Moody’s is the most recent credit rating agency of the big three to downgrade Russia’s sovereign debt rating to non-investment grade. In January 2015, Standard and Poor’s downgraded Russia’s debt to non-investment grade, shortly after Fitch affirmed the country’s investment grade rating at BBB-. This is particularly significant because Moody’s decision has shifted the consensus view among the major credit rating agencies on the country’s debt toward a common classification of that debt as junk and could compel many bond investors to liquidate their Russian government bond holdings, pushing bond yields even higher. (For related reading, see article: The Risks Of Sovereign Bonds.)
Moody’s cited several factors for their decision, among them “the existing and potential future international sanctions, the erosion of the country's foreign exchange buffers and persistently lower oil prices." It additionally noted that "high and rising inflation will take a negative toll on incomes as well as business and consumer confidence.” Another reason it gave for the downgrade is, “the expected further erosion of Russia's fiscal strength and foreign exchange buffers” as well as doubts about the government's ability to sustain fiscal and financial strength. (For more insights into how bonds are assessed, see: How Do Companies Like Moody's Rate Bonds?)
Are The Credit Rating Agencies Right?
So are the credit rating agencies correct? Is Russia really less able to service its debt commitments? Perhaps the credit rating agencies are just reacting to events in the news and are ignoring the actual macroeconomic fundamentals. (For a background on credit rating agencies, see article: A Brief History Of Credit Rating Agencies.)
A few points are important to note when assessing a country’s ability to service its debts. One of them is the state of the government’s finances. Just like individuals or companies, governments need a source of income. It's thus important to consider how much income is generated from tax revenue or the source of foreign currency needed to service external debt. On both these fronts, Russia isn’t faring too badly.
Tax Revenue and Balanced Budget
The Russian government is in the process of revising its budget due to the fall in international crude oil prices, but the devaluation of the ruble has helped prevent a sharp deterioration in the country’s budget balance. As the chart below shows, the Russian government's budget deficit as of 2014 was just 0.5% of GDP -- better than those of other emerging markets such as Brazil (0.63% deficit), Mexico (4% deficit), and Turkey (1.3% deficit), according to Trading Economics.
Moody's expects a consolidated government deficit of approximately RUB1.6 trillion (2% of GDP) in 2015 as well as a widening of the non-oil deficit, but this may be too pessimistic. Dollar-denominated income from taxing oil exports may be down, but receiving more rubles from each dollar earned allows the government to maintain its income level in local currency. With spending cuts on the cards, the government may be able to limit deterioration in the fiscal budget balance in 2015.
Foreign Currency Earnings
Another important factor is the amount of money earned from exports, measured by the country’s current account surplus. Even with the drop in oil prices, the Russian Central Bank is still forecasting a current account surplus in 2014, meaning the country will have a fair amount of export-generated earnings. The chart below shows the history of Russia’s current account position which, although slowing relative to the recent past, compares favorably to that of other countries such as Brazil, India, and Mexico, all of which reported current account deficits to GDP in 2013 according to Trading Economics and are nonetheless still rated investment grade by S&P. (For a better understanding of what a current account surplus or deficit indicates about a country's economy, see article: Exploring The Current Account In The Balance Of Payments.)
Foreign Currency Reserves
Just like companies or individuals, the amount of savings one has in the bank for a rainy day is also important to assessing credit worthiness. Despite a sharp draw-down in Russia's reserves in 2014 from a high of nearly USD $486 billion in 2013 as shown in the chart below, according to the Central Bank, Russia still has reserves of around USD $376 billion that are sufficient to meet near-term debt service obligations.
More importantly, President Putin has made changes at the Russian Central Bank that could slow future outflow of foreign exchange reserves. Forbes reports “Ksenia Yudayeva, the No. 2 at the Bank, was replaced by Dmitry Tulin, an economist trained at the Moscow Financial Institute. Yudayeva was the main architect of the rouble’s predictably poor defense in the fourth quarter of 2014.”
Total Debt as Measured by Debt to GDP
Another important factor to assess a country’s credit worthiness is the amount of debt it has relative to the size of its economy. Here again Russia comes out on top with its debt amounting to just 13.4% of GDP as of 2013, compared to 56.8% for Brazil, 22.4% for China and 67.7% for India, according to Trading Economics.
Even with a slowing economy, Russia’s debt load isn’t big by any means, meaning servicing this debt shouldn’t be a problem. Although the chart shows some deterioration over time, the last time Russia was in real trouble, and actually defaulted on its debt payments, was back in 1998 or 1999 when debt to GDP reached 100%, according to Trading Economics. Presently, Russia is a long way away from those poor credit metrics and is still likely to have a lower debt burden relative to GDP in 2014 than other closely associated emerging market countries such as those listed above. (See: The Risks Of Investing In Emerging Markets.)
Russia Is Not Without Its Problems
Russia is not without its problems, of course. The economy is likely to fall into recession in 2015, with Deutsche Bank forecasting a contraction of 5.2% and the IMF expecting a smaller contraction of 3%. Additionally, capital continues to leave the country, with the Russian Central Bank predicting net private sector capital outflows in 2014 reaching USD $151 billion, but this is not a dramatic shift from previous years when the country was rated investment grade. The chart below shows the history of capital flows, and while 2014's is bigger than those of previous years, a more alarming pattern would be a series of large inflows in previous years (2008-2013) followed by a dramatic outflow in 2014.
This would be a more worrying sign of a negative shift in investor sentiment than a continuation of an established trend that was occurring when there were fewer concerns about the country’s credit worthiness.
Developing Banking Crisis
A bigger concern is perhaps developing in the country’s banking sector, and can be seen in the increasing number of non-performing loans. In February 2015, Alexei Simanovsky, a Russian Central Bank official, said Russian banks' non-performing loan ratio for retail lending was at 6.3 percent in January and could rise to 8 percent by the end of the year. Reuters reports that Russian banks' loan quality has been deteriorating as an economic slowdown makes it harder for borrowers to meet their loan repayments. Furthermore, a bank crisis could force the government to intervene to support several banks, depleting foreign currency reserves.
While the trend in loan performance is negative, it needs to be analyzed in context. In 1998 when the country defaulted, the ratio of non-performing loans to total loans reached a high of 17.3%, according to the World Bank. While the current ratio for non-performing loans is far from this figure, Russia’s number of non-performing loans -- at 6.5% of total loans in 2014 -- is high relative to other emerging markets such as Brazil (2.9%), China (1.1%), Turkey (2.7%) and India (4%), according to World Bank data. This is a potential red flag, especially if the trend accelerates in 2015.
The Bottom Line
Moody’s decision to downgrade Russia’s sovereign rating to non-investment grade is a major shift in the capital markets because it changes the balance in the overall assessment of Russia's debt, with two of the three major credit rating agencies now seeing the country’s debt as junk. Russia is likely to suffer significantly higher long-term borrowing costs with two non-investment grade ratings when financial sanctions preventing the government from borrowing on international capital markets are lifted. Additionally, existing investors could be forced to liquidate their current Russian government bond holdings as a result of this decision. (For related reading, see article: How Russia Makes Its Money -- And Why It Doesn't Make More.)