Why S&P Lowered Russia's Rating

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Sovereign credit analysts endeavor to "rate through the cycle." This means taking a long-term view on the creditworthiness of a national economy, regardless of whether total output is growing above or below its potential, or of any temporary decrease or increase in the borrowing needs of a government or the broader economy. This approach works well during ordinary times, but it is not entirely sufficient during extraordinary ones.

Make no mistake: We are living in extraordinary times. The current global economic downturn, which has accelerated during the last two months, is no mere "correction." We are seeing not only a marked worsening in the outlook for global growth and, hence, a weakening in debtors' capacity to service debt, but also a deterioration in global creditors' ability to lend. Demand is not merely weakening on average; it is, in fact, falling nearly everywhere. Of the 16 wealthiest European economies that it rates, Standard & Poor's expects 12 of them to contract during 2009. The outlook in Asia and the Americas is similarly dire.

Nor is Russia in any way exempt, despite its recent robust record of growth. Indeed, it will be affected severely.

What also makes the current economic downturn more than cyclical is the fact that financial lending is seizing up across the globe. As a result, we are witnessing not only a weakening in debtors' capacities to service debt but also a deterioration in the ability of global creditors to lend.

The most explicit channel through which a weakening global economy will hit Russia is falling oil prices. That decline alone, if sustained, will almost certainly result in a contraction of dollar-denominated gross domestic product next year.

But the much larger and more upfront negative shock to Russia has occurred through the sharp retrenchment in lending by foreign banks to the country's debtors. Some $170 billion in foreign debt is scheduled to be refinanced next year. As is the case with other countries with high foreign currency refinancing needs -- including Hungary, Turkey, Latvia, Romania, Ukraine and much of the rest of emerging Europe -- the appetite for low risk among foreign banks has increased the likelihood that the state could ultimately end up nationalizing some component of corporate and banking-sector liabilities.

The risk of a sudden stop of capital flows into all these countries -- in addition to other factors, including the related potential for disorderly exchange rate adjustments -- has led Standard & Poor's to make nine negative ratings actions over the last two months. Among these was last week's one-notch downgrade of Russia's investment grade rating to BBB.

Since 2004, banking assets in most of emerging Europe have grown far faster than savings, a process that was accompanied by a lowering of credit standards. Russia participated in this credit boom as enthusiastically as its peers. From 2003 to 2007, domestic credit growth in Russia averaged 45 percent. A sizeable component of the lending was financed by foreign banks, which are no longer willing or able to lend.

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It was also rapid credit growth that helped to fuel the brisk increase in imports, which rose by 30 percent in 2007 in volume terms, or at more than four times the pace of import growth. Some of these were capital goods, which helped to improve efficiency in key sectors, such as metal production. But a larger component of the imports was consumption goods that have not contributed towards improving Russia's capital stock.

Accompanied by generous government spending, the credit boom also fueled inflation, which weighed on the competitiveness of Russia's noncommodity sector. As wage growth averaged nearly 30 percent over the last two years and the ruble-denominated cost of production rose, domestic manufacturers found it very difficult to compete with cheap high-quality imports. As a consequence, entrepreneurs logically avoided manufacturing and, instead, invested in much more profitable and more import-intensive sectors, such as banking, retail and construction.

The resulting structural imbalances were well camouflaged by the extraordinary growth in energy and other commodity prices. For six straight years, the earnings from Russian oil and commodity exports on world markets have increased much faster than the cost of imports, offsetting the less flattering volume effects. From 2003 through this year, the cumulative difference between export and import price inflation in Russia was a fairly remarkable 74 percent. This put upward pressure on the ruble, encouraging borrowers to take loans in dollars or euros at negative real interest rates, under the assumption that the ruble would appreciate indefinitely. But it also provided an important source of financing.

During the boom years, while the savings rate of the private sector declined precipitously, the government had the foresight to channel a portion of the windfall oil gains into the two state reserve funds, which together are worth 14 percent of the country's GDP. These buffers are likely to be called upon to recapitalize banks and to fund restructuring in the corporate sector. That is, they will be used to pay down liabilities accumulated by a small subset of the country's population. Any hope that public savings might have been used to invest in infrastructure needs is fading fairly quickly.

Russia's other buffer is its high foreign currency reserves, which are currently at $437 billion, or a comfortable 10 months of current account payments. What is a concern, however, is that since the onset of the country's financial crisis in August, reserve levels have declined nearly 25 percent from their peak of $600 billion.

Much of the decline is a result of the Central Bank's dollar sales to enable corporations to repay foreign debts or to hedge themselves against further ruble depreciation. But the sales are also financing resident capital flight from the formal banking system. This is a big concern. Instead of reinforcing confidence in the monetary regime, the slow, step-by-step adjustment of the nominal exchange rate may be perpetuating a steady stream of deposit withdrawals and dollar purchases. This showed up in the 5.9 percent contraction in money supply in November.

The challenges to monetary policy are significant and complex, and a recovery of oil prices could very possibly stabilize the situation. Moreover, with a fairly significant chunk of banking assets denominated in foreign currencies, monetary authorities are understandably reluctant to countenance a sharp and sudden devaluation of the currency.

Perhaps even more important, a strong ruble is generally viewed by the population as an important proxy for the competence of the state. Nevertheless, if key export prices remain weak, the relative prices of domestically produced goods to imported ones will need to adjust to improve the competitiveness of the domestic economy and the sustainability of the balance of payments. This is generally achieved via a sizeable exchange rate adjustment, since the possibility of a wage or price adjustment is remote. Over the longer term, as the ruble weakens, the economy ought to rebound as the domestic manufacturing sector regains competitiveness. One key question is what the Russian government intends to do to attract long-term capital flows -- in particular, direct investment into the country's noncommodity sectors.

Russia's economic potential, in any case, remains enormous. Whether or not the country's policy-makers embrace more flexible solutions to the crisis will determine how much of that potential will be realized.

Frank Gill is the director of European sovereign ratings at Standard & Poor's in London.