Over the past three years, Standard & Poor's took seven positive rating actions affecting the Russian Federation's foreign debt. S&P's long-term foreign currency rating on Russia is now BB, two notches below BBB-, the lowest investment-grade rating.
What would it take to get S&P to raise this rating to investment grade? To determine its sovereign ratings, S&P considers five analytical categories: Political Environment, Economic Structure and Growth, Fiscal Flexibility, Monetary Stability, and External Flexibility. Let's review each to see where Russia stands and where it needs to improve:
Russia's seven positive rating actions from December, 2000, to December, 2002, have all been the result of the Putin Administration's commitment to push for important political and economic reforms. Russia has been developing a more reliable political environment, which increases the likelihood of broad policy continuity through future political transitions.
Nevertheless, the political, legal, and institutional frameworks are still very weak, and a lasting track record has not yet been established. Progress on implementing judicial and administrative reforms has continued, but improvements to the functioning of the state and judicial operations continue to be modest. More important, the political decision-making process remains highly concentrated.
Attempts to curb the freedom of the media also don't augur well for strengthening democratic processes and institutions. Russia's state bureaucracy is enormous and continues to extend its hand over society too far and too often. Political risk, therefore, remains a constraint on Russia achieving an investment grade.
Income, Economic Structure, and Growth Prospects
Russia's per capita income is moderate, although at about $2,920 at yearend 2003 it's significantly lower than the BBB median ($5,064), but about 50% higher than BB median. Russia's economic structure continues to be a serious constraint on its achieving investment grade over the near term.
The economy is driven by the extraction and export of natural resources, mainly oil and gas, and investment has so far been concentrated in this sector. Economic diversification has been very slow, and as a result, growth remains vulnerable to a decline in oil prices. Although recently strengthening, Russia's banking sector remains a serious constraint on its credit standing. Unless reform of the financial system accelerates and its weaknesses are addressed, an upgrade to investment grade could be stalled. Russian financial markets are too weak to channel the country's significant oil windfalls toward the rest of the economy and, thereby, to contribute to higher growth in other sectors.
Fiscal Flexibility and Debt Burden
Russia's tax regime has been radically improved over the past three years. Less progress has been made on the expenditure side, and serious spending rationalization will not be undertaken before the 2003 elections. Overall, the consolidation of public finances remains Russia's most important accomplishment. Consensus among the political elite about fiscal responsibility has been strong. The period of high oil prices has been used sensibly to establish sizable fiscal reserves. Although some structural fiscal issues still need to be addressed, these do not affect Russia's ability to achieve investment grade.
The recent decline in indebtedness reinforces Russia's long-term solvency. Net general government debt will stand at an estimated 35% of gross domestic product at yearend 2003, equal to the BBB median and less than BB median. Interest payments on general debt accounted for an estimated 7.5% of general government revenue in 2003, similar to BBB median and well below 12% for the BB median. S&P acknowledged Russia's significantly improved fiscal flexibility on December 5, 2002, when it upgraded its long-term ruble debt by two notches, to BB+ from BB-.
The Central Bank of Russia (CBR) is bureaucratic and opaque, but it's improving. Banking supervision has strengthened recently, and monetary policy has been transparent and competent. Given the bank's limited role as a provider of financial resources in Russia, however, monetary policy instruments are limited. Monetary and exchange-rate management, therefore, remains difficult, while foreign-exchange markets and the buildup of reserves continue to serve as the major tools of monetary policy.
Overall, Russian monetary policy has been effective in its impact on price and exchange-rate levels, and in this sense, the CBR's operational performance isn't preventing Russia from achieving investment grade. However, its support for the development of a sound financial system has been weak and must strengthen.
Russia's liquidity ratios (reserve coverage of external financial requirements and reserve coverage of short-term debt) are strong, well above those of the BBB median. Net public external debt declined to an estimated 43% of current-account receipts in 2003. This is still significantly above the BBB median.
Overall, Russia's ability to service all of its debt has strengthened significantly since the August, 1998 default. The sensitivity of external accounts to oil prices is high, however, and, given the country's short track record, external flexibility hasn't yet achieved investment-grade level.
The political and economic risks for Russia's creditworthiness have materially diminished since a combination of political, economic, and structural factors led to the 1998 debt crisis. Nevertheless, the risk is serious enough to keep the ratings on Russia two notches below investment grade. As pointed out above, the two analytical areas where key constraints need to be addressed are the political environment and the economy's structure.
S&P appreciates Russia's recent significant progress on political stability, structural reform, and macroeconomic stabilization. These accomplishments supported our upgrade from selective default status to the B category in 2000. S&P also acknowledges the important legislative steps toward political, administrative, and economic institution-building achieved during 2002. The major gains in these areas sustained several positive rating actions last year.
Nevertheless, there's a long lag between the enactment of many structural, legal, and administrative reforms, their subsequent implementation, and their actual impact on political legitimacy and economic performance. In the meantime, the absence of a viable banking sector, low labor mobility, slow progress in demonopolizing the economy, and weak institutional structures make Russia vulnerable. The reform process has perhaps progressed beyond earlier expectations, but it's far from complete.
By Helena Hessel, S&P sovereign credit analyst, in New York