Decision has no economic Justification. Russia is in a very strong financial position and is fully able to meet its debt obligations
This post first appeared on Russia Insider
As widely expected Fitch Ratings, the US ratings agency, has downgraded Russia’s credit rating from BBB to BBB-, one notch above a junk rating. The statement Fitch has published explaining this decision appears below.
There is absolutely no logic behind this decision. Russia's sovereign debt is just $57 billion of which no more than $2.3 billion is due for repayment this year. The idea that Russia is going to default on its sovereign debt is a fantasy and Fitch does not in fact say that such a risk exists. On the contrary Fitch admits:
"Russia's starting position remains strong: the policy framework is robust, public debt is low (estimated at 12.4% of GDP at end - 2014), and the sovereign net foreign asset (SNFA) position is still appreciable (20% of GDP)"
If there is no possibility of a default on Russia’s sovereign debt, could it be that the reason for the downgrade is a high risk of default by Russian corporates (especially state owned corporates)?
Some Russian companies did run into temporary foreign currency payment difficulties in December (the reason for the rouble crash on 16th and 17th December 2014) but with help from the government and the Central Bank (the main reason for the reported fall in the reserves to $388 billion) that problem has passed.
The companies in question are Russia's major exporters with a significant part of their cash flow in dollars and with significant foreign currency reserves of their own. They are not by any stretch of the imagination insolvent. Whatever temporary payment difficulties they run into they can ride them out.
The money they were given by the government and by the Central Bank to help tide them over their problems in December was provided in the form of loans, which they are required eventually to pay back.
There is no doubt they both can and will do this so the fall in the size of the Central Bank’s reserves that took place in December is not the big issue it is being made out by some to be (see for example this typical scaremongering piece by Ambrose Evans-Pritchard in the Daily Telegraph).
Fitch says the reserves are smaller than they were at the start of the financial crisis in 2008, implying that there is less scope to help corporates if they run into difficulties than there was in 2008. However Fitch conspicuously fails to mention the crucial difference between the situation today and the one in 2008.
In 2008 Russian companies were net debtors in relation to their foreign currency assets and liabilities. Today they are net creditors, owning more foreign currency assets than they have liabilities.
They do not therefore need support from the state to the extent that they did in 2008 so that the fact that the reserves are now smaller than they were in 2008 is not the problem Fitch and others like Ambrose Evans-Pritchard say it is. This is especially so given that with the rouble now floating Russia does not have to spend reserves to defend it at any particular level as it did in 2008.
As for the devaluation of the rouble, whatever problems it causes Russian corporates who have to make payments in foreign currencies, it should at least ensure that the country continues to run a trade surplus and that its budget is protected.
Fitch is even forecasting “…..a rebound in the current account surplus from USD55bn (2.9% of GDP) in 2014 to USD72bn (5.3% of GDP) in 2015 as imports shrink.” Such a cash flow will ensure that Russian corporates have no difficulty meeting their foreign debt commitments this year.
Could it be then that Fitch expects the Russian state to go on a borrowing or money printing spree to try to fund its way out of its difficulties?
No. As Fitch admits the policy framework remains “robust” and “The revised 2015 budget is expected to be based on an oil price of USD60/bbl and is likely to entail expenditure cutbacks across the board”.
Fitch does predict a budget deficit of 3.7% of GDP (hardly excessive) but admits that “part of this will be met from the Reserve Fund, illustrating the sovereign's significant (if declining) fiscal financing flexibility.”
Are there any other possible reasons that might justify the downgrade?
Fitch refers to poor “governance” (misleadingly misreported as “government” by the Daily Telegraph in a highly selective and thoroughly mendacious report about the downgrade).
Russia does suffer from problems of poor governance. However these are no worse now than they were before the downgrade. As such they hardly explain the downgrade.
To prove its point about poor governance Fitch cites two surveys about Russia, one prepared by the World Bank and one by Transparency International.
No one familiar with these two surveys would place equal weight on them. The World Bank “Ease of Doing Business” survey is acknowledged to be a rigorous and reliable survey that tries to stick to objective criteria. By contrast the methodology of thel Transparency International survey is much more impressionistic and anecdotal. For a discussion of the Transparency International survey see here.
Despite the fact that the two surveys cannot in any way be considered comparably reliable Fitch mentions them in the same sentence, granting equal weight to both of them.
Not only does Fitch give equal weight to two surveys with entirely different levels of reliability. It also conspicuously fails to mention the single most important fact about the the far more reliable World Bank survey. This is the dramatic improvement in Russia’s position in this survey.
According to the World Bank, in the space of just a few years Russia’s position has risen from 120 (out of 183) in 2011 to 62 today. If governance in Russia is a factor in assessing its credit rating (which it should be), then the World Bank survey provides reasons for upgrading Russia’s rating, not downgrading it as Fitch has done.
What about the sanctions? Perhaps these justify a credit rating downgrade?
It is true that the sanctions have for the time being made it impossible for Russian corporates to borrow in Western financial markets. However that is more a function of politics than of Russia’s economic situation. Only a small number of Russian businesses and individuals are in fact covered by the sanctions.
That western banks are for the time being largely refusing to lend to any Russian businesses at all - even those not formally affected by the sanctions - is ultimately a consequence of the present fraught political situation, which is making western banks nervous of lending to anyone in Russia.
Unless the sanctions are further tightened, a possibility that cannot be wholly discounted but which seems increasingly unlikely, this sentiment over time will fade. The probability is that western banks will at some point then resume lending to those Russian companies that are not directly affected by the sanctions even if the sanctions themselves are not formally lifted.
The function of a credit rating assessment ought to be to tell western banks whether when that happens it is safe for the banks to lend to their Russian clients in light of their credit position. Given the non-existent risk of sovereign default and the general solvency of those Russian companies that are likely to want to borrow from western banks, the overall message should be that it is.
The sanctions do not therefore justify reducing Russia’s rating to a notch just above junk status and there is nothing in the Fitch report to suggest that they do. If they did then Russia's rating ought to have been reduced not now but when the sanctions were imposed.
Ultimately, the only objective factor Fitch can provide to justify the downgrade is that because of the fall in the oil price Russia is likely to face recession in 2015 and 2016 (but with a return to growth in 2017) and is likely to see higher inflation in 2015 than it would otherwise have done.
This is strange logic. A credit rating assessment is not an economic forecast. Rather it is supposed to be an assessment of credit worthiness.
The mere fact that an economy experiences a recession or inflation is not usually considered a reason to downgrade its credit rating if the recession or the inflation do not call into question the economy’s ability to pay its debts.
All the leading western economies have at various times experienced recession, which is an economic fact of life. They have also known periods of high inflation. Sometimes the two have happened together at the same time.
This does not usually result in the ratings of these western economies being downgraded. Given that there is no risk of Russia defaulting on its debt obligations, and given that Fitch does not actually say there is, why treat Russia differently?
Of course it is always possible to fantasise about farfetched catastrophe scenarios that might radically alter for the worse a country’s debt payment position. However that is equally true of every country and not just Russia.
There have for example been any number of such predictions made recently about countries such as the United Kingdom and the United States. There is for example a strong and very vocal school of thought that says that the US dollar’s days as the world’s reserve currency are numbered and that this will cause severe economic problems for the United States.
Fitch does not however take these speculative catastrophe scenarios into account in assessing the credit worthiness of countries like the United Kingdom and the United States. Nor should it do so since such speculations however fact-based or plausible they may be belong more to the world of futurology than to business analysis.
As it happens Fitch does not predict a catastrophe scenario for Russia. On the contrary it predicts a return to growth in 2017, a prediction which incidentally is in line with Putin’s own forecast. If so, then does a two year recession really justify downgrading an economy's rating to a notch just above junk status when the risk of a default does not exist?
The sum total of Fitch’s predictions about Russia are (1) a recession in 2015 and perhaps 2016 of by no means remarkable severity, with a return to growth in 2017 and (2) a high but by Russian and world standards a by no means unusually high rate of inflation in 2015 caused by the one-off effect of the rouble's devaluation. Given the underlying solidity of Russia’s financial position, this hardly justifies a ratings downgrade to just above junk status.
If there is no cogent economic reason for Fitch's decision why then did Fitch make it? The answer has everything to do with politics and nothing to do with economics.
Claims to the contrary notwithstanding, US ratings agencies are not politically neutral or objective organisations.
The reason Russia’s credit rating has been so low for so long despite Russia’s very strong financial position and the prudent nature of its macroeconomic policy, and the reason why Russia has now been downgraded further to just above junk status is not because its government is mismanaging the economy or because the country is a credit risk. It is because Russia finds itself in a state of political confrontation with the United States.
In fact Fitch actually admits this.
In its statement Fitch identifies what it says are the two factors which might persuade it to reverse its decision and grade Russia’s rating up again. These are - in significant order of priority - (1) the lifting of sanctions as a consequence of an improvement in Russia’s relations with what Fitch calls “the international community” (a standard western euphemism for the United States and its friends) and (2) a recovery in oil prices.
In effect what Fitch is saying is that bar a surge in oil prices it will not upgrade Russia’s rating regardless of what Russia does to its economy unless and until Russia makes political concessions to the West so that the sanctions are lifted. What could be a clearer statement of the political motive behind Fitch’s decision than that?
Unfortunately, despite its blatantly political nature, the downgrade (and those by Moody’s and Standard & Poor which are certain to follow) will have consequences. Some loans will become due for earlier repayment because of the downgrade. In a radio interview Russian Economics Minister Ulyukaev guesstimated that the cost for the country of a downgrade will be between $20-30 billion in 2015.
This will add to the total cost Russia has to bear this year, ensuring that pressure on the rouble will be greater than it otherwise would have been. The cost of making these extra debt payments is bound to increase the headline total of capital outflow from Russia in 2015, a fact that will create more negative publicity for Russia. Against that it will mean that the process of paying off western debt takes place faster.
The news is however not all bad.
First of all this blatantly political downgrade ought to reinforce a point that should have been obvious long ago. This is that it is unwise for Russia to rely on funding for its economy that comes from countries that are politically hostile to it.
There is more than sufficient capital in Russia to fund the development of its economy. Russia does not need to rely on western capital to finance its development.
Russian corporates have nonetheless looked to the West for funding because of the poor quality of Russia’s financial system. There has been much talk over the years about sorting this out but little has been done because access to Western capital has meant that the incentive to do something has not been there. That incentive is now there and the Russian government is finally showing signs that it is giving this issue priority.
The weakness of Russia’s financial system is Russia’s economic Achilles heel. Contrary to what is often said, Russian has strong manufacturing, agricultural and service industry sectors and also has a very advanced science and technology base. Talk of Russia being a one-dimensional oil economy is simply wrong.
Though there is inevitably some argument about the precise figures, the best study suggests that rents from the oil and gas industries in 2012 probably accounted for perhaps 16% of Russia’s GDP, with total natural resource rents (including coal mining, forestry etc) being around 18-19% of GDP as compared with over 44% in 2000.
It is because Russia’s financial system is weak making Russian corporates look abroad to the West for capital that Russia’s economy is so affected by changes in oil and commodity prices. This is the key difference between Russia and other economically more mature oil and commodity exporters such as Canada, Norway and Australia, which have much stronger financial systems than Russia.
If the problems in Russia’s financial system are sorted out (and there is no objective reason why they cannot be) then the great underlying strengths of Russia’s economy - which are even evident in the the Fitch report - will come through. If this episode speeds this process up then in the end it will have done some good
The days of untrammelled leadership in credit rating assessment by the US ratings agencies are anyway drawing to a close. Their reputation has already taken a knock from the sub-prime mortgage debacle and their systemic misassessment of eurozone sovereign debt risk.
Now for the first time they are being challenged directly on their own ground by ratings agencies in China whose economy in purchasing power parity terms has now overtaken that of the United States. With almost $4 trillion of reserves China is in a powerful position to compete with Western institutions as a credit provider and there is little doubt that it will increasingly do so.
Dagong Global Credit, one of the leading Chinese ratings agencies, has also just undertaken an assessment of the Russian economy. In doing so it has looked at exactly the same set of facts that Fitch did but has come to diametrically opposite conclusions. Dagong's conclusion is that Russia’s position is strong and that a downgrade is unwarranted.
China is of course Russia’s friend and Dagong’s assessment is no doubt every bit as biased and political as the one by Fitch. The idea that credit assessment of whole countries can ever be politically neutral is a fantasy. On the facts it is however the Chinese view of Russia’s economy and of its credit position that is the correct one.
A Bloomberg report of the Dagong assessment is also provided here directly after the one by Fitch. My thanks to Eric Kraus for referring the Dagong report to me though I should stress that the opinions set out here are my own.
Fitch Ratings-New York/London-09 January 2015: Fitch Ratings has downgraded Russia's Long-term foreign and local currency Issuer Default Ratings (IDR) to 'BBB-' from 'BBB'. The issue ratings on Russia's senior unsecured foreign and local currency bonds have also been downgraded to 'BBB-' from 'BBB'. The Outlooks on the Long-term IDRs are Negative. The Country Ceiling has been lowered to 'BBB-'from 'BBB'. The Short-term foreign currency IDR has been affirmed at ‘F3'.
KEY RATING DRIVERS
The downgrade reflects the following factors and their relative weights:
The economic outlook has deteriorated significantly since mid-2014 following sharp falls in the oil price and the rouble, coupled with a steep rise in interest rates. Western sanctions first imposed in March 2014 continue to weigh on the economy by blocking Russian banks' and corporates' access to external capital markets. Having grown by just 0.6% in 2014, Fitch now expects the economy to contract by 4% in 2015, compared with our previous forecast of minus 1.5%, as steep falls in consumption and investment are only partially offset by an improvement in net exports, driven by a sharp drop in imports. Growth may not return until 2017.
Plunging oil prices have exposed the close link between growth and oil prices, notwithstanding the impact of a more flexible exchange rate. For 2015, Fitch is assuming oil prices average USD70/bbl, markedly lower than the USD100/bbl we assumed in July 2014. If the oil price stays well below this, it could precipitate a deeper recession and put further strain on public finances, severely limiting the authorities' room for manoeuvre.
Rouble depreciation, intense market volatility and sharp hikes in policy rates to 17% from 10% constitute a major shock to the banking sector. The authorities have stepped in to preserve financial stability, doubling the cap on insured deposits, offering subordinated loans from the National Wealth Fund to systemically important banks with at least RUB100bn of equity and offering other banks up to RUB1trn of non-cash subordinated loans. Given the pressure on capital ratios and asset quality, the sovereign may have to pay for further bank support. Regulatory forbearance will mitigate the impact on banks' reported balance sheets of the sharp fall in the rouble and decline in the value of securities portfolios.
International reserves, the sovereign's stock of liquid foreign assets, have fallen faster than Fitch expected and they remain on a declining trend. A key development since the last rating review has been the accelerated transition to a freely floating exchange rate, ahead of the introduction of formal inflation targeting on 1 January. This move has slowed the depletion of international reserves and cushioned the public finances from falling oil prices. Nonetheless, reserves ended the year at less than USD390bn, down more than USD120bn from end-2013 and lower than our previous forecasts of USD450bn by end-2014 and USD400bn by end-2015.
Reserves/M2, a measure of the economy's ability to cope with capital flight, stand at around 50%, while the stock of reserves relative to liquid external liabilities is still robust at 220%. Fitch is forecasting a rebound in the current account surplus from USD55bn (2.9% of GDP) in 2014 to USD72bn (5.3% of GDP) in 2015 as imports shrink. Nevertheless, in the absence of renewed access to international capital markets and based on the assumption of net private capital outflows of USD130bn (including net debt repayments) Fitch expects reserves to decline to around USD315bn by end-2015.
Per capita income in US dollar terms is likely to shrink by over one-quarter one-third in 2015, illustrating the blow to national income and debt tolerance from the oil price shock and rouble depreciation.
Inflation ended 2014 at 11.4% y-o-y and is likely to remain in double digits throughout 1Q15, pointing to falling real incomes and depressed domestic demand. In light of recent trends, the prospects of the CBR realising its end-2015 inflation target of 4.5% now look remote, particularly if the exchange rate falls further, potentially leading to still higher interest rates. Fitch forecasts end-2015 inflation of 8.5%.
Russia's 'BBB-' IDRs and Negative Outlooks also reflect the following main factors:
Economic policy coherence and credibility in the face of external shocks remain important supports for the rating. The authorities have acted swiftly in raising interest rates and supporting the financial sector and plan early revisions to the 2015 budget. However, Fitch expects the policy framework to come under growing pressure as external vulnerabilities weigh on the macroeconomic outlook.
Russia's starting position remains strong: the policy framework is robust, public debt is low (estimated at 12.4% of GDP at end-2014) and the sovereign net foreign asset (SNFA) position is still appreciable (20% of GDP). However, sovereign wealth funds are lower now (USD169bn, or 12% of expected 2015 GDP) than they were in 2008 (16% of GDP), while the broader SNFA position has also deteriorated. Moreover, the longer sanctions remain in place, the greater the risk of non-sovereign external liabilities migrating to the sovereign balance sheet and eroding these rating attributes.
Renewed intervention to support the rouble, whether by the Central Bank (CBR) or the Finance Ministry, could further reduce reserves, as would rising levels of dollarisation in the face of financial sector instability. Renewed bouts of chronic exchange rate volatility would also raise the spectre of exchange controls. The authorities continue to rule out capital controls but have applied moral suasion, compelling state-owned exporters to convert foreign exchange revenues into roubles, for example.
Extraordinary financial sector support of Rs1trn (1.4% of GDP) has transformed an expected 2014 federal budget surplus of 0.4% of GDP into a deficit of 1%. The revised 2015 budget is expected to be based on an oil price of USD60/bbl and is likely to entail expenditure cutbacks across the board. Nonetheless, some deterioration in the fiscal metrics is to be expected, challenging adherence to the 2012 fiscal rule. Fitch is forecasting a general government deficit of 3.7% of GDP in 2015 (up from 1.5% in 2014). Part of this will be met from the Reserve Fund, illustrating the sovereign's significant (if declining) fiscal financing flexibility.
External deleveraging is running at its highest level since 2009 as banks and corporates make net repayments in the face of near complete exclusion from international capital markets. Consequently, Fitch estimates that Russia's net external creditor position stood at 15% of GDP in 2014, virtually unchanged from 2013, as both external liabilities and reserves declined. Data on roll-over rates is limited. However, given the share of inter-company lending to the non-bank sector, it would not be unreasonable to assume that up to a third of this sector's liabilities are being rolled over by parent entities.
Structural factors are weak relative to peers. Commodity dependence is high: energy products account for almost 70% of merchandise exports and 50% of federal government revenue, exposing the public finances and the balance of payments to external shocks. Governance is a relative weakness: Russia scores badly on World Bank and Transparency International indicators, for example. Russia's current predicament has done little to hasten the onset of a more liberal economic policy agenda and raises the risk of greater isolationism. The business environment has long hampered diversification outside the energy sector.
The following risk factors individually, or collectively, could trigger a negative rating action:
- Continued exchange rate volatility, leading to broader financial sector instability requiring greater public financial support.
- Sustained low oil prices and/or continued recession in 2016, with adverse implications for the public finances and financial sector stability.
- Faster than forecast depletion of international reserves, reflecting larger than expected capital flight and/or accelerated dollarisation domestically;
- An intensification of sanctions or a geopolitical risk event.
The Outlook is Negative. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a positive rating change.
Future developments that could individually, or collectively, result in a stabilisation of the Outlook include:
- A reduction in tensions with the international community, resulting in an unwinding of sanctions and renewed access for Russian entities to international capital markets
- A sustained recovery in the oil price, coupled with an easing of macroeconomic and financial stress
Russia's ratings are based on a number of key assumptions:
Fitch prepared its forecasts on the basis that the (Brent) oil price averages USD70/bbl in 2015 and USD80/bbl in 2015
Fitch assumes that Russia continues to experience broad social and political stability.
A currency crisis, recession and plunge in the price of its key export don’t mean Russia is any less creditworthy than the US according to one of China’s biggest debt-rating companies.
Just the opposite -- it’s a better credit risk, says Dagong Global Credit Rating Co. The firm, which downgraded U.S. government debt in October 2013 to A-, today said it has decided to maintain Russia’s rating at A with a stable outlook.
“The debt repayment environment has somewhat deteriorated but is expected to stabilize in the medium term,” Dagong said in an emailed statement regarding its assessment. “As the economy stabilizes and the monetary policy normalizes, the domestic credit environment will gradually recover.”
Russia’s economy is forecast to contract 1.8 percent this year versus 3 percent growth in the U.S., which would be the fastest pace in 10 years, according to economists’ projections. Dagong’s optimism contrasts with the biggest ratings companies: Standard & Poor’s said last month it will probably lower Russia to non-investment grade within 90 days, while Fitch Ratings will announce the results of a review tomorrow.
Privately-held Dagong, established in 1994, isn’t formally tied to the Chinese government. It started sovereign ratings in 2010 in a bid to break the monopoly of U.S. rating firms, according to the company’s website, mirroring the government’s strategy of gaining greater influence on the global stage.
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