NEW YORK (KWR) -- February 27, 2007 -- Russia has come a long distance from the bad old days of the 1990s when it was forced to default on its domestic debt, the economy almost slipped into free-fall, and the country's politics were unsteady. Over the last few years the oil and commodities boom has translated into rapid economic growth, a substantial rise in foreign exchange reserves (over $311 billion as of February 16, 2007), budget surpluses, and the rise of strong national champion companies, such as energy giant Gazprom. Russia's political life is more stable as well -- but at the cost of its democratic politics. President Vladimir Putin and his intelligence network allies have broken the power of the oligarchs and many now live in London. This has diminished the liberal and Communist wings of national politics, and implemented a quasi-authoritarian system.
Yet, the year ahead is likely to be another testing period for Russia and its leadership. As Fitch noted on January 25, 2007: "...trends in oil prices, fiscal policy, investment and the management of the political transition of power could have a significant bearing on Russia's development and creditworthiness in 2007". This is especially the case as oil prices are likely to be lower, Russia's foreign investment policies have not exactly been welcoming as of late, and the country faces both parliamentary and presidential elections over the next 16 months. While Russia is not likely to undergo the same type of crisis as occurred during the Yeltsin years -- and default is only a distant consideration -- uncertainty is never a good thing for investors and that is the terrain into which Russia is heading.
We believe that Russia faces tougher times ahead. This does not mean any major economic crisis or the threat of debt default, but the country's economic progress will be much more difficult to obtain, even with further reductions in external debt. The key issue is that Russia is basically an energy and commodity producer, with some relatively uncompetitive industries attached. While prices for oil, natural gas, nickel and others stay high, the government is able to pursue a more relaxed fiscal policy and spread the wealth around, especially as Duma elections are scheduled for December and presidential elections in March 2008. A sharp fall in oil prices would certainly hurt government finances, but prices would have to slip below $38 per barrel on a sustained basis to make a difference over the medium term.
In its annual Article 4 report, the IMF emphasized that while Russia had made considerable progress, it had concerns that the oil and natural gas boom was concealing structural problems. As the report states: "Structural reforms outside the banking sector remain very slow. The authorities agreed that structural reforms are behind schedule and claimed that high oil prices and robust growth make it difficult to mobilize political support for reforms." In particular, the IMF pointed to government finances, which are highly dependent on hydrocarbon revenues. The development agency warned "about the risk of a gradually emerging non-oil deficit and a spending structure that cannot be sustained if oil prices were to drop sharply, raising the specter of pro-cyclical fiscal tightening and the real exchange rate overshooting its long-term equilibrium."
To the IMF's concerns we would add Russia's policies vis-à-vis foreign investment. Starting with Yukos, the big Russian oil firm bankrupted by overzealous tax inspectors, and following through with the 2006 Gazprom "offer that you cannot refuse" to Mitsui, Mitsubishi, and Royal Dutch Shell's Sakhalin project, the Putin administration has made corporate governance a matter of falling in line with national interests as determined by the Kremlin. Foreign investors were treated poorly in both cases, leaving the door open to questions as to how safe it is to invest there.
Yet, there has been a take-off in investment in Russia, with growth of around 12 percent in 2006, reflecting net private capital inflows of $42 billion. This is up from $1 billion in 2005, and record foreign direct inflows of $31 billion were achieved. It would appear that excess liquidity in international markets is still attracted to riskier assets. The Economist (December 16th, 2006) noted the ongoing attraction of investment in Russia's hydrocarbon sector: "With exploration prospects drying up in much of the Western world, and with countries of the Organization of the Petroleum Countries unwilling to open the taps, Russia is one of the few countries that could produce more oil..." This could be a case of the devil taking the hindmost - the last investor in could get hit with the worst deal.
The major concern with Russia is political. While it is probable that whoever Putin decides to succeed him will enter the Kremlin as the nation's next president, we have entered a period of uncertainty as to who that person will be. This means that policy continuity is probable. It also means that Russian politics are entering a phase of sharp elbows, as potential candidates jockey for position. It will also influence the conduct of the Duma elections in December. This is not so much a question of how Putin's United Russia party will do -- it currently controls 309 seats out of 450 -- but how factions within it will do and how they will help reinforce presidential bids.
The danger is that the fight within the government turns nasty and has an impact on policies. As Fitch noted: "However, weak and opaque democratic institutions and the 'winner takes all' nature of the contest could see a disconcerting battle for position between different post-election business and political groups in and around the Kremlin. A post-election shift in economic policies or heightened uncertainty over property rights cannot be ruled out." Considering Russian problems in controlling the use of polonium, there could be a lethal undertone to factional infighting that cannot be entirely ruled out.
Related to this is Russia's use of hydrocarbons as a means of influence on its neighbors. Over the last two years, Gazprom has been a state champion in raising prices of oil and natural gas in transit and being used by a group of countries encompassing Georgia, Belarus, Moldova and Ukraine. In most cases, Russian energy was being sold at considerable discounts to those governments. However, the hardball politics employed by Russia to push for higher prices (which it eventually got) also caused some disruption in energy supplies to the European Union. For Putin, energy is a source of funds, but also is critical in Russia's return to great power status. As The Economist noted: "No longer need Russia go to the West cap-in-hand for money, as it did in Boris Yeltsin's day."
Consequently, we are left with a Russia still in transition. Where it is going is not exactly certain. Most likely we will see a country still dependent on energy and other natural resources, dominated by state capitalism and a ruling elite build up around the security apparatus and a fig-leaf of democratic procedure. In this scenario, badly needed structural reforms, important to the non-energy sectors and government finances, are likely to remain on the backburner until after the Duma and presidential elections, when a new government is in place.
What does this mean for investors? For debt investors this means Russia's Baa2/BBB+/BBB+ ratings are stuck where they are now, but volatility can be expected to creep into the picture. Any major widening on Russian debt could provide a more attractive entry point, considering their current tight nature.
On the equity side we do have one recommendation - Mechel OAO, one of the country's integrated mining and steel companies. Mechel has an ADR traded on the NYSE (MTL), which we think has room to grow and in which we currently own shares. The key attraction is that the global steel industry is in the process of consolidation and Russia's steelmakers are actively engaged. MTL will also benefit from the imposition of duties against European Union stainless-steel sheet imports announced in February 2007. Currently steel production counts for around 5 percent of MTL's revenues, leaving it plenty of room to expand.
With a market capitalization of $4.7 billion, MTL either continues its current growth or it gets acquired. In addition, the steel sector is one of the few areas where Russian companies are competitive outside of oil and gas. As a Standard & Poor's report stated of the top four Russian steel-makers (January 24, 2007): "Their access to inexpensive labor, energy, and captive raw material sources offset any technological disadvantages, and allow the companies to post strong operating margins." We are looking for an ADR stock price of $40 a share over the next six months. MTL is currently trading around $34.
Consequently, we are left with a Russia still in transition. Where it is going is not exactly certain. Most likely we will see a country still dependent on energy and other natural resources, dominated by state capitalism and a ruling elite build up around the security apparatus and a fig-leaf of democratic procedure. In this scenario, badly needed structural reforms, important to the non-energy sectors and government finances, are likely to remain on the backburner until after the Duma and presidential elections, when a new government is in place.
Concluding Thoughts
Russia has come a long distance from its 1998 default, but it still has a long way to go to move out of its Emerging Market status. This provides investors with opportunity, especially considering the run up in so many Emerging Markets in 2006. However, we would caution that seeking to take advantage of Russia's ups and downs is highly speculative and not for the faint-hearted.
