Going From Crash to Smug

It was a statement that left its mark on Russia’s capital markets. In August 1998, when Russia devalued the ruble and defaulted on its domestic debts one irate Western banker said he would “rather eat nuclear waste” than touch Russian debt again. Twelve years on, Russia could be forgiven for feeling a tad smug as the bond markets fret about the creditworthiness of several major Western economies and sovereign risk shifts conspicuously from emerging markets to developed ones.

In stark contrast to previous debt crises, when sovereign defaults were confined to less creditworthy emerging markets, it is now several A-rated Western countries that face unsustainable debt positions, although default is unlikely. PIMCO, the world’s largest bond fund, recently placed several West European states, the United States and Britain inside a “ring of fire” of countries that it claims are most at risk from a prolonged period of deleveraging.

PIMCO’s views chime with McKinsey’s research on debt and leverage in 10 Western countries and four emerging markets. The study finds 32 examples of sustained deleveraging after a financial crisis, mostly through austerity that caused a contraction in gross domestic product for two to three years. Not surprisingly, the likelihood of deleveraging (and therefore of an austerity-induced downturn) is considerably less in the four emerging market countries — Brazil, Russia, India and China — whose levels of leverage are far below those of their Western peers.

From a deleveraging perspective, Russia is best placed among the 14 countries analyzed by McKinsey with a total debt-to-GDP ratio of only 71 percent, about half that of Brazil and China and a quarter of developed markets. Russia fares particularly well from a government debt standpoint, now the primary focus of the bond markets. JPMorgan expects Russia’s government debt to remain under 8 percent of GDP by the end of this year, compared with 122 percent in Greece and 86 percent in France. The bank expects Russia’s budget deficit to be roughly 4.5 percent of GDP by the end of 2010, one-third that of Greece and Britain and roughly half that of Spain and Portugal.

With household debt in Russia amounting to only 10 percent of GDP, there is still considerable scope for both the government and consumers to gradually increase their borrowing requirements without endangering financial stability — one of the key long-term drivers of growth in Russia. Indeed with inflation likely to remain in single digits for a sustained period, there is a case to be made that the 2008 financial crisis, while causing a severe contraction in Russia’s economy, will lay the groundwork for stronger, yet more balanced, internally driven growth, supported by greater availability of credit and much-needed investment in infrastructure.

With strong creditworthiness relative to many other developed economies and unencumbered by the need to deleverage large amounts of government and household debt, Russia has the potential to be one of the world’s best performing economies over the next several years. It boasts one of the widest natural resource bases and is the overwhelmingly dominant emerging market in Europe, with the largest consumer market. Funds dedicated to Emerging Europe are already rebuilding their exposure to Russia, according to UralSib.

The Russian economy’s biggest flaw, which the financial crisis so glaringly exposed, is its overreliance on commodities. That its fortunes hinge so heavily on exports of oil and gas only serves to fuel the risk aversion toward Russia on the part of many international investors. Despite its relatively strong fundamentals and huge growth potential, Western fund managers and prospective investors still find Russia a tough sell. Perennial concerns about the rule of law understandably deter many investors.

Yet there are signs that investors’ perceptions of Russia may soon change. If GDP growth reaches 4 percent this year, as expected by the European Bank for Reconstruction and Development, Russia would be Europe’s fastest-growing major economy. In a world in which countries’ economic and fiscal standings are increasingly relative given the severity of the downturn, Russia’s performance, coupled with its stronger creditworthiness, would be exceptional. Set against the uninspiring outlook for all major advanced economies in 2010, these factors should help generate stronger demand for Russian assets.

Nicholas Spiro is an independent consultant in real estate and macroeconomic strategy in emerging markets.