Putin's bailout bank needs a rescue

Some of the projects were concealed from public view with code names like "Lily of the Valley," according to Bloomberg.

VEB was hit by Western sanctions last year and has stopped new lending. The cost of its bailout could reach 1.3 trillion rubles ($18 billion), according to several senior government officials, ballooning the budget deficit at a time when plunging oil prices are forcing spending cuts.

"The government can’t just leave it alone to face the problems caused by the financial and economic situation in the country, speaking directly, by various kinds of sanction pressures," Prime Minister Dmitry Medvedev told a VEB Board meeting devoted to discussions of rescue options on December 22.

Over the past eight years, VEB came to epitomize Putin’s hybrid system that combined elements of market financing with tight Kremlin control, according to the report.

The Bank is said to have invested billions in industrial and infrastructure projects back in the days when oil prices were high and foreign credit was easy.

Read alsoKudrin may return to Putin government: mediaBut U.S. and EU sanctions imposed in 2014 over the Ukraine crisis cut off VEB’s access to international financial markets, leaving it without a source of cheap funding and facing as much as $16 billion in foreign-currency debt just as the ruble began its collapse.

At the same time, falling oil prices accelerated Russia’s slide into recession, pushing many of VEB’s projects deeper into the red, Bloomberg reports.

Putin earlier this month said many development agencies "have turned into garbage dumps for bad debts," in what officials said was a clear reference to VEB.

Losses on the bank’s huge catalog of Kremlin-mandated projects could reach 1.2 trillion rubles, according to the Finance Ministry, or nearly half the expected budget deficit for next year. VEB faces $7.3 billion in debt repayments over the next few years and effectively has only one source of significant funding  ̶  the state.

VEB got its start under Soviet founder Vladimir Lenin as a bank to finance foreign trade. Putin overhauled it in 2007. Flush with cash from high oil prices, he pumped 180 billion rubles (worth about $7.3 billion at the time) in to boost capital and took over as chairman of the board a year later.

Read alsoPutin earns low grades for managing Russia's economy"Putin believed when he set up the state corporation that it would become a development institution," like state-run lenders in Germany and Japan, Alexei Kudrin, who was finance minister at the time, said this month.

When the global financial crisis struck in 2008, VEB became Putin’s main tool for managing the shock. It got 1.25 trillion rubles (worth about $50 billion at the time) from the government and central bank to shore up the plunging stock market, help failing banks and bail out tycoons who were facing the loss of their companies to foreign creditors.

Thanks largely to the quick recovery in the oil price, Russia’s economy bounced back fast. Some of VEB’s bailout investments even paid off, boosting the bank’s profits. Foreign credit was plentiful and VEB’s implicit government backing made borrowing cheap. By the end of 2009, its balance sheet had more than tripled from before Putin’s overhaul began.

Standard & Poor’s gave it the highest ratings for any borrower in the country in 2011, saying VEB was "the de facto financial vehicle for the Russian federal government’s intervention in the economy."

Behind the facade of western-style accounting and international credit ratings, the bank’s decisions were often driven more by politics than business, officials now admit, according to the report.

"The bank, because of its status, took on certain tasks that can at times hurt its balance sheet," VEB chief Vladimir Dmitriev said December 22.

Read alsoPreliminary list of banned Russian products publishedFighting between Ukrainian forces and Russian-backed separatists in the region has damaged many of the plants VEB paid for. A senior Russian official said it’s not even clear whether VEB has any claims to the assets now because the transactions were conducted offshore, according to Bloomberg.

Now the government is considering scrapping VEB’s original hybrid model as part of the bailout. The already-stretched government budget will probably have to take on the huge losses of the "special projects," while a reorganized VEB would serve as an agency for dispensing what little state money remains for industrial ventures, officials said. Terms of the bailout could be decided as early as this week.

"With each passing year, VEB was used less as the government’s agent for development and more as an off-budget fund for the state to pay for its special projects," said Karen Vartapetov, analyst at Standard & Poor’s.

"These projects were effectively budget expenditures, only put off into the future," he added.

"That future has now come and the government will have to pay."