Author: Kim Iskyan

Casual readers of the business press over the past year could be forgiven for thinking there  is only one major company in Russia. The long-running soap opera of the so-called Yukos affair has so dominated headlines that it has virtually eclipsed all other news. But there’s actually been a lot more to Russia recently than Mikhail Khodorkovsky and Co.As with much of Russia, the signals are confus-ingly contradictory and paint the pic-ture of an economy that is, on the one hand, expanding robustly and, on the other hand, crippled by capital flight and seismic shudders in the banking sector.
Developments on the macroeconom-ic front continue to be resoundingly upbeat. After expanding by 7.3% in 2003—its fifth consecutive year of post-ing growth above 4.5%—the Russian economy is on pace to grow by at least 6% in 2004. Most estimates suggest that Russian GDP will grow by at least 5% a year through 2010. Industrial produc-tion grew by 7% last year and is on tar-get to grow almost as much in 2004. In-flation is falling, from 12% last year, and will likely fall below 10% in 2004. For-eign reserves, at around $90 billion, have increased more than eight-fold since 1999. Russia has a current account bal-ance of around 11% of GDP and had a positive trade balance of some $60 bil-lion in 2003. The Ministry of Finance reported a budget surplus equivalent to 3.4% of GDP for the first half of 2004.
Russia has strong commodities prices to thank for much of its prosperity: Roughly three-quarters of the country’s exports are composed of fuel (oil and gas) and metals. But there’s more to Russia’s growth than oil. Growth in consumer demand and capital spending remains strong, with retail turnover jumping 11% and fixed investment growing 13% over the first five months of 2004, according to Russian govern-ment statistics agency Goskomstat. The nominal average dollar wage per month, according to Moscow-based investment bank Renaissance Capital, leapt from $85 in 1999 to $227 in June this year.
Meanwhile, Russian President Vladimir Putin is using some of his sub-stantial political capital to push through a series of reforms that strip away large segments of the system of social benefits that are a carryover from the Soviet era, in favor of a more transparent and mar-ket-oriented approach. Other elements of the broad Putin reform program,such as administrative reform, power-sector reform and long-anticipated changes to the shareholding structure of govern-ment gas giant Gazprom, are moving forward, albeit slowly.

Storing Up Problems

But there are deep fissures in Russia’s seemingly sturdy macroeconomic façade. Perhaps most concerning is capital flight, which threatens to undermine Putin’s key achievements of stability and eco-nomic growth.Alexei Moisseev,an econ-omist at Renaissance Capital, argues that Russian authorities are in effect encour-aging capital flight. “What the Russian authorities are doing is really quite coun-terproductive,” says Moisseev. “They’re shooting themselves in the foot and po-tentially laying the groundwork for prob-lems further down the road.”
Confidence in domestic investment has been seriously eroded by the Yukos affair, while the Central Bank of Russia’s contradictory aims of a weak ruble and low inflation are resulting in capital leav-ing the country.After an outflow of $3.9 billion in the first half of 2003, Moisseev estimates that $10.1 billion fled the coun-try over the same period in 2004.That’s a lot of money for a country that experi-enced foreign direct investment of just $1.1 billion in 2003.
The figures carry echoes of previ-ous crises. One of the hallmarks of Russia’s financial crisis in 1998 was sunny optimism on the part of for-eign investors at a time when locals were running for the exits. Recent evidence suggests that foreigners again aren’t as concerned about deterioration in the Russian investment environment as do-mestic Russian investors.Within the past few months, a few high-profile purchas-es—by Heineken of two Russian brew-eries, by European tobacco firm Altadis of a local cigarette maker and by BNP Paribas of Russia Standard Bank, for ex-ample—indicate that many foreign in-vestors consider Russia an attractive in-vestment destination. Perhaps most significantly, US oil major Cono-coPhillips is seeking to buy up to a 25% stake in LUKoil, Russia’s second-largest oil producer. Meanwhile, although Russian shares are down 25% from early April 2004 all-time highs, they’re still up 8% over the past year—and up more than 15-fold since all-time lows in late 1998. Unfortunately, there may be little room for upside, since, excluding key under-performers Yukos and Sibneft, the Russ-ian market is near all-time highs. And “valuations of the rest of the oils,” which comprise roughly two-thirds of total market capitalization, “are far from screaming buys on either a historical or comparative basis,” says Caius Rapanu, senior analyst at Nikoil investment bank. “Should LUKoil be valued close to the same EV/EBITDA level as the superma-jors? I don’t think so,” he adds.

Banking Sector Remains Fragile

Russia’s banking sector has also re-cently been under fire. Over the summer it was clearly exposed as one of the economy’s weakest links during the most serious banking crisis since the August 1998 implosion of Russia’s currency, bond market and banking sector. This time around, a severe case of the jitters in the banking sector began when the Central Bank of Russia revoked the li-cense of SodBiznesBank, a politically well-connected institution, amidst accu-sations of money laundering. A few weeks later, CreditTrust, a bank linked to SodBiznesBank, announced that it was entering voluntary liquidation following large deposit withdrawals. With inter-bank interest rates spiking and retail de-positors rushing to withdraw their de-posits as fears spread of a broad sector meltdown—fueled by rumors of a gov-ernment “black list” of targeted financial institutions—the banking sector looked to be heading into a vicious spiral.
The crisis was tamed in mid-July— but only after claiming another victim, Guta Bank, the Russian banking system’s 22nd-largest institution, which was tak-en over by state-controlled Vneshtorg-bank. In a bid to boost liquidity, the cen-tral bank reduced banks’ mandatory reserve to 3.5%, and the lower house of parliament hastily passed an interim de-posit insurance law that covered banks that were not yet accepted into the full deposit insurance scheme. Also, state savings bank Sberbank was encouraged to use its massive pools of liquidity to support the inter-bank system. Massive depositor outflows eased, and confidence in the stability of the sector slowly began to return. “Things were really touch-and-go for a while,”says one Lon-don-based Russia analyst who asked not to be named.“If the central bank had waited any longer to plug the dike, we could have had a seri-ous systemic problem on our hands.”

The short-term fallout of the crisis was less severe than anticipated,with retail de-posit withdrawals lower than initially forecasted. “Private depositors are gener-ally displaying remarkable resistance to the media hysteria—which is positive and the best indication that people are keep-ing their faith in financial institutions,”re-ported Moscow brokerage Troika Dialog. In the meantime, foreign banks with re-tail operations in Russia and Sberbank, which is supported by a long-standing state guarantee, are the most likely flight-to-quality beneficiaries of the crisis.
Russia’s most recent banking crisis may help improve overall levels of stabil-ity and transparency in the sector.“In the end … the crisis will aid the government in its quest to make Russian banks more competitive,” remarked intelligence provider it may accel-erate the process of implementing a wide-ranging—and long-delayed—re-form program focused on enabling con-solidation, improving corporate gover-nance, bringing capital adequacy in line with Basle requirements and improving transparency. But, as ever, the risk re-mains that implementation will fall far short of good intentions—and in the meantime, Russians have anywhere from $20 billion to $50 billion or more in “mattress money,” a potentially huge source of investment and growth going forward.

A final wildcard for Russia, of course, is the specter of terrorism. But the recent hostage-taking in southern Russia—re-sulting in the death of hundreds of schoolchildren, their parents and teach-ers—barely moved Russian markets.“In-vestors in Russia have thick skins,” says Rapanu. Barring the assassination of Vladimir Putin, or an attack of similar gravity, terrorism is unlikely to signifi-cantly rattle investors in Russia.
In the meantime, Russia remains a market rife with paradoxes—of vast op-portunity, but with large downside for those not nimble enough to navigate its minefields.