What to make of Russia's downgrade - an update from Henley Group Chief Economist Martin Hennecke.

1. WHAT TO MAKE OF RUSSIA’S DOWNGRADE
In light of the ongoing tensions in Ukraine as well as the downgrade of Russia by Standard &
Poor’s (S&P) last week we would like to provide an update on the situation.
Firstly, with regards to Russia’s credit rating and its downgrade, it should be noted that the rating actually
appears to be rather odd based on the country’s financial numbers: For the purpose of comparison, Japan has
got a debt/GDP ratio of 227% and a S&P credit rating of AA-, the United States has got a debt/GDP ratio of
102% and a rating of AA+, and Hong Kong a debt/GDP ratio of 33% and a credit rating of AAA. We can see
that normally the lower a country’s debt the higher its credit rating. Yet Russia, at a negligible debt/GDP ratio of
9%, is blessed with a rating of BBB-, which raises the question of a potential political bias.
CAN YOU SPOT THE ODD ONE OUT?
Sure, it can be argued that credit ratings should not be solely based on debt/GDP ratios, but that other factors
come into play also, for example the strength of an independent legal system, corruption and many other
things.
So let us consider for further reference as well the sovereign credit ratings of another US based ratings agency
named Weiss Ratings which appears to be much more independent as it prouds itself on removing political bias
from the analysis process. Interestingly Weiss rates both Japan and the United States ‘C-‘, while Hong Kong still
gets the highest rating ‘A’, and Russia comes in at ‘C+’. So it is noteworthy here that although Russia’s rating is
again lower than that of Hong Kong despite the more favorable debt/GDP ratio (partly due to Hong Kong’s
governance advantages), Russia does rank two levels above what is considered to be the ultimate safe haven
debt of Japan and the United States.
28 April 2014

2. In any case, whether or not Russia’s low credit rating by S&P is justified or not, what is important to understand
here is that it does not matter too much to the country, since it’s extremely low debt also means that there is
little if any risk of a debt crisis: Russia basically does not need investors to buy its debt as its financial position is
strong.
Besides, investing in Russian equities is different from investing in Russian sovereign debt. Russian corporates
generally have strong financial positions as even the major rating agencies admit.
On this occasion we should also be reminded of the present valuation of Russian equities. Not only do they trade
at an approximate 70% discount to the global average, but also at a 110% discount to Russia’s own historical
valuations average. Such prices tend to be typical of market bottoms.
EMERGING MARKET P/E RATIOS VS. THEIR RELATIVE HISTORICAL AVERAGES

3. Yes, further sanctions are be a potential risk and threat, but since Europe actually happens to export more goods
to Russia than the other way around, and since natural gas exports from Russia to the EU will be harder to
replace (at least anytime soon) than the export of manufactured goods from the EU to Russia (most of these
could be imported from China instead), it seems that the EU is just as dependent on Russia as Russia is on the
EU.
Moreover, Russia can turn towards the east. China’s worsening pollution problem may result in a mega energy
deal between the two countries signed in the near future, as China is actively seeking to reduce coal use in favor
of cleaner burning natural gas.

4. Expanded oil and natural gas supplies (via shipped LNG) to India are also being discussed at present, and
although Japan talks a bit tougher (presumably with some US prompting), at the end of the day the country is
highly energy import dependent too, as is South Korea, and both of these countries have been seeking to
expand energy imports from Russia as well.
In this regard you may also want to see our recently published article in the Hong Kong Standard (as separately
attached to this email) and a Bloomberg interview on the topic of our chief economist.
In summary, while risks are clearly present and volatility of the Russian stock market tends to be high especially
given the ongoing geo-political uncertainties, taking all factors into account we maintain our positive outlook on
the market and recommend a degree of exposure as part of a diversified portfolio for medium to long term
investors.
Regards
The Investment Committee
The Henley Group
28 April 2014