LIFE AFTER DEBT - RUSSIA RESURGENT
by Eric Kraus
Russia in the 20th century was the unfortunate beneficiary
of several full-scale experiments in the implementation of
ideologies. It should not be forgotten that Soviet
communism was not merely a system of repression and fear -
though, of course, these figured prominently - but rather,
a complex system of belief, economic management, and
social control.
The Soviet system was founded upon a strong ideological
base, Marxism-Leninism, to which all gave lip-service, but
in which many deeply believed. The economy was
characterized by the extreme centralization of control,
the almost-total absence of private property, and
especially, the absence of any regulatory role for money.
Prices were fixed by administrative fiat; rubles were
essentially accounting units, with scarce goods allocated
by various non-market mechanisms, ranging from a complex
system of privileges centered on the Party and the
factories, to the interminable queues in which much of the
population, especially the very young and the old, spent a
significant part of their lives.
The collapse of the Soviet system spawned the greatest
privatization in the history of mankind, coincident with
the collapse of a top-heavy bureaucracy which had, until
then, micro-managed all sectors of the economy. The Soviet
system was quickly dismantled before there were new
institutions ready to take its place; society was thrust
very much into a vacuum.
The downside to the remarkably peaceful transfer of power
was that Russia never saw the wave of de-Sovietization
undergone by the Eastern European countries - many former
high-ranking members of the Party, the Komsomol, and the
security services simply changed sides and became,
belatedly, enthusiastic capitalists.
It is thus hardly surprising that, while vast sectors of
the population were thrown into destitution, the
privatization of Soviet assets - oilfields, mines,
factories - yielded extraordinarily rich pickings for
well-connected ex-apparatchiks; alert, lupine young
businessmen; and the "Red directors", the former bosses of
Soviet industry.
Russia's history has been a long alternation between good
and bad tsars. We have long argued that Putin's election
may well be the best thing to happen to Russia in the past
century; under his presidency, the turbulent process of
creative destruction which began with the 1991 breakup of
the Soviet Union appears to be giving way to a period of
state-building and sustainable growth.
Totally misread by the Western press (at the time, on an
anti-Russia kick after having been wrong-footed by the
1998 crisis), Putin quickly established his credentials as
a Westerniser and Reformer, surprisingly proving to be a
brilliant politician, a skilled diplomat, and, most
importantly, a determined and steadfast administrator.
As anyone who reads a modern language and has access to
media more intellectually challenging than MTV is aware,
especially since September 11, there has been a sea change
in Western perceptions. Out go the "Spymaster-Turned-
President" stories; in come the "Russia Reforms and
Prospers" features. The mainstream press is turning
frankly laudatory - a recent paper in the New York Times
was fawning beyond anything even we have written, while
even The Economist has belatedly gotten religion.
The effects of this shift upon capital flows and foreign
investment will drive the next phase of the Russian re-
rating. In fact, the list of reforms initiated under Putin
is rapidly becoming unwieldy. (We would remind non-Russia
specialists that, in the absence of steadfast political
support by Yeltsin, none of the reforms we've been
following could have been attained during the previous
decade!)
While not exhaustive by any means, we list here a few of
the principal changes, in order of decreasing importance
for foreign investors: The first major reform by the Putin
administration is a wide-scale experiment with the Laffer
curve. Russian income tax rates have been set at a flat
13%, while corporate taxes have been simplified and
slashed. As a result, Russia moved from a chronic budget
deficit to a 4.5% primary surplus, and indeed, a 1.4%
gross budget surplus (i.e. after debt service).
And although there are still scandals within the corporate
sector, they are nowhere near as egregious as in the past.
The assets stripped from Gazprom by its rapacious former
management are being clawed back, while most of the
transfer pricing schemes used by oil majors to strip
revenues have been folded. Corporate governance and
transparency at the best Russian companies is now arguably
no worse than for the lower quartile of US-listed firms -
and indeed, infinitely better than some of the more
notorious among their American peers!
We have also repeatedly noted that banking reform was the
worst failure of the post-1998 restructuring, citing
Russian central bank chief Victor Gerashchenko as possibly
the single greatest obstacle to Russian reform. Suddenly
this spring, the dinosaur was unceremoniously sacked
following a heroic last stand, during which he manfully
held off the entire Duma - and large sectors of the
administration - by blocking passage of a much-needed
package of bank reform legislation.
Gerashchenko has been replaced by the technocratic
Ignatyev and the market-savvy Vyugin, long-time chief
economist for Troika Dialogue. The bank reform bill, a
vital first step in a long reform process, is now in the
process of enactment.
What results have these reforms produced for the potential
foreign investor? Along with the budget surpluses referred
to above, the current account balance is hugely positive.
Net forex reserves have skyrocketed by more than 400%
since the crash, currently standing at nearly US$45
billion - that is, more than the net present value (NPV)
of the entire outstanding Russian Eurobonds and MinFin
bond issues!
Given the deceleration of capital flight and the steady
increase in mineral exports, reserves are now increasing
by about US$300 - $500 million per week.
Parliamentary approval has just been granted to the
finance ministry to do what it has been doing anyway for
the past two years - that is, the repurchase of Russian
debt on the secondary markets. Due to these buy-backs, the
2003 "debt mountain" looks increasingly like a mole-hill.
Russia's total indebtedness should drop to 40% of GDP by
year-end 2003, less than that of most G7 countries.
Continuing debt service depends both upon a country's
willingness and its ability to pay. The willingness of the
Putin administration to service debt, whether or not
contracted by Russia, as opposed to the Soviet Union, was
clearly demonstrated by the assumption of un-restructured
Paris Club obligations. The ability to pay is subtended by
rapidly increasing oil exports, good (if unspectacular)
growth, fiscal rigor, and the large current account
surplus.
As of this writing, the situation in global markets seems
more threatening than at any time since 1998. Eighteen
months ago, when we first used the term "flight to
quality" in relation to Russia, we were slightly ironic.
No longer! Russian debt has continued to gradually
decorrelate from the remainder of the EMBI asset class,
largely due to Russia's excellent economic performance and
unaccustomed political stability.
On the other hand, as the equity market progresses from
"wildly undervalued" to "relatively cheap," it is becoming
somewhat more correlated with global trends.
Given the cheap valuations for many of the equities, as
well as the absence of any fundamental, economic mechanism
for transmission of global turbulence - as opposed to
short-term volatility caused by financial contagion - we
firmly believe that, in the medium term, Russia will
continue the massive outperformance of recent years.
Sincerely,
Eric Kraus,
for the Daily Reckoning
p.s. If Putin is truly successful, in 2008 he will exit
the presidency leaving behind a two-party system with
strong national implantation, a loyal, moderate
opposition, and a broad middle-ground. This is still a
long way off.
Nevertheless, when two years ago we noted that, on the
fundamentals, Russian debt should be trading well inside
of Brazil, Argentina, and Venezuela, people cocked their
heads to one side and wondered what we had been smoking.
In Russia, one comes to expect the unexpected!
Editor's note: Eric Kraus is the Chief Strategist/Head of
Equities at Sovlink LLC, a Moscow-based trading firm. He
is also the editor of Truth and Beauty (and Russian
Financial Markets) serving institutional clients. For
advice on positioning your portfolio to take advantage of
a potential boom in Russian equities, or to learn more
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