Russia: Is the sovereign rating useful?

 

Does Russia’s sovereign rating tell us any more than the oil price?

Fitch Ratings today published a press release revising the “Outlook” on its “BBB” rating of Russian government bonds to positive from stable (see a Fitch press release below).  Rating agencies – Moody’s, Standard & Poor’s and Fitch – have been under fire since their high structured real estate ratings were downgraded rapidly during the recent financial crisis, suggesting that these ratings were wrong and therefore not a useful guide to investors.  Over the last two years, financial regulators have had their plates full preventing a 1930s-style banking collapse.  As a result, though they would like to kick the rating agencies in the pants to shake out the mediocrity, they haven’t had the time.  Are credit ratings useful? 

Yes and no.  Sometimes rating agency analytical reports are good, comparatively unbiased guides to the safety of bonds from sovereign governments and corporations, especially relative to investment bank reports.  However, the ratings themselves are sticky and often follow changes in creditworthiness (sudden ones anyway) rather than lead them.  Rating agencies don’t want to stick their necks out.  Conflicts of interest (agencies are paid by the bond issuers) are not to be dismissed, though somehow there is a more arms-length analytical relationship between bond issuers and the agencies than between the same and the investment banks, who fall over themselves to extol the virtues of clients that issue debt or equity.

Furthermore, sometimes a bond issuer’s profile is so tied to the price of a commodity (say, oil) that an investor is better off tracking the commodity price than bothering with ratings.  This is the case with “Rising Power” Russia.  Russia’s economy has long been dominated by energy exports.  Little has been done to diversify the economy in the way that its BRIC peers — China, Brazil and India — are diversified.  Energy prices rise and Russia’s ratings improve, and vice versa.  Yet the agencies go to great lengths to spell out the details of Russia’s credit profile in their reports.  As I said, sometimes the reports are good, especially for an econ nerd; but, the rating actions themselves – the reason agencies are paid so handsomely — can be of little use.

With oil prices rising rapidly over the last decade, Russia’s sovereign ratings rocketed from near-default levels (CCC) in 2000 to investment grade levels (BBB) today.  The ratings peaked at BBB+ from 2006 to 2008, when the price of a barrel of oil topped out at around $140 before collapsing to near $50 during the dog days of the global economic crisis in the fall of 2008.  That’s coincidentally when Fitch put Russia’s ratings on a Negative Outlook, before lowering the ratings to BBB in February 2009.  Since then, oil prices have clawed back to around $75 per barrel, and Fitch has again moved the Rating Outlook, first to Stable and then today to Positive.  This is all well and good, but the oil price was nearly as useful a guide as the ratings over this time frame, just as it was in 1998 when Russia defaulted on its bonds amid oil prices in the neighborhood of $10 a barrel.  Yes, the rating reports are informative, but if the agencies are to be more useful to investors (and society), they should try harder to predict financial developments and have their ratings lead, rather than follow, these developments.  And, they should show some skill at this before the regulators get around to kicking them in the pants.   

FROM FITCH RATINGS TODAY:

  Fitch Affirms Russia at ‘BBB’; Revises Outlook to Positive   
08 Sep 2010 8:04 AM (EDT)

Fitch Ratings-London-08 September 2010: Fitch Ratings has today affirmed Russia’s Long-term foreign and local currency Issuer Default Ratings (IDRs) at ‘BBB’. The Outlooks for the Long-term IDRs have been revised to Positive from Stable. At the same time, Fitch has affirmed Russia’s Short-term foreign currency IDR at ‘F3’ and the Country Ceiling at ‘BBB+’.

“The Russian economy is recovering after being hit hard by the global financial crisis. The outlook revision to positive reflects Fitch’s belief that the decline in inflation, shift to a more flexible exchange rate policy, sizeable repayments of private sector external debt, stabilisation of the banking sector and rising foreign exchange reserves should serve to reduce the country’s financial vulnerabilities,” says Ed Parker, Head of Emerging Europe in Fitch’s Sovereigns team.

Real GDP grew by 5.2% year-on-year in Q210, having contracted by 7.9% in 2009. Fitch forecasts growth of 4.3% in 2010 GDP and 4% in 2011 and 2012 – broadly in line with estimated potential. Recovery appears to be fairly balanced, and is supported by the rebound in oil prices, rising real incomes and stabilisation of financial confidence and capital flows.

The private sector has strengthened its balance sheets, where vulnerabilities had built up in the boom years. It repaid a net USD80bn in external debt in the two years to June 2010, including USD51bn of short-term debt, reducing its refinancing requirements and foreign currency exposures. Banks are liquid and have high reported capital ratios of around 19%. Asset quality appears to have stabilised, though Fitch estimates total problem loans at about 25% (including restructured loans at extended maturities and off-balance sheet exposures). A sizeable current account surplus, which Fitch forecasts at 4.6% of GDP in 2010, is helping Russia to rebuild its foreign exchange (FX) reserves, which have risen by USD92bn from their low in Q109 to USD476bn – the third-highest in the world – providing a formidable buffer against shocks. Russia is a large sovereign and overall net external creditor, the latter equivalent to 24% of GDP at end-2009, compared with a net debtor position for the ‘BBB’ range median.   

Inflation has declined to 6.1% in August, from double-digit rates 12 months previously. The Central Bank of Russia has shifted to a more flexible exchange rate and independent monetary policy regime, with positive real interest rates, which has the potential to help reduce inflation, dollarization and the risk of financial instability. However, the Central Bank of Russia has yet to build up a track record in this area.

Russia’s public finances have deteriorated over the past two years, though remain a rating strength. Fitch forecasts the budget deficit at 4.7% of GDP in 2010. Moreover, the budget balances at an oil price of around USD100pb, highlighting its vulnerability to a severe and sustained oil shock. However, general government debt is low, at only 10% of GDP at end-2009, compared with the 10-year ‘BBB’ range median of 35%. Moreover, the government has USD127bn (9% of GDP) in its sovereign wealth funds (1 September 2010), providing substantial financing flexibility, as demonstrated in 2009.

Weaknesses that weigh on Russia’s sovereign rating include its poor governance, institutions and corruption; a weak business climate that constrains investment, diversification and growth; exposure to commodity prices (and therefore the global economy); and a history of high and relatively volatile inflation.

In terms of potential triggers for future rating actions, a tightening of fiscal policy that significantly reduces Russia’s non-oil and gas budget deficit and its vulnerability to oil price shocks could lead to an upgrade. Material structural reforms that improve the business climate, banking sector and governance could also lead to an upgrade. A longer track record of implementing a more flexible exchange rate policy and anchoring inflation at the mid-single digit rate could put upward pressure on the ratings; as could a material strengthening in the external balance sheet. Conversely, a severe and sustained drop in oil prices could lead to negative rating action.

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