Stability from a split perspective
Last year Russia divided its sovereign wealth fund into two. James Johnson explains the roles of the two new funds
Sovereign wealth funds have been the heavyweights of the investment world over the past year, propping up ailing banks, lobbying the US government to rescue Freddie Mac and Fannie Mae, and acting as a liquidity source of last resort for a cash-poor world.
Amid the commotion, Russia's own petrodollar pot, formerly known as the Stabilisation fund, has remained remarkably invisible. Russia has not taken massive stakes in any of the major financial institutions. It has held the debt of US government-sponsored enterprises - although perhaps ‘sponsored' is too mild a word these days - but has not openly contributed capital to any of the big private equity funds that are chasing undervalued financial assets.
It has also undergone some major changes of its own in the last 12 months that have gone practically unnoticed in the ongoing credit pandemonium. Until early this year, the $157bn (€123bn) fund retained its ‘stabilisation' moniker and invested in foreign sovereign debt, with 45% in US dollar assets, 45% in euro holdings and 10% in sterling. Like Chinese government reserves, it aimed to reduce liquidity, reinvest it and thereby rein in inflation. It could also help stabilise the economy in the face of a serious shock - hence the name assigned to it.
But in February, the fund underwent a subtle strategic shift. It split into two entities - the $125bn National Reserve fund and the $32bn National Welfare fund, also known in English as the National Wealth, National Wellbeing or National Prosperity fund. Despite the financial crisis, the structure has persisted, and the Russian government has already outlined its plans on how it will invest them.
The Reserve fund cannot grow larger than 10% of GDP. As a result, any excess cash would flow into the National Welfare fund. Its investment policy proved broadly similar to the Stabilisation fund, and, in effect, it supplements the government's main reserves, which are considerably larger.
But the National Welfare fund is a different beast. The government has said it aims to invest up to 5% of the fund in direct assets, 30% in corporate bonds and 40-50% in strategic equity holdings, to be retained over a 10 to 15-year horizon. It will also channel 0.6% of GDP a year into the pension system, which the state acknowledges needs further funding to meet its liabilities and help prop up the domestic market.
In extreme cases, state financial institution Vnesheconombank can deploy up to 40% of the fund to help stabilise the financial system. The government can also use it to cover future deficits in the budget.
Since February, the fund has swelled to $61bn, according to Marina Akopian, (pictured right) partner at emerging markets boutique Hexam Capital Partners. This figure is compared with the $161bn in the National Reserve fund and the $460bn of Russian currency reserves. As Akopian points out, the National Reserve fund is still mainly invested in US treasuries, which has bolstered its position due to the strength of the dollar. She adds that Russia may eventually invest some of its reserves in renminbi assets, which prime minister Vladimir Putin has made a case for as a reserve currency. But for now, the portfolio remains conservative.
The fate of the National Welfare fund remains more intriguing. As Akopian observes, Russia's critical weakness during the latest financial crisis was that it had little long-term domestic capital underpinning its equities. Outflows of foreign capital meant the government had to inject emergency money into the currency and the money markets, and as overseas investors fled and the stockmarket crashed. Akopian says more foreign money exited Russia in 2008 than during the country's financial crisis the previous decade.
The major casualties this time were not state institutions, but oligarchs. The Russian super rich had used equity to collateralise their debt, which in turn enabled them to expand their business empires at home and abroad. When the value of the collateral fell and risk-averse banks demanded more, the oligarchs had to turn to the government for help. The National Welfare vehicle and other sources of funding will create winners and losers among the power brokers of Russia on a scale not seen in 10 years.
"The oligarchs are to blame for what has happened," Akopian says. "The Russian government is not going to bail out their equity stakes unless they are in a strategic industry. How much the oligarchs will have to pay for their capital, we will see later this year, although none of the major Russian companies that have issued eurobonds will be allowed to default."
The government's other major priority relating to the stockmarket crisis is, quite simply, preventing it from occurring again. Fortunately, this coincides with another of its objectives, which is to reform the domestic pension system. For many years, the system has proved inadequate in providing for Russian retirees. But if the government manages to collect more money from the population for its pension and invests more of it in Russia's previously fast-growing equity market, there will be better cushioning for stocks in times of distress.
Akopian says the government is likely to introduce a national insurance scheme to help support this development, a factor that presidential aide Arkady Dvorkovich outlined during the crisis, in October last year.
"In the next six to 12 months, the reform of the pension system will be accelerated," she says. "You have national insurance contributions in the UK, but you don't have that in Russia. If you are looking at a population of 141m, then savings in personal pension plans are non-existent. Having said that, there is the Vnesheconombank state pension fund, which is worth tens of billions of US dollars. Gazprom allocates a significant amount of its net income to its employee pension scheme. For that, it gets tax breaks. Lukoil and all the largest companies also have their own pension systems in place."
The large equity allocation of the National Welfare fund is likely to be used to support this development. Given the current climate, Claire Simmonds, (pictured left) an emerging markets portfolio manager at JPMorgan Asset Management in London, says the money should also generate a healthy return.
"Clearly, those companies which are exposed to the domestic economy are going through short-term problems," she says. "Current sentiment indicates an extreme of pessimism, which is usually associated with a buying opportunity."
Simmonds also points out that investing in the private sector would help consolidate the banking system. "The top 50 banks in Russia control 85% of the assets. The fate of the other 1,000 banks will be left up to the owners and the market."
Other possibilities include a government vehicle that invests in the credit default swaps of major Russian companies, some of which are pricing in a strong probability of default, according to Akopian. There is even a possibility the government may use external asset managers, although experts are uncertain as to what form this would take.
The question that remains is whether the fund might be used to stimulate employment and consumption above and beyond bailing out private enterprise. Russia's projected $1trn of infrastructure spending over the next 10 years will come partly from the government budget and partly from the private sector. Although the requisite capital is unlikely to emerge from the National Welfare vehicle, the government may use the fund to help prop up the budget if the oil price stays at around $50 a barrel.
"You have to remember this government is very capable and very committed to increasing GDP growth. Their plans are ambitious, although one can find them laughable given the current environment," Akopian observes. "To say they will stop the infrastructure projects is going too far. Whether they will slow them down depends on commodity prices going forward."
All in all, the potential return on investment for Russia's stabilisation funds is substantial, whether one looks at it from a monetary or a political perspective. The one problem the portfolios face over the next decade is revenue. If the oil price stays low and Russia reins in its lucrative oil export tax, the fund's growth will look anaemic by comparison with that of the past decade. But as governments continue to promote infrastructure as a way of spending out of recession, it might be too early to call the end of the boom in commodities and sovereign wealth funds as yet.