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19 April 2016

Banking on Politics

VEB’s bailout highlights ‘the privatization of profits and nationalization of losses’  

There is trouble brewing in Russia’s economy. Growth forecasts for 2016 are inching towards a contraction of 2 per cent, although the recent recovery in oil prices may temper this somewhat.  While even this is a recovery from the 3.7 per cent contraction for 2015 that Rosstat announced in January, there is a growing concern that Russia’s recession could stretch into 2017. Many hope a turnaround plan is just around the corner or that a rebound in oil prices will set budgets back in order. However, even such developments would not change the Kremlin’s reality that political concerns will trump those in all other spheres, including the economy.

The 29 March announcement of a 150bln ruble (US$2.2bln) bailout for Vnesheconombank (VEB), Russia’s second largest financial institution, should serve to set alarm bells ringing. Not because of the bailout itself, which was long foreshadowed, but rather because although the Kremlin is not ignoring the realities of the situation, it has deliberately chosen to prioritize political concerns at the expense of the wider economy.

Firstly, the bailout is undoubtedly insufficient. Further state aid is highly likely to be necessary, with reports from December 2015 forecasting that the bailout could rise to US$18bln. VEB has more than US$3bln in foreign currency-denominated debt due this year and more than US$4bln in such debt due in 2017. The development bank long relied on raising foreign funds to help it finance state-backed projects but its inclusion on Western sanctions lists has made re-financing difficult, particularly as the US has also warned banks off underwriting Russian sovereign bond issuances.

Furthermore, the bailout serves as a prime example that political concerns will continue to be prioritized at the expense of the wider economy. Last December, as rumours of a VEB bailout were mounting, President Vladimir Putin stated, development agencies "have turned into garbage dumps for bad debts". Given the Kremlin’s preference for a strong power vertical, either this message has worryingly not been received or, more likely, it was abandoned. When announcing VEB’s bailout, Prime Minister Dmitry Medvedev stated that, “despite the current situation, we are not talking about changing the general goals for which VEB was created”.  In other words, the bank’s business aims will remain political rather than commercial.

To outside investors, this all-too-common preference for using state-firms as the means for political rather than business ends is surely off-putting. Yet it is Kremlin policy and Russia’s reality. As if to make this clear, Aleksandr Nikolaevich  Patrushev, sits on VEB’s board of directors. Nikolai Patrushev, Aleksandr’s father, was Putin’s successor as FSB director and is now in his seventh year as head of Russia’s Security Council. When pressed on the issue at the 2007 Valdai Forum, Putin told a joke about the universal nature of nepotism.

Yet this nepotism is more nefarious than simply placing the sons of high-profile Kremlin officials in positions of power and influence. Natalia Zubarevich defines the phenomenon as “the privatization of profits and nationalization of losses”.  VEB is certainly emblematic of this, with the bank having been heavily used to finance state-backed projects with little financial reasoning, such as the Sochi Olympics. As a result, VEB now controls more than US$3bln (200bln rubles) worth of money-losing hotels, ski resorts and other projects related to the 2014 winter games. The bank also holds hundreds of millions of dollars in debt owed by businesses and businessmen based in eastern Ukraine issued in the years before the Euromaidan revolution, when ensuring the loyalty of power brokers under the Yanukovych government was the political order of the day.

As political interests change, so does VEB’s focus of business. Since the implementation of sanctions in the aftermath of Russia’s annexation of Crimea, VEB has undergone another such shift, loaning heavily into businesses aligned with the Kremlin’s stated aims of developing import substitution. In October, the bank announced that it had approved participation in 26 import substitution projects, with VEB accounting for 354bln rubles (US$5.5bln) worth of financing in these projects. This is unlikely to stop the banks bleeding and as aforementioned, it is extremely likely the bank will require additional bailout funds over the coming months.

VEB’s bailout highlights concerns over the Kremlin’s handling of economic matters more generally. While the government has indicated for months that the bailout would be forthcoming, the 29 March announcement was underwhelming at best. At least one further, and much larger, infusion of cash is expected. Yet even the government’s latest economic stabilisation plan provides no indication as to how VEB’s bailout will proceed. While it is unforeseeable that Russia will allow the bank, which accounts for some 5.5 per cent of GDP to default, a mangled bailout will trigger jitter amongst Russia’s existing debt holders.

Amid these issues, there is also a growing concern about the potential impact of further credit downgrades, with Russia’s rating currently standing at BB+, the highest junk rating. One downgrade has largely been priced in already but a second could trigger a breakdown in the increasingly fragile liquidity system built up by the Russian central bank, which has been allowing lenders to deposit the securities of leading state-owned firms, such as Rosneft and Gazprom, in its liquidity auctions. In effect, this has allowed Russian lenders to continue operations largely at their pre-crisis levels. Although there was economic reasoning for doing so, the decision to avoid any mention of the house of cards it risks creating was purely political. However, further declines in Russia’s sovereign rating would exacerbate the gap between the true value of the debt and number of loans held against it. Even Russia’s political partners, and potentially even Russia’s oligarchic class, will be keen to avoid such a bubble.

In summary, the Kremlin’s desire for political stability is fuelling economic instability because losses are being shared across the economy. All boats are sinking. In good times, Russia’s economy fuels its political class. For how long the Kremlin can ride out the inverse scenario, however, remains to be seen. 

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