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. Last Updated: 07/27/2016

Free of Debt Stigma but Stuck on Oil

With its Paris Club debt now fully cleared, Russia appears more likely to emerge as an economic powerhouse. Yet the current rosy financial indicators hide a sobering truth, economists say: The country remains as vulnerable as ever to a collapse in energy prices that could wreak havoc on state finances and wipe out years of economic growth.

With this week's announcement that the last $23.7 billion had been paid to the club of sovereign creditors, Russia has reduced its debt to just 11 percent of gross domestic product, compared with 34 percent for those countries with A-rated debt, according to Fitch.

Sitting atop $250 billion in foreign reserves, the Kremlin can boast of twin surpluses in the budget and current account, annual GDP growth of 6.6 percent and real wages growth of 17.7 percent, according to the latest figures. At first glance, the stubborn rise in consumer prices -- already 6.9 percent since the beginning of the year -- appears to be the only cloud on the horizon amid a steady stream of positive data.

But analysts, economists and former government officials say the long-term economic view is far less rosy.

"Russian reserves are in very good shape because of oil. That's it," said Boris Nemtsov, a deputy prime minister in the Yeltsin era. "If oil prices will be less than $27, Putin's capitalism will be destroyed immediately."

Besides the threat of low oil prices -- which contributed to the collapse of the Soviet Union and the 1998 financial crisis -- experts say they're alarmed at how state-controlled companies and banks are racking up billions of dollars in foreign debt, even as the state works to pay down its own debt.

When Russia announced its final deal with the Paris Club earlier this summer, officials hailed a new era of prosperity that would remove the stain of the country's 1998 default -- and analysts predicted knee-jerk upgrades to Russia's sovereign credit from the three principal ratings agencies.

Yet while Fitch upgraded its sovereign credit rating for Russia one notch to BBB+, Standard & Poor's and Moody's said they would hold off on an upgrade, citing political uncertainty and structural weaknesses in the country's economy.

"It's not something that's going to move our ratings, and it's something that we've known about for a long time," said Alexandra Mousavizadeh, an analyst at Moody's Investors Service in New York.

Moritz Kraemer, a sovereign debt analyst at S&P, said that taking money out of reserves and using it to pay the Paris Club ahead of schedule did little by itself to improve the overall financial picture.

"The debt goes down, but so do the assets, and anyway the government is not richer or poorer than before," Kraemer said.

Kraemer said the "elephant in the room" that worried analysts was the onset of Dutch disease, the economic malaise that afflicts countries with natural resources wealth. Under this scenario, the steady flow of petrodollars leads to a strengthening of the local currency, which in turn makes other domestic industries less competitive abroad.

The term "Dutch disease" comes from the decline in manufacturing that followed the discovery of gas off the coast of the Netherlands in the 1960s. Kraemer identified early symptoms of Dutch disease in a report this summer about Russia's "hydrocarbon habit."

Alliterative economic disorders aside, Russia's current finances are looking good, and bond traders around the world are treating the country's foreign debt as if it were A-rated. The yield of the Russia-30 benchmark bond has moved to just one percentage point above the yield of the 10-year U.S. Treasury, implying that Russia's debt isn't much riskier than Uncle Sam's.

Unfortunately, that optimism hasn't been trickling down to the population at large: In an annual poll by the Levada Center, 47 percent of Russians recently said a repeat of the 1998 crisis was quite possible in the next year. The percentage with that opinion has changed very little since 2002.

Economists say Russia's finances are strong in the short and medium term but are uncertain beyond that.

"In the long term, I still have some doubts whether the economy will be strong enough not only if oil prices go down, but if oil prices stop growing," said Yevgeny Gavrilenkov, chief economist at Troika Dialog.

Gavrilenkov said the government relies on constantly rising oil prices to keep exports ahead of imports and drive economic growth. A plateau in energy prices could jeopardize that growth and bring back budget deficits.

"Now everything is too good for the government, so they can afford spending more," Gavrilenkov said. "If the oil price stabilizes, it doesn't matter at which level, roughly in two or three years we'll see dramatic changes in the economy."

Low oil and gas prices could also jeopardize state-controlled companies that have been accumulating loads of cheap foreign debt.

"I am very skeptical about their ability to grow, at least not as fast as they're accumulating debt," Gavrilenkov said.

While the state's foreign debt has shrunk from $158 billion at the end of 1998 to $60 billion currently, foreign corporate debt is expected to rise to an estimated $216 billion by the end of this year, compared with $30 billion in 1998, according to Troika Dialog.

Thus, while high natural gas prices have made Gazprom the world's third-largest company by market capitalization, the company's debt stood at $33.1 billion last December. Rosneft's debt stood at $12.2 billion, while UES had a $5 billion debt as of the end of 2005, according to analysts.

Nemtsov said corporate debt in Russia was much less transparent than sovereign debt.

"If you have to debt to the Paris Club, everything is open and under discussion," he said. "If you borrow money to buy an oil company, no one knows what's happening. If you look into transactions like AvtoVAZ, Sibneft and others, the money that you will borrow for the transactions will be very gray."

The debt of Russian companies can weaken the state as well, since the state would probably step in during a crisis to bail out state-controlled companies as well as private companies in key sectors such as banking.

Kraemer said he and other analysts assigned probabilities to these potential collapses and bailouts when computing the state's sovereign credit rating.

Speaking to reporters this week, former Prime Minister Yegor Gaidar said slowing down state-controlled companies' accumulation of debt was the first step the Kremlin should take to reduce the possibility of another financial crisis.

Gaidar and Kraemer praised the government's stabilization fund -- which captures oil revenues that accrue on account of oil trading at more than $27 per barrel -- as an unquestionable success in saving for future periods of low oil prices. The fund currently represents 10 percent of GDP, a significant nest egg, but still far below Norway's fund, which represents 70 percent of that country's GDP, Gaidar said.

The fund also keeps the government from directly investing too much in industry or infrastructure, where the money could fall into corrupt hands or contribute to high inflation.

"The Soviet Union did not create hard currency reserves; it invested money. When oil prices plummeted, the Soviet Union went bankrupt. Why should we do the same again?" Gaidar asked.

As well as paying down debt and saving cash in the stabilization fund, Gavrilenkov said the Kremlin should do everything in its power to slow the growth of government bureaucracy, the cost of which he expected to increase by 50 percent next year in nominal terms.

Instead of expanding its own payroll, the state could spend more of the oil revenues on education, for example.

"It's such small money that they invest in human capital," Gavrilenkov said, referring to the government. He cited the examples of Norway, Sweden and Denmark, which have invested heavily in education. He noted, however, that better education only shows up in the economy after 15 or 20 years.

Still, educated workers have the advantage of benefiting a country in any economic climate, no matter what the oil price is. And that could come in handy for Russia in the unknowable future.

"The most important thing is to understand that no one in the world knows how to forecast oil prices," Gaidar said.