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. Last Updated: 07/27/2016

Ease Up on Debts

Russia is coming to a critical juncture in its resurrection, yet amid renewed growth and hope, shortsightedness by several European countries that refuse to renegotiate Russia's Paris Club debt is threatening to derail the incipient economic recovery.

While there is a growing perception in the West that Russia is at last showing signs of recovery after 10 years of a catastrophic downward spiral following the collapse of communism, many do not fully appreciate just how fragile this rebound remains. The shear devastation wreaked first by communism itself and then by the collapse of the Soviet Union simply defies description. Poverty is still rampant, regional imbalances are huge, the economy is recovering from 70 years of Soviet irrationality followed by a decade of under-investment.

Even under the most optimistic scenarios, Russia will remain highly vulnerable to growth rates of the Group of Seven leading industrialized nations and world commodity prices for a decade at least. In order to continue as an industrialized nation, Russia requires huge capital expenditures just to maintain — much less renew — her dilapidated infrastructure and industrial plants.

Paris Club debt is government lending, generally extended on noncommercial terms, often for political, military or humanitarian considerations. The bulk of Russia's Paris Club debt was in fact German corporate welfare: government lending to the Soviet Union, then a bankrupt totalitarian state, as a covert subsidy for domestic exporters in sunset industries.

Modern Russia has less than half the population of the Soviet Union, as well as a vastly different economic geography. If during the brief honeymoon following the collapse of communism Russia accepted legal responsibility for all Soviet debt (Soviet assets proved to be largely worthless), this was done in the misguided belief that, with a few orthodox fixes, Russia could quickly resume its place among the industrialized nations. Alas, it was not to be.

In early 2000 the London Club successfully renegotiated Soviet-era bank debt now held by private creditors. This deal included approximately 45 percent debt relief — about the average for Brady-type deals and similar to those granted Poland and Bulgaria. While Russia is now quite logically requesting comparable treatment for Paris Club debt, the main Paris Club creditor, Germany, has repeatedly proclaimed that it will settle for nothing less than full payment. This position is unjustifiable, shortsighted and frankly dangerous.

Even if it were possible for Russia to pay the Paris Club debt in full, this would starve the country of vital investment.

The issue of morality ("gentlemen repay their creditors") is here quite simply irrelevant. More than 50 sovereign debt restructurings have been carried out since the Mexican pre-Brady deal of 1989 put an end to "La Decada Perdida," the lost decade for Latin America. Much like corporate bankruptcies, these workouts aim at salvaging value for creditors, leaving the debtor with a challenging but sustainable debt load. Recent sovereign debt workouts have seen an important innovation: The Paris Club and international financial institutions have successfully demanded "burden sharing," i.e. that private creditors suffer a write-down similar to that granted by public entities. To put it mildly then, it is surprising that the Paris Club now indignantly refuses to offer the same terms already accepted by the London Club.

Sovereign debt restructurings usually focus on what is doable. Russia is already paying well over $10 billion per year — some 25 percent of its total budget — in foreign-debt service and amortizations. In the absence of a Paris Club write-down, the debt load in 2003 would be an unmanageable $18 billion. Even if it were possible to pay in full, this would starve the country of vital investment, rendering the economic edifice highly susceptible to macroeconomic shock.

While it might seem self-serving to claim that Russia's rescheduling of Paris Club debt is actually in the best interests of the creditors, this may nevertheless be the case. An unsustainable debt burden is, by definition, destined to be defaulted upon, but in the meantime, pumping all available resources out of the country for debt service would lead to arrested development, grinding poverty and eventually, a strengthening of populist-extremist forces, whether of the left or the right. It should be obvious that Europe has a strong interest in political stability in Russia — such stability in the absence of economic recovery would be illusory.

Russia remains in transition. There has not yet been time to establish the checks and balances of advanced parliamentary democracy. After at least 700 years of dictatorship, liberalism is barely a decade old. The crash of 1998, attributable to a combination of domestic rapacity and strikingly incompetent (if well-intended) Western economic advice, put an end to the most pro-Western regime in Russian history. The successor regimes, first under Yevgeny Primakov and now under Vladimir Putin, while not overtly hostile, have been primarily concerned with the defense of specifically Russian interests.

Fortunately, the demons of nationalism and xenophobia are being kept in abeyance by rising living standards and new hope. Were incomprehension from the West and a crushing debt load to push Russia into renewed recession, the current political consensus would be fatally imperiled. While no one can predict what the successor regime would look like, if history is any guide, it would not be friendly to the West. It is certainly not a risk worth taking.

Eric Kraus is head of strategy at NIKoil Capital Markets in Moscow. He contributed this comment to The Moscow Times.