Maxim Oreshkin, chief economist at VTB Capital, fully agrees with the politicians who have hailed the newly constructed bridge connecting the city of Vladivostock with the island of Russky as a highly impressive engineering feat. Spanning 1,185 metres, the gleaming new construction is a source of much national pride, given that it has eclipsed China’s Sutong crossing to become the world’s longest bridge.
The snag, says Oreshkin, is that the economic benefit of the new suspension bridge is questionable. Built at a cost of about $1.1bn, the bridge was opened in time for it to be shown off to delegates travelling to last year’s Apec summit, which was held on Russky Island. But Russky has a population of little more than 5,000, which is why the new construction has been labelled by some sceptics as a “bridge to nowhere”.
“It’s a fabulous bridge,” says Oreshkin. “But it will turn out to be very expensive in terms of its IRR, which will probably be negative.” He has similar reservations about much of the infrastructure being built in advance of next year’s Winter Olympics in and around the city of Sochi on the Black Sea coast, much of which has called for extensive (and expensive) tunnelling.
Oreshkin’s unease is shared by other analysts. In a recent update, Morgan Stanley notes that “there are concerns about the efficiency of infrastructure spending, particularly given the high cost of some projects against international comparisons, and the steep rise from initial estimates.”
“For example,” adds Morgan Stanley, “the cost of the Sochi Winter Olympics, which… does include extensive associated infrastructure, has risen from an initial $12bn estimate in 2007 to a forecast $50bn today, which is more than any other Olympics, including the Beijing Summer Olympics.”
The resources being channelled into swanky showcase projects such as the Russky Bridge and the Sochi developments worry analysts because Russia has many more pressing, long term projects that are in urgent need of funding.
In fairness, says Jacob Nell, Russia economist at Morgan Stanley in Moscow, in recent years Russia has seen a notable rise in infrastructure investment, from an average of 4.4% of GDP between 1995 and 2006 to 6.8% between 2007 and 2011, which he says stacks up well compared with peers such as South Africa, Brazil and Turkey. In 2011 alone, however, infrastructure investment reached Rb4tr ($130bn) or 7.3% of GDP, which according to Morgan Stanley, was the highest level since the end of the Soviet Union.
Nevertheless, the consensus is that Russia’s infrastructure, most of which was inherited from the Soviet Union, remains in urgent need of wholesale modernisation. “Almost all sectors of the Russian economy will face huge capex requirements over the coming decades,” says Sergey Nekrasov, first vice-president at Gazprombank in Moscow. “Some industries, notably oil and gas, did enjoy high levels of investment following the collapse of the Soviet Union, but more is needed. The power industry requires upgrading and is in need of new capacity. The transportation sector, including railways, also needs to respond to the challenges of a modern economy.”
Drag on development
It is critical that Russia plugs this gap not just to deliver an infrastructure compatible with the living standards expected by the country’s aspirant and growing population. Infrastructural inefficiencies, say bankers, are creating a meaningful drag on economic output. “Existing obsolete infrastructure in Russia may become a real barrier for economic growth,” says Gazprombank’s Nekrasov. “According to some Russian economists, the current level of investment in infrastructure may restrict annual GDP growth to 2%-3%.”
It is also essential that Russia upgrades its infrastructure in order to improve on its feeble record of attracting the foreign direct investment (FDI) it needs to wean the economy away from its dependence on oil and gas. Most obviously, crumbling and inadequate transport infrastructure limits the appeal of Russia as a manufacturing base for companies looking to distribute their products through it and the Commonwealth of Independent States. Bottlenecks in the transportation sector, notes Morgan Stanley, are “delaying successful development of the economy. The current state of the transportation system poses significant obstacles to the government’s economic development plans, we think.”
Peter Stonor, global head of infrastructure and transport at VTB Capital, agrees that Russia’s rundown transportation facilities have a quantifiable negative impact on trade. “It is estimated that about 25% of the cost of finished products in Russia is accounted for by transportation costs, which is two to three times what you would expect in a developed economy,” Stonor says. Little wonder, then, that only about 1.5% of the container trade between Asia and Europe passes via the northern Russian route, he adds.
Estimates of how much Russia will need to invest in infrastructural modernisation over the coming 15-20 years vary. Morgan Stanley forecasts that the current level of infrastructure investment (7% of GDP) will continue up to 2018, when Russia will host the Fifa World Cup. “The market doubts the scale of infrastructure spending due to the lack of detail and the expense,” Morgan Stanley acknowledges. “However, our analysis shows that infrastructure spending will grow at a 3% CAGR …to $157bn in 2017, in line with Russian GDP growth.”
Looking further ahead, a recent McKinsey study puts Russia’s likely infrastructure expenditure between 2013 and 2030 at $1.5tr, which VTB Capital’s Stonor says is broadly in line with other estimates. “The run rate most people talk about in terms of future infrastructure spending is around $100bn a year, roughly half of which will be accounted for by transportation projects,” he says. “We expect about 80% of this to be government-funded, with the remaining 20% of finance coming from the private sector.”
Historically, says Pavel Brusser, managing director and head of infrastructure in the project and structured finance department at Gazprombank, equity for large scale Russian infrastructure projects has been provided by a limited number of major banks, large Russian engineering, procurement and construction (EPC) contractors, international operators and investment funds.
“Regarding lending,” he adds, “for the larger projects, in particular, only Sberbank, VTB and Gazprombank are regular players. As the Russian banks’ cost of funds in foreign currencies for medium to long term tenors is higher than that of foreign banks, they do not usually focus on euro or dollar-denominated projects, which is typically covered by the international banks.
“However, the Russian banks can be competitive in projects generating rouble revenues, for certain types of structured facilities and in the case of clients that the major international banks find more difficult to understand.”
Capital market solution?
To date, says Denis Shulakov, first vice-president at Gazprombank, the capital market has been regarded as an attractive but generally elusive source of project finance. “Relatively few projects have been able to secure significant funding on capital markets for a number of reasons,” he explains. “Projects can be too complex to sell to investors, the liquidity may or may not be there at the moment of funding, and intercreditor issues can prove tricky if there are other financing sources.
“Add to all this the element of Russian risk, and projects can appear daunting for the capital market. That is not to say that Russian borrowers have been unable to access the capital market. There are plenty of examples of very successful corporate issues in Russia. But the combined effects of all these elements can be an uphill battle for Russian borrowers.”
One funding option is so-called infrastructure bonds, which have been the subject of animated debate in Russia for a while. According to a recent presentation from the Renaissance Group, state corporations, in particular Russian Railways (RZD), have lobbied for the issuance of infrastructure bonds that would be bought by pension funds. The same presentation adds, however, that this proposal has traditionally met with resistance from the Ministry of Finance, which has argued that infrastructure bonds would worsen Russia’s debt position. Additionally, the Renaissance presentation advises that private pension funds are “strongly encouraged by government rules not to invest in infrastructure”.
Much of this opposition seemed to melt away in January, when president Vladimir Putin announced that pension funds should be used as a funding source for railway projects. This paved the way for RZD to announce plans to issue Rb100bn worth of infrastructure bonds in each of 2013, 2014 and 2015, with maturities of between 15 and 30 years.
Bankers say that RZD has been issuing bonds in the domestic as well as the international market for a number of years, which are — almost by definition — infrastructure bonds. “There is no legal definition of infrastructure bonds in Russia, so we can’t describe these as a separate asset class,” explains Alexander Kudrin, head of fixed income research at Sberbank Investment Research in Moscow. “The main difference between the recently announced infrastructure bonds and corporate bonds issued by companies raising funding for infrastructure projects is their maturity and interest rate.”
The maturity of the so-called infrastructure bonds has extended the yield curve in the domestic market, with a Rb25bn bond from RZD in early June led by VTB Capital, Gazprombank and Sberbank CIB offering investors an opportunity to buy 30 year corporate debt in the rouble market for the first time.
The coupon, meanwhile, was in line with the pricing formula established for the new infrastructure bonds, which is 100bp over consumer price inflation (CPI). “Right now Russian inflation is 7.4%,” says Kudrin. “So compared to the yield on long-term sovereign bonds of 7.5%, a 100bp premium over inflation looks attractive.”
Small buyer base
For the foreseeable future, say bankers, demand for infrastructure bonds will be confined largely to the state pension fund and other government-owned entities such as Vnesheconombank, which has publicly announced that it will be buying infrastructure bonds issued by RZD and the Federal Grid (UES FGC). “The bulk of institutional investors in Russia are commercial banks, which have relatively short-term investment portfolios, so their demand will be limited,” says Kudrin.
Whether or not foreign investors will be attracted by these issues — effectively corporate inflation-linked bonds — will depend chiefly on their broader appetite for rouble denominated corporate bonds. Analysts expect this to increase markedly following a series of financial market reforms, including the creation of the Russian Central Securities Depository (RCSD) and the opening of access to international depositories such as Cleastream and Euroclear.
Commenting on these and other reforms in a recent report, Moody’s forecast that they would encourage foreign investment in the corporate rouble bond market to rise to around 10% of the total, or between $10bn and $15bn, over the next two to three years, from less than 2% to 3% today.
Others agree that international investors are set to become much more active in the domestic bond market and, by extension, more influential in the funding of infrastructure via the capital market. “Tectonic changes are already taking place in the rouble bond market,” says Nekrasov at Gazprombank. “It is expected that global investors, with more than $60tr in assets under management, will be given access to all segments of the Russian bond market as a result of liberalisation.”
Easier access to the domestic market will complement the opportunities international investors have already been offered to buy into the Russian infrastructure story via the international funding programme of Russian Railways. “Russian Railways has been very active in the capital markets, issuing in five currencies, including sterling and Swiss francs as well as dollars and euros,” says VTB Capital’s Stonor.
Russian Railways’ most recent international transaction, in April, was a €1bn eight year issue led by Natixis, RBS, Société Générale and VTB Capital and priced at a 3.375% yield. “Recent transactions from Russian Railways have been very competitively priced, and its issue in April was notable for achieving the lowest ever corporate fixed yield for any tenor from a CIS borrower,” says Stonor.
Another play on the Russian rail sector is the freight lessor, Brunswick Rail, which was last in the international market in October 2012, with a $600m five year issue. Led by Goldman Sachs, Raiffeisen, UBS and VTB Capital, the Brunswick Rail issue was priced at 6.5% and generated orders of around $3bn.
PPP growth
Stonor says that beyond the straight Eurobond market, private-public partnerships (PPP) are building an increasingly encouraging track record as a viable financing mechanism for infrastructure projects in Russia. Russia’s first PPP project, in 2010, was the Pulkovo airport development in St Petersburg, which was regarded at the time as establishing an important blueprint for future infrastructure projects in Russia.
The construction of the new terminal at Pulkovo, aimed at doubling traffic numbers at the airport, was supported by a €716m long term debt package put together by the European Bank for Reconstruction and Development (EBRD), International Financial Corp (IFC), Eurasian Development Bank (EDB), Nordic Investment Bank (NIB), and Black Sea Development Bank (BSDB). The borrower was Northern Capital Gateway, a consortium made up of VTB Group, Germany’s Fraport and Horizon Air Investment, which has a 30 year concession from the City of St Petersburg to rebuild, finance and operate the St Petersburg airport.
Another showcase project for PPP in Russia, says Brusser at Gazprombank, is the Western High Speed Diameter (WHSD), which at $6.4bn is the world’s largest toll road project. The 46 kilometre highway will relieve traffic congestion in St Petersburg by redirecting haulage trucks from the city’s seaport to the federal highways, bypassing the city.
Gazprombank is the sponsor, financial adviser and mandated lead arranger on the WHSD project, the funding for which is also being provided by VTB Capital, Vnesheconombank, EDB and EBRD. According to EBRD, the significance of this project, the first PPP in the Russian road sector, “goes beyond the project’s specific scope and lies in its ability to demonstrate the effectiveness of PPP structuring as a means of attracting private sector funding for the significant transport network upgrading and expansion programme in St Petersburg.” This, says the EBRD, will “increase the capacity and effectiveness of not only the city’s transport system but also that of the region”.
VTB Capital’s Stonor agrees. “St Petersburg has led the way in terms of having the most developed PPP concession framework, but other regions are expected to follow,” says Stonor. “Both the Pulkovo terminal and WHSD PPP project have demonstrated that there are viable alternatives to government funding and bank lending.”
The EBRD also has exposure to the Russian infrastructure story through its holding in the Macquarie Renaissance Infrastructure Fund (MRIF), which was set up in 2008, and has some $670m under management. Other investors in the fund include the Eurasian Development Bank, the IFC, the Kazakh sovereign wealth fund (Kazyna Capital Management) and Vnesheconombank.
The returns that have been earned by investors in some major projects have clearly been a draw for investors such as these. Nekrasov says that even allowing for inflation, IRRs in some projects have reached 25%-30%.
Governance concerns
While returns in the Russian infrastructure market may be appealing, bankers concede that corporate governance and the legal regime in Russia remain concerns for some investors. “It is true that there remain certain challenges in using limited recourse finance structures in Russia, many of which are the result of the legal environment,” says Sergey Zhukov, managing director in the project and structured finance department at Gazprombank. “For example, it is difficult to put together a lending syndicate under Russian law as security cannot be shared among lenders with the same ranking. Pledges of accounts are not effective as it is legally impossible to prevent a borrower from debiting an account it owns, even if that account is pledged.”
Zhukov adds: “Russian law does allow a borrower, or even any obligor, including guarantors, to keep foreign sales proceeds abroad to pledge them in favour of lenders, but that facility is reserved for exporter-borrowers, not exporters in general, and only with respect to the loans provided by foreign lenders for a period of more than two years. These and other restrictions explain why it is common to structure loan and equity participation documentation in Russia under English law (but this requires participation of at least one foreign entity) and why specific ‘Russian solutions’ have been devised over the years.”
Nekrasov says many other regulatory aspects need to be taken into account for Russian projects. “For example, the requirement to obtain permits for projects requires careful planning process depending on the industry,” he says. “Tariffs for pipelines, airport fees, road tolls, property rights, construction, operation of some classes of assets and many other economic issues are regulated and must be understood. There is an on-going deregulation process in the gas and power industries, which is profoundly changing the landscape and prospects for investment. A good understanding of the process and the constraints is the key to successful project planning.”