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Analysis & Opinion
17.06.08 Wishful Reality
Comment by Felix Goryunov

At a time of global economic uncertainty, it is heartwarming to hear talk of a prosperous future, even if it sounds more like wishful thinking. In recent years, it has become a tradition for Russian leaders to share breathtaking ideas at annual St. Petersburg International Economic Forums. The last forum attracted special attention from abroad, since the ideas voiced by the new Russian president reached well beyond domestic issues. Commenting on the dire state of the global financial market and the downturn in developed economies, Dmitry Medvedev proposed a discussion on the means of constructing a modern global regulatory system. Moscow can be a convenient place to initiate such a discussion, he said, as the city aims to become a global financial center.

The president’s ambitions were fostered by Vice Premier Igor Shuvalov, who said that Russia needs to aim for international leadership and to create an economy that may serve as an example for other countries. Both politicians see these plans as components of the “Four I’s” paradigm – Institutions, Infrastructure, Investment and Innovation, which constitutes a roadmap of Russia’s new economic and social strategy.

The turmoil in global capital markets and the emergence of a few developing countries as the world’s growth engines is convincing enough to claim that a new world order must be put on the agenda. It is widely recognized that the postwar Breton Woods system, based on the supremacy of the U.S. dollar, is becoming outdated. The weakening U.S. currency plays a large part in widespread inflation and skyrocketing commodity and food prices.

Wealthy and weak

Under the circumstances, Russia’s international ambitions look timely and validated. The country can boast of a reasonably favorable stance in the global economy. By this June, Russia has accumulated $549 billion in foreign currency reserves (the third largest hoard after China and Japan). It has also set aside a $32 billion National Welfare Fund and a $130 billion Oil Reserve Fund for a rainy day. The latter is growing every day by another $1 billion, thanks to appreciating crude oil prices.

Domestic financial fundamentals are also encouraging. Despite inflationary pressures, Russian households’ saving rate last year was 8.9 percent, much higher than in profligate United States (0.7 percent), though far behind a thrifty China (30 percent). Last year, China saved about half of its GDP, or some $1.1 trillion, thus accumulating ample domestic fuel for sustainable growth. This is why the investment/GDP correlation in China is 40 percent, while in Russia’s it is about 20 percent, and its economic growth is predominantly driven by the consumer buying spree.
The low rate of investment is a result of the financial system’s underdevelopment—its growth is lagging behind the economy’s needs. Russia’s money markets are unevenly positioned, with corporate equity growing fastest of all. Since 1999, the stock market capitalization increased 22-fold and now exceeds $1.5 trillion, which is about equal to Russia’s GDP. The assets of the banking system were growing at a lower rate, and now account for only 61.4 percent of the GDP. Still less developed in Russia is the insurance industry, not to mention the minuscule role played by institutional investors—pension, investment, mutual, and hedge funds. In developed countries, the total assets of all financial institutions combined are four to five times larger than their GDPs.
All money resources combined, Russia’s financial system is still too weak not only to claim a noticeable role on world capital markets, but even to fund domestic growth. Moreover, even the more developed Russian stock market (last year it reached 2.4 percent of total capitalization of world equity markets) is very vulnerable to inflows/outflows of foreign currency. Non-residents remain major institutional and portfolio investors in Russian shares.
Though foreigners do not play a decisive role in domestic banking, as they own a little more than 25 percent of the Russian banking assets, Russian businesses need foreign funding. Domestic credit institutions rarely finance even medium-term projects due to the lack of long-term money. This is why in 2005, large Russian corporations and banks, mostly state-owned, had to borrow heavily to finance mergers, acquisitions and some investment projects. This quickly increased Russia’s foreign indebtedness: by the end of 2007, the corporate debts amounted to about 30 percent of the GDP.

Thus, state funds and state-owned banks remain core players in Russia’s financial system and the chief sponsors of the “Four I’s” strategy. Though a public-private partnership is incorporated into the paradigm, a reliable mechanism of this cooperation is yet to be developed. Prime Minister Vladimir Putin’s decision to boost business activity by easing the tax burden, as well as his deputy Igor Shuvalov’s recent promise to limit state interference with private businesses, are heartening indeed. But these new policies are yet to be substantiated by laws and regulations. In short, there are pleasing commitments and declarations of intent, but too few practical measures to upgrade the financial system.

The same can be said about plans to create an international, or at least a regional, financial center in Moscow. The Ministry of Finance is expected to draft a concept of such a center, which is supposed to include a large block of corporate and financial legislation. The government promised that the draft will be passed to the Duma for approval only after the business community has been consulted.

Beating out a road

Fantastic as it may seem, the creation of a center of financial gravity for the Eurasian region in Russia is a viable idea. The majority of countries in the region need concentrated financial resources to protect themselves from the vagaries of U.S.-dominated international capital markets. Russia, with its largest economy in the region, can become a consolidating base for such concentration, if and when it concentrates its domestic economic clout and implements policies addressing its financial vulnerabilities. Curbing inflation is the first challenge that the Russian government has said much about, but has not yet tackled.

It is a recognized fact that Russia’s inflation is driven not as much by an excessive money supply or by expensive imports, as by systemic price hikes of state monopolies. Their inefficiency has long been the talk of the town, but the government continues to cover their costs at the expense of private businesses and the economy as a whole. The claim that these price increases are designed to increase investment barely holds water. The required funding can be attracted from the equity market, and thereby more financial discipline could be enforced on monopolistic governance.

Economic and social losses from the monopoly-friendly policies become unsustainable for the Russian money markets, because inflation eats into the potential of personal savings and spare capital that can strengthen the financial system. Inflation-pushed negative bank interest rates make Russian consumers and company managers boost spending, instead of saving for fear of further depreciation of the ruble. No less lamentable is the fact that the deficiencies of these financial policies are not compensated for from the monetary reserves accumulated by the Central Bank of Russia (CBR) and by the government.

The total amount of Russia’s foreign reserves in international securities by the CBR is estimated at $278 billion. The outlays of the Oil Reserve Fund are also lavishly invested abroad at three to four percent interest rates. The paradox is that while planning to make the country into a financial haven, the Russian government continues to fund foreign capital requirements. This funds allocation policy is still more surprising, given the fact that many Western companies boast that returns on their investments in Russia are higher than in China, the global leader in attracting foreign direct investment.

In case the Russian leadership earnestly wants to create a global financial center, it must first of all ensure an efficient allocation of financial resources. The “Four I’s” strategy of economic and social development is a fundamental base for such allocation. It can beat out a road from the inflationary, consumption-led growth, to an investment-driven development of Russia’s economy, as well as to the expansion and strengthening of its financial system.

Some estimates suppose that the realization of this strategy will require from $3 to $8 trillion. Can the Russian economy generate such piles of cash? It surely can, through more sophisticated development of its financial system. Besides personal savings and capital accumulation, along with the state reserve and welfare funds, there is a third, largely untapped, source of funding, which economists call the national wealth.

It was estimated that less than seven percent of Russia’s national wealth is appreciated by the market. More or less appraised are assets of financially liquid commodities – natural gas, crude oil, timber and a few other natural resources. Fixed capital, arable land, pure water, real estate, intangible assets (patents, intellectual property rights), scientific, R&D and educational potential are not yet assessed by the market. If just a part of this enormous wealth is made legally tradable as public or private property, Russia’s financial system will receive collateral for low-risk financing that will make it one of the most attractive capital markets in the world.

Hopefully, the planners of an international financial center in Moscow will consider all possibilities for upgrading Russia’s financial system. As to setting examples for other countries, there is a recent one worth mentioning. To make the terms of consumer credit transparent to clients, especially to credit-card holders, the CBR has ruled this June that Russian banks must disclose all information about the full cost of credit. Sen. Barack Obama, the Democratic presidential contender, only promises to make creditors inform consumers about the risks involved in credit cards.

Felix Goryunov is a Moscow-based economic journalist.
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