Streetwise Professor

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.