A strange situation is emerging in Russia: local brokerages have started to express concern over how much local corporates are borrowing externally, while the foreign investors to whom they are selling these bonds say everything is going fine.

As the IMF noted in its global financial report, the amount of outstanding emerging sovereign debt is decreasing. In Russia alone, it halved last year, from $105 billion at the end of 2005 to $49 billion at the end of 2006, as Russia used its stabilization fund to buy back foreign debt.

However, the amount of money flowing into emerging market debt portfolios is greater than ever, with $6.2 billion in new money flowing into emerging market debt funds last year.

That’s pushed sovereign spreads down to record lows, and made fund managers more prepared to look beyond sovereigns to the corporate sector for yields.

Emerging market corporates are therefore able to borrow money from abroad easier and cheaper than ever before. Total emerging market corporate issuance was up 20% last year, to a record $125 billion. Much of that growth has been from Russian corporates, says the IMF.

Local brokerages have expressed anxiety about the situation. Troika Dialog’s respected economics team, led by Evgeny Gavrilenkov, published a report in April, that raised concerns that outstanding Russian corporate debt had more than doubled in 2006, from $108 billion to $260 billion.

The figures, Gavrilenkov says, are “quite staggering”. The economy is “getting more and more addicted to external borrowing”.

Where is the new issuance coming from? The banking sector is providing a lot of new deals. Russian banking external borrowing doubled in 2006, reaching $100 billion by year-end, as banks borrowed to finance their rapidly expanding loan portfolios, which in the cases of the top banks are growing at rates of 100% a year.

Investors are being treated to the return of the ‘unpronounceables’, as little-known banks like Locko Bank, Credit-Europe Bank and Absolut Bank find credit easily, while more established names like Vneshtorgbank (VTB) and Sberbank are borrowing heavily in a variety of currencies and through a range of subsidiaries.

State-owned Russian energy companies have also been particularly strong borrowers. That’s partly because the state is increasing its ownership of assets in the energy sector, as part of a new policy of the state keeping ‘strategic resources’ under its control.

As a result, Gazprom and Rosneft, the state’s two designated energy champions, are going on a debt-financed acquisition bonanza. The two companies’ combined foreign debt reached $56 billion in Q1 of this year, about $10 billion more than the sovereign. Rosneft alone borrowed $22 billion in one go, to buy assets from the Yukos auction.

Gazprom and Rosneft also have big capex requirements for their investment programmes, let alone their acquisition programmes. Some of this will take place through subsidiaries, such as Gazprom subsidiary Nordstream, which needs to borrow several billion dollars to finance the construction of a new gas pipeline from Russia to Germany.

State pipeline monopoly Transneft also has daunting financing requirements. Just one of its projects, the eastern Siberian oil pipeline, which will take oil from Siberia to China and Japan, requires somewhere between $11 billion and $20 billion in financing, according to different analysts’ estimates. The company has re-organized its structure to make its finances more transparent and investor-friendly, and launched its first $1.3 billion Eurobond in March. It is likely to be a regular visitor to the markets.

Russian Railways also needs to invest heavily in new infrastructure. Its CEO, Vladimir Yakunin, told president Putin in April that the company requires Ru30 trillion ($1 trillion) over the next 20 years or so, if the railways are not to drag down national economic growth. The company itself has not been a big borrower so far, but it can only raise so much from IPOs of subsidiaries, which are set to raise around $4 billion over the next 18 months.

President Putin suggested to Yakunin that the company use public-private partnerships (PPPs) to raise capital. PPPs are “the great white hope of the Russian government”, as Roland Nash, chief strategist at Renaissance Capital, puts it.

The government has put around $2.5 billion into an investment fund to support PPP projects, while billions of dollars more is set to flow from western banks. Already, BNP Paribas is set to arrange $3 billion in project financing for a new oil refinery in Tatarstan, while ABN Amro is and Calyon are arranging another $2 billion for a new hydroelectric dam and aluminium smelter in central Siberia.

What are the risks if this borrowing addiction gets out of control?

The first risk is a short-term one, that deals will come too tightly, and then do badly in the secondary market. We’re already seeing that happen. Transneft’s recent Eurobond debut, for example, was described as “a disaster” by one investor. It lost 75 cents in value in three days when it was launched in February. Investors complained the deal had been priced too cheaply, presumably because Transneft was only too aware of the huge financing requirements it faces going forward. 

A more serious risk is that companies can’t service all this debt in the future. That’s a risk for CIS banks, says the IMF. Their rapid growth in corporate and retail lending “could lead to deterioration in asset quality if banks’ credit assessment strategy becomes over-stretched. This is of some concern because capital adequacy levels are declining”.

Even state-owned champions like Gazprom and Rosneft could be at risk to foreign exchange volatility, says Troika Dialog. Gavrilenkov says: “Will Russian banks and corporations such as Gazprom and Rosneft be able to service their debt and keep growing were the rouble to depreciate? We doubt it.”

This raises the question of whether the Kremlin would step in to bail out state-owned corporates if they got into trouble. Renaissance Capital’s fixed income analyst, Pavel Mamai, thinks not necessarily.

Mamai thinks that Gazprom and VTB are the most likely to enjoy state support if they got into debt trouble, followed by Bank of Moscow and Sberbank. He thinks AvtoVAZ, Rosneft and Gazprombank are likely to enjoy state support at the moment, but that could change in the medium-term, depending on who’s in favour in the post-2008 Kremlin.

The other 25 or so state-owned corporate borrowers, he says, cannot be relied on for receiving state support “even in the event of a looming default”.

He adds: “Even if an issuer is bailed out by the state, bondholders are exposed to numerous risks. These include the state’s ability to ensure issuers remain in business despite default; creditor discrimination; and an arrogant approach towards investors.”

Who are exposed to the risk of default? Western banks have taken on large amounts of Russian corporate loan risk, but they’ve chopped up those loans into structured notes, and then sold them on to other investors, particularly insurance funds.

Emerging market institutional investors also have large exposure to CIS corporates. But they seem unworried as of yet. Raphael Kassin, head of emerging market debt at ABN Amro asset management, says: “There’s a flood, but it’s a good flood. I love the state-owned companies. The problem isn’t the credits, it’s the liquidity. It’s hard to get your hands on some of this paper, so the banks need to support the liquidity.”

The Russian government is also exposed to state-owned companies’ default risk, but it doesn’t seem too worried either. Sergei Storchak, deputy minister of finance, says: “Big monopolies like Gazprom necessarily have very big investment needs. For example, Gazprom needs money to invest in new LNG technology. Russian financial markets are still too small to meet all of these companies' financing needs, so they must go to the international capital markets.”

But he adds: “We want them to pay attention to the manner in which they borrow, so that they are borrowing in long-term maturities, without sudden peaks in re-financing requirements”. Rosneft’s $22 billion loan package, for example, was mainly 12-month debt.

What can be done to minimize the risks from the region’s corporate borrowing? The IMF would like to see better regulation of Russia’s banking sector, with more demands made of banks’ capital adequacy ratios. Share offers by banks like Sberbank, VTB, Ursa Bank and others will help mitigate the situation, but many more banks are borrowing debt than will be able to do IPOs. Some will go bust, others will be bought out.

As for Russian energy companies, Troika’s Evgeny Gavrilenkov suggests that they are victims of the Kremlin’s stabilization fund, which has improved the sovereign’s credit profile by heavily taxing energy companies, thereby pushing them to raise capital on the foreign debt markets at high interest rates. “The present structure doesn’t make sense”, he says. So perhaps the sovereign should let energy companies keep more of their profits, in exchange for borrowing less externally.

Jules Evans, a British freelance journalist based in Moscow.

April 13, 2007