Major League Debtors Part II

"The ranks of BBB- credits are a lot like AAA baseball
teams," we observed in last Friday’s Rude Awakening, "Both
groups include ‘players’ that aren’t quite Big League material."

The BBB- echelon, which is just one downgrade away from "junk,"
contains both tired, old has-beens like General Motors and brash
up-and-comers like the Russian government. These two borrowers
may both be BBB- "teammates" for the moment, but we doubt they’ll
be on the same team for long.

When we peaked under the hood of General Motors last Friday,
we were rather disturbed by what we found. The giant American
automaker’s balance sheet strains under a towering $244 billion debt
load, as well as growing pension and healthcare liabilities.

Thus, this once-and-former AAA credit seems to deserve every bit of its
near-junk rating. By contrast, the Russian government had never
managed to earn an investment-grade rating…until a few weeks
ago. "Like a career minor leaguer," we noted last week, "the Russian
government’s credit rating bounced around in the junk ranks for several years.

Then, in 1998, this troubled borrower validated its lowly rating by defaulting
on its sovereign foreign debts."

Since those dark days, however, the Russian economy has clawed
its way back to international respectability, finally garnering
an ‘investment grade’ rating from S&P late last month.

Even so, does the government of Russia government really deserve
the same credit rating as General Motors?

"Yes, indeed," Standard and Poor’s would cautiously reply. Late
last month, the rating agency boosted Russia’s long-term foreign
debt to BBB-. "The upgrade reflects recent, crucial improvements
in the government’s debt level and external liquidity," says Helena
Hessel, a Standard & Poor’s credit analyst. "These improvements
are so significant that they now outweigh the serious and growing
political risk that continues to be a key ratings constraint on Russia."

"S&P’s upgrade," the Moscow Times reports, "gives the country a
prestigious triple investment rating for the first time ever
after upgrades by Fitch Ratings in November and Moody’s Investors
Service in October 2003."

Russia’s improving "income statement" and balance sheet would
seem to validate the recent expressions of confidence in its
credit-worthiness. Thanks largely to a "petrodollar" windfall,
Russian economic performance has been improving dramatically
over the last several years. GDP jumped about 6% last year to
$600 billion – the sixth straight year of GDP growth above 4%.

Meanwhile, the government has enjoyed five straight budget

"While some oil-exporting nations such as Venezuela have used
windfalls from soaring crude prices to finance massive spending
binges," the Wall Street Journal recently observed, "Russia – long
a financial basket case – has transformed itself under President
Vladimir Putin into a model of fiscal rectitude. The country has
salted away billions of its petrodollars instead of spending them."

The former communist nation has amassed $124 billion of foreign
currency and gold reserves – slightly more than the $113 billion it
owes to foreign lenders. And Russia is retiring these liabilities
much faster than most folks expected. The government recently
announced, for example, that it will repay $3.33 billion in loans
from the International Monetary Fund ahead of schedule.

These new realities aren’t lost on fixed-income investors. GM and
Russia might both carry a BBB- credit rating, but the debt securities
issued by these two borrowers do not seem to elicit a similar
enthusiasm from bond buyers.

The nearby chart presents the yield curves of three "near junk" entities,
relative to U.S. Treasury yields: An index of BBB- credits, Russia’s
dollar-denominated foreign debt and General Motors’ debt.

Every gimlet-eyed reader will note that GM must pay the highest
yields of the three. In other words, most bond investors prefer
Russian debt to GM debt…and for good reason, we think.

"The [Russian] economy is growing for a seventh straight year," the
Moscow Times reports, "driven by a consumer boom and high prices
for Russia’s biggest commodity exports…That is a massive turnaround
from 1998, when Russia defaulted on domestic debt and devalued the
ruble, sending shock waves through world markets.

But Russia’s considerable economic achievements since 1998 reside
in the annals of history. The future is what matters most to bond
investors, and the future of the Russian economy may contain a
risk or two.

"Little effective reform was accomplished in 2004," the S&P
ratings team admits. "Attempts to reform the judiciary and public
administration have been ineffective, the restructuring of the
electricity sector has stalled, and the reform of Gazprom has
been delayed. A further significant worsening of the domestic
political scene, together with unsustainable economic policy
decisions, would dent investor confidence and lead to rising
private sector capital flight. This would weaken…potential
economic growth and its strong liquidity position, which could
negatively affect sovereign creditworthiness over time."

On the other hand, assuming oil prices remain firm and assuming
Russia’s economic reforms continue – even in a jarringly Russian
style – the economy should continue to flourish.

This up-and-coming financial phenom is not certain to become an
all-star, but we would not dismiss the possibility.

Did You Notice…?
By Eric J. Fry

Twenty years ago, who could have imagined that the Russian
government and General Motors would share an identical near-junk
credit rating? Who could have imagined either that GM’s credit
standing would deteriorate so badly, or that Russia’s would advance
so dramatically?

These opposing trends illustrate a fascinating macro-economic
phenomenon: the poor are becoming richer, while the rich are becoming
poorer. The Russian economy, like that of many developing nations,
has been steadily improving, while the historically strong
economies of the West have been gradually deteriorating.

As such, these trends illustrate a kind of "Beatitude Syndrome,"
in which the "first shall be last" and the last are rapidly becoming first.

"Credit-rating agencies can’t say enough good things about emerging
markets these days," the Wall Street Journal reports. "Eight
countries from developing Asia, Europe and Latin America
secured upgrades in January…It’s not a one-month trend…Moody’s
Investors Service has announced 50 sovereign upgrades since the
beginning of 2002 and only 17 downgrades over that span – a sharp
reversal from 1998, when it carried out 22 downgrades and just
two upgrades amid the financial crisis and Russian debt default."

As a result of the upgrade binge, almost 45% of the weighting
on the 31-country EMBI Global Index had achieved an investment-grade
rating by the end of January, up from 4.1% a decade ago and 16%
five years ago.

Meanwhile, America’s national finances are going from bad to worse.
Not only is our savings-short economy absorbing $600 billion per
year of the world’s savings to plug its current account deficit; not
only is our government’s budget poised to operate in the red for as
far as the eye can see; not only is the average American household
shouldering a record level of personal debt; but also, many former
American industrial powerhouses are succumbing to forces of
financial entropy.

Excessive debts and inadequate cash-flows have a way of bringing
down financial enterprises, no matter their pedigree or their past glories.

And The Markets…



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