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Boom and gloom

The Russian economy may appear messy but Ben Aris asks whether the future really as bleak as it seems.
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At first glance, this looks like the worst time to invest into Russia. Reforms have stalled because of political

in-fighting among the ruling cadre, investors are jumpy because of the turmoil surrounding the fate of embattled oil company Yukos, and the banking sector has just emerged from a mini-crisis that threatened to bring Russia’s financial edifice down for a second time in six years.

But behind these banner headlines, investment continues. Portfolio investors may be getting cold feet, but foreign direct investment is pouring into Russia and the economy is roaring ahead. Over the first half of this year, growth in hard currency reserves, fixed investments and direct investment all set new record highs. The government upped its GDP growth estimate to 7.1% for this year and says that it will probably go even higher. More importantly, the rate of growth of non-energy sectors has overtaken the traditional raw material producers as the economy begins to diversify and is increasingly driven by booming consumption.

Investment and growth

Russia just put in one of its best quarters on record. Foreign inflows were up 50% to a record $19bn, which includes $13.6bn of general loans and $1.6bn of trade loans. And the hard-to-get foreign direct investment was up by one-third to a record $8.7bn, smashing Prime Minister Mikhail Fradkov’s full-year estimate of $8bn.

Russia’s growth is due mainly to oil prices hovering around a record $50 a barrel, while strong demand from countries such as China have also made other commodity prices surge. Raw material production still accounts for 70% of national production and attracts three-quarters of invested capital, according to the Economic Development and Trade ministry, but the non-extraction industries are already taking over as the economic engine for growth: all five of the core industrial sectors grew strongly in the first half of this year with machine building leading the way, up 14.2%, while raw material production was up 6.8%.

The rising tide of petrodollars is the cause for the sparkling macroeconomic performance and, with money supply rising by two-fifths a year, banks have plenty of cash. Lending has grown strongly in the past few years on the back of negative real interest rates. However, a mini-banking crisis that peaked in July (see box on page 70) has put a temporary brake on the increases.

The crisis began with the closure of Sodbiznesbank in May, a relatively small bank that accounted for only 0.3% of Russia’s banking assets. But with the memory of the 1998 financial crisis still fresh in depositors’ minds the first post-crisis closure sparked a nasty bout of insecurity that threatened to turn into a full-scale meltdown. The crisis hit its peak in July when depositors started withdrawing money from Alfa Bank, Russia’s largest commercial bank.

Ed Parker, lead Russian analyst for ratings agency Fitch, says: “The banking crisis was triggered by implementation of tighter regulation of the banking sector, which was welcome. However, it also revealed the general level of distrust in the banks. In the current climate, it didn’t take much to start runs on deposits.”

But the Central Bank of Russia’s (CBR) quick reactions staved off a meltdown. The CBR pumped $2.4bn into the sector, the Duma rushed through the long-awaited deposit insurance scheme legislation and calm was restored by the third week of July.

Banks were already under pressure thanks to a rise in capital flight (see chart, left) caused by the Kremlin’s assault on Yukos and only precipitated by Sodbiznesbank’s closure.

After haemorrhaging between $1bn and $2bn a month for most of the past 14 years, Russian money began to return home last year when the CBR reported a net capital inflow of $3.8bn for the first time since the fall of the Soviet Union.

The finance ministry was expecting a net inflow of between $3bn and $4bn for this year, but the bank sent over $8bn over the first six months of this year, according to investment bank Aton. The curious thing is that while foreigners are investing in Russia, Russians are sending their money overseas. Russians buying $6.6bn-worth of dollars as a hedge against a strengthening dollar are offsetting the inflows. Likewise, companies spent an estimated $19bn on foreign securities, salting away a little something in case the Yukos affair spread to other companies.

The CBR has revised its estimates and says capital flight will rise to between $6bn and $8.5bn this year, but many economists say this much money has already left and expect the end-of-year number to be much higher. However, because of the strong macroeconomic performance, most agree that the return of capital flight is temporary. It’s not yet clear how the overall flow position will look at the end of the year.

“We are going through a transition period,” says Anton Khmelnitsky, head of equities for Brunswick Asset Management. “There is a pick up of capital flight because of the general nervousness, but the overall structure to provide long-term growth is in place. That is why people are investing.”

Instability

Russia should be enjoying a phenomenal boom. As with the 1996 re-election of Boris Yeltsin, investors have been encouraged by the improving macroeconomic picture (except, this time round, the economy is clearly on a path of strong and sustained growth) and were only waiting for the political risk of presidential elections to pass.

However, the comparison of FDI and capital flight (see chart on page 68) appears chaotic. FDI took off at the end of last year only to plunge after the arrest of Yukos’ former CEO Mikhail Khodorkovsky and then resumed soaring after investors were convinced by Kremlin rhetoric that the attack on Yukos would not be extended to other companies.

Capital flight was reducing steadily until the Yukos affair began with the arrest of Yukos shareholder Platon Lebedev last summer. Russian businessmen are clearly more sensitive to political turmoil and capital flight has bounced around widely since, roughly following the twists and turns of the Yukos story.

The return of capital flight could be permanent if Russia changes course and Russian businessmen – unlike the foreign investors – think a change of course is a real possibility.

Instability, Russian-style, doesn’t mean President Vladimir Putin is in danger of being ousted (he remains wildly popular) nor is his hold on the reins of power going to be shaken, but he is facing stiffer resistance from his political opponents and increased bickering among his deputies. Yukos’ Mr Khodorkovsky’s stand against the Kremlin from his prison cell in Matrosskaya Tishina prison is the most obvious example of a creeping malaise that has infected the government.

“The key reforms have stalled,” says Chris Weafer, head of strategy at Alfa Bank. “The cabinet appear divided over what needs to be done, which means they are doing nothing. [Economic development and trade minister German] Gref and [finance minister Alexei] Kudrin are agitating to get on with reforms but Mr Fradkov is saying no.”

The conflict broke out into the open during an August cabinet meeting to set next year’s budget parameters. Mr Gref said that Russia was unlikely to put in the 7%-plus growth the economy needs to hit President Putin’s doubling of GDP by the 2010 target, and Mr Fradkov simply told him to change the numbers. Tempers frayed. Mr Kudrin said that the government has “screwed up” reforms to the energy sector and Mr Fradkov threatened to have both ministers sacked. President Putin had to “consult” with the prime minister before Mr Gref’s more realistic numbers were adopted as the official goal next year.

Benefits cancelled out

Both Mr Gref and Mr Kudrin believe that the negative impact of the banking crisis and a sharp increase in capital flight have cancelled out the benefits of $50 a barrel of oil, which Mr Fradkov says justifies a 7.5% GDP forecast for next year (the minimum rate needed to see the economy double by the end of the decade). The pessimism was born out by unexpectedly poor fixed investment figures for July. Although fixed investment was still up 10.7% in July, year-on-year this was the smallest increase since 2002, due to a dramatic fall in construction growth, which is heavily dependant on bank credits.

The liberals won this round and Russia’s budget will now officially predict 6.0-6.5% growth for next year, but war continues. The infighting between the traditional Kremlin fractions – the Family (well connected oligarchs), liberals (lead by Mr Gref) and Siloviki (former KGB generals) – has ended in a complete rout by the Siloviki, who are increasingly interfering in economic policy and starting to worry investors.

“The Siloviki has defeated the Family and now is turning its attention to the reformers,” says Mr Weafer. “This fight calls into question Mr Putin’s ability to drive the process forward and the loyalty he can command from the Siloviki. He has said clearly that he wants to move out from under the security of the ‘oil blanket’, but there are plenty of people that only see the huge amounts of money flowing into the country [because of oil] and want to enjoy the good times.”

Yukos and Bank crisis chronology

Wed July 2 Platon Lebedev, the director of Group Menatep, the majority shareholder in the Yukos oil major, arrested.

Sat Oct 25 Mikhail Khodorkovsky arrested.

Wed May 12 Sodbiznesbank was stripped of its general Central Bank license for violations of money laundering law.

Thurs June 3 Kredittrust liquidates itself, appointing a liquidation commission and ceasing payments to clients.

Monday June 14 CBR cuts Fund of Obligatory Reserves (FOR) rate, from 9% to 7%, as well as the refinancing rate, from 14% to 13%, signalling an easing of monetary policy.

Monday June 21 NAUFOR, the National Association of Stock Market Professional Participants, suspended its rating for Bank Paveletsky, citing numerous complaints from counteragents as well as payment delays; the Central Bank declared a moratorium on all operations with Paveletsky, which stopped paying out cash and private deposits and did not pay shareholders Rbs3m in dividends due for 2003. Subsequently bank management asked the Central Bank to institute external management.

Monday June 21 Commercial Savings Bank (Kommerchesky Bank Sberezhenii) suspended operations, citing problems with liquidity due to “the general banking system crisis”; at the same time, 95% of bank personnel were let go as part of a staff reduction.

Monday June 21 Promeksimbank is having problems with payments to clients and, according to media reports has virtually ceased to exist, having to let go 80% of its staff.

Tue June 22 Dialog Optim Bank restricted cash payments to Rbs10,000 per recipient due to liquidity problems. NAUFOR has suspended its rating of the bank.

Wed June 23 The Central Bank revoked Kredittrust licence for “improper accounting procedures and breach of banking laws”.

Thurs June 24 The Moscow Arbitration Court ordered Sodbiznesbank’s liquidation.

Monday June 28 Novocherkassk City Bank was stripped of its central bank licence for violations of money laundering law and failure to make payments.

Thurs July 1 Guta-Bank fails to honour some Interbank payments.

Friday July 2 Dialog Optim Bank board chairman Alexander Polyakov said the bank had sold all its liquid assets and feared its licence would be revoked by the Central Bank.

Tue July 6 Guta-Bank, ranked number 22 in Russia by assets, was unable to meet its payments, including payments on personal accounts, and closes its doors.

Wed July 7 Peak of crisis as runs on deposits at Alfa bank start.

Wed July 7 CBR cuts obligatory reserve rates again to 3.5% injecting at least $3bn into the banking system which has total banking assets of about $190bn.

Sat July 10 Duma rushes through the deposit insurance legislation, passing all three readings in a single extraordinary session.

Monday July 12 CBR lends Vneshtorgbank (VTB) $700m credit to buy out credit portfolios of smaller banks as way of targeting cash injections to help struggling small banks.

Fri July 16 VTB buys Guta-Bank for nominal $34,000.

Monday July 19 Moody’s sounds the all clear as confidence returns and crisis recedes.

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Read more about:  Central & Eastern Europe , Russia