Inefficient Capital Allocation

In my last Russia Reading List I bemoaned Putin dictating how banks should operate and their lending policies. There are a number of problems with this sort of state meddling, but one I did not touch on in this post was the resulting inefficient capital allocation. Over at SA, Peter Fuhrman has authored a cut-to-the-chase post on how state meddling in banks' lending policies can skew the efficiencies of the free market - in a China context. Now obviously Russia and China are different beasts - but there is an uncanny correlation in how state authorities in both countries apply pressure to banks resulting in how debt is deployed to who for how much. I misquote Peter Fuhrman: Capital is not a problem in Russia. Capital allocation is.

Hitler Misses the Bottom

This is fantastic. And probably the best of the series these guys have done. We might have seen the bottom. But I'm not sure we won't yet see the lows again. The second dip is nigh. (HT MGJ)

Russia Reading List

After almost a month, I am back online.

Much has happened with Russia the last few weeks. . . .

Back on the 25th of July Joe Bidden, US VP, was interviewed by the WSJ. Biden said that “Russia has to make some very difficult, calculated decisions. They have a shrinking population base, they have a withering economy, they have a banking sector and structure that is not likely to be able to withstand the next 15 years, they’re in a situation where the world is changing before them and they’re clinging to something in the past that is not sustainable”. Whether this eventuates will remain to be seen. But Biden echoes what has been written on this blog in the past - that the Russian Federation has a serious and perhaps terminal population problem. Obviously for such a xenophobic and anti-immigration government and society, immigration isn't going to provide a solution without a structural shift in attitudes. And the secondary problems that arise from a shrinking and horridly aging population trickle down to become territorial, fiscal and economic growth based too. It's difficult to have a sustainable growth economy without a growing or at least stable population base and all that comes with it. The long run outlook could be better. Much better. But we don't live in the long run. Can Russia (read: Putin) turn this party around? Watch this space. Giving an opposing view, there is a good piece over at Seeking Alpha on why Biden is wrong. Seeking Alpha also curiously points out that the state of California is a more risky investment proposition than the Russian Federation - at least measured by CDS pricing. And Time points out Medvedev's latest initiative to reverse the shrinking Russian population - stop them boozing. Obviously Mr Medvedev has not come across the Borg or he would already know that with such matters resistance is futile.

Two Russian Akula class fast-attack hunter-killer submarines have been tracked on patrol off the Eastern seaboard of the USA. The NYT reports that such activity has not been reported for about 15 years. Writing on matter, STRATFOR stated (05.AUG.2009) "These are the most modern and capable attack submarines in the Russian fleet, often compared to the U.S. Los Angeles class". Russia continues to ensure its power projection efforts are not missed. But as STRATFOR has more recently noted (10.AUG.2009), this was an interesting event and perhaps part of some form of wider Maskirovka strategy, but ultimately of little importance.

STRATFOR also wrote (10.AUG.2009) that most of Russia's other sabre rattling was ultimately of little consequence to the US too. However, two potential events present potential global geopolitical structural breaks of the highest order. Firstly, if Germany were to ally itself with Russia, rather than the Europe/ US. This is not entirely out of the question considering the increasing cosiness of the Merkel government with that of Putin's, largely and at least initially predicated on energy trade. Secondly, if tensions with Iran escalated to a serious level. STRATFOR on this second scenario states "If the Iranians were to successfully mine these waters [Strait of Hormuz], the disruption to 40 percent of the world’s oil flow would be immediate and dramatic. The nastiest part of the equation would be that in mine warfare, it is very hard to know when all the mines have been cleared. It is the risk, not the explosions, which causes insurance companies to withdraw insurance on vastly expensive tankers and their loads. It is insurance that allows the oil to flow". This reference to the importance insurance plays in the movement of petroleum products cannot be understated. The piracy situation off the coast of Somalia in the last 12 months has shown on a smaller scale how insurance and re-routing costs can rapidly spiral upwards and perhaps affect the end cost of the shipped goods. Interestingly this is a key reason encouraging Israel not to bomb Iran's nuclear facilities unilaterally - Iran would immediately respond by mining the Strait of Hormuz using small water craft, rendering the blame for the resultant global oil crisis firmly at Israel's feet.

It appears that Russia is also facing the possible beginnings of a grain crisis. Put in the context of the global financial problems, Russia's dramatic recent slowdown in mineral/ petroleum based revenue, the deepening of the global food shortages, and the slump in Russia's federal reserves, this is a real concern to the Kremlin. Circumstances have not yet begun to approach the fictional scenario laid out in Frederick Forsyth's "The Devil's Alternative", where almost all of the Soviet grain crop is decimated. But the butterfly effect can take hold and go the distance swiftly and without warning. Stranger things have happened. STRATFOR wrote (18.AUG.2009) "Several Russian grain-producing regions have suffered serious problems during the winter harvest, the period from June to August when grain crops planted during the previous winter are harvested. Severe drought and scorching hot temperatures have caused fires that have reduced the year’s wheat output, particularly in southern Siberia east of the Ural Mountains, on the eastern frontier of Russia’s grain belt. In particular, Chelyabinsk oblast (or district) has reported that 80 percent of its grain harvest has been burned away, Sverdlovsk oblast has lost 40 percent and Tyumen oblast 30 percent". Because of this, Russia faces at least an 12% grain deficit on this year's harvest. Historically Russia has exported 20% of its grain harvest to Europe on average, which constitutes a considerable 17% of global grain production. This will probably result in two things to varying degrees. Firstly, Russia will likely become, at least temporarily, a net importer of grain this year. This has implications for an already troubled Ruble. Secondly, if supply of grain for sale on world markets is reduced, all things being equal, equilibrium price will move North. Of course all things aren't equal - despite the general trend for demand across the board having decreased contemporaneously with the recent global economic downturn, demand-supply drivers are very firmly in place to fuel the soft commodity super cycle.

Last week the Russian Federal Statistics Service reported that foreign direct investment (FDI) into the Russian Federation for H109 had decreased year-on-year a whopping 45%. Obviously the massive capital flight following the Russian invasion of Georgia last year has not reversed. Interestingly in Q209 the RTS index recovered considerably from tumbling values of the previous 9 months. Prima facie it would appear that there is a weak correlation between the RTS and FDI. Certainly a number of prominent investors have recently opined that the Russian investment proposition is merely a beta-tracking play on oil & gas. Clearly such comments refer to investment in the Russian stock market and even the most superficial of analyses will reveal that (on a cap-weighted basis) this market is significantly driven by the fortunes of its oil & gas constituents, giving the thesis immediate merit. Seeking Alpha has yet another article on the Russian authorities bullying foreign investors. Not the smartest way to encourage fresh FDI and engender faith in the Rule of Law. The article states ". . . another cautionary tale for investors: what’s theirs is theirs, and what’s yours is theirs–if they want it. Given Russia’s dependence on foreign capital flows, this is a counterproductive attitude that will impede Russian progress for years to come". And if you thought that Medvedev was the vanguard of corruption fighting in Russia, a detailed article on the Medvedev-Putin show over at Seeking Alpha might change your mind.

Last week Business Week published an interesting article on Putin's statist and increasingly centralist moves to control how commercial banks lend to their customers. Namely he was dictating how interest rate levels were set. Hardly free price equilibrium and certainly not a mechanism central bankers/ democratic governments would use in influencing interest rates. The article states "In economic terms, this was an extremely debatable decision. Banks had been keeping interest rates high not only out of greed, but because the crisis makes it very difficult to distinguish between good and bad borrowers, i.e. those who are able to pay back their loans and those who will soon go bankrupt. So if the interest rate on loans is kept high, the inevitable losses from unpaid debts are to some extent covered". Putin's actions actively detract from any free market policy and at best muddy the waters of an efficient finance market. It will be interesting to see how this affects the interest rate swap market for longer dated terms vis-a-vis property debt. Sure, the big Russian banks are backed by one government hand while being told how to conduct commercial enterprise with the other. This set of affairs will continue to deliver as long as the government is a willing donor with its reserves and can garner international credit. The article goes on to discuss the congenital weakness of the Ruble, the lack of faith all parties have in the national currency and what it means for Russia. Well worth a read. (HT Mister Gupta).

The August edition of the McKinsey Quarterly has an excellent piece on the state of Eastern European banking. This is a must read for anyone involved in any way in the CEE/ Russia/ CIS market space. Especially those in an asset-backed capacity. The whole article is worth quoting, though some choice bits are "Over the longer term. . . a reemphasis on careful [cost of debt] pricing, brought about by a higher cost of capital and liquidity, will actually help reinflate [banking] margins. We expect that banks will successfully pass on to customers their higher cost of funds; margins correlate well with funding costs". This is followed by an insightful graphic showing the uptrend in the risk free rate. Obviously this has ramifications for asset values. The article goes on to state "To reflect the higher cost of funding and the risk their clients face, banks must adopt a new pricing discipline. . . Many have already begun efforts to improve pricing but are stumbling because they lack capabilities. Specifically, they need to react quickly to market changes in funding costs. They will need the ability to calculate, in real time, a target credit margin for each customer, taking into account the up-to-the-minute cost of financing, the client’s business climate (its size, macroeconomic conditions prevalent in its geography and industry, and so on), and its risk exposure". Clearly there are opportunities for those with the expertise and market insight to position themselves to proactively provide this information to banks in the region. Perhaps even more so for asset-backed lending. Moving from solely a client instructed position providing the end product to the banks, to creating a true go-to/ supplier-partner of choice for the banks. For additional reading and for those who can't get MQ access, Seeking Alpha has a brief article with links to not so brief reports on the fast approach of the death spiral of CEE heavy lending banks.

Finally, two last articles from Seeking Alpha on the state of the Russian economy, consumer spending, consumer lending, inflation and the Ruble, here and here. Both well worth a sobering read - as the second article states "Russia faces extreme difficulties. Its political brittleness, and the rigidity of its labor market (due in large part to the monocities, the legal and institutional nihilism and state capitalism that stifle small business and encourage large, cumbersome enterprise, and other Soviet inheritances) make it very difficult to adjust to large economic shocks; in this system, large enterprises serve as welfare agencies. But this threatens to turn them into zombies–and take the rest of the Russian economy with it". Clearly, those who will make money in/ from Russia in the years to come will have true connectedness to those who can/ will pay for their offering and a clear understanding of why it will be demanded. Naturally for real assets, these factors will be key in ultimately driving income yield.

mulletover

It's been a frenetic couple of weeks and will be at least another one or so to come. . . . Hence the dearth of posts.

So until then I leave you with the trusty sounds of mulletover (hat tip MGJ).