Life After Debt - Russia Resurgent
Dutch tulips…US Internet shares…and now Russian equities? Russian financial specialist Eric Kraus speculates on internal reforms and subsequent prospects for foreign investors from deep within the big Bear.
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.
for the Daily Reckoning
October 21, 2002
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.
Put the latest rally in perspective.
Week after week, month after month, stocks fell. We are already in the 29th month of a bear market. Except for 2 periods in the ’30s, this is already the longest bear market of the century. But the grinding down of stock prices couldn’t last forever. We figured it was time for a major rally – or a panic crash.
So, the S&P rallied 13% from its Oct. 9th low. It’s still 18% below its level of a year ago and 42% below its March high.
Otherwise, the trends that we thought ‘couldn’t last much longer’ seem to be eternal. The trade gap, for example, rose to a new record in August. Americans bought from foreigners $38.5 billion more in August than they sold to them. The gap was biggest with, guess who? The Chinese, with whom the U.S. had a $10.9 billion shortfall.
The trade gap will eventually be closed, we keep telling you, by a fall in the dollar – which will make American exports more attractive and imports less so. Earlier this year, the dollar fell about 15% against the euro…but recently, it has seemed strong and continues to resist our predictions.
Dollar-based investments will blow up on the foreigners sooner or later. We’re in no hurry.
We’re also waiting for the housing market to collapse. The median house in Orange Co., California, sells for $368,000, up 20% in the last 12 months. In LA county, meanwhile, the median price has risen 16.5%. How long can property continue to rise 8 times faster than personal incomes?
"Rents falling, but prices still soaring," says a headline from San Francisco. That is a trend that can’t last forever, either.
But of all the trends we thought should have ended long ago, the spending patterns of the U.S. consumer is the most inspiring. We know where they are getting the money – they are taking it out of the ‘equity’ in their homes. Everyone will regret it, sooner or later, we think. The lenders no less than the borrowers.
"Consumers have grabbed the bacon," says an article in the International Herald Tribune, "and banks seem happy to let them run with it." Consumers spend about $1.20 for every dollar they earn. This, too, cannot last forever. But, we admit, it might last longer than we do.
But let’s check in with Eric on the latest news from the Bear Market Rally:
Eric Fry in New York…
– The buying panic on Wall Street continued for a second straight week, as the Dow Jones Industrial Average surged 472 points to 8,322. Since hitting its recent low of 7,286 one week ago Wednesday, the blue chips have soared 14%. Meanwhile, the Nasdaq, which jumped 6.4% last week to 1,287, has vaulted a stunning 15.5% from its 6-year low on October 9th.
– Is this the Mother of All Bear Market Rallies?
– "It will be said," observes Barron’s Michael Santoli, "that respectable earnings from some big companies convinced investors last week to stop banging their heads against the wall." However, Santoli points out, the decent results from IBM, Citigroup and Microsoft were more than offset by the dismal earnings reports from the likes of Intel, Coca-Cola and Sun Microsystems. "Overall," he says, "the quarterly-profit picture remains tough. That leaves wide open the prospect that a handful of well-received earnings reports was not the primary driver of the indexes’ strong run off recent lows, but simply accessory to the fact."
– Well said. We suspect the main reason stocks went up last week was ‘just because.’ In other words, they rallied for no particular reason – good, bad or otherwise.
– "Sometimes stocks just go up for no good reason," we remarked last week (exactly one day before the latest rally on Wall Street began). "And who knows, maybe they’ll keep going up for no good reason…for a while…Furthermore, the market ‘deserves’ a little rally. But after stocks stop going up for no good reason, we suspect they’ll fall again…for plenty of good reasons."
– As stocks raced higher, gold drifted lower. The yellow metal became slightly less precious during the week by slipping $3.60 an ounce to $312.50. The bond market also played yin to the stock market’s yang by tumbling about 3 and 1/2 points over five days. The yield soared to 4.10% by the week’s end, up sharply from 3.78% just a week earlier. In bond market terms, that’s a mini-crash.
– The tumbling bond market gave subscribers to John Myers’ Resource Trader Alert a golden opportunity to cash in on the 10-year Treasury note puts he recommended on September 27th. The subscribers who acted on John’s recommendation chalked up a 49% gain in just three weeks. As it happens, we mentioned this trade in "real-time" in the September 30th edition of the Daily Reckoning.
– "The stock market’s excruciating slide has been chasing investors out of stocks and into bonds," we wrote. "The result has been a bond market rally every bit as spectacular as the stock market’s collapse. Has the bond market become simply the latest of the serial bubbles floating through our economy? We don’t rule out the possibility…
– "The abrupt reallocation from stocks to bonds is forcing equity mutual fund managers – already low on cash – to continuously sell stocks in order to meet the redemptions. Meanwhile, the increasingly flush bond fund managers feel compelled to do something with all the cash flowing into their funds. So they keep buying bonds, no matter how low the yields fall. Obviously, there’s a self-fulfilling aspect to all of this that has nothing to do, necessarily, with underlying economic fundamentals."
– Myers, upon observing these trends and various other bearish developments for bonds, advised buying puts on the 10-year Treasury. In a trading alert dated September 27th, he wrote, "Welcome to the bubble economy…Capital pouring out of the bursting bubble in stocks has created another bubble in bonds, as bloodied investors scramble for safety…I believe the time is right for a bearish play in T-notes."
– Nice call, John. John thinks the sell-off in the Treasury market is over for the moment, but still takes a dim view of bonds. "The big drop in T-notes has left this market oversold and vulnerable to corrective rallies," he wrote last Friday. "Let’s go ahead and book some profits now and look to use a corrective rally as an opportunity to re-enter on the short side."
– Myers and his professional network of contacts have been producing a steady stream of winning option trades for several months.
Back in Paris…
*** The biggest bond buyer in the world – Bill Gross, who runs the PIMCO fund – is in the news again. You will recall that he guessed that stock prices would come to rest at around 5000 on the Dow. Now, he is urging corporate America to give investors a break.
Late, degenerate American capitalism was distinguished, we noted years ago, by a kind of perverse exploitation. Capitalism was supposed to allow the capitalists to exploit the workers. We rather liked Marx’s idea, but we discovered that in the real world, it worked the other way around. Investors ponied up the money, which was used for the benefit of the workers, notably those at the top of the payroll. Executives enjoyed multi-million dollar compensation packages, even as they drove share prices into the ground.
But now investors are being a little more careful. If you want us to buy your bonds, Gross implies, you’ll have to go easy on the executive compensation.
*** My old neighbor out in the country, François, came over yesterday. He wore his hunting jacket and carried a shotgun. It is hunting season, and the woods are alive with the sound of hunters blasting away at anything that moves.
François reached into the back of his jacket and pulled out a nice, plump hare with blood dripping from its nose.
"It’s for you," he said, smiling broadly. I let Francois hunt on our farm. He brings me a bird or a rabbit from time to time.
In the countryside, hunting rights are more precious than marriage vows.
*** By the way, I write to you from time to time about our experiences here in France…mostly because I enjoy writing about them. Every day, our office in Ireland receives letters from readers all over the world who have found their own paradises…readers who are living the good life in places like Panama…Nicaragua… Ecuador…Ireland…Spain…Turkey…South Africa… New Zealand…Mexico…and they send them out in a weekly e-mail they call International Living postcards. If you enjoy reading my notes about life in France, you may also like to hear from folks doing interesting things elsewhere.
*** Seems like the whole family is setting off for America. Elizabeth is on her way to try to sort out furniture and visas; it is a pure co-incidence that it is fox-hunting season in Maryland…
Maria has left for New York, where her modeling career will enter a new phase — maybe good, maybe bad…we will see.
And Jules is leaving tomorrow for his class trip – to Baltimore, of all places! His host family is expecting a French kid. We don’t know whether they will be disappointed or relieved when Jules shows up. Should Jules pretend he is French, we wondered.
A Daily Reckoning reader offers advice:
"As another of Baltimore’s far flung children, please consider this: if Jules pretends he doesn’t speak English very well, no one might notice."
Your editor is also leaving town. He’s on his way to Germany, from whence he will report in again tomorrow.