Such was Russia’s economic plight a year ago, it was feared that the country might be plunged into civil war. Now there is far more cause for optimism, says Elena Loginova of Deutsche Bank
Investing in Russia is definitely not for the faint-hearted. Everyone knows that emerging markets tend to be volatile, but what has happened in Russia over the past few years should be called ‘super-volatility’. The stock market index rose about 300% for the year from the presidential election in 1996 to its high between September and November 1997, the time of the first Asian crisis. It then dropped substantially, leaving less than one tenth of its value in the after-crisis of October 1998. But it proceeded to rise two to three times by July 1999.
Russia’s market development is illustrated in the RTS1-Interfax index chart below.
A year ago, many predicted the coming of apocalyptic times in Russia. Hyperinflation with three to four digit percentage points; the collapse of the Russian rouble; default on all country debt; severe contraction of the economy; the disappearance of the stockmarket due to renationalisation; hunger riots and even a civil war were predicted. Now, the macroeconomic situation looks much more optimistic. Industrial output for the second quarter of 1999 was up 5% on last year, and the trade surplus for the first five months of 1999 widened to $10.9bn, compared to a mere $300m in the first five months of 1998. Current forecasts for inflation in 1999 are about 50%. The nominal exchange rate has not changed significantly since the beginning of the year.
The single most important reason for the revival of the economy has been high oil prices. This has helped the government to increase tax collections, mainly from oil companies, and to avoid printing money. The positive trend in oil prices is likely to continue as a result of Opec’s decision to maintain its production quotas until March 2000. It will probably be rolled over in the future, although perhaps without such a high rate of compliance. As total devaluation since the last October crisis has outpaced inflation almost twice over, the ruble depreciated by about 50% in real terms. Real wages also dropped by almost 40%. Domestic manufacturers have benefited from the import substitution effect, as imports are no longer affordable for Russian consumers.
At the moment, Russian firms are priced very cheaply at a fraction of their historical highs, and perhaps even cheaper than in the time of privatisation. Although buying low and selling high is a recipe for prosperity, a light-headed mechanistic approach is not enough. Many other factors, together with the current stock price, should be considered in order to sell high in the future. The crucial factors are the liquidity of company shares, the company’s track record of dealing with minority shareholders, the overall style of corporate governance, oligarch influence and other political issues and, of course, the company’s economic performance.
In October 1997, investors had the choice of several hundred companies to invest in. Now, however, investors are limited to barely a dozen companies that can be considered as relatively liquid. An oligarch’s influence on a company should also be considered negatively. This influence can indicate a number of things, such as bad corporate governance, additional political risks or involvement of a company in doubtful deals such as transfer pricing, asset stripping and connected lending.
Over the last year, a number of programmes have been developed to ensure that minority rights are protected. One such initiative is Naufor’s (National Association of Securities Market Participants) Programme for the Protection of Shareholders. Naufor was set up in an attempt to change the corporate attitude towards minority stakeholders. The programme unites stockholders whose rights were violated by the policy of some companies.
After considering all the factors mentioned above, there are probably less than 10 companies left that are worth investing in. This can make it difficult for investors to diversify. Also, since the Russian stock market is extremely thin, with a daily turnover of approximately $10m, even the monetary inflow and outflow of relatively small investors can drive the market significantly up or down.
Forthcoming major political events, such as the Duma election in December 1999 and the presidential elections in the summer of 2000, create the greatest risk as well as the greatest opportunity. If Russia finally has a president and the Duma are not in dispute, and if the Russian government is able to move forward without obstacles from the Duma, then the prospect of faster and more successful economic reforms could bring the Russian stockmarket to a record high.
Russia is currently an incredible investment opportunity, due to its strong economic fundamentals created by the weakened Russian rouble and the high prices for oil and other natural resources. At the same time, investors should be aware of the political risks, due to the forthcoming elections.
With such a high level of market instability, selecting the right business partner is key. Deutsche Bank, which was granted a full custody services licence in 1998, has a reassuringly deep knowledge of Russia. The bank has had a presence in the Russian federation for over 25 years and, along with its subsidiary company, Deutsche Morgan Grenfell, has built up a solid reputation. Deutsche Bank, which has a full banking licence, is actively trading in Russian
equities and in government fixed income instruments.
As a branch office of Deutsche Bank AG, national and international investors are assured the security of a bank with the highest credit ratings. Deutsche Bank is also a member of the Naufor Programme for the Protection of Shareholders. In an unstable marketplace, Deutsche Bank has remained committed to Russia, as has its staff, who all joined in 1995 and are still employed by the bank.
Foreign Investment in the Russian Federation Act
On 14 July 1999 a new law ‘On Foreign Investments in the Russian Federation’ setting out basic guarantees of rights and terms and conditions of entrepreneurial activity carried out by foreign investors on the territory of Russia was officially published and was effective from that date. The law does not apply to foreign investments in banking and insurance institutions or in non-commercial institutions. The main purpose of the law is to encourage foreign investment by granting investors guarantees of stable legal, taxation and regulatory regimes in Russia. The law provides for the protection of foreign investors and enterprises with foreign investment against the increase in tax rates.
A so-called ‘grandfather clause’ states that amendments to existing tax laws and statutes providing for increased rates of import duties, federally imposed taxes and withholding obligations to off-budget state funds shall not be valid for foreign investors and enterprises with foreign investment where such regulation imposes an increased aggregate tax burden on them, however, grandfathering exemption shall not apply to all existing taxes.
Elena Loginova is head of custody services (Russia) at Deutsche Bank