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Analysis & Opinion
02.09.08 A False Alarm?
By Sergei Balashov

Russia’s new foreign policy, which resonated negatively in the world, shattered foreign investors’ confidence. In the first half of this year, foreign investment in the country declined by 30 percent compared to the same period in 2007, while in the first week of the South Ossetian conflict alone, over $7 billion was transferred out of the country. The Russian Trading System (RTS) share index, which suffered from the Mechel skirmish, declined by another six percent following the recognition of South Ossetia and Abkhazia, reaching 1,547.1 points, the lowest figure since October 2006.

Taking down the market

With political risks guiding the behavior of investors (especially foreign ones), the connection between these political events and the freefall of the stock market is obvious. “Speaking of the South Ossetian conflict, there are emotional factors at play here,” said a Professor of the Higher School of Economics Nikolai Berzon. “It is feared that Russia will be subject to sanctions and will be isolated.”

However, economically, the impact from such sanctions would be minimal. “If we look at our trade with the United States, it only makes up 1.5 percent of our total trade, so it will be quite difficult to isolate us,” said Berzon. “It only shows that investors are very mindful of the political risks and every splash like Putin’s statement on Mechel or the war can lead to capital outflow.”

The risks that possible international isolation bore for Russia diminished after the latest EU emergency meeting in Brussels, where the union made it clear that it would not pass any sanctions against Russia, especially considering the fact that Europe is Russia’s key energy trade partner.

“Foreign investors have been conscious of the situation that we’ve had over here for a while,” said the General Director of the Center for Political Information Alexey Mukhin. “I remember how British businessmen who at the time were doing business in Russia laughed off Prime Minister Tony Blair’s appeals to evaluate the risks when investing in Russia more closely, basically asking to stop doing business in this country. There is no fear of any apocalypse at foreign companies operating in Russia,” he added.

A blast from the past

Investors are believed to be more wary of internal rather than external political risks. The fears are mostly connected to the past feuds between the government and some of Russia’s biggest companies, the now jailed oligarch Mikhail Khodorkovsky’s YUKOS and Mikhail Gutseriev’s RussNeft.

Putin’s notorious statement on Mechel, accusing one of Russia’s leading metallurgic companies of selling coking coal abroad at a lower price than inside the country, sparked fears that history could repeat itself, and Mechel, with its majority owner Igor Zyuzin, could be turned into the new YUKOS.

Mechel’s situation was resolved with a heavy $32 million fine and 15 percent lower coal prices. The government sent a clear message that it was not looking for another YUKOS-type disaster. Besides, given the ownership structure of Russia’s largest businesses such a scenario seems very unlikely.

With the exception of TNK-BP, which is currently going through a shareholder dispute, almost all of the strategic assets in oil, gas and metallurgy are either controlled by the government via state-owned companies such as Rosneft, Gazprom and its oil branch Gazprom Neft, or by private individuals that tend to be on good terms with the Kremlin, or in a pursuit of such.

“If we want another YUKOS debacle to take place, we have to form a real economic opposition, i.e. large business owners with their own political agenda, and due to the fact that we don’t have anything like that right now, a repeat of YUKOS is not possible,” said Mukhin.

Mukhin also argued that some of the occurrences that were sometimes interpreted as the government’s attempt to nationalize strategic assets were not seen as such by the foreign investors. On the contrary, the measures recently taken by the government bode well for foreign capital.

“What the state is doing, most notably the taxation optimization and the anti-raider legislation, inspires optimism in our foreign partners,” said Mukhin. “Russian business is becoming more European.”

Berzon estimated that there are about $242 billion worth of accumulated investments in Russia. “Half of these are direct investments or investments into major projects, into charter capital or stakes in companies with the intent to participate in their management and development. This kind of investment can’t be pulled out in a week, a month of even half a year.”

Where the shoe pinches

But even if the foreign investors present in Russia know exactly what they’re doing, it still does little to explain the market’s sensitivity to any turbulence, either exogenous or endogenous. A closer look at Russia’s investment structure reveals a lot. The funds flowing into the country can be divided into speculative investment and purposeful, long-term financing. The former investors are much more likely to take their money back at the earliest sign of trouble, and their premature reaction is seen as the force that brought down the stock market.

“If we break down the investments, the speculative money is mostly invested into blue chip shares, or shares with high liquidity, like those of Gazprom, VTB and Norilsk Nickel,” explained Berzon. “Once these profiteers sense a threat, they get rid of these shares immediately. They leave and we see a general decline in the stock market.”
“We need long-term investors regardless of their jurisdiction,” said the Head of the National Rating Agency Viktor Chetverikov. “Speculators are motivated by current volatility; all they try to do is get the maximum possible profit, whether share prices are falling or rising. Long-term investors provide funds for companies and help develop the economy.”

Blue chips were among the leading factors contributing to the downfall of the RTS index. Gazprom shares were the most frequently traded in the month of August, registering a 17.86 percent decline in price. Gazprom was followed by Sberbank and LUKoil, who lost 20.97 percent and 10.66 percent respectively.

“Sberbank’s minority owners were selling gigantic amounts of shares, up to two to three percent, which amounts of hundreds of millions,” said Berzon. “Of course, the market will collapse.” Foreign share speculators are more susceptible to whatever risks affect the market, and their shares are more volatile. Foreign investors currently make for some 70 percent of the market.

“We are very dependent on their mood,” said Berzon.

The resources within

Attracting Russian investors to the market could eventually make it more stable in its response to external factors, as foreigners are still affected by the lack of information about the economic situation inside the country and tend to know less about current Russian affairs than would suffice to evaluate the risks. Domestic investors are seen as better informed and unlikely to sell.

According to Berzon, in the United States, over 100 million citizens directly or indirectly own stock. This number is believed to be at the level of 500,000 in Russia.

“Our people aren’t very financially literate, they don’t understand the market and don’t invest,” said Berzon. “If we want our market to be stable, we have to set up the right conditions for them to bring money to the market, and then we’ll be less dependent on foreigners,” he added.

It is also debatable whether there is a need to avoid investment declines at all, as the stock market posted impressive growth after the 1998 financial crisis and had a record breaking year in 2005, right after the YUKOS debacle, growing tenfold from 2004.

“People have come to understand that there is a certain low point that has to be passed and it’s possible to make money on the decline; after all, it’s impossible to have an ever-growing market,” said Chetverikov. “The market will develop positively and we have a good chance to get back to where we were before the market started to decline.”
As for the current crisis, the investors appear to be creating a massive capital outflow on their own, in order to lower the prices and then return to the very same market to profit from its subsequent growth. “The more they talk about leaving Russia, the less likely they are to do that,” said Mukhin. “The long-term investors are happy to stay, they understand that the high volatility of the market gives them a great chance to make profits, they know they won’t get such opportunities on any other market in any other country.”
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