Streetwise Professor

October 30, 2008

The Price of Political Risk

Filed under: Derivatives,Economics,Energy,Politics,Russia — The Professor @ 7:45 pm

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.

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  1. And the reserves keep falling…. Russia now has less than $500 billion and this includes losses as the central bank spends dollars and other foreign currencies to protect the ruble, and a decrease in value of the Euros the Russian central bank has stockpiles. This from Vedomosti (Da Russophile will be happy as it calculates both losses due to the Euros drop in value relative to the dollar, and the drop due to the central bank spending to protect the ruble). In 4 weeks, the reserves have dropped by $78.1 billion, and Vedomosti notes that the reserves have never shrunk so quickly:

    За неделю по 24 октября резервы Центробанка уменьшились на $31 млрд до $484,7 млрд. За четыре недели они упали на $78,1 млрд.

    Так быстро резервы не таяли никогда. Скорость превзошла ожидания экономистов. Накануне бывший первый зампред ЦБ Сергей Алексашенко в своем блоге предположил, что за счет падения курса евро к доллару резервы ЦБ усохнут на $13-15 млрд, а на валютные интервенции ЦБ потратил $7-9 млрд (всего — $20-24 млрд).

    Of the remaining monies, half or so has already been committed according to Vedomosti, leaving $250 billion in the reserve funds:

    Но долго тратить деньги на поддержку рубля теми же темпами ЦБ не сможет, ведь примерно половиной резервов он уже не распоряжается. Порядка $180 млрд — средства Минфина (фонды резервный и благосостояния, по курсу на 1 октября), еще $50 млрд обещаны Внешэкономбанку (ВЭБ) на рефинансирование внешних займов, а $8-10 млрд — на поддержку банков, перечисляет Алексашенко. Остается около $250 млрд.

    According to one leading banker, spending the reserves at such a rate is “irrational”:

    Тратить резервы такими темпами на поддержку рубля нерационально, полагает председатель совета директоров МДМ-банка Олег Вьюгин, ранее — первый зампред ЦБ.

    Next week, Russia will be spending another $10 billion to help the first of the Russian corporations refinance their debts:

    “Ð’ следующие недели резервы будут уменьшаться еще и за счет перечисления денег ВЭБу, полагает экономист «Траста» Евгений Надоршин. Ð’ среду председатель ВЭБа Владимир Дмитриев объявил о выделении первых кредитов ($10 млрд) российским компаниям на рефинансирование внешних займов. Наблюдательный совет ВЭБа решил выдать кредиты 27 октября и на прошлой неделе эти деньги из ЦБ еще не поступали, говорит источник, близкий к ВЭБу. Представитель ВЭБа от комментариев отказался.”

    At this rate, there won’t be much left in the reserves. I do have one question for the Streetwise Professor: how much of the reserves do you think is tied up in investments that cannot be recovered or cannot be cashed in the near future? I.e. money tied up in Lehman Brothers and other such ventures. Simply put, how much of the money in the Russian reserves is on the books, but can’t be spent because of the financial crisis in the United States or Europe?

    Comment by Michel — October 31, 2008 @ 1:56 pm

  2. I have another thesis. CDS spreads can themselves exhibit bubble-like behavior. I mean, a lot of them are truly irrational, and I’m not just talking about Russia. Just going off memory, South Korea is at 500 (which has $250bn reserves), but indebted Britain with twin awning deficits is only at 70. Probably investors heard the phrase “East Asia crisis” and the spreads on Korea skyrocketed. Otherwise, how to explain this situation?

    Comment by Da Russophile — October 31, 2008 @ 3:02 pm

  3. DR–I extend an invitation to put your money where your mouth is–sell protection on Korea, buy it on the UK.

    More seriously, reserves are not immaterial, but they are not a sufficient condition to explain sovereign credit/default risk. Indeed, they point to an important issue–the currency in which a country has borrowed. I haven’t looked in detail, but I imagine that virtually all UK government debt is denominated in sterling, so it can always print pounds to cover its obligations. Korean banks and corporations have large dollar denominated debts, and its households are heavily leveraged. Korea just extended $100 billion in guarantees of the foreign currency borrowings of its banks, essentially converting private foreign currency denominated debt into government FX denominated obligations. These debts have become even more onerous due to the decline in the Won (30 percent at one point.) In present circumstances (and analogous to the argument I made re Russia some weeks ago) a country can run through $250 billion extremely quickly.

    And the trade deficit/surplus issue could actually be working against Korea. With export earnings almost certain to decline due to a worldwide recession, the main prop of the Korean economy will be weakened. This will put a crimp in earnings of foreign currency (making it harder to service the foreign currency denominated debt), weaken the Won (which has already occurred), and reduce personal income (creating problems due to the substantial leveraging of Korean consumers noted above.) Reductions in personal income and business profits from exports will reduce tax revenues, putting a strain on Korea’s ability to service its debts, and likely causing public indebtedness to rise.

    Korea’s political system is also more brittle than Britain’s, and large corporations and financial institutions in Korea are often successful at obtaining government support when they are in trouble. This means that the FX reserves are at the beck and call of Korean business and banks. (This is similar to the issue I’ve been raising re Russia, including in this post.)

    So, I wouldn’t be so hasty as to conclude that Korea is the QED on the proof that sovereign CDS markets are irrationally priced.

    One other issue. Yield spreads do not just price the likelihood of default, and recovery rates. They also reflect the pricing of systematic risk, and differences in systematic risk across (in this instance) countries. Default probabilities and recovery rates affect cash flows. CDS yields reflect cash flows AND the rate at which cash flows are discounted. Discount rates should vary depending on systematic risk, and cash flows that exhibit a higher correlation with overall wealth/consumption movements should be discounted more heavily (leading to higher yield spreads.) So, two countries with identical default probabilities and recovery rates could be priced differently, depending on how those defaults are correlated with overall world economic activity.

    Korea’s export dependent economy implies that its economic fortunes are particularly closely tied to the state of the world economy. The world economy does badly, and Korea is especially hard hit. This contributes to very high systematic risk, higher discounting, higher yield spreads.

    Put another way, it’s not just the probability of default that matters, it’s when that default occurs. A Korean default is most likely to happen when the world economy is in the dumper–which is just when a unit of consumption is particularly valuable. Cash flows on securities that are most likely to default when economic conditions are especially bad are discounted most heavily because they pay cash flows reliably in good times but are more likely not to pay in bad times when such cash flows are particularly valuable. That is, they are sunshine friends, paying when you don’t need it as much, and not paying when you do.

    Now of course most debt instruments are more likely to default when worldwide economic conditions are bad (which is why all defaultable spreads tend to widen during weak economic times), but the relevant issue in evaluating relative spread movements is the relative sensitivity of default to economic conditions. Export driven economies like Korea’s are highly sensitive to world economic conditions, and hence their spreads are most sensitive to weakening world economic circumstances.

    This could be a serious issue with Russia too. The dependence of its economy on oil, the price of which is highly sensitive to world economic conditions, injects serious systematic risk into Russian debt. There are several channels, including the fact that weakening oil prices puts pressure on the Ruble, making it a lot more costly for Russian firms to service their dollar denominated debts. (Depreciation relative to the Euro has been much more modest as you’ve noted.) Moreover, cash flows of Russian borrowers are lower when oil prices are lower, making it more difficult for them to service their debts. Russian government revenues fall too.

    Historically, oil prices tended to move in the opposite direction of world stock prices. This was because supply shocks were the dominant source of oil price movements, and adverse supply shocks raised oil prices and dampened economic activity, leading to a negative correlation. Thus, oil historically had negative systematic risk; it did well when economies were doing badly, making it a valuable hedge against bad economic news.

    Things are different now. At present, the main factor driving oil prices is expectations regarding economic growth worldwide, and growth realizations. You tell me what world stock indices did today, and I’ll tell you what oil did–they move the same way, and oil is shackled to the major indices. This means that oil now has a very high systematic risk loading, and that anything that has cash flows that are oil price sensitive (i.e., almost anything related to the Russian economy) and those cash flows will be discounted extremely heavily.

    This is one reason why it is quite sensible that movements in Russian stock prices have been so much more exaggerated than those in the US and Europe. It also contributes to the very high yields on Russian debt (not just CDS spreads on Russian sovereign debt, but on private debts e.g., Gazprom.)

    So, Russia faces a perfect storm, largely reflecting its acute dependence on oil prices. This dependence has two extremely deleterious effects. One is the systematic risk considerations I’ve discussed in this comment. The other is the corrosive effect of natural resource rent dependence on political institutions, which is the gravamen of the political risk analysis in the main post.

    The ProfessorComment by The Professor — November 2, 2008 @ 9:38 am

  4. […] 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. […]

    Pingback by Streetwise Professor » The Market Price of Risk, More Generally — November 2, 2008 @ 6:31 pm

  5. Thanks for the detailed reply, it cleared a lot of things up in my mind. I’ll read your new posts properly when I have some time (which unfortunately I won’t until after Tuesday).

    “DR–I extend an invitation to put your money where your mouth is–sell protection on Korea, buy it on the UK. ” – SWP

    No thanks. I know very little about finance. That’s why I’m asking these question. 🙂

    “I haven’t looked in detail, but I imagine that virtually all UK government debt is denominated in sterling, so it can always print pounds to cover its obligations. Korean banks and corporations have large dollar denominated debts, and its households are heavily leveraged.” – SWP

    Why can some countries denominate their debts in their own currencies, while the peripheral countries have to borrow in dollars?

    Is there a site which lists a breakdown of national debts and what they’re denominated in?

    Comment by Da Russophile — November 3, 2008 @ 4:09 am

  6. Glad you’re not drinking Kim Zigfeld’s koolaid. La Russophobe looks like somebody’s obsessive blogging project which somewhere around late 2006 started receiving crumbs from the table of someone like Randy Scheunemann’s Orion Strategies and other pro-Ukraine and pro-Georgia in NATO lobbying groups. And based on the level of vitriol and pettiness on Kim Zigfeld’s blog (all commenters saying the slightest thing critical of her posts or declaring BS on her “facts” are banned or ridiculed), I can’t imagine it being the work of a woman but a man posing as a lady with a vaguely Semitic name. This seems to be the better to claim victimhood when “Kim Zigfeld’s” lies about real individuals using their real names (such as U.S. citizen and “Russians for Reagan” founder Dr. Edward Lozansky on the Right, and Prof. Stephen F. Cohen, the husband of Nation editor Katrina Vanden Heuvel, on the Left) are exposed.

    Anyway, Prof. Pirrong, Kim Zigfeld regularly draws vast conspiracies connecting the Kremlin with all manner of blogs, individuals, and websites in the U.S., in true John Birch Society fashion, even though many of these entities are up front about who supports them (while nobody knows who the heck pays La Russophobe to keep the lights on in NYC). Charles Johnson, of Little Green Footballs notoriety, also did the same thing, and in the process has alienated practically everyone who contributed to his website when it was just an anti-jihad forum (Robert Spencer, Gates of Vienna, et al) by connecting them to allegedly fascist anti-Islamic immigration parties in Europe.

    Kim Zigfeld also brags about having received 600,000 visits to her site since it started three years ago. I know for a fact tje joke/image site English Russia gets about that many hits in a month, or more, and other Russia blogs also get more. Kim pretends that the number of linkages to her blog somehow proves anything about how many people actually read it. But obviously Kim feels the need to demonstrate her traffic to whoever is paying for the site, and disavows fundraising because he/she is using copyrighted articles and doesn’t want to be sued for infringement (which she ought to be).

    Kim also employs a whole host of sock puppets who apparently enjoy no existence outside of the La Russophobe website, such as “David Essel”, “Jeremy Putney”, “Leonard Daulton” et al, and denounces individuals for contributing to “Kremlin shills” like Russia Profile, while using content from RP contributors like Prof. Ethan Berger of Georgetown. But at least Prof. Berger, unlike yourself, has some sense of shame about having his content posted by Kim Zigfeld and has quietly stopped contributing to “her” site. Oh, and did I mention that Kim has the chutzpah to declare that if individuals educational credentials in Russia cannot be obtained via an English language Google search then they must be fake, and people who do not have Google or Wikipedia pages are “losers” (I guess that would include the aforementioned Putney and Essel!).

    Anyway, since Kim Zigfeld’s statements can’t even survive a one minute reading, the basic purpose of the site remains to Google bomb certain individuals. That’s why I created La Russophobe Exposed to fight back. However, once “La Russophobe” and “Kim Zigfeld” return my rebuttals in Google searches, these smear tactics will fail, just like Scheunemann and his crowd failed to elect their easily manipulated Russophobic puppet McCain. Whether Z. Bzerzinski will be able to similarly manipulate Obama remains to be seen. My guess is Obama is enough of a pragmatist to quietly drop the missile defense system in Poland in return for the Russians withdrawing the Iskander missiles from Kaliningrad. That seems to be the endgame that Medvedev is playing for. And whether or not some of those 2 million $200 contributions came via online credit cards funnelling money out of Russian, Arab, and Venezuelan bank accounts remains to be seen.

    Comment by Steve J. Nelson — November 6, 2008 @ 12:50 pm

  7. Steve–

    I don’t drink anybody else’s KoolAid. I prefer to imbibe my own:) At the same time, I hope that those who read what I write do so with their critical faculties fully activated. Montaigne said something to the effect that everything I write is by the way of discourse, and nothing in the way of advice. I would not be so hardy to speak if I ought to be believed. I have my opinions, try to bolster them with facts and logic, but it’s up to the readers to make up their own minds.

    Re LR, apropos my earlier comment in reply to “David,” his/her/its real identity is a matter of indifference to me. I prefer to focus on facts and analysis, and to the extent that you can demonstrate that LR is wrong on either score, more power to you. Likewise, to the extent that LR scores a few hits, power to him/her/it. That’s all that matters. “True identity” is a distraction at best, but more likely an irrelevance. But it’s your bidness as to how you spend your time and efforts.

    The ProfessorComment by The Professor — November 7, 2008 @ 1:48 pm

  8. Re LR, apropos my earlier comment in reply to “David,” his/her/its real identity is a matter of indifference to me. I prefer to focus on facts and analysis, and to the extent that you can demonstrate that LR is wrong on either score, more power to you. Likewise, to the extent that LR scores a few hits, power to him/her/it. That’s all that matters. “True identity” is a distraction at best, but more likely an irrelevance. But it’s your bidness as to how you spend your time and efforts.


    Yeah right!

    Comment by Siegfried — July 25, 2010 @ 4:59 am

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