector (e.g., consumer goods producers and retailers and construction firms are also vulnerable due to the link between their sales in Russia and the price of oil.) Russian investments, including government debt, are likely to do very badly when oil prices are low. Since the price of oil is likely to be low when overall economic activity is low, this poor performance is especially costly to investors, leading them to discount Russian investments more heavily.

Third, the factor I mentioned in The Price of Political Risk, namely the greater susceptibility of the Russian state to disorder when oil prices are low, exacerbates these problems. The low oil price stresses the weak institutions, and which contributes to pressures to spend reserves. It also increases the probability of popular unrest, government infighting, clan warfare, and in the extreme, political chaos and collapse.

So, the facts that (a) the Russian economy, and perhaps more importantly, its public finance and the demands on its public purse, are heavily dependent on the price of oil, and (b) in current market conditions oil-sensitive investments bear substantial systematic risk, imply (c) investments in Russian government or private debt, or Russian equity, have been especially hard hit by the credit crisis. Moreover, (a) and (b) imply that Russian investments will exhibit exceptional sensitivity to oil prices. So much for an island of stability and tranquility.

If you’ve been following the markets lately, you’ll observe that Russian stocks and US and European markets have been moving in the same direction (up on the same days; down on the same days), but that the movements in Russian stocks have been far more violent. (One consequence of this is that since markets overall are down in recent weeks, Russian markets have fallen more.) This is consistent with the foregoing that suggests that due to the oil price connection, Russia exhibits very high systematic risk. Moreover, the very low P/E ratios of Russian stocks are also consistent with this analysis.

Although the Russian market experience is a particularly interesting, this analysis demonstrates a very important point that is missed too often. It has application, for instance, to the ongoing financial crisis and the collapse of mortgage securities prices. This very interesting paper by Coval, Jurek, and Stafford argues that CDOs (and other tranched securities) exhibit very high systematic risk by the very nature of their structure. CDOs invest in multiple instruments, and therefore are highly diversified. What’s left is all systematic risk. What’s more, per C-J-S, this systematic risk is very high because of (a) the fact that the underlying investments are very sensitive to overall economic activity, and (b) the optionality (and hence embedded leverage) in the structure of the instruments.

For instance, the highest tranches of CDOs are likely to payoff when the economy does well. Defaults occur when the economy is doing badly. Thus, low payoffs on these instruments occur when the value of consumption is greatest. This means substantial systematic risk.

C-J-S note that rating agencies only modeled default probabilities and recoveries when rating these instruments, and did not take into account their high systematic risk. The investment grade credit ratings were therefore a very misleading indicator of the risk of capital gain or loss on these instruments.

In sum, finance theory tells us that systematic risk matters. Different instruments have different systematic risks. Russia’s dependence on oil prices and the structure of CDOs both create substantial systematic risks that the market discounts heavily.

As C-J-S note, too often people focus only on the cash flow projections, and pay too little attention to the discounting. (That’s what the rating agencies did in the CDO market.) Seemingly anomalous pricing may well reflect specific systematic risk characteristics of the instrument being priced. (Ignoring this is why arguably why Bernanke thinks that CDOs on bank balance sheets should be worth a lot more. His public statements have seemed to focus on the cash flow projections, rather than the discounting assumptions.) Thus, when evaluating the pricing of a particular instrument, you need to ask: in what states of the world are the cash flows going to be low? Are they going to be especially low during those periods when the cash flows on most other investments are low too? If the answer to that question is “yes”–you need to discount heavily.

LaRussaphobe pointed me to this interesting post from the Conde Nast MarketMakers blog.* The post discusses credit spreads for BRIC countries (Brazil, Russia, India, China). These credit spreads measure the creditworthiness of the sovereign debt on each of these countries. The higher the spread, the bigger the market’s estimate of a default (and/or the greater the market’s estimate of the loss conditional on default.)

You will note that as the credit crisis has exploded since late-August, all of these spreads have blown out, meaning that the market estimates that their risks of default have exploded. And surprise, surprise, surprise (cue Gomer Pyle voice), guess whose risk exploded most? Your favorite country and mine, Vlad’s paradise, that island of tranquility in troubled economic times.

In a nutshell, the market has deemed Russia the junkiest of the junky BRIC sovereign credits. And to think, this is the spread on government debt, the government that is sitting on $500 billion. Think of the market’s assessment of the credit risk of the “private” borrowers, eg Deripaska, Fridman/Alfa, Gazprom, Rosneft who are queuing up hat-in-hand to get charity from that government. Well, perhaps one reason for the wide spread is that market participants estimate that the $500 billion will be largely blown bailing out the oligarchs to keep strategic “crown jewels” out of the hands of the cursed foreigners.

Excellent MarketMaker blogger Felix Salmon expresses surprise at Russia’s poor performance relative to Brazil: “So the fact that it’s now 500bp wide of Brazil is kinda crazy. After all, they’re both mainly commodity plays, and their stock markets have both been devastated. But the credit markets show a huge distinction between the two countries which isn’t easily visible elsewhere.”

Not crazy to me, Felix. You’ve focused on just the economics (“both mainly commodity plays”) and missed the political risk angle. My conjecture is that the differential spread is the market price of political brittleness, weak institutions and property rights, corruption, and the absence of a rule of law. Now, Brazil is hardly Adam Smith’s vision of a classical liberal state, but it is miles ahead of Russia in that regard. Trying times test institutions, and times are now tough. The credit swap market is putting its money on the proposition that the current strains will overwhelm Russia’s political, legal, and economic institutions. That as a result, (a) the $500 billion plus that Russia has amassed in the seven fat years is at extremely high risk of disappearing down ratholes, leaving little behind to pay sovereign debtholders, and (b) the prospect that the gravy train is ending will spark political turmoil and infighting that threatens political stability in Russia, and sovereign debtholders hate political instability.

There are numerous stories on the web that help flesh out that story. Indeed, there are too many to mention, so I’ll just pick a few. First, this piece by Robert Skidelski in today’s FT:

Russia carries a heavy burden of political risk. This is the real economic legacy of the Putin years. Mr Putin does not understand the need for a degree of consistency between economic and foreign policy: or rather the reconciliation he has sought has been based on Russia’s energy windfall. If this has now ended, as seems likely, the key assumption of his politics – that Russia can use its energy power to boost its world power without paying much attention to the sensitivities of anyone but the Russian electorate – has been destroyed.

Russia needs to scale down its geopolitical ambition to its real weight – that of an emerging economy with only 3 per cent of the world’s gross domestic product and a quarter of America’s living standard. Also, it desperately needs to develop its human capital. The Putin era is over but Medvedev’s has not begun. This is the real Russian crisis.

(The last bit on human capital doesn’t relate to the political risk theme, but it does agree with what I’ve been arguing–not without opposition, to be fair.)

Then there’s this report describing how Russia is riding roughshod over the rights of minority foreign investors to save an oligarch (Mikhail Prokhorov) by rigging the game to allow him to escape his obligation to buy out minority investors at the price that he paid to acquire a controlling interest in power generator TGK-4. That’s not something you do when you’re thinkin’ ’bout tomorrow. If you are thinking about the future, you don’t want to do something that so damages your reputation with foreign investors. But reputation is about the future, if you are in sauve qui peut mode, it’s all about today.

One last gem, this one from the WSJ. VEB has extended a $4.5 million dollar to Rusal and Deripaska. But the rules said that the VEB assistance was limited to $2.5 billion. Rules? We don’ need no stinkin’ rules:

With the $4.5 billion Rusal loan, VEB appears to have made an exception to internal rules that limit lending of more than $2.5 billion to any one borrower. Norilsk, a major platinum producer, is considered strategic by Russian authorities. Without commenting directly on Rusal, Mr. Dmitriev said in an interview on a state-run news channel that the bank’s board — where Prime Minister Vladimir Putin is chairman — has the authority to make exceptions.

I’ll bet he does.

Both the Rusal and TGK-4 “exceptions” are only the most flagrant illustrations of the complete lack of any stable, rule-driven (and hence predictable) governance. Instead, they show that winners and losers are determined arbitrarily as a result of the exercise of influence and the exchange of political favors. They demonstrate that the system is one of personalized rule, with Putin exercising the ultimate power like the Godfather dispensing his favor on the lucky few. The Rusal exception also shows that Putin is willing to pay up to keep the “crown jewels” in Russian hands. That means that with various Russian companies owing well over $500 billion in foreign debt, there is a high risk that Russia’s reserves will be spent keeping control of these companies in Russian hands–another political decision, and one that just might be in the interest of connected people in the government. (BTW, it’s pretty sad that in the 2000s that an aluminum company is a country’s crown jewel. Think anybody in the US thinks that about Alcoa?)

In short, these episodes illustrate perfectly, Felix, why Russia trades at a 500 bp premium to freakin’ Brazil, of all places.

* I can just picture commentor David, and his fellow gang members (he does admit that he is a member of a group, and I have received emails from others expressing similar views), sitting somewhere in Poland or points east, saying “OMG, I just KNEW IT! Pirrong and LaRussaphobe ARE card-carrying members of a vast anti-Russian conspiracy!!!” You can change your drawers now, Dave, but I’m sorry that I’ll have to disappoint you. LR sent me an email, from the same email address that’s on her website, [email protected]. She signed it Kim. No hint of her/his/it super-secret identity. The email reads, in its entirety (excepting the salutation and signature, and the MarketMakers link that I’ve posted above): “Can’t make heads or tails of this, thought you must be able to.” Pretty loose association, don’t you think? Or, maybe that was code. But I never got my decoder ring, so I’m at a loss. And, to my disappointment, there’ve been no PayPal alerts telling me that money has been sent to me from shadowy sources to compensate me for my work for the conspiracy. Guess I’ll have to try harder.

I’ve argued that the current financial strife in Russia is an opportunity for sharks to take big bites from state funds, for the connected to get at the various reserve funds that have tempted them for a long time, but have been out of reach until now. Pavel Baev’s recent piece in the Eurasian Daily Monitor agrees:

All these voices are lines in a long rhyme that invariably ends with the reference “… in the house that Jack built,” and everybody in Russia knows who the architect in question is. That Vladimir Putin has never been able to admit a mistake is only part of his motivation for stonewalling the analysis of the unfolding disaster. A greater part of this determination comes from the need to keep the system of unaccountable redistribution of financial resources going for as long as possible, while the key players seek to compensate their colossal and totally unexpected losses.

Two features of this desperate looting of fast-shrinking reserves came into sharper focus last week. First was the mind-boggling scale of the external indebtedness of Russian companies, not only of all state-owned energy giants like Gazprom and Rosneft but also private “oligarchic” empires close to the Kremlin. The sharp fall of their market capitalization has triggered many “margin calls” for repaying the borrowed money since the collateral has lost value. As a result, Russian “champions” have to pay back up to $210 billion by the end of 2009 (The New Times, October 20). The political decision to rescue the loyal entrepreneurs by providing $50 billion for refinancing their foreign debts can solve some immediate problems, but the applications have already exceeded the designated sum, and many investment programs that are supposed to support Russia’s continuing growth, for instance in the newly-privatized electricity sector, have been gutted.

The second feature is the spectacular increase in corruption schemes and channels in the emergency situation of siphoning off hard-currency reserves that still amount to half a trillion dollars, which is approximately equal to the corporate debt. The decisions about rescuing banks that are known to be “close” to certain officials and opening credit lines to companies with unknown ownership structures are so opaque that the international financial services company Standard & Poor’s revised its outlook on Russia’s sovereign credit rating from “stable” to “negative” last week (www.newsru.com, 23 October). Corroborating this was Transparency International, which gave Russia its worst mark in eight years, so that in the Corruption Perception Index it now shares 147th place (out of 180) with Bangladesh, Kenya, and Syria (Nezavisimaya gazeta, October 24).

Medvedev quite possibly feels the need to add more substance to his anticorruption initiatives and provide some explanations for the apparent lack of results from the much-advertised interventions. Putin, however, cannot tolerate dissent from his junior partner, since any crack in the monolithic system of power could trigger an avalanche of desertions and revelations that would demonstrate that corruption is not a mere defect in his course of expanding state control over the economy but its core substance. His approval ratings may still remain high; but the social contract of “Putinism,” according to which the population enjoys the fruits of petro-prosperity while ignoring the shameless thievery of the ruling elite, is about to expire (www.gazeta.ru, October 22). The peculiar two-headed form of leadership was designed by the over-confident “tsar” for presiding over a permanent party of distributing tons of easy money; but it cannot function in the situation of escalating squabbles between elite clans and gathering social discontent. Cutting Medvedev down to size with his address was easy, but now Putin has to decide how much longer he can postpone the hard tasks of managing rather than explaining away the crisis that has transformed his pet projects into toxic assets.

Three of Baev’s points in particular echo my previous analyses: (a) “the spectacular increase in corruption schemes and channels in the emergency situation of siphoning off hard-currency reserves that still amount to half a trillion dollars”, (b) “any crack in the monolithic system of power could trigger an avalanche of desertions”, and (c) “the social contract of ‘Putinism,’ according to which the population enjoys the fruits of petro-prosperity while ignoring the shameless thievery of the ruling elite, is about to expire (www.gazeta.ru, October 22). The peculiar two-headed form of leadership was designed by the over-confident ‘tsar’ for presiding over a permanent party of distributing tons of easy money; but it cannot function in the situation of escalating squabbles between elite clans and gathering social discontent.”

In a nutshell: Baev portrays a brittle natural state with stability dependent on simultaneously redistributing wealth to favored and powerful interests while generating enough growth to pacify the larger populace that is vulnerable to collapse due to defections of the powerful when the rents run low.

The impetus for Baev’s piece is that Medvedev’s speech to the Duma scheduled for last week has been delayed indefinitely, with no explanation that passes the laugh test. It is passing strange that in the midst of an existential crisis, the President’s speech has been delayed. It certainly gives the lie to the air of confidence that the government is attempting to project.

Maybe Kevin Bacon can do a public service announcement to help them out.

Let’s start a campaign: Free Dmitri Medvedev!

Ambrose Evans-Pritchard has a fascinating article in today’s Telegraph. It is fascinating on many levels.

For one, it helps explain why European banks have been battered even worse than American ones. European banks invested in made-in-America subprime (which suggests that Americans are not uniquely culpable for that problem), but they also plunged far greater sums into emerging market investments, all of which are plummeting in value. The travails of European banks, and the prospects of worse to come, also helps explain the dramatic weakening of the Euro, the pound, and the Swiss franc.

Although US subprime has attracted most of the attention, because it cratered first, it is clearly not the only source of toxicity in bank balance sheets. It is becoming increasingly evident that low interest rates, attributable in part to the Asian savings glut and partially to liberal US monetary policy (less so European directly, but in an open economy Europeans didn’t have complete control over their interest rates) that encouraged yield shopping in a big way, and yield shopping means “add risk” in any language.

For another, the article also has some interesting tidbits about Russia. To wit:

Russia too is in the eye of the storm, despite its energy wealth – or because of it. The cost of insuring Russian sovereign debt through credit default swaps (CDS) surged to 1,200 basis points last week, higher than Iceland’s debt before Götterdammerung struck Reykjavik.

The markets no longer believe that the spending structure of the Russian state is viable as oil threatens to plunge below $60 a barrel. The foreign debt of the oligarchs ($530bn) has surpassed the country’s foreign reserves. Some $47bn has to be repaid over the next two months.

As Michel pointed out in a comment to another post, the heavy indebtedness of the oligarchs presents the Russian government with several unpalatable choices (though DR does not find them as bad.) Bailing the oligarchs out of their foreign denominated debt would put a large dent in, and perhaps exhaust, the massive reserves that Russia has so assiduously accumulated in the past several years. Since most of the debt is collateralized by shares in companies, many of which are Russian (though, again per DR, some are in the US and Europe), oligarchic default would transfer large ownership positions in “strategic” Russian businesses to despised foreigners. Or, the Russian government could expropriate the oligarchs/nationalize their businesses, and hang the Western lenders out to dry. By so doing, they would keep their “crown jewels” out of the hands of foreigners (and, conveniently, in the control of the siloviki in the government), but (a) this would turn Russia into a pariah that would have acute problems accessing capital markets in the future, and (b) destroy value by concentrating even more control over enterprises in state hands, which distorts incentives and encourages rent seeking.

My guess is that in the short to medium term, the government will try to buy time and dole out financial support to the oligarchs in the hope that things will turn around. Only if the country’s reserves are depleted too rapidly, or the reserves fall to an uncomfortably low level, will the government contemplate something more extreme. And if it comes to that, I would wager that Russia would choose “pariah” over ceding substantial stakes in “strategic” businesses–even minority stakes–to foreigners. The latter option is too much at odds with the entire rationale for Putinism, and would drive the nationalist elements in Russia around the bend, thereby jeopardizing Putin’s domestic support. Given the choice between stickin’ it to The Man (i.e., foreigners) and living without foreign capital (who needs those bloodsucking bastards anyways?), and being labeled a traitor to the motherland, I think it’s pretty clear which way Putin would jump. But maybe he’ll get lucky, things will turn around, the price of oil will recover (along with the world economy) and Putin will never have to make that hard choice. That’s why buying time and spending the reserves makes sense in the near term.

But, suffice it to say, that the worm has truly turned in the last three months. During that short time, Russia has gone from globe straddling giant (in its own mind, anyways) to a gambler looking to survive by drawing an inside straight. Not that things are rosy in the USA, but as bad as things are here, I’d rather play our hand than Putin’s.

How Gazprom’s financial travails will affect the prospects for Nordstream and South Stream.   Not too favorably, I’d wager.   (Though that depends on whose perspective you take.   Here, by “favorable” I mean “increasing the odds of completion.”)   By the same token, Europe and the US don’t have the money to throw at Nabucco, and are, shall we say, otherwise occupied with their own issues.   Thus, for the near future the Gas Wars may become just another Frozen Conflict.

Actually, the $63.90 question–that’s today’s price (per the WSJ) of Urals Med–is: how much stress will this lower oil price put on the Russian government? Flagship firms are feeling the bite in a major, major way. Gazprom, down 6.36 percent on the day, 48 percent on the month, and 63.8 percent on the year. Rosneft down 5.71 percent on the day, 49.8 percent on the month, and 61.3 percent on the year. Gazprom credit protection costs up 145 bp (about 13 percent) in a single day. (Couldn’t find similar figures on Rosneft.) Tatneft was down 40 percent.

These are the firms that are supposed to be the cash cows that fund all the goodies for the big shots and the country at large–and they are turning to the government in search of cash themselves. That situation is not sustainable, and will exacerbate the factional frictions–seething just below the surface even in high times–within the Russian ruling elite.

Moreover, high energy prices had masked the inefficiencies at these firms. It is easy to look smart when the price of your product is sky high. The real challenge of management is dealing with hard times. There is room for serious doubt as to whether the chekist cadres that run these companies are up to the task of navigating through such turbulent waters. They weren’t promoted for their management acumen, or their knowledge of the oil and gas business. Their skills are not the skills that are needed in current circumstances. High prices covered a multitude of sins, and those sins are about to be revealed in a big way. Which will only contribute to the backbiting and infighting.

And we needn’t revisit the implications for the Russian budget, and the political ramifications of that.

Regardez la deluge.