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Comment of Vladimir Potapov, Global Head of Portfolio Management Business at VTB Capital Investment Management to Bloomberg


Tags: portfolio management

Aug 20, 2012
The law changes threaten the rally in bonds because pension funds had 923 billion rubles invested in government debt at the end of last year, accounting for almost a quarter of that market, according to Alexander Lvov, deputy executive directory at VTB Group’s pension fund. Without this money, the average yield on state and corporate debt may add as much as 2 percentage points, according Vladimir Potapov, global head of portfolio management at VTB Capital Investment Management and Mikhail Dmitriev, a former deputy economy minister from 2000 to 2004 who now heads the Moscow-based Center for Strategic Research, a consultancy taking part in government discussions. 

Russia’s plan to cut a pension deficit of almost 1 trillion rubles ($31 billion) risks triggering a jump in borrowing costs as less retirement funds will remove money invested in Treasuries and corporate bonds.
President Vladimir Putin’s government has said it will present proposals by Oct. 1 to tackle pension spending that the International Monetary Fund predicts may double to 16 percent of economic output. Russia’s cost to borrow over U.S. Treasuries has fallen 123 basis points this year to 198, while the spread for emerging markets has narrowed 79 basis points to 298, according to JP Morgan Chase & Co. EMBI indexes.
The law changes threaten the rally in bonds because pension funds had 923 billion rubles invested in government debt at the end of last year, accounting for almost a quarter of that market, according to Alexander Lvov, deputy executive directory at VTB Group’s pension fund. Without this money, the average yield on state and corporate debt may add as much as 2 percentage points, according Vladimir Potapov, global head of portfolio management at VTB Capital Investment Management and Mikhail Dmitriev, a former deputy economy minister from 2000 to 2004 who now heads the Moscow-based Center for Strategic Research, a consultancy taking part in government discussions.

Dealing a Blow
“This will clearly deal a blow to the foundation of long- term money in the country,” said Dmitry Dudkin, head of fixed- income research at UralSib Financial Corp. in Moscow, who predicts the average yield on so-called OFZs will grow about 1 percentage point several months after a decision is made. “It will seriously undermine the investor base, especially at the long end of the yield curve,” or bonds with maturities of 7 years or more.
An index of five-year government bond yields compiled by Micex dropped 88 basis points, or 0.88 percent, since June to 7.6856 on Aug. 17. The yield on Russian five-year government bonds is 149 basis points lower than for Brazilian debt, up from an almost three-year low of 76 basis points on July 23, according to generic prices on Bloomberg.

As part of the pension system overhaul overseen by Putin in 2002 during his first presidential term, the government sought to create a three-pillar system based on a voluntary pension component, mandatory defined benefits and mandatory defined contributions. Even so, most expenses are still covered on a pay-as-you-go basis, with current workers financing pensions for retirees, according to VTB.
State Pension Fund The State Pension Fund channels 16 percent of the 22 percent it receives to pay pensions to current retirees and shifts 6 percent to asset management firms. Vnesheconombank, Russia’s state development bank known as VEB, manages about 80 percent of the funded part of the system. While pension savings are transferred to VEB by default, employees can also choose a non-state company.
“The mandatory part of pensions provides a stable flow of money” into pension funds, Dmitry Dolgin, an economist at Alfa Bank, said by phone on Aug. 16. “Abolishing the funded component will halt these inflows, strongly breaking with the idea of creating in Russia an international financial center. It also contradicts the idea of accumulating pension money and hinders the development of long-term savings market to finance investment.”

Straining the Budget
Labor pensions have more than doubled in the period from 2007 through 2011, straining public finances, according to the IMF. Without an overhaul, state expenditure on pensions is forecast to grow from 9 percent of economic output in 2010 to 12 percent in 2030 and 16 percent 20 years later, the Washington- based lender said in a report released this month.
Average expenditure on public pensions is projected to remain stable in emerging Europe at about 9 percent of gross domestic product until 2030 and advance to 11 percent by 2050, according to the lender. Advanced economies are predicted to raise the share of pension spending from 8 percent of economic output in 2010 to 11 percent in 2050, the IMF estimates.
After creating its funded pension system in 2002, the Russian government predicts its assets will reach about 2.3 trillion rubles by end of this year, up from 1.7 trillion rubles in January. The pension system deficit, including transfers from the budget deficit, may increase from 5 percent of GDP, or 2.6 trillion rubles, to 8.5 percent by 2030 if no measures are taken, according to Citigroup Inc.
Fewer pension assets would also place corporate debt under stress, according to Fedor Naumov, head of research at Moscow- based Kapital Asset Management, which manages the equivalent of about $7 billion in assets.

Short-Term Fix
“Because of very aggressive increases in pensions, the government is looking for ways to finance that raise,” Naumov said by e-mail on Aug. 16. “But instead of looking for ways to balance the system in the long run, they are simply trying to fix this problem for a few years.”
The fiscal burden of shifting future costs to the government may deter investors from Russia’s sovereign debt in the longer term, according to Naumov.
If the accumulation part of the pension system is abolished, “the government will have to pay pensions in the long run, which investors will perceive as more risk,” he said.
“Such a cancellation also means that in the long run the government will have pension responsibilities to be paid from the budget. Why would anyone want to buy their long-term debts?”

Curtailing Demand
Even so, if the government cancels the mandatory accumulation system, the budget deficit will also shrink, reducing the need for borrowing and curtailing supply of state bonds, Andrey Kuznetsov, a Citigroup Inc. equity strategist in Moscow, said by e-mail Aug. 17.
“It’s the corporate bond market that will suffer the most if the pension system will return back to pay as you go,” he said. “So I would not expect any meaningful impact on OFZ yields, though the size of the market should shrink.”
The ruble slid 0.7 percent to 32.1 per dollar at the 7 p.m. close in Moscow. Non-deliverable forwards, which provide a guide to expectations of currency movements, showed the ruble at 32.5610 per dollar in three months.
The yield on sovereign dollar bonds due in April 2020 fell two basis points to 3.164 percent. The yield on ruble notes due
August 2016 increased four basis points to 7.56 percent on Aug.
17. Russia’s ruble Eurobond due in 2018 fell, lifting the yield four basis points to 6.409 percent.

Mexico, Brazil
The extra yield investors demand to hold Russian debt rather than U.S. Treasuries rose two basis points to 224, according to JPMorgan’s EMBIG index. The difference compares with 163 for debt of similarly-rated Mexico and 164 for Brazil, which is rated one step lower at Baa2 by Moody’s. The cost of protecting Russian debt against nonpayment for five years using credit-default swaps rose two basis points to 173 basis points, according to data compiled by Bloomberg. Russia is rated Baa1 by Moody’s Investors Service, the third-lowest investment-grade ranking. The contracts cost eight basis points less than for Turkey, which is rated three levels lower at Ba1 by Moody’s. The swaps pay the buyer face value in exchange for underlying securities or the cash equivalent if a government or company fails to adhere to its debt agreements.

Pension Overhaul
A pension overhaul in Russia that abolishes the mandatory accumulation system would threaten the government’s bid to develop the domestic financial market, said Jacob Nell, a Moscow-based economist for Morgan Stanley,“Long-term, I think the cost of scrapping the funded pensions is that the Russian financial markets will continue to be more volatile, and consequently do a worse job of matching savings and funding, which will hit growth, and leave Russia more dependent on foreign providers of funding, which is also risky,” he said by e-mail.

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