By Maximilian Hess

In December, President Vladimir Putin summoned Russia’s wealthiest men to the Kremlin and announced to the room he was throwing his support behind a rumored plan to enable them and their fellow oligarchs to repatriate money held abroad through a special Eurobond issuance. Putin laid out ambitious goals, saying the “beryozki bonds” (birch bonds), as they have come to be known would operate under a special legal regime. A week later, the Ministry of Finance (MinFin) claimed demand from Russian oligarchs for the bonds had already topped US$3bln and that they would receive preference in buying the next issuance. On 16 February, VTB sold US$4bln of the beryozki bonds, though they were more than twice oversubscribed. However, only US$838m came from Russian investors, of which only US$200m was under amnesty terms set out to enable the repatriation of capital.

 

Demand for Russian bonds

Russia is a well-established player in emerging market sovereign debt. The August 1998 default that shocked the globe and helped bring down what was then the world’s largest hedge fund is well behind Russia today. The government has a low debt-to-GDP ratio and purported new spending plans that could be introduced in Putin’s fourth term would only raise the figure to 16 per cent, around where it was in 2015 and far below the 50 per cent figure reported in Putin’s first year in office back in 2000.

Credit ratings agency S&P’s February upgrade of Russia’s sovereign rating made Russian Eurobonds eligible for passive bond funds as two of the three major ratings agencies now rate Russia as investment-grade. The improved rating therefore could potentially usher in billions of dollars’ worth of demand for its notes. Yield-hungry investors have largely waved away sanctions concerns and have even been piling into Russia’s local ruble bonds, with the share held by foreigners hitting a six-year high this month.

This bull market in emerging market debt may well have also played a role in the development of Putin’s suggestions for using bonds to repatriate funds, notes that effectively include hedging instruments against currency risk. Argentina’s infamous ‘FRAN’ bonds demonstrated how attempts to hedge could prove immensely for the issuer. Interestingly, when the proposal for a special oligarch bond was first reported, Reuters claimed it was being pushed by oligarchs themselves. Kremlin spokesperson Dmitry Peskov soon said the idea’s genesis lay with Grigory Berezkin, from whom the bonds have gotten their nickname*.

 

Eurobonds as a deoffshorization vehicle

The day after Putin’s announcement, Finance Minister Anton Siluanov announced to United Russia’s conference that Russian investors would be able to purchase the bonds anonymously through Russian banks working with Russia’s National Settlement Depository. This enabled them to avoid doing so through Euroclear, the firm whose acceptance of bonds lubricates their ability trade internationally. The risk that this would make Russian-held Eurobonds less liquid than those held abroad was not addressed.

Siluanov also promised legislation that that would enable individual Russian holders of the bond not to pay taxes on a difference in the ruble value of the securities if they were sold, effectively hedging against a further deterioration in the value of the ruble against the dollar. To further incentivize participation in ‘deoffshorization’ via the Eurobond, the amnesty on taxes for Russians returning capital to the country was also extended until the end of 2018.

Just before the bond’s sale, TS Lombard’s Christopher Granville labeled the note “a very good instrument for Russians who are concerned about the safety of their capital”, while Timothy Ash of BlueBay Asset management predicted “the mainstay (among buyers) will be Russian origin investors” . Given such laudatory statements and the Kremlin’s push, including promises to give Russian investors preference to in buying the bond, the question naturally arises as to why Russians ultimately accounted for a small share of investors into the two Eurobonds.

 

Nice dollars you’ve got there, would be a pity if something happened to them

Firstly, not all blame lies with the Eurobond itself. The Kremlin’s various other attempts at deoffshorization have also disappointed.  Capital flight rose to US$31.3bln in 2017, from only US$10.5bln in 2016, although these figures pale in comparison to the more than US$150bln in outflows in 2014. These outflows are a serious matter for the Kremlin as not only do many of its most powerful oligarchs hold their wealth abroad potentially out of its reach, but the flows also negatively impact the state’s own foreign currency reserves.

As to why the Eurobond deoffshorization was similarly underwhelming, one key fact is that Siluanov’s proposed legislation releasing Russian nationals who hold the notes from paying taxes on the bond’s appreciation in ruble terms is still being prepared. The two notes sold – US$1.5bln worth of Eurobonds maturing in 2029 and US$2.5bln of the other, due in 2047 – do, however, include some unusual terms with regards to foreign currencies. Namely, the ability for the Russian Central Bank to repay principal or coupons in euros, Swiss francs, or British pounds, effectively a hedge against sanctions.

The 2029 Eurobond also allows holders to elect to receive coupon in rubles. This enables those seeking returns in ruble terms to profit off any weakening in the ruble against the dollar, something only likely to appeal to Russians seeking to re-domesticate funds. It could also benefit Russian corporations, an interesting aspect given that the proposed legislation to remove the income tax burden on ruble returns caused by currency fluctuations was proposed only for individuals. In the event that sanctions prohibit repayment in any dollars or the aforementioned European currencies, the bond also enables Russia to  make repayments in rubles at the rate set by the National Settlement Depository. This may, in part, explain the discrepancy between the percentage of Russian investors’ participation in the two new issuances – 13% of the 2047 note versus 35% of the 2029 note.

 

Further bad discoveries?

The bonds could still increasingly find their way into Russian hands if their initial buyers move to re-sell them. This is what occurred with Russia’s last non-standard issuance, its 2030 sovereign bond. This note also has an interesting genesis as it emerged from a swap with foreign private creditors in 2000, the second restructuring in three years of debts Russia inherited as the legal successor of the Soviet Union. However, Russia’s nominally-private lender Bank Otkritie eventually came to hold 74% of the 2030 bond. But by August 2017 Otkritie had to be rescued by the Central Bank (CBR), which subsequently claimed it had falsified its accounts by overinflating the value of this holding. Never mind that it was the CBR’s willingness to loan to Otkritie that enabled the scheme in the first place.

Perhaps it is of little surprise then that US$3.2bln of the US$4bln raised in the latest bond sale will be used to repurchase Russia’s 2030 Eurobond. As Raiffeisenbank Russia noted, this should boost Otkritie’s finances. As Otkritie is now owned by the state and set to be merged with another bank that had to be taken over by the CBR, the bond sale effectively served to help finance the cost of cleaning up Russia’s banking sector. While it will also improve Russia’s nominal debt profile, the day of the bond sale, Reuters also reported the CBR was considering injecting another trillion rubles (US$17.5bln) into the banks, which will not.

To summarize, the Kremlin claimed it would sell a special bond to help oligarchs repatriate capital. It then failed to pass a bill in time to bring into law the very incentives it promised, while the for oligarchs remains unresolved. It’s arguably unresolvable since the problem with having your money in Russia is that your money is in Russia. There should be similar concerns for non-Russians investing into the notes given the questions about the novel alternative payment provisions. All this to help the CBR pay for the restructuring of banks whose implosion it enabled. Perhaps the question is not why so few Russians purchased the bonds, but instead why so many others did.

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* Full disclosure: Berezkin is the owner of media outlet RBC, which is one of the leading financial news outlets in Russia. RBC’s reporting is a key source for this piece.