A risky game with the Paris Club

Russia never seems to play by the same rules as the rest of us. Its macroeconomic indicators for 2000 were the country’s best in 30 years. The economy grew by somewhere between 7% and 8%; tax reforms – part of a wide-ranging economic reform plan – helped the government record a fiscal surplus of 3% of GDP, after many years of high deficits; the strong oil price helped Russia to rebuild its foreign currency reserves to $28 billion. Leading Russian companies took steps to improve their dismal record of abusing minority shareholder rights, under pressure from a government that understands the urgent need to attract foreign investment. The government itself concluded a renegotiation of commercial debts with the London club of private sector creditors in August 2000.

Then at the start of January 2001, came the big surprise. The Russian government failed to meet a payment due to Hermes, the German export guarantee agency, on a Soviet-era debt. An angry exchange of words followed between Berlin and Moscow. The German government warned that it would deem late payment of Paris Club debt as effective default. The prospect arose of the whole crumbling edifice of Russian debts once again crashing down.

Investors were shocked that Russia should so capriciously endanger its standing with foreign creditors, especially amid such apparent financial health. Analysts at Credit Suisse First Boston quickly warned that: “A formal Paris Club default may constrain the Russian government’s return to the international capital market, for example to refinance its Eurobond due in November 2001.” They also point out that, to the ratings agencies, a sovereign payment approach based on selective default is incompatible with credit ratings of B+/B1 and higher. So while there are no cross default clauses between Paris Club and private sector debt, a default would clearly harm sentiment towards Russia’s other liabilities, especially its Soviet-era debts, such as the MinFin IV and MinFin V bonds.

But the market reaction was more mixed. Yields on Russian Eurobonds even declined as some investors took the view that less money going to the Paris Club leaves more to service Russian-era Eurobonds. And rumours of Russian government buy-backs helped stem the falling price of MinFin bonds.

At Euromoney’s Central European Issuers and Investors Forum in Vienna in mid-January, Katya Malopheeva, vice president at Renaissance Capital, tried to explain the internal logic of the Russian government’s latest surprise move. Malopheeva first points out that the selective default will have surprised no-one who read the Budget Law for 2001. This clearly shows a pre-meditated decision not to meet the full $3.9 billion of Paris Club payments falling due this year. Instead the budget law indicates an intention to pay no more than $900 million.

“Servicing external debt is still the largest spending component of the Russian budget,” Malopheeva points out. “But it is becoming a lower priority. The government faces strong opposition within the Duma to fully servicing this debt which it cannot entirely ignore. There are political constraints and the economy is deteriorating.”

It may sound glib for a government airily to relegate debt service down its list of priorities, but it’s worth remembering that the Russians, particularly prime minister Mihkail Kasyanov, are renowned negotiators and, amid the apparent confusion, Russia almost certainly has a game plan, warped or otherwise.

The message to the domestic audience is that Russia is more concerned with domestic political stability than with its reputation among international creditors.

Russia’s foreign debt service burden rises this year to $15.4 billion from $11.6 billion in 2000, with Paris Club payments accounting for a large part of this. They increase from $700 million to $3.9 billion, with much of the burden falling due in the first quarter. Russia has chosen carefully which component of its complex external liabilities to attack: not simply its debts to other governments, but specifically Soviet-era debts and, among those, payments that either have never been restructured (the $350 million due last month) or were subject only to a previous Paris Club agreement in 1996 ($1.2 billion due this month.)

Russia is now trying to reverse the conventional order by which troubled debtor governments first seek a restructuring of Paris Club debts and then seek similar terms from private sector creditors. Having concluded a key deal with private creditors last summer the government may well have reasoned that its negotiators should be able to extract similar concessions, including deferred payments, from the Paris Club. “The London club acknowledged that Russia had not received any forgiveness for old Soviet-era debts, as had other transition economies in 1992,” says Malopheeva.

The likely outcome is tough to predict. One thing is clear: Russia’s apparently impressive financial performance in 2000 will not continue. World oil prices are falling – a $5 decline cuts 1% off Russian GDP growth – growth in its international reserves is slowing and budget surpluses are unlikely to persist. This is a country whose economy is less than 70% the size it was in 1990. (Poland’s economy is now 150% of the 1990 level).

Tactics come into play now. Russia’s negotiators will have an easier task the worse the economy fares and so may be prepared for a long game. Meanwhile no Paris Club renegotiation can take place without Russia first stacking up some arrears – hence selective defaults at the start of the year – and without a recommendation from the IMF that this is the only way to prevent wholesale default. An IMF mission is visiting Moscow this month. The IMF criticized the government on its last visit in November for slow progress with certain key reforms, especially on banking. There has not been much progress since, so the IMF may be in no mood to be accommodating. Speedy resolution is unlikely.

One intriguing possibility is that Russia may try to buy off its government creditors with its own forgiveness to other debtor countries or debt-for-equity swaps. The government might want to redouble pressure on Russian companies to improve their corporate governance, if the prospect of owning minority stakes is ever to entice foreign governments.