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Russia
The 2nd Wave Is Coming

15 April 2009
By Natalya Orlova

While it appears that the worst of the financial crisis has already hit the international financial markets, the full effect of the crisis on Russia lags behind developed markets and will likely only be felt here in the second half of 2009, manifesting itself in the form of bad corporate debt.

After experiencing some turbulence on the interbank market, the Russian financial system first felt a considerable impact from the international financial crisis in the second half of 2008. The first wave of the banking crisis was accompanied by a liquidity squeeze, instability in the exchange rate and significant withdrawal of bank deposits. But since there was a similar run on the largest banks in summer 2004, these developments were neither new nor particularly ominous. Having learned from previous experience, the Central Bank took action by cutting banks reserve requirements and enlarging refinancing options to provide banks with the needed liquidity.

What is more threatening for Russias banking sector is the question of nonperforming debt that looms on the horizon. This debt is particularly dangerous for Russian banks because they do not have experience working with bad loans. In the 1990s, all banking sector activity was focused on the currency market and later moved on to the state bond market. Prior to 1998, loans made up only 40 percent of bank assets -- compared with the current level of 60 percent -- and were concentrated on interconnected borrowers. Thus, in 1998, bad loans in a number of cases reflected bank owners decisions to sacrifice their banking business in order to save the productive assets of the group.

Lending began to grow in Russia in 2003 and 2004, fueled by the penetration of foreign banks into the local market as well as the wider availability of foreign capital flowing in from global markets. In the period from 2002 to 2008, corporate loans as a portion of gross domestic product grew from 15 percent to 30 percent, and the retail lending market sprouted from a ridiculous level of 1 percent of GDP in 2002 to 9 percent of GDP in 2008. In recent years of high economic growth, bad loans -- particularly bad corporate debt -- were not an issue for the banking sector. In the first half of 2008, the level of nonperforming loans under Russian accounting standards was about only 1 percent of banks lending portfolios.

But today, Russian banks are vulnerable to one overarching risk -- the palpable decline of economic activity that is affecting all the sectors of the countrys economy. The current economic downturn means that all banks will face mounting nonperforming loans to one degree or another. Exporters are suffering from the decline in commodity prices and the unavailability of foreign capital, and under these circumstances they will certainly face liquidity problems. Furthermore, the decline in the countrys construction sector suggests that the credit quality of companies operating in the manufacturing, transportation and trading sectors will deteriorate. The dramatic drop in equity and real estate prices have caused a reduction in the value of collateral used by borrowers. Retail clients will also have trouble servicing their long-term debt.

The bigger issue for Russia is short-term corporate debt of $220 billion (out of a total corporate debt of $780 billion) that comes due before the end of this year. Half of this amount is denominated in foreign currency loans, which means an additional financial burden considering the significant depreciation of the ruble since September.

The $220 billion debt makes up roughly 20 percent of Russias current GDP. Given todays environment of declining global and local demand, it is indeed difficult to imagine that the real sector of the economy will be able to generate the necessary revenue flows to service its outstanding debt. The peak for nonperforming loans can be expected in the third quarter, at which point Russia will experience its "second wave" of the crisis.

Given the fact that $220 billion has to be paid this year, it appears that a 15 percent level of bad loans is inevitable. A domino effect of bad debt could lead to a level of nonperforming loans as high as 30 percent. Clearly, banks are working to reduce their exposure to troubled borrowers to limit the prevalence of bad loans. This, in turn, is exacerbating the problem for struggling companies that face severe liquidity problems now. Insolvency for many of these companies is a real possibility.

There is, however, a silver lining. First, the Russian economy as a whole is still not highly leveraged by global standards. The total debt that Russian companies owe to domestic and foreign banks represents approximately 52 percent of GDP. In the East Asian economies that were overwhelmed by the financial crisis of 1997, corporate debt accounted for up to 150 percent of GDP. After bad loans reach their peak in the second half of the year, the Russian economy could resume its growth by expanding its leverage. Thus, the economic downside potential for Russia appears to be considerably limited. The question lies in its ability to generate a higher upside.

Second, this crisis offers an excellent opportunity for a much-needed consolidation in the banking sector. At present, 200 banks control about 90 percent of the countrys entire banking sector. This suggests that there is a significant opportunity for smaller banks to improve efficiency of their business through consolidation as well as find synergies to address the current crisis. Consolidation would also substantially improve the Central Banks monitoring function.

Natalya Orlova is chief economist at Alfa Bank.

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