Last year saw Russian debt issuance start quickly but fade in the second half. This year, the year saw a more modest beginning, but the market has picked up in the second half, just as problems elsewhere have become most acute. In an age where state intervention has become an international norm, Russia has the benefit of years of practise. By Michael Pugh, partner at law firm Lovells.
Since July 2007, the international bond markets have had limited appetite for new Russian debt issuances. Although the first half of 2007 started very strongly, with issuances in the first seven months of 2007 almost exceeding the entire volume of issuances in 2006, the amount of issuances in the second half of 2007 was much lower. This year was slow to start, but by April issuances were back on a monthly level comparable to the first half of 2007. Although many of these 2008 issues were characterised by higher pricing than in the previous year, they provided a useful source of liquidity to issuers able to tap the markets.
Since September 1 2008, the primary international bond markets have been effectively closed. September's bitter harvest of insolvencies and takeovers, together with the war with Georgia, has meant that it is unclear when investor appetite for new issuances from Russia will emerge. Deep discounts and over-supply in the secondary bond market put additional pressure on primary issuers as they attempt to make primary issuances. These circumstances, combined with other developments, such as the drop on September 15 in crude prices to a seven month low, triggered panic on Russia's main trading platforms RTS and MICEX. September 2008 saw the RTS down 60% since May 2008 – the largest single drop in a Russian stock exchange for more than a decade.
The Russian Government and the Central Bank of Russia (CBR) were quick to react and closed both exchanges several times in the week starting 15 September. This was intended to buy time to allow them to decide on action to stabilise the market and bring an end to the panic selling, which had been gathering momentum.
The panic selling in the RTS and the MICEX, along with the continued fall-out in the major world markets, has been greeted with dismay by Russian issuers that had hoped to re-enter the bond markets to raise new funds and refinance their existing debt obligations. The drop in securities prices also impacted the market by triggering the instability that results from margin calls and tight liquidity. The first notable casualties of the knock-on effects were KIT Finance and Svyaz Bank. In the case of KIT Finance, it reportedly failed to meet its liabilities as a result of its own clients' failure to satisfy their liabilities to KIT Finance on time. The public failure of two prominent Russian banks has also contributed to the suppressed appetite of the bond market for Russian banks.
For Svyaz Bank, the main trigger that pushed it into difficulty appears to have been the large drop in the value of the RTS. Svyaz Bank reportedly had a large proportion of equities on its balance sheet, which it used as collateral for repo transactions. When the price of Russian equities fell dramatically, Svyaz Bank faced margin calls from its creditors that it was unable to satisfy.
The bear acts quickly
In both cases, the issues have no doubt been exacerbated by the reduced liquidity in the banking sector, partly as a result of the patchy access to the bond markets since August 2007. The Russian Government has recognised this and has been quick to react. For KIT Finance, Government-controlled Gazprombank provided KIT Finance with Rbs22.5bn to satisfy its current liabilities within three days of Kit Finance's announcement (September 17). Around the same time, Gazprom's pension fund manager began negotiations to acquire a controlling stake in KIT Finance. In the case of Svyaz Bank, Government-owned Vneshekonombank announced that it had received the go-ahead to buy Svyaz Bank and that it had taken steps to enable Svyaz Bank to meet its current liabilities.
The Russian Government has taken further measures to compensate for the lack of bond funds. Such measures include making available Rbs600bn in emergency funds through Ministry of Finance auctions. It also extended participation in such auctions from the largest Government-controlled banks – Sberbank, VTB and Gazprombank – to include 25 additional banks. The plan is that these recipients will use the funds to support the interbank market. In the short term, the CBR's policy seems to have been successful: interbank lending continues, and in the fourth week of September there was sufficient liquidity in the market to enable funds earmarked for auction to be withdrawn amid weak demand.
In terms of the competitive environment, as Russian banks release their H1 2008 IFRS financial statements, buyers in the bond market will see some strong results emerging, which should bode well for future issuances once the markets calm. In some cases, such as Alfa Bank, net profit after tax increased 129.5% and net interest income increased by 69.5% in the first half of 2008, as compared to the first half of 2007. In the mid-tier, Bank St Petersburg grew its net profit by 110% and net interest income by 113% in the same period.
Quality trumps quantity
Such results can, in part, be attributed to more conservative lending policies within the banking sector, which has focused on a drive to quality, rather than volume. Another factor to explain the increases is that, although the cost of international bond debt has increased in the last year, those who are still lending are able to command higher margins. This trend stands in stark contrast with the last few years, when greater liquidity in the banking sector, pushed interest margins downwards.
At the time of writing it is not clear to what extent the problems faced by KIT Finance and Svyaz Bank will be manifested in the Russian banking sector as a whole. Svyaz Bank's heavy reliance on equities contrasts starkly with the balance sheets of certain other Russian banks. Many have gradually reduced the proportion of equities on their balance sheets due to concern about the volatility of such shares in the context of the global financial crisis.
Similarly, conservative-minded banks have focused on the quality, rather than the size, of their loan books. They have sought to provide existing customers with a wider range of fee and interest-earning services, rather than work with walk-in customers that represent a higher risk. Reduced funding from the bond markets and has meant that banks have worked hard to develop other sources of funding, such as customer deposits, which at the time of writing remain stable.
In terms of sources of funding, it is understandably hard to predict when and to what extent investor appetite for new issues from Russia will develop in the short term. Recovery appears to be contingent in part upon a recovery of the price of Russian bonds traded in the secondary bond market.
Overall, the intervention of the Russian Government and the CBR in the banking sector appears to have achieved its aim, at least in the short term, as it has calmed the market and sent a signal to the investors of the Government's commitment to avoiding a default scenario.
On September 29, Vladimir Putin announced plans to inject US$50bn into Vneshekconombank, Russia's Development Bank, to be lent out to Russian banks and companies to repay foreign debt incurred before September 25 this year. Russian Government support appears be timely and to the extent that it should help to create a more attractive issuer landscape for when the bond markets are ready to re-open for primary Russian issues.