Page 42 - IFR Opportunities in Russian capital markets

CHAPTER02
ifrintelligence reports/Opportunities in: Russian Capital Markets
Devaluation and currency risk
Exposure to currency risk brought down the banking sector in 1998 when the ruble was cut to a quarter of its value against the dollar on 17 August. However, it was not the devaluation per se that did the damage, but margin calls on the forward contracts Russian banks had signed with foreign investors into the bond market.
The Yeltsin administration was financing a 7–8% budget deficit for most of the 1990s with the now infamous GKO ruble-denominated sovereign bonds. In the run-up to the crisis the government was paying up to 20% a month.
The CBR was holding the ruble in a slowly depreciating trading band and to protect themselves against the possibility of a devaluation, foreign banks signed forward contracts with Russian banks that locked in an exchange rate at the time their bonds matured.
When the ruble devalued these contracts came due and left Russian banks with a bill of an estimated US$40bn, which they were unable to pay. Almost all the Russian banks defaulted, on the grounds that a forward contract was a type of gambling and as such Russian banks were not liable to pay if the foreign banks lost their bet. This ruling was to have profound repercussions on the development of the derivatives market. (See also Chapter 12.)
Russia's banks have learnt their lesson. The negative real interest rates have limited foreign investment into sovereign bonds and with over US$300bn in gross international reserves against the approximately US$9bn of reserves the CBR had on the eve of the crisis, another devaluation looks very remote.
Banks’ exposure to currency risks has tanked in the last seven years. Liabilities in foreign currency have fallen from 35% of total bank sector liabilities to 0.6% of the capital value of the 30 largest banks as of October 2006, according to Vnesheconombank.
Exposure to equities
As the only security in Russia that delivers a positive real return, Russia's banks have been investing heavily into the stock market. The rise of the investments in equities made by banks tracks almost exactly the rise of the leading RTS index, rising from RUB200bn at the start of 2002 to about RUB1.5trn by the end of 2006.
Another stock market crash like that of 1998, where the collapse of the market wiped 40% off share values in a matter of months, would hurt banks but not kill them – Vnesheconombank estimates a repeat of the 1998 falls on the stock market would wipe out 10% of current banking capital.
Investing in banks
Given its obvious appeal, how can investors get exposure to the Russian banking sector? The short answer is: with great difficulty.
The main entry to Russia's banking sector in 2006 has been through the acquisition of banks. Strategic investors have been buying Russian banks since 2004 and the action became frenetic in 2006 with half a dozen big deals. However, these investors have been paying a heavy premium for entering at such a fashionable time: the cost of a bank has risen to about 3.5 times the bank's book value, well over twice what strategic investors paid for banks in Central Europe in the 1990s. The main mergers and acquisitions (M&A) by foreign banks are detailed in Table 2.7.
35