Is Russia Returning to a Debt-Based Economy?
2007.3
Akio Kawato
Russia once built a debt-based economy by raising funds in the West using government bonds as collateral until 1998. This approach invited a collapse of the economic bubble in August 1998. At that time I gave a speech at Harvard in which I said “Russia has become an out-of-control borrowing machine. I wonder when the house of cards will come tumbling down?” And then the Russian bubble collapsed on that very same day.

Now Russia’s overseas borrowing is once again rapidly increasing. I want to examine the question of whether we will witness a reoccurrence of the events of August 1998.

1. In the midst of the booming oil economy, the Government of Russia was able to repay all of its 23.7 billion dollar public debt to the Paris Club in August 2006, ahead of schedule.
On the other hand, Russia’s banks are creating profit margins by borrowing short-term funds in the West and using them to provide consumer finance in Russia. Some of them are even extorting interest at a real rate of 50%, by disguising the interest charges as bank fees, etc.

However, the people of Russia are fascinated by the new (for them) system of payment by installment, debit cards, and so on. They are on a consumption binge. The balance of consumer loans at banks has increased from zero to 35 billion dollars in the last three years (Reuters).

Also companies are borrowing merger and acquisition (M&A) funds overseas, borrowing to refinance previous debts, and so on, and as a result Russia’s external debt is rapidly increasing and three-quarters of the current cumulative debt total of 287.4 billion dollars is private debt.

2. Raising funds in overseas capital markets and IPOs on stock markets have become very popular.
The City of London is being rocked by a series of IPOs by Russian companies. Russia’s Sberbank, the largest (governmental) bank, also plans to raise 10 billion dollars through an IPO in the near future. In this way Russian companies can easily obtain funds far greater than their annual revenues.
In the City of London, some observers are warning against unrestricted IPOs by Russian companies because they are lacking in transparency and highly politicized (The Guardian).

3. On the other hand, the capital of Russians themselves is flooding out of the country in search of long-term high interest rates. In the third quarter of 2006 a total of 12 billion dollars left Russia, three times more than in the second quarter and 13% more than in the same quarter the previous year (Economic Development Center).

Until recently Russian companies carried out most of their M&As in the countries of the former Soviet Union (a cumulative total of 120 billion dollars of investment by 2005. However a large portion of the 123.2 billion dollars from the Virgin Islands can be regarded as Russian funds). Now the focus is shifting to companies in Eastern and Western Europe. In 2005 Russian companies carried out 83 M&As in the West, worth a total of 5.1 billion dollars. The first half of 2006 saw a further increase to 57 M&As worth a total of 3.3 billion dollars (Vedomosti).

Now people are starting to whisper, half in jest,that a buyout of BP or Shell by Gazprom or LUKOIL is on the cards. However, European business leaders are underrating Russia and underestimating the risk of their own companies being absorbed by the Russian ones.

4. The Russian economy is better off than it was in 1998 and even the levels of debt described above are not a problem for the time being. Foreign currency reserves have reached 270 billion dollars and the Stabilization Fund, built up to sterilize the fiscal surplus, climbed to 2,049 trillion rubles, about 76.5 billion dollars, on 1 November 2006, and is accruing at the rate of 6 billion dollars a month (Mosnews.com).
(The Stabilization Fund is a tricky thing, though. It exists on paper. In real terms it is fictitiously converted into foreign currency, constituting a part of their foreign currency reserves. So, it seems that the real size of their “shock absorber” is no larger than the amount of the foreign currency reserves.)

Russia’s Institute for the Economy in Transition published a simulation showing that even if the price of oil fell to 25 dollars a barrel over a three-year period Russia would be able to stay afloat using its stabilization funds and other resources.

5. However, destabilizing factors remain.
(1) It was as long ago as June 1991, but when then Prime Minister Valentin Pavlov inspected the national coffers and made the bombshell statement that there were almost no foreign currency reserves remaining, he plunged the country into panic. Could something like that happen again?

(2) Russia’s external private debt of 215 billion dollars is equal to approximately 20% of its GDP and approximately twice its trade surplus. Moreover, Russia’s banks are small. The balance of bank finance is no more than 20% of GDP, much lower than the level in the West. If domestic loans become non-performing assets and simultaneously the ruble crashes, the ability of Russian companies to repay their external debt will be severely damaged and a run on bank deposits or other financial panics could occur unless the government injects public funds into the banks quickly.

(3) When the bonds that have been issued during this time of peak oil and gas prices are reissued in future to refinance the loans, the debt burden will increase along with any fall in oil and gas prices, because the ruble rate will go down accordingly.

(4) In Russia large-scale consumer finance has only just begun and any viable system to check consumers’ creditworthiness has not been developed yet.

6. Other destabilizing factors
(1) It is reported that in 2006 the annual rate of increase in consumer prices was below 10% for the first time since the collapse of the Soviet Union. However, according to statistics produced by the Economic Development Center, between January and September 2006 the prices of mining and manufacturing industry products increased by 15%, the cost of energy resources extraction increased by 24%, and the prices of domestically-produced electrical goods increased by 14%. Even an energy-producing country like Russia suffers a rebound effect from the increase in international energy prices.

(2) In the middle of the current consumption boom imports are growing at a faster pace than exports. Imports in the third quarter of 2006 came to 43 billion dollars, marking record-breaking growth of 53% on the same quarter last year. As a result of this, the growth in imports exceeded the growth in exports for the first time (Economic Development Center).
Therefore some observers are forecasting that Russia’s balance of trade will even out over the next few years.
(3) There is a frightening possibility that the negative factors in the economy will all emerge at once in the election years of 2007 (when there is a general election in December) and 2008 (when there is a presidential election in March).