The name’s bond: Russia’s debt pressure on Kyiv leaves it Vulnerable to Caracas     

Guest contribution from Max Hess

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Embattled Venezuelan President Nicolas Maduro meets with Vladimir Putin

In December 2013, Moscow signed off on a US$3bln loan to Ukraine. The loan, in the form of a two year Eurobond, was intended to be the first of US$15bln in such loans, which Russian President Vladimir Putin hailed as a lifeline to Ukraine. The bonds paid an annual interest rate of 5%, far below the market rate at the time. Yet this maneuver threatens to cost Russia dearly in the future, even as the final status of the Eurobond continues to be litigated in UK courts. While useful as geopolitical leverage, Moscow’s actions in its debt disputes with Ukraine puts it at risk of losing billions of dollars in debt owed by Venezuela, currently teetering on the edge of default.

The US$3bln bond included a number of unique provisions, rare in the largely boilerplate world of sovereign bond contract wording. One of the provisions even explicitly acknowledges that relations with Moscow will impact Ukraine’s ability to refinance or repay the debt. Another controversial clause would have allowed Moscow to force repayment if Ukraine’s debt-to-GDP ratio spiked, although it ultimately chose not to trigger the provision when that occurred in late 2015. Two other measures, known as cross-default and acceleration clauses, would have forced Ukraine to immediately make payment on other outstanding obligations, likely harming Ukraine’s relations with other creditors. Arguably the most notable aspect of the loan was the structure of the bond, designed so it could be sold on in private markets by Russia’s National Welfare Fund. When Ukraine’s default occurred, however, the Kremlin insisted the bond be treated as official debt, although there is no precedent for treating tradable Eurobond in this manner. Simultaneously, Russia refused to take part in Paris Club negotiations — the traditional venue for settling official debts – on restructuring the note.

This argument proved particularly troubling for the IMF, which wanted to avoid being seen as a party to the dispute. However, concerns were also widespread that Russia could block Ukraine from receiving funds under a US$17bln IMF bailout agreement in May 2014. Backed into a corner, in December 2015 the Fund changed its regulations and ruled that while the debt was official, it would now lend to countries with outstanding debts to official creditors. The IMF previously would only lend to countries that did not have outstanding obligations to other states, a policy in part intended to avoid politicizing the Fund’s actions. Others have argued the decision could benefit Ukraine, although views on the decision remain mixed. Its classification as official debt meant that a final restructuring agreement struck with Kyiv’s private creditors did not apply, and weakened Ukraine’s argument before London courts that the debt should be treated as private. Meanwhile, the designation of the debt as official freed Moscow from the need to participate in Paris Club negotiations.

Russia’s attempts to mix public and private debt have played a role in the sole UK court ruling on the dispute to date. The tradeable nature of the bond allowed the court to rule against Kyiv claims the bond should be dismissed as ‘odious debt’. A relatively-rarely invoked legal defense, odious debts are those unwittingly or forcibly incurred that run counter to the interest of the debtor. Questions have been raised about this ruling and it is undoubtedly a key point in Ukraine’s appeals. It should be noted even the most favorable judgement for Russia may be complicated by Britain’s ‘clean hands doctrine’ that requires the claimant (Russia, in this case) demonstrate it is not acting in bad faith to the debtor. Nevertheless, Russia may well escape the 20% haircut that by Kyiv’s private debtholders agreed to.

Ambiguity around Ukraine’s finances and the threat of Russian claims against Kyiv remain a crucial component in Russia’s ongoing attempts to destabilize the Ukrainian state. The bond dispute is as much a part of this as Gazprom’s lawsuits, ongoing military activity in the Donbass, or cyberattacks on Ukraine’s financial infrastructure and banking networks.

Russia’s bond battle with Kyiv could expose it to another fight with Venezuela. The December 2015 IMF rule change allows the Fund to ‘provide financing to a country even when it has outstanding arrears to official bilateral creditors’. As a result, should Venezuela default, including before official creditors, it could still receive an IMF bailout. Given the geopolitical nature of Venezuela’s debt, Western interests in the country, and the Venezuelan opposition’s recent warnings it may not honor some debt mean the current rules pose a significant concern for Moscow.

As a result, should Venezuela default, including before official creditors, it could still receive an IMF bailout.

Venezuela has an estimated US$139bln in external debt, and as of May, only US$10bln in foreign currency reserves. Russia and Russian state-owned companies are amongst Caracas’ largest creditors. The exact size of these loans, mired in the murky relationships between state oil firms Rosneft and PDVSA, is difficult to estimate. The main complicating factors are Venezuela’s offers to swap debt for stakes in oil assets, complex agreements between Rosneft and PDVSA, VTB’s purported holdings of Venezuelan debt, and perhaps most intriguingly the joint Russian-Venezuelan ownership of Evrofinance Monsarbank, which underwrote a number of Venezuelan debt issuances.

However, Russia’s status as one of Venezuela’s leading, and most politically exposed, creditors is indisputable. As of January 2013, Rosneft had invested at least US$10bln in Venezuela, although CEO Igor Sechin’s words should be taken with a grain of salt given his previous claim investment in the Carabobo-2 field would top US$16bln. Rosneft has since agreed several other loans and investments, most prominently the US$1.5bln loan for which it received 49 per cent of PDVSA’s US subsidiary Citgo as collateral in December 2016. Russia also offered Venezuela up to US4$bln in credit for arms purchases, of which Venezuela reportedly used at least US$3.6bln. In total, the Russian government’s loans to Venezuela likely exceed US$10bln and may rise to US$13bln, excluding interest.

Even with Maduro government still in power, payment issues on its debt to Russia have already emerged. Russia’s Audit Chamber announced in June that it expected not to receive some 53.9bln rubles (US$900m) of the US$2.84bln owed to Moscow under a 2011 loan agreement, which has already been restructured twice. In April, Sovcomflot seized a PDVSA oil shipment over late payments to the Russian state-owned shipping firm. Meanwhile, credit rating agency Fitch warns a default by PDVSA this year is probable, and credit default swap rates imply a 90% chance of a sovereign default over the next five years.

Ukraine’s debts to Russia before the 2015 default included US$605m in bilateral loans and nearly US$1bln in state-guaranteed sub-sovereign debt on top of the US$3bln Eurobond. While Russia improbably claimed nearly US$30bln in debts to Gazprom at the time, the Arbitration Institute of Stockholm Chamber of Commerce ruled against this claim in May. In total, Ukrainian debt owed to Russia in 2015 totaled roughly half of what Venezuela owes Russia today. Venezuela is set to sink further into crisis, and its opposition has warned it would consider much of its recently-issued debt as ‘odious’ should it come to power. The IMF’s rule change means Russia risks major losses should the Maduro government collapse. Russia’s financial fight against Ukraine may well prove penny wise and pound foolish should Caracas default.


Max Hess is a Senior Political Risk Analyst with AKE International. He is a graduate of the School of Oriental and African Studies at the University of London and Franklin & Marshall College. Max has written for The Intersection Project, The Moscow Times and The Telegraph and been featured on the BBC, Radio Live, Rossiya 24, Deutsche Welle amongst others. His focuses on trade networks, sovereign debt, political economy and regional relations in Eurasia.

A Word on Russian Models

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Economic growth models, obviously — what else did you think I meant?

These days if you’re Russian, ongoing economic difficulties (and anger over corruption because of them) are probably issue number one for you. Not Crimea, not Trump, not Russia’s performance at the World Hockey Championship — it’s the economy, durak (stupid). There’s been a lot of commentary about how Russia’s economy has entered a period of stagnation and is in need of a new growth model. What I haven’t seen is a good, straightforward explainer of what specifically is wrong with Russia’s economy. That’s to say, why is the old model is no longer delivering growth? To explain in a simple way, I’ll have to paint in some fairly broad brushstrokes, so note that the real picture is of course more nuanced.

Holy Excess Capacity, Batman! 

A translation that I recently ran on Bear Market Blog is the sort of piece that while highly sector-specific and a bit technical, is indicative of a much broader issue. The short version is that Russia and its Customs Union colleagues have had to delay – for a third time – regulations that would mandate the modernization of privately owned and aging locomotives. Some 73% of that fleet will be beyond its service life in only three years. That may not seem like a huge deal, except that that requirement would run companies over 100 billion rubles, well over a billion dollars.

To understand the roots of the problem, we have to jump back to the end of the Soviet Union. The Union’s splintering economy was flush in capital (the heavy machinery kind) — far more than there was an economic basis for. That’s for a number of reasons: an emphasis on large factories, a constant war footing, a command production system that encouraged larger, heavier products, etc. But the key point is that there was a large volume of industrial equipment. As the country – and economy with it – collapsed, this machinery didn’t go anywhere. It was turned off, and there’s a pretty good chance it wound up in the hands of one of many new oligarchs through voucher privatization – a development that has left many Russian skeptical of privatization until today. The result was excess capacity – Russia had the industrial might to be producing far more than it actually was. This condition pervaded until the default of 1998, which the ruble tumbling – causing some short term stress, but also rapidly boosting the competitiveness of Russian exports. The above led to a rapid turnaround in Russia’s economic fortunes at a time when oil was still below $30/brl.

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Not too shabby.

More competitive exports and soon, sustained growth in oil prices, meant a renewed need for all of that Soviet-era machinery. Part of the reason for the rapid growth following the default was an excess capacity cushion – all that was required rebooting the machinery I mentioned above, perhaps after some retooling. With oil revenue pouring in and richer Russians, Russia for a time found its stride, as evidenced by the growth rates of the early 00’s.

The Hard Part

In 2013, before sanctions or oil prices took their toll, it became clear to observers and Russian officials alike that the economy was starting to sputter. To note, the issue wasn’t recession – not yet, at least – but slowing growth. What was the issue? At a certain point, Russia ran out of excess capacity. In other words, there were no more machines to reboot. Any new growth would have to come from investment in new capital [1, 2]. That’s been a weak spot for Russia for some time. For one, new equipment is expensive (this brings us back to the locomotive example). Especially in cases where Russia can’t import Western gear due to sanctions, either imposed by the West or by Russia. It’s a domestic political economy issue as well: building a new factory or purchasing new hardware isn’t merely a consideration of future demand, but confidence in a stable tax code, trust that the court system will defend your property, and an absence of fear that Igor Sechin may get hungry for your business. As such, talk in Russia these days, at least as far as economic policy goes, is all about boosting private investment. The issue is that the aforementioned will ultimately require sustained and deep institutional reform, the kind for which the Kremlin has no appetite — or, for that matter, capacity to deliver.

[1] This is not to suggest that no new machines or factories were built in Russia. That is not the case. As I noted above, broad strokes!

[2] The above is a pattern that has turned up in many places across the economy. It’s also been an issue for the military, as well. Russia had no issue delivering the first half of its ambitious modernization plans – which saw the modernization of a lot of legacy equipment. However, the acquisition of new hardware has proven more difficult, not only because of economic crisis, but because new hardware is expensive.  While the Mig-35 may be a higher, bigger number than the Mig-29, its ultimately not a new platform.


Hope all are having a good summer! I have some big news about Bear Market Brief coming soon, so stay on the lookout.

In Translation: Train (Modernization) in Vain

Article by Anastasia Bedneyeva, Natalya Skorlygina, and Anatoliy Dzhumailo. Translation by Nick Trickett.

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Customs Union regulations on locomotive modernization look set to be delayed. Again. (Art: Viktor Chumanev, Kommersant)

Companies may win an exemption from the Customs Union’s technical regulations for privately-owned locomotives. Their inclusion under Union regulations would threaten the use of 60% of privately-owned locomotives in the Russian Federation, and the modernization of the fleet, per analysts’ estimates, could run up to 100 billion rubles ($1.67 bln). The government plans to decide the matter at the end of year, while the regulations, yet to enter force, will again be delayed – this time until August 2018.

Privately-owned locomotives running on non-public use routes may be exempted from the Customs Union’s technical regulations, according to the minutes from a June 15th interdepartmental working group on rail transport chaired by Arkady Dvorkovich. The Ministry of Transport (MinTrans), the Ministry of Industry and Trade (MinPromTorg), and the Department of Transport Oversight (RosTransNadzor) are required to submit relevant proposals on regulations for privately-owned locomotives by December 15th of this year. Under current regulations, upgrades and maintenance for old locomotives were to be completed by August. Now the Russian government has proposed a further delay to the implementation of the regulations for privately-owned locomotives August 2nd, 2018.

The Customs Union’s technical regulations, which forbid an extension of the working lifetime for old locomotives without cost-intensive modernization, were slated to come into effect in 2014. The locomotive owners won a two-year delay in June 2014, and in June of 2016, they secured another one, until August 2017. MinPromTorg pushed for an introduction of the regulation without further delay, though was prepared to offer an exception for locomotives operating on non-public routes (see coverage from 10 June 10th, 2016).

A letter from Mintrans to the government dated August 19, 2016 cites data from Russian Railways (RZhD) to show that as of 1 August, 2016, 60% of locomotives—almost 2,000—on non-public use routes were operating beyond their service life. The letter notes that the implementation of the ban in 2017 would put 13% of the cargo base at risk, or 158 million tons per year. By 2020, 2,400 would be beyond their service lives – some 73% of the fleet – and most companies lack the means to replace them.

By 2020, 2,400 (locomotives) would be beyond their service lives – some 73% of the fleet – and most companies lack the means to replace them.

Kazakhstan, Belarus, Armenia, and Kyrgyzstan have all offered to scrap the technical regulations for rolling stock before they go into force. Industrial players, however, have led the charge against the rules. On May 11th, Russian Steel a non-commercial partnership that unites the Russian Federation’s metallurgists, requested that MinTrans exempt locomotives on non-public use routes from these technical regulations so their implementation proceeds “in a more merciful manner”. As the Russian Steel asserts, the locomotives in question – ones that have operated for 20 years or more – are in satisfactory condition and don’t require modernization, the cost of which is roughly 80% of the cost of a new locomotive. A letter with similar requests and arguments was directed to Dennis Manturov, head of MinPromTorg, by the Russian Association of Fertilizer Producers on May 18th. At the same time, chemical industry players have advocated for the exemption of locomotives that do not pass connecting stations.

A Kommersant source in the market notes that on average, company locomotives operate three to six hours a day, the non-public use routes don’t cross those of passenger trains, and that increased security requirements are not needed. He recalls that a similar decision on open cars had led to a rolling stock deficit and tripling of operating rates to 1,.5 thousand rubles per diem. Aleksei Belinskiy, General Director of the LocoTech Group, believes that if the operation of privately-owned locomotives on non-public use routes were to be immediately effectively immediately, their owners would “flock to buy new ones” and existing industrial production capacity would not be able to meet the avalanche of demand. Conversely, demands leading to a planned changed for the sector would allowed this demand to be absorbed without issue.

Mikhail Burmistov, head of the Infoline Analytics agency, says that the modernization of switch engines (the affected locomotives) could, on average, cost between 25 and 30 million rubles per unit. With around 4,000 units making up the fleet and in need of modernization, the process could require 100 billion rubles. Besides that, the introduction of the technical regulations this year carries the risks the collapse of loading and unloading centers as well as a widespread deficit of wagons due to a slowdown in turnover. In the Burmistov’s opinion, the modernization of the private locomotive fleet must be stimulated in a manner similar to newer railway wagons and that subsidies should be no less than 1 billion rubles a year.

In Translation: Government, facing a demographic crunch, debates birth rate stimulus

Article by Margarita Papchenkova, Tatyana Lomskaya. Translation by Nick Trickett.

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The Social Block wants to extend a childbearing incentivization program that pays new months. MinFin wants to switch to targeted support. (Photo: E. Razumniy, Vedomosti)

The Government’s social block has proposed a package of measures to stimulate Russia’s declining birth rate, two Federal officials have told Vedomosti. Vice Prime Minister and Social Block leader Olga Golodets’ press secretary confirmed the move, noting the necessity of continuing current measures and the development of new ones.

After a baby boom in the 2000s, one that peaked in 2014, the birth rate began has resumed falling. Per Rosstat data, in Q1 2017 the birth rate fell 10.1 percent year-on-year. Natural population decline reached 76,100 people against 34,700 a year earlier (see graphic).

The Ministry of Labor has sent the Ministry of Finance a large list of possible measures, two of which require large budget injections, say officials. A meeting on demographics and stimulating Russia’s birth rate with President Putin took place in mid-June, which Kremlin Press Secretary Dmitry Peskov confirmed.

The Ministry of Labor has called for the continuation paying out birth incentives – the maternal capital program – until 2023, said Minister Maksim Topilin. The program was launched in 2007 and is currently authorized to run through to 2018. It costs around 400 billion rubles a year, with half state expenditures going to maternity support. Additionally, Prime Minister Dmitry Medvedev ordered extra support for women who give birth to two kids before the age of 30. MinFin is against the simultaneous extension of birth incentives through 2023 and the new incentive, notes a ministry official: “The automatic extension of the birth incentive program will actually disincentivize giving birth to two kids, since there remain few years until the program is scheduled to end.” And it’s not just a matter of significant long-term budget commitments. MinFin, as usual, doesn’t like the lack of targeted-ness and criteria for needs, he adds.

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MinFin, whose representative refused to comment, has proposed an alternative, two officials say: to extend payments of maternity benefits to 2019 and then reform the program. The Ministry, in its words, has put forward two conditions: only pay the incentives in regions where the birth rate is lower than the average in Russia through natural population loss from internal migration, and only to those families whose incomes fall below the subsistence minimum after the birth of a second child. MinFin is ready to direct the money saved to other birth rate stimulus measures, such as additional targeted payments and benefits.

Another of the Social Block’s ideas is to significantly increase the childcare allowance for women who give birth before they turn 25. A representative of the Ministry of Labor confirmed the idea to incentivize women to have their first child earlier. But a different demographic problem then arises, says an official. “There’s a risk that women won’t receive their education or acquire a profession in time before they’re 25 – and this will lead to the withdrawal of women from the labor market which, in conditions of a declining working population, will further exacerbate the labor deficit.” It’s unlikely the measure will lead to an explosion of fertility, says Tatyana Maleva, Director of The Institute for Social Analysis and Forecasting of the Russian Academy of Sciences. “This is a global trend: a woman is career-oriented.” It “will still be pennies,” Yevgeny Gontmakher, Deputy Director of The Primakov Institute for World Economy and International Relations, is convinced. “They’re talking about an increase of 200-500 rubles” (between $3-9).

Officials in the Economic and Financial Block agree: it’s necessary to understand the causes of birth rate decline before stimulating it. The drop in Russia’s birth rate is connected with demographic waves, says one of them: the baby boom of the 2000s was linked with the baby boom of the 80s. Now the children of the 90s are entering their childrearing years and in that decade, there was a birth rate collapse. The fall of the birth rate can also be connected to the growth of poverty, another federal official believes. In such a case, it may necessary to fight poverty rather than to encourage the poor to give birth.

It will still be pennies… they’re talking about an increase of 200-500 rubles.

Meanwhile, the real income of households has fallen for the fourth year running. Experts at the Higher School of Economics Policy Institute calculate that for the two years leading up to the start of 2017, incomes contracted 12%, and by 2.2% in the first four months of 2017. Over 2014-2016, the percentage of Russians living below poverty line grew to 13.5%. Even more important for the birth rate is the level of subjective poverty, notes a Federal official. On average for 2016, 40% of the Russians experienced problems purchasing food or clothing. To give birth, people need believe in the future, argues the official.

Most of all, people put off having children due to material difficulties and uncertainty about tomorrow, according to almost half of respondents in a Rosstat poll conducted in the first quarter. A little more than a third of respondents cited housing difficulties. In fourth place on the list of obstacles was a lack of men for women and lack of work for men.

It’s generally accepted that for ten years, birth incentives were effective, but the program was working a backdrop of economic growth, social stability, and a favorable demographic situation, says Tatyana Maleva. Even now, incomes are falling, social stability has been replaced with tension, and the number of mothers of reproductive age is “obscenely low.” She points out that “this is the demographic cliff that emerged in the 90s.” Gontmakher agrees, saying that in order to see an increase in the birth rate, people should see good prospects, and this depends on the general policy of the state,

Gontmakher says that the overwhelming majority of families who received a certificate for maternity benefits have not yet spent the money. Of the three possible goals – education for the child, living conditions improvements, or a co-contribution to the mother’s pension – most often the money is spent on housing. However, not every family needs it, or they choose to take a small amount in cash, he says.

Maleva advises that more beneficial measures to boost the birth rate could include, as in the rest of the world, the development of services for families with children, access to obstetrics, the construction of kindergartens and nurseries, and the development of the market for nanny services.

Essar Wrap: A Word on Rosneft’s India Move

The news just dropped that Rosneft’s repeatedly delayed acquisition of Essar Oil, its massive refinery, its 2,700 filling stations, and the deep-water oil port of Vadinar has finally gone through. The Obama administration attempted to use Treasury’s Office of Foreign Assets Control (OFAC) and existing financial sanctions to scuttle the deal last August. Beyond that, much of the roughly $13 billion deal was Rosneft and partner Trafigura buying Essar Oil’s debt. Essar had hoped for an equal stake agreement between the two firms, but Essar’s poor debt gave Rosneft leverage to push for captive power and the port in the deal. As one might expect when CEO Igor Sechin has a financial edge, the deal wasn’t exactly friendly. It’s quite possible that the negotiating process and shutout of India’s firms will leave a poor taste in the mouths of India’s corporate leaders interested in acquiring Essar on the cheap, making the deal a classic Russian proposition: a tactical advance with a less clear strategic rationale or calculus.

It’s quite possible that the negotiating process and shutout of India’s firms will leave a poor taste in the mouths of India’s corporate leaders interested in acquiring Essar on the cheap, making the deal a classic Russian proposition: a tactical advance with a less clear strategic rationale or calculus.

Rosneft’s acquisition is big news for several reasons. First, Russia has historically struggled to sell oil to the Indian Ocean for the obvious reason that Gulf producers are right there. By acquiring a refinery in Gujarat at a capacity of about 400,000 barrels a day, Rosneft has a guaranteed entry point for oil supplies. It’s been suggested that Rosneft would source its Venezuelan production, perhaps less likely given political instability there now but a link between Russia’s foreign policy interests in the Caribbean and its Asian oil strategy. On top of that, the OPEC cuts have eaten at the margins for specific Gulf blends commonly traded in the region, giving Russian oil traders a more competitive look on the Indian market as prices for Russia’s Ural blend are too low to not draw interest. Furthermore, ONGC Videsh and other Indian firms have bought into Rosneft’s Vankor field, which is likely contributing to a rise in Russian oil exports to India. Finally, it gives Russia a deep-water port in a region fast becoming central to Russia’s foreign policy outlook. The Eurasian Economic Union is already pursuing free trade agreements with Iran and India and has just announced interest in reaching one with Pakistan. Russia isn’t a major infrastructure investor, but can use this port to broaden its commercial reach regionally.

Before getting ahead of ourselves, India’s Home Ministry and its Intelligence Bureau have red-flagged the acquisition of the port for security reasons. It’s relatively close to Pakistan, India has military installations in the region, and it will provide Russia a facility that could potentially be used for espionage activities. Despite the refinery deal, it’s still possible in the future with rising production in Iran or elsewhere that Russia’s oil simply won’t be competitive. The likeliest reason to prefer Russian oil supplies would be that East Siberian and Far East fields yield oil that burns cleaner, important for climate and health sensitive policies. Overall, it’s big news and a win for Rosneft and Russia in the region. But security fears and the bad blood over the deal may still derail the acquisition of the port.

Analysis by Nick Trickett

In Translation: Incomes to Bounce Back by 2020, Pensions Won’t At All

Article by Olga Kuvshinova and Aleksandra Prokopenko. Translation by Nick Trickett. 

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Pensioners, under the Ministry of Economic Development’s plan, will pay for growth today or tomorrow. Will the Kremlin risk throngs of angry babushki? (Photo: Andrei Gordeyev)

In the target scenario of its macroeconomic forecast through 2035, which assumes a growth rate higher than the world average, the Ministry of Economic Development sees near zero real growth for pensions over the next 20 years (“Vedomosti” has seen the document).

To raise the economy’s growth rate in the target scenario, the plan proposes increasing the number of those employed, boosting investment activity, and improving labor productivity. Employment growth is achieved, among other things, by raising the retirement age to 65 for men and 63 for women following from the demographic parameters presented in the forecast. The number of pensioners by 2035 falls 23%, or by 7 million people compared to 2017 (without reforms, it increases by 5.4 million people) with the growth in total employment by a million (without reforms, a decrease of 3.2 million).

However, the increase in the retirement age is accompanied by a sharp drop in the level of pensions: their size in relation to wages falls from the current 35% to 22%. In this way, at least a fifth of the population not only won’t benefit from the realization of the plan to increase the economic growth rate but will lose: their incomes will actually fall in relative terms.

In this way, at least a fifth of the population not only won’t benefit from the realization of the plan to increase the economic growth rate but will lose: their incomes will actually fall in relative terms.

This double reduction – the replacement rate and the number of pensioners – will almost halve the ratio of pension outlays to the National Pension Fund – from 28% to 15%. Then investments can grow 1.5-2 times faster than the economy, and productivity faster than wages.

Wages and incomes will grow more slowly than the economy over the next two decades, growth that, per the prognosis, won’t be outstanding.

In case of the successful realization of reforms, economic growth reaches 3.5% by 2026, after which it will slow down somewhat but by then, the Ministry of Economic Development calculates, world growth will be lower. As a result, the real income of households, which has fallen by 10% over the last three years, will only reach their pre-crisis 2013 levels in 2022.

In comparison with 2016, incomes will increase by 55% over the next two decades, real wages by 56.5%, GDP by 78%, and pensions by all of 2.5%. Their growth resumes in 2024, but they’ll be reduced in real terms until 2032, the Ministry suggests. As a result, pensions will remain 4% below their 2013 level by 2035.

In the target scenario pensions are indexed annually from the 1st of February in line with the previous year’s inflation rate, clarifies an official at the Ministry. Additionally, there are plans to raise pensions from the 1st of April in accordance with the growth of the Pension Fund’s incomes – but by no more than 1% per year. In calculations, pension indexation is reserved for non-working pensioners, he specifies.

According to the forecast, with 2.5% real growth for pensions, the pensions of non-working pensioners increase 20% in real terms over 20 years. This means that converting into today’s rubles, the average insurance pension in 2035 will amount to just a bit more than 13,000 rubles and the pension of a non-working pensioner will increase to about 15,500 rubles.

It would be strange if the savings from an increase in the retirement age weren’t directed – at least in part – to pensions, but to other spending items. It’s a very tough situation, comments an expert (who asked not to be named to avoid a quarrel with Ministry). All the latest proposed innovations in the pension sector — for example, the transfer of a fixed payment to the budget or savings on transfer — are similar to an attempt to make a poverty benefit out of insurance pensions worries Yuri Gorlin, deputy director of the Institute for Social Analysis and Forecasting of the Russian Academy of Science and Technology.

Alexei Kudrin’s Center for Strategic Research (CSR), judging by the Ministry’s calculations, supports increases the retirement age to 65 for men and 63 for women. However, the CSR assumes the age increase and other measures to tighten conditions for the allocations pensions are see maintenance of the salary replacement rate at about the current level: no less than 35%. Raising the retirement age offers some savings, it would be fair to share them with pensioners says Tatyana Maleva, director of the Institute for Social Analysis and Forecasting of the Russian Academy of Science and Technology. There isn’t really talk of raising the pension provision now. Even the realization of the whole range of measures proposed by the CSR allows only to maintain the ratio of pensions and salaries at a socially acceptable level.  The actual freezing of pensions for 20 years is fantastical, Oksana Sinyavskaya, deputy director of the Institute for Social Policy of the Higher School of Economics, believes. It’s socially dangerous. Similar forecasts, apparently, are poorly calculated and don’t take into account how they mesh with reality, she believes.

That a reduction in workloads will lead to increased investment by freeing resources for enterprises is completely unrealistic, says BCS chief economist Vladimir Tikhomirov. Low investment growth is a worldwide problem, he notes: companies aren’t investing, despite historically low interest rates and the colossal sums of cash on their balance sheets. When demand doesn’t grow, there’s no point investing in expansion: it’s highly doubtful that it can be the other way round in Russia, he says. Although, on the other hand, cutting costs really gives a stimulus for investments, he continues, but this is related to automation, robotization i.e. accompanied by a reduction in jobs – it leads to growth in labor productivity but not to employment growth. The situation is aggravated by the growth in the number of pensioners. As a result, states are forced to reduce previous social obligations. By 2035, these world trends will reach Russia, Tikhomirov predicts.

In Translation: Problem Loans Make Up 40% of VEB’s Portfolio

Article by Margarita Papchenkova. Translation by Nick Trickett.

Vedomosti has examined VEB’s credit portfolio as of the 1st of May. An employee at the state bank revealed a list of loans with names of debtors, the amount of debt, the amount of reserves for the debt, and how bad the debt is. Another confirmed its authenticity. VEB’s press secretary declined to comment on the document, saying that the list is a commercial secret.

unnamedWithout accounting for subsidiaries Svyazbank and Globex, VEB has issued 155 loans worth 2.2 trillion rubles. The state bank has divided them into four categories depending on their quality: green, yellow, red, and black. The first two, in the words of a VEB employee, denote good or acceptable loan performance. Red implies a difficult situation while black means a very difficult one – as a rule, default.

The credit portfolio attributed to the black category is worth 275.6 billion rubles, but it’s near entirely covered by loss provisions – 251.7 billion rubles (91.3%). For the red category, these figures stood at 685.6 billion, 110 billion, and 16% respectively. Yellow loans are reserved at an even higher average rate of 17.8%. And for many, this figure exceeds 50%. If 51% of the credit is reserved, then it can already be considered problematic, suggests Anton Lopatin, an analyst at Fitch Ratings.

However, last year, VEB received government guarantees worth 547 billion rubles for Ukrainian assets. The bank, for example, credited Russian investors’ purchase of control in the Industrial Union of Donbas, as well as owning the local Prominvestbank. Government guarantees allowed the bank to release reserves, explained an employee from VEB.

“VEB is a development institution, and no one said such an institution should have a good portfolio: it’s often used where business won’t go,” added a VEB employee. On the other hand, there are projects in the real estate section of the portfolio, he remarks, “of which many are in the black zone. What does that have to do with development?”.

On the other hand, there are projects in the real estate section of the portfolio, he remarks, “of which many are in the black zone. What does that have to do with development?”

According to the consolidated financial statements under IFRS for 2016, VEB’s credit portfolio was worth 2.7 trillion rubles, including 2.5 trillion for the parent bank. Of these, 580 billion have been depreciated and 480 billion are overdue. At the same time, nearly 800 billion rubles in provisions for depreciation were created, notes Lopatin. In general, things look better than they did 2-3 years ago. It’s difficult to evaluate just how adequate reserves are, continues Lopatin. Every loan has to be considered individually.

The Central Bank defines 5 categories of borrowers by quality. Depending on the risk, reserves are created for them at 0%, 1-20%, 21-50%, 51-100%, and 100%, comments S & P analyst Sergei Voronenkov. There are hard, formal attributes referring to the categories: for example, if a restructuring took place higher than in third category, it can’t be carried, an expert explains. But the amount of reserves can decrease by the level of collateral. VEB operates without a banking license and can formally not comply with a regulator’s demands, using them only as guidelines, Voronenkov concludes.

Last year, VEB created 510.4 billion rubles in reserves. This led to an annual loss of 111.9 billion rubles. VEB has not yet disclosed how much more it needs to create reserves. Voronenkov calculates that VEB will see profits again next year.

VEB has been used to finance political projects, but the issuance of loans has become toxic, overlaid with funding problems due to sanctions. As a result, at the end of 2015, the bank needed help from the state – 150 billion rubles per year in capital. Now the state betting big on VEB as a source of project financing, but before they can, VEB has to sort out old problems, notes a high-ranking official. VEB prepared three strategies for all its assets: credit, default, and a combination. The first involves a continuation of work with the borrower. The second involves the sale of assets, possibly at a discount, employees of VEB say. Most of the black debts fall under the default strategy as stated in VEB’s materials.

The history of VEB’s fall was presented as an outcome of being overloaded with political assets, but a very large share of bad loans came from pettiness not connected to big politics, says a person whom the government consulted when creating VEB. The top 5 red and black accounts come to about 500 billion rubles, or more than half of all problematic loans. Yet all the rest are small loans, many of them within the range of 10 billion rubles.

“On one hand, the bank itself set up the issuance of loans poorly; there wasn’t any expertise. On the other hand, it was perceived to be an anti-crisis tool and the bank often didn’t take any real collateral,” a VEB employee retorts. VEB is trying to change this and that now, Vedomosti’s source says: it’s reforming its business subdivisions, advancing fixes to loan syndication that will allow co-investment with other investors under the same conditions and under a single deposit.

In Translation: China has decreased investments in the new “Silk Road”

Article by Gabriel Vildau and Ma Nan. Translation by Nick Trickett.

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Certain state companies are complaining about the unprofitability of projects associated with China’s ambitious One Belt One Road Project. (Photo: Greg Baker)

Investments in President Xi Jinping’s high-profile project One Belt, One Road declined in 2016, evidenced by several indicators. This calls into doubt commercial enterprises’ preparedness to sink money into the strategy, which pursues not only economic but geopolitical goals.

The leaders of 28 states will gather this weekend in Beijing at a conference dedicated to the initiative, which includes the creation of two transport corridors – the Economic Belt of the Silk Road, and the Maritime Silk Road of the 21st Century. First proposed in 2013, they call for the construction of road and trainline networks, ports, fuel pipelines, and power plants on the route connecting China with Southwestern and Central Asia, the Near East, Africa, and Europe. The new Silk Road has even occupied a central place in Beijing’s economic diplomacy and become a subject of its propaganda. But certain data suggest that the hype surrounding the initiative may be exaggerated.

China’s Foreign Direct Investment (FDI) into the countries taking part in One Belt, One Road dropped 2% in 2016 and another 18% year-on-year from the beginning of 2017, according to data from the Ministry of Commerce. Non-financial FDI into these 53 countries stood at $14.5 billion in 2016 – a mere 9% of China’s total volume of FDI. This volume rose to a record 40% last year, which forced Chinese regulators to restrict the foreign activity of local companies and the outflow of capital. Additionally, the geographic distribution of FDI connected to the initiative makes one question how much money is actually going into infrastructure. Singapore received the largest amount of investment in 2016 and has well-developed infrastructure.

“With large investments, especially abroad, the numbers won’t necessarily grow each year,” says Xiao Qing, chairman of the Committee on Control and Management of State Property of China (SASAC). He stresses one should not watch the growth of investment in annual terms, but the development of the projects themselves. Xiao therefore expressed confidence that in the long-term, investments in the Silk Road countries will grow. According to SASAC, 47 Chinese state companies were involved in 1,676 projects in these countries.

But privately, some bankers and representatives of state-owned enterprises complain that the government forces them to take part in unprofitable projects. “Many state-owned companies are now fixated on this: the government forces us to do what we do not want,” says a recently retired top manager of one of the largest state-owned enterprises.

In addition to FDI, cross-border lending is an important part of the initiative. But the loans issued by the China Development Bank (CDB) fell by $1 billion to $100 billion in 2016, according to information on its website. The share of CDB loans going to Silk Road countries peaked at 41% in 2014, falling to 33% in 2016. The CDB declined our request for comment.

Chinese experts insist that these figures don’t reflect the full picture. According to Jia Jinjing from the Chunyang Institute of Financial Studies at the People’s University of China, most Chinese FDI passes through other countries before reaching its final destination. This makes the Ministry of Trade data an unreliable tool for assessing investment in the countries of the Silk Road. “To assess them, you need to look at how many countries signed a memorandum of understanding to participate in the One Belt, One Road initiative and how many heads of state or other important guests and delegations will attend the summit. That’s the most important thing,” says Jia.

In Translation: Officials Drill Ahead on Oil Tax Reform

Article by Margarita Papchenkova and Elizaveta Bazanova. Translation by Nick Trickett.

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Photo: E. Razumniy, Vedomosti

On April 20th, a long-awaited reform for oil sector taxation was approved during a meeting with Russia’s Deputy Prime Minister, Arkady Dvorkovich. According to two federal officials, the transition from the severance tax (MET) to a tax on added income (NDD) will take place from next year. Dvorkovich’s representative refused to comment on the matter.

Unlike the MET, which depends on the quantity of extracted oil, the NDD is taken from the revenue of oil sales against the deduction of expenses for extraction and transportation. The rate will be 50%, with an export duty preserved in  a reduced form, as well as a small MET. The new tax is intended for the pilot fields in Western Siberia that are 20-80% depleted (as of 1 January, 2016) with production up to 10 million tons a year, as well as for new fields with depletion rates at 5%. In order to insure against budget losses, there will be limited expenses accounted for before the tax is calculated: the initial bar was 9,510 rubles per ton, but the Ministry of Finance then lowered it to 7,140 rubles.

The Ministry of Finance and the Ministry of Energy had been unable to reach an agreement on the reform for two years, and when they finally reached a compromise, Rosneft upset their plans at the finish line. Last year, the company requested an exemption from the MET for its gigantic Samotlor field due to its high water cut. Prime Minister Dmitry Medvedev was tasked with working through the request, but the Ministry of Finance laid down an ultimatum: take the NDD or the exemption. “You can’t carry out tax reform with one hand and continue giving out exemptions to the MET with the other. It’s not a systematic approach,” Alexei Sazanov, director of the Ministry of Finance’s tax department explained. The Ministry of Finance proposed Samotlor be included on the list of projects covered by the NDD.

You can’t carry out tax reform with one hand and continue giving out exemptions to the MET with the other. It’s not a systematic approach.

Dvorkovich approved the NDD without a binding decision for Samotlor. According to a participant at the meeting, the Deputy Minister pledged to evaluate the effect of an exemption for Samotlor without offering a concrete timeframe. According to an official from the Ministry of Energy, it’s not necessary to bind the NDD to the Samotlor exemption – it’s guaranteed that the exemption will increase production at the field, and the NDD is still an experiment. He added that the whole sector would benefit from the NDD, and that Rosneft would be the only exemption.

According to two officials, the fate of the Samotlor exemption will likely be decided by the president. One high-placed official is certain that if the question isn’t raised again, it’s possible the “topic will go away.” Officials told Vedomosti that Andrei Belousov, aid to president, supported an earlier exemption to the MET for waterlogged fields.

Falling budget revenues from the Samotlor exemption may reach 80 billion rubles, by the Ministry of Finance’s calculations. The NDD reform will also bring losses – around 25-30 billion rubles proceeding from the latest parameters of the bill. The Ministry of Finance points out that it will create a hole in the budget together with possible losses from small returns from state companies’ dividends (less than 50% of net income under the IFRS). The Ministry of Energy objects, says one official: there are additional oil and gas revenues, primarily from the freeze on oil extraction, which can plug the hole.

It’s surprising that a reasonable decision was reached in the end, remarks Grigoriy Vygon, Managing Director of Vygon Consulting. He says that the bill on the NDD was ready long ago and needs to get going. Direct accounting of costs in the taxable base helps make the tax system more complete and develop new reserves that are unprofitable in the current conditions, says Denis Borisov, the director of Ernst and Young Moscow Oil and Gas Center. “The quicker the experiment with the NDD starts, the better.” Vygon is patient, saying that for two to three years, they’ll administer the reform and then talk about scaling the experiment can start. “In the coming years, the current regime will remain the basis of the tax system – no fewer than three years are needed for the pilot tests of the NDD and the assessment of results,” says Borisov. Borisov believes that point-based tuning should continue on the basis of “win-win” (more extraction, more budget and company revenues, more revenues from related sectors), including the creation of stimulus for fields with a high water cut. “It’s a question of a compromise between budget interests, companies, and the country’s economy,” he says. “It’s necessary to evaluate the need for exemptions, not only for privileged waterlogged fields, but for the industry as a whole.” Vygon is categorical in saying that this calls for thinking about modifications to the NDD’s  parameters, not a new exemption per the MET: “in this way, the decision will be systemic rather than targeted as it has been thus far”.

Dirty Jobs: Being a Governor in Russia is Proving Tough

Guest Contribution from Fabrice Deprez

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Sverdlovsk Oblast acting governor Evgeniy Kuvaishev. (Photo: Valeriy Sharifulin)

It’s a rough time to be a regional governor in Russia. Since last year, arrests and resignations of local leaders have piled up and accelerated in the last few weeks, with five governors gone since February. Described by some as a way for the Kremlin to prepare the presidential elections, whether by pumping “new blood” into Russia’s political system or by demonstrating its will to fight corruption at the highest level, the shake up is putting the regional establishment into a difficult position.


Russian media outlet Gazeta described the position of governor in a recent op-ed as “a dangerous job”. “Ten years ago, it was difficult to imagine a criminal case being opened against a governor. Now though, they are being arrested almost on an industrial scale”, Gazeta wrote.

Last year, the gubernatorial turn-over had been interpreted as a way for Putin to tighten its control over the regions by installing little-known but loyal people, who often had a background in the security services. Later, it took the appearance of an anti-corruption drive aimed at addressing Russians’ number one concern one year before the presidential election.

Carolina De Stefano, a visiting researcher at Moscow’s Higher School Of Economics, writes that “there is the feeling—particularly in non-economically relevant regions—that local politicians could increasingly become the target of an anti-elite stance, which is mainly aimed at lending an impression of honesty to the federal leadership”.

Whatever the real reason, Moscow’s recent preference for young technocrats from the state apparatus and the anti-corruption rhetoric had the consequence of making goverernship less appealing than ever. “Not only have governors stopped to be untouchable,” Gazeta writes. “On the contrary, the position now feels like it’s being put in front of a firing squad”.

The arrest of the governor of Mari El only added to the general feeling that local leaders cannot trust Putin’s word anymore, say Russian journalist Andrey Pertsev. As he accepted Leonid Markelov’s resignation, Putin publicly declared that Markelov wanted to “find a new job”, implying that, as that often happens, the politician would get a cozy semi-retirement position, maybe in the Senate. Instead, one week later, Markelov was arrested on suspicion of taking a RUB250m bribe.

“On the contrary, the position now feels like it’s being put in front of a firing squad”.

“If not for this remark, Markelov’s arrest would have been trivial”, Pertsev writes. “[But] the word of Vladimir Putin is almost the foundation of Russia’s personnel policy”.

“Other guarantees of one’s political future could change: support from “United Russia”, protection from people close to the president, economic success, good relations with the “People’s Front”…it can all come and go, but the president’s promise has always served as a reliable beacon.” With Markelov’s arrest, Pertsev argues that “[the] beacon doesn’t exist anymore for the Russian elite”.

The problem is not simply the feeling that any governor could be forced to resign or arrested on short notice, or that they no longer have the support of the Kremlin. Regional heads are also feeling pressure from below.

A Protest Headache

The March 26 anti-corruption protests, surprising in their regional reach, has made the task of governing even harder. Governors are now being forced to deal with rising discontent in a crucial electoral period while, in some instances, being short on cash.

“All governors, whether technocrats, security officials or public politicians, have to work with the constant eye of the Kremlin looking over them”, Gazeta writes. “Citizens, in turn, are well aware that they are being sent obscure officials. And they can either look around philosophically and think “we’ll survive this”, or they can start protesting.”

Some already have. In the Siberian city of Novosibirsk, a planned rise of utilities pricing by local authorities mobilized several thousand people into the streets over March and April, over at least seven separate protests. The gatherings were organized and mostly attended by local pensioners, a strategic constituency for the Kremlin, but opposition figures were also in attendance, including Alexey Navalny.

In oil-rich Tatarstan, the surprise collapse of one the region’s biggest bank in March lead to pickets, then larger gatherings of locals demanding access to their savings. Just like in Novosibirsk, protests that started for purely economic reasons in Tatarstan turned political, with protesters in both regions demanding their local governor’s resignation. It was unsuccessful in Tatarstan, but managed to convince Novosbirsk’s governor to back down on the utilities rate rise. The rare win for protesters illustrates the tough situation local heads are discovering themselves in.

The Delicate Balance of Regional Politics

Despite this, Putin has had no problem so far finding willing officials to take the job. But Moscow’s situation is one of delicate balance, according to Tatyana Stanovaya, a Russian political specialist. Stanovaya says that the Kremlin needs “effective regional managers who can be painlessly removed if things go wrong”, that is, people good enough to handle local issues efficiently and hand Putin a good score in next year’s election, but not so good that they could start enjoying electoral support and be tempted to become more independent.

In fact, Carolina De Stefano believes, this may very well have been the strategy behind the reinstatement of direct gubernatorial elections in 2012: “it performs [an] important task in times of trouble: in case of popular discontent, there is someone other than the central government to blame”.

This danger may appear far-fetched in the short term: local authorities traditionally enjoy far less support than the president. They tend to bear the brunt of mismanagement and corruption accusations, while Putin is seen as the potential solution rather than part of the problem (in both Novosibirsk and Tatarstan, the protesters demanded the resignation of their locals authorities while asking the federal center for help). According to a Levada poll, 48% of Russians approved the work of their local governor in March, a steady rise since a historic low of 30% in October 2014, but a far cry from Putin’s steady 80% approval rate.

This could explain why Putin has been replacing leaders in troublesome regions with loyal siloviki: the regional establishment stills holds significant power and, Stanovaya argues, could potentially form a new “counter-elite”:

Recently, the Kremlin has been appointing as governors not strong managers but men associated with the security services and conspicuous only by their loyalty. This attempt to simplify and strengthen governors’ subordination to Moscow will only result in more mistaken and dangerous decisions at the regional level.

If federal power gets weaker, the overwhelming majority of the regional political establishment will end up in opposition to Moscow. Literally the whole of the regional elite, with the exception of those with personal ties to the president, can potentially turn into a counter-elite.

That is, of course, a big “if”. For now, Moscow’s “power vertical” is alive and well, and governors are stuck with contradictory obligations to ensure their political survival. They need to be loyal to the Kremlin, but maintain some semblance of independence when managing their regions. They must be effective, but still unpopular enough to take the bullet for Putin when protests arise. They should help Putin get elected next year, but not mind the potential threat of arrest or forced resignation.

A tough job indeed.