- The transitional nature of Russia’s economy from centralization to a market economy means that it has dealt with the global financial crisis relatively ineffectively
- High dependence on commodity and energy exports is a strength as much as a weakness
- Diversification of the economy is desirable, but to be effective requires fundamental reforms
- The banking system is still in serious need of reform and faces formidable problems with bad loans
- Russia’s relations with domestic and foreign investors are still an area of uncertainty
- Capital markets are woefully underdeveloped and need the underpinnings of fundamental reform and reconstruction of the financial system
Delegate biographies: Learn more about the panelists
It is clear that Russia has not fared as well as similar economies during this crisis. Let’s explore some of the knee-jerk answers that are given to explain this. These include the notions that Russia’s policy response to the crisis has been weak; Russia is a one-trick commodities pony; there is a lack of transparency in policymaking and execution, particularly with regard to oligarchs’ assets; there is insufficient action in the banking sector; there is a failure to respect the rule of law and investors’ rights; and a lack of market mechanisms to transmit money and information throughout the economy. First, do you agree that Russia is lagging badly and that policy response has been weak?
WB, VTB Capital
Yes. If you just look at the Bric four [Brazil, Russia, India and China], Russia is the worst performing of them. Yet, it should not be. Within six weeks of the global financial collapse reaching China, the Chinese turned around an economy that is a lot bigger than the Russian economy. Within the fourth quarter of 2008, China fell very sharply and then recovered just as fast, and had relatively strong growth by the end of that quarter. Even in India, where the government is effectively bankrupt, they still managed to generate 3% to 4% GDP growth. Russia should be in a much stronger position because it is largely industrialized and urbanized, but the concentration of wealth in the hands of the oligarchs has meant that there has been reduced external focus. But there are opportunities: it is about capital allocation, the focused use of capital that you can generate from being a one-trick pony. And that focus has been lacking in Russia.
The issue with Russia is that unfortunately it is still in transition. It has largely moved away from the centralized model of 20 years ago but we have not yet completed the transition to policy implementation based on strong institutions. So it is stuck in the middle, and sometimes when at the top policymakers move a lever, for example fiscal stimulus, they are never quite certain what happens in the end. In China, the decision-making and implementation is still highly centralized and it is easier, for example, to ramp up infrastructure spending to support the economy as it is easier to prevent money from being wasted.
It is also important to note that Russia before the crisis was growing above its capacity. Large current and capital account inflows were not fully sterilized and have led to overheating, mostly consumption-driven growth. As domestic consumption could not be met with domestic production, imports increased rapidly and inflation began to creep up. In this regard, in my view, Russia liberalized its current account prematurely, before it was ready to implement a fully flexible exchange rate regime. I believe that exiting the de facto fixed exchange rate regime during the crisis amplified the shock to the economy. For example, Brazil also suffered from large external shocks, a combination of terms-of-trade shock and a sudden freeze on capital flows, but its flexible exchange rate regime allowed it to adjust with fewer disruptions to the real sector. The Russian central bank was forced to choose a new nominal level of the exchange rate during the crisis and to tighten domestic monetary policy to defend it. As a result the real economy suffered from almost two quarters of tight monetary policy, while other countries could afford to start monetary easing to cushion the adjustment. In the case of Russia the combination of overheating growth before the crisis and the exchange rate defence, in my view, explains why it contracted the most among the Bric countries.
Elina, in terms of credibility, where would you say that the government ranks in terms of dealing with the crisis?
There are two issues. One is credibility and the other is quality and speed of the policy response. In terms of credibility, I think Russia has done well. Having chosen the new level of the nominal currency boundary, the central bank tightened monetary policy to defend it, even if it meant sharper contraction of the real economy. At the same time the central bank provided enough liquidity to support the banking system through an exceptional liquidity shock.
In terms of quality the jury is still out. If you look at any financial crisis, you have three stages. The first is liquidity, the second one is solvency and the third is working out corporates’ balance sheets, together with banks’ balance sheets. Here, at the time of the publication, we would have passed the first stage, but likely have only started on the second stage.
II, VTB Capital
You have to make really sure that your monetary policy is aligned with what the economy needs. What did the Chinese do? They made sure that the capital that they provided went to the economy. It did not stay at banks.
The policy should really address the fact that credit should go lower, so that it is pro-cyclical. The problem is we are still living with double-digit inflation. It is impossible to start doing anything unless this problem is addressed. The ultimate answer is to provide capital independent of the capital flow. Yes, in that case you will probably have some shocks but now we have a money supply that is too tight for an economy of the size of Russia. It is only 30% of our GDP – no country in the G20 has such a low ratio.
So let’s start with the criticism that Russia is a one-trick pony. Is it? And does it matter if it is?
WB, VTB Capital
Well, commodities are 87% of exports, or were last year. So, yes, Russia is a commodity-linked economy, with oil and gas as its two key commodities. Looking at comparisons with the 1998/99 trough, the drivers for commodity prices were very different from now. From 1970 to 2003, commodity markets were driven by cyclical factors that were essentially consumption-linked; 1970 was effectively the end of the expansion of Europe and Japan after the Second World War, which had been a secular period when demand was driven by very different factors, namely industrialization and urbanization. From 2003, we have returned to secular drivers again with China, of course, as the key. However, it’s not just China, this encompasses the whole of the emerging market world. The difference here is that in the 1950s and 1960s there were about 250 million or 300 million people going through the urbanization and industrialization process. Now we are talking about a population base of 3.5 billion people and China is a third of that alone. So the trends are much stronger; they are much greater; they are much faster.
The other major difference is that supply was not an important factor before but this time around it is critical. We have seen 35 years of underinvestment in the supply side of all commodities. We have a very limited pipeline of major new projects. Environmental concerns are now becoming predominant and are crucial in driving costs, even in developments in frontier areas. Fifteen years ago, you could get an environmental licence for a new project within six to 12 months in most countries. Today, even in Brazil and Mongolia it can take three to five years, hence new projects take, on average, 12 to 15 years from discovery to full-scale production. So it is very likely that we will have supply squeezes in a number of commodities in the future, and the winners should be countries like Russia where these operating constraints are not as onerous.
So while I am sure that the one-trick pony analogy is not something that the government is necessarily comfortable with, it is an inevitable consequence of a number of global trends that are going to become more intense over the next five to 10 years and will in fact be very positive for Russia. I suspect that whatever diversification opportunities materialize, they will still largely be driven by the capital that comes from what I believe will be another very positive period in commodity prices. What we have seen in the past five years could well just be a precursor to an even greater boom in commodities in the next five to 10 years.
AY, VTB Capital
If you track the evolution of government thinking since the 1990 crisis, yes, the rhetoric is still that Russia should diversify. And so domestic consumption and infrastructure investment became economic priorities. But if you look at what Putin did, especially in the second term, he focused on what he was really doing as opposed to saying, on making Russia an energy superpower. And that is not just rhetoric; that is ultimately driven by understanding that you always look at where you are most competitive, and energy and commodity is where Russia is most competitive. Then you decide for yourself if that is something that is going to be in big demand for many more decades, because you are a big nation with a shrinking population.
Those are the kinds of challenges that the government has in mind when formulating long-term policy plans. Diversifying is fine. Using state capital to build other sectors of the economy, be it hi-tech, the aviation industry or defence, is fine. But ultimately you focus on your strengths and your competitors. For example, in the gas market there is the tension between the present customers in Europe and the longer-term market that is China; then there is competition from LNG – like in Australia – and cheap gas from Iran. That is the kind of thinking, that is the kind of evolution that the government, in terms of policymaking, went through in 1998 and 2008, so I think they understand very well the cyclical trend. That is the ultimate priority.
I do not think there is anything wrong with being a one-trick pony. I think the issue is being realistic. Dreams of developing hi-tech and other glamorous sectors quickly are not realistic. We have to focus on more achievable, smaller targets and the one thing that we can achieve is not importing everything that we consume.
That means attracting foreign direct investment; without that it will be hard for Russia to produce more domestically. But the FDI we’ve seen comes in for a very narrow part of the value chain. We import parts, we assemble them here, then sell them domestically. So you have to create also a sense at the regional level or the central level for the supply chain to be created for these companies.
A further complexity of Russia is fiscal federalism and this profoundly affects the country’s overall business friendliness. What incentive does a region have to be business friendly? Very little, because if you are business friendly and you attract a company, then you collect corporate income tax, you contribute it to the headquarters and that is it. If you do nothing, then you get a transfer from the centre. Through the good times maybe 10 or 15 have been profitable out of the regions. The rest just collect from the centre so they do not have any incentive to be business friendly.
Yes. Look at countries like Canada or Australia; they do perfectly well exporting resources. The question for Russia is how to do it as well as they do. One answer is to be less statist. Too much effort has been made to try to make champions of failed state industries. This does not work. Another answer is to ensure that the money created in the national resources sector finds its way into other parts of the economy. Traditionally, that transmission happens through banks, especially commercial banks. Here, Russia still has some way to go. Commercial banks right now pretend to be in good shape but they are not. Banks need recapitalization and a clean-out of their portfolios. That is a very big task that is ahead of the sector and of the economy as a whole.
II, VTB Capital
I think one can argue that Russia is not just a one-trick pony. The government is trying to encourage investment in other sectors. For example, Russia needs to secure a stable and growing agricultural industry that produces wheat, meat – anything that we now import both from the near abroad and from countries such as the US. And the government understands that and invests in that. Another sector that I would be really optimistic about at this stage is the power sector. Despite all its problems, Russia will have shortages in power again, so we definitely see opportunities there. We will definitely see both government participation and private sector investment there.
Surely two years ago there was talk of billions of dollars of investment in infrastructure. What is happening in that sector?
AY, VTB Capital
The answer is that not a lot has been executed and there was lots of ambition that has never even been properly documented. The key things will be done, such as the Olympics, but the rest is a long way off.
The banking sector
One of the key events of 1998 was the destruction of parts of the Russian banking sector. Will we see a repeat?
DD, VTB Capital
Unlike 1998, today the real economy and the Russian banking sector are much more dependent on each other. In 1998, we had a crisis of state finances, and the banks suffered because of their relationships with the state. This time, the crisis started with the banks, spread to the real economy and is now coming back to the banks again in the form of deterioration in the asset pool.
I still see little chance of real improvement in the banking sector or in terms of the asset pool. While there is no demand, either external or domestic, for all this capacity being built, a lot of assets will not be profitable – sooner or later, the banks or the state will have to deal with attempts to get recovery from these assets.
II, VTB Capital
Unfortunately, our central bank is trying to juggle too many things. They ignore, somewhat, the impossible trinity principle, which argues that in the presence of free capital mobility, you have to choose between the fixed exchange rate and monetary policy. Credit expansion is usually pro-cyclical. A benign business cycle in the global economy creates good credit conditions for Russian borrowers. However, as the cycle turns, monetary policy gets too tight for the prevailing conditions. Our credit is now prohibitively expensive. We have to let the rouble fluctuate naturally to address this. It would also help Russia to become a financial centre and for the rouble to become a regional reserve currency.
Consumption was one of the really big drivers of the Russian economy throughout 2002-07. It will have a significant influence on the outcome of this crisis. So far consumption has been quite robust and the government has been proactively addressing this issue in its policy. We have also managed to avoid the social implications of economic stress and the political situation has remained stable (unlike in 1998). There is almost no sign of social unrest in Moscow or elsewhere in Russia, despite the gloomy numbers of significant GDP decline in the first quarter. So we are definitely not in 1998 even though we may see a deeper contraction and need to take tough policy decisions to smooth the cycle and escape the emerging market stance.
The chance for banking reform was lost in 1998 and there has still not been much improvement. Will this crisis force the industry to consolidate and become more efficient?
DD, VTB Capital
My view is that the number of banks is not the central problem. The problem is transparency. Having a large number of small, very vulnerable entities undermines trust in the whole banking sector. Consolidation is needed and the central bank is trying to stimulate it. On the other hand, though, it is something of a political issue. What I think is possible is to identify the healthy part of the banking sector and focus on that while creating a regulatory environment that gets rid of the undercapitalized institutions.
AY, VTB Capital
The ultimate reason the banking sector is what it is is because pretty much nobody needed it. Every decent Russian corporate – and Russia is a country of big corporates, because you cannot be a smaller company if you own a significant proportion of global oil demand – can borrow at better rates than the banks. Now, if your largest banks can barely borrow at the same rate as your largest corporates, your largest banks are doomed to be lending to second-tier corporates.
Oleg, as part of a banking group at Ernst & Young, what do you see as the key issues facing the financial services industry right now?
OY, Ernst & Young
I would support Dmitry’s position that the central bank is very cautious about what it is doing.
What was needed for the banking system at the end of 2008 was liquidity and the central bank is succeeding in providing liquidity. How much of that liquidity will be paid back to the central bank is a question. On the other hand, there was no panic in the markets. At least the lending did not stop.
The next question will be what is going to happen this autumn in the banking sector?
If you look at the share of non-performing loans: at the beginning of 2008 it was about 3% of total loans and the expectation is that it will grow to 10%. So you can imagine that there is going to be a huge impact on the whole banking system; the banking system will require a substantial recapitalization.
With regards to consolidation in the banking sector, clearly it will go on. There are the first signs of that trend: two large private banks being about to merge – MDM and Ursa. However, the number of small banks will not drop significantly because they serve the particular needs of industrial groups.
Another very important question is how the banks are going to deal with NPLs. If they simply demand collateral enhancement, we will see a real shock to the whole economy.
That’s important. The bad debt crisis we face is something that no one in this market has ever faced before, including 1998. Nobody has any experience of how we are going to deal with this and, as you rightly say, if they do the wrong thing, if they try just to dump real estate, for example, on to the market at any price, that will send shock waves through the market.
So banks have to learn, and learn fast, how to work with bad debt and how to restructure it. Right now, what they call restructuring is simply a prolongation, that is, an extension of the loan often with a lower interest rate. They have to come up with something more sophisticated and that will be the key challenge.
DD, VTB Capital
But there is a prize to be won if the banks come out of the crisis. There is a big opportunity for Russian banks in the wider region. Do not forget that Sberbank is the largest bank in the region and it ranks in the top 40 banks globally.
The rule of law
Do you think we are getting enough clarity from the Russian government in terms of how it feels towards seizing assets and protecting the rights of foreign creditors?
AY, VTB Capital
I think the government will protect some of the biggest strategic states and what they perceive that they have rescued. The notion that they are rescuing the excessively leveraged oligarchs, who did not manage their wealth properly, in my view is completely incorrect. They are not just giving loans, they are taking collateral and ultimately, if these people are not able to fund themselves, then the taxpayer, or the Russian sovereign, is always protected and can take the asset.
Clearly it is a tricky process. It will never be 100% transparent, but ultimately, you are not going to end up throwing away billions of dollars of government money and having this or that oligarch with exactly the same economic exposure and economic asset that he or she used to have before the crash. And that is hugely important. Rescues are taking place but on terms that are reasonably acceptable, for the Russian taxpayer and the Russian state, and that ensures the new cycle of loyalty and commitment in the current political agenda.
And it is not only the government. It is probably the corporates themselves that are changing rapidly. I see more and more, for example, not only expatriates working in these corporates but also more and more western-educated Russians, people who not only talk the talk but actually know what is behind it and are gradually trying to implement that. I find it good that there is not so much easy money floating around these days as there used to be, because it means that you have to do serious business to make money, not just to make a few bets here and there and do a few back-room dealings. So by and large, that is very good.
Really? Surely one issue is that we have moved beyond ability to pay to unwillingness to pay. Defaults are the new fashion in the Russian rouble market and so corporates are creating a big credibility problem.
AY, VTB Capital
Yes, true. But the reason is that in the short run they are using the inefficiency of Russian bankruptcy regulations to their advantage. Say you are a big foreign-debt investor, say there is a pool of big foreign-debt investors and there is a big Russian national champion. You have two options: you either restructure or you gear up for years, getting a little piece of what’s left. The ultimate reason you are more likely to use restructuring in Russia is because you realize the inefficiencies of the Russian banking and bankruptcy process. And the government knows that as well. On the one hand the government has used this to persuade some of the big foreign debt players to negotiate and be nice to some of the big Russian corporates. On the other hand, they realize that that is really probably not the way to do it in the long term.
With regard to the TNK/BP issue, that was seen as part of the new corporate cold war. Would you feel that once the dust has settled people will realize that it is effectively an inter-company dispute and not Russia versus the west, as it is built up to be in some quarters?
WB, VTB Capital
I think they will. If you look back, there were criticisms of BP management at that time but that has now changed as well. BP is a different company with a different culture today, a better culture that perhaps is more typical of many of the so-called supermajor resource companies. So I suspect that the willingness to lend and the willingness to invest is probably going to come back in a different, more sustainable way and, as you say, on a partnership basis rather than on the previous basis of ‘Let’s go in there because we’ve got the capital and we can make it work for us’, which is what big, multinational resource companies have tended to do in the past. Those that have been successful are the ones that have changed and adapted their strategies and their interaction with governments and local people and recognized the need to share for the common good.
Better market mechanisms
Finally, isn’t it clear that Russia needs to develop much better market mechanisms for transmitting capital through the system domestically as well as taking steps to become a regional or even global financial centre? What do they need for this to happen?
Well, two fundamentals are necessary to become a regional or global financial centre.
First, political stability and Russia has had that, especially over the past 10 to 12 years. Second, Russia needs a strong economy. And to do this it needs to diversify. If Russia continues to depend mainly on high oil and gas prices to drive the economy, then the prospects of Russia becoming an important regional financial centre are not bright. Many have argued that the days of very high oil and gas prices are over, at least in the near future. Thus this crisis should drive home the point to Russian policymakers that more resources should be allocated to develop other sectors of the economy. Some here, like Ivan, have argued that the power and agricultural sectors need more investments, and in hi-tech industries as well.
To create a Russian financial centre, you need an investor base. Has the government done enough to create markets and institutions to allow this to happen?
EL, Pioneer Investments
The oil-driven affluence of 2004-08 did not do good to the Russian financial markets. On the state level, the significance of borrowing became minuscule. Russia stopped the placement of external debt, and development of RUR bonds was regarded as a secondary issue. And the country is paying the price for it now.
A financial centre is something to invest in and get investments from. To create a domestic investor, which from my point of view is the most important and yet the weakest point of the Russian financial system, government has to face three major challenges.
First, incentivize the population and institutional clients to invest in Russian markets, and the only way to do that is tax reform. Whatever you say, whatever you try to do, you can put one law from one regulation to another regulation, or you can ease it or you can be more precise in some procedures, but it will not help you at all.
You need to introduce a credible tax regime for pensions. You need to encourage the insurance segment to invest in the market. I don’t think that really our government supports this type of reform.
Second, create a liquid debt securities market, sovereign as well as corporate. In China, for example, the domestic debt securities market represents almost 60% of GDP, while the Russian is just 7% of GDP. The US market statistics are even more impressive – the domestic debt securities market is 173% of GDP.
Third, reform the legal base and judicial system to ensure minority and strategic investor rights protection, improvement of market infrastructure through the creation of centralized depository, replacement of paper documents flow by electronic, etc.
This is the minimum of what needs to be done. I am sure that we cannot talk about a healthy market – to say nothing of a financial centre – until we solve these tasks.
A number of different things affect investor perceptions of Russia, from the volatility of the markets to the lack of corporate governance and upholding of shareholder rights, to the dominance of just a handful of blue chips.
Just 5% of GDP is generated by SMEs in Russia; there are probably only three or four debt issuers that investors could buy into. For the rest, you have to do your credit research, you have to meet the company and you have to understand that your risk will be much higher.
I would like to draw your attention to the fact that there is one part of the investor market that has been very well protected – the banking deposit market. So far, every depositor has got his money back, even if the bank defaulted, and that is a huge achievement over what we saw in 1998 and 1992/93.
That should not be underestimated and, therefore, the trust in the Russian banking system of the population is not bad, considering where we were a couple of years ago and especially compared with western markets, where people used to trust the banks above everything and now they are asking questions. Here we have reached this crisis and people say: ‘Yes, this banking system can deal with the pressure’. So that is good.
However, the retail investor, the middle class and even the upper class are not the people you are going to see dealing in bonds and equities. We need institutional investors and a lot has to be done in regulation in order to increase the institutional investor base.
AY, VTB Capital
Russia does have a domestic investor base but it is oligarch money and this is broadly understood. The reason it is oligarch money is because that is how wealth is concentrated.
There are many more institutional funds in Europe, because those are strictly speaking socialist countries, where the government takes away a lot and you need to put the work into domestic savings to make sure that they work for the economy. We did not need that in Russia, because the bulk of wealth was concentrated in 10 or 15 areas. Now, just as in the US, that will change. It is a picture of the history of big US money in the second half of the 19th century. But it takes time.
Karl, on the regulatory side, what changes do you think could be done quite quickly that would have a big positive effect? In terms of public issues for example, would making it compulsory for any public issue of debt or equity domestically to report to International Financial Reporting Standards improve transparency in that sense?
KJ, Ernst & Young
There are a number of things that could be done but we are at a crossroads. If we do not get institutional reform, we will continue to suffer. We need tax reform, we need to incentivize the pension and insurance sectors. We need to encourage the use of international accounting standards.
We have been talking about it for a long time and, initially, it was just getting acceptance of these standards. Now it is the execution of them. So the conversations with the government are good but action is less easy. But if we can get some progress in these areas then it would build confidence and trust so that you could then build on the domestic savings market and then build some longer-term sustainability.
II, VTB Capital
To the point about the absence of a domestic pool of liquidity: it is really simple. Remember last year we saw deposit rates at about 6% or 7% and inflation at 13%? Would you be willing to invest in a country with negative real rates? I would not. If there is a decent real rate, you would be investing in it.