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Analysis & Opinion
03.12.08 Breeding Domestic Investors
By Sergei Balashov

The Russian stock index continued its freefall this week. The hastily deteriorating conditions evoked a strong reaction from Prime Minister Vladimir Putin, who called the situation in the stock market ugly. Overdependence on foreign stock markets, the lack of strong domestic investors, and the insufficiency of existing financial institutions were said to be behind the decline in the Russian Trading System. But although all of these factors certainly play a part in the aggravating conditions, they are hardly the main force that is driving the Russian economy down.

As the U.S. stock market hit its five year low this week, the Russian RTS index followed suit, falling below 600 points to reach its lowest figure since 2004, posting a 75 percent decline since July. This drop came right after Vladimir Putin addressed the issue of declining stocks at a government session on Monday, pointing out that the capitalization of some companies has even gone below the available funds on their balance sheet, making them grossly undervalued and stripping them of good means to raise funds. He argued that isolating the Russian economy from external influences was not an option, but cutting down its dependence on the outside certainly was.

Stimulating internal investment and boosting regulation mechanisms to protect the investors from stock fraud losses were the measures proposed by the prime minister. “Our goal is to set up a massive stratum of domestic investors and create our own strong financial institutions,” Putin said.

This statement resonated with the financial experts around Russia, broaching discussions about the possible incentives that could draw Russian money into the stocks. The Web site quoted the Deputy Chief of the Analysis Department of Arbat Capital Alexei Pavlov, who said that Russian investments amounted to just eight percent of the stock market, while the global average stood at 50 percent. He opined that this was the main reason behind Russia’s leading the global stock market decline.

But the experts’ eyes seem to be off the real problem. Russia’s insurance policies are flawed, and the legislation should indeed be worked on, as insider trading is yet to have been made illegal in the country. It is also true that domestic investors remain cautious, preferring to simply keep their money at home or, at best, in savings accounts at banks. Also, Russian stocks are still dominated by energy companies, the main drivers of the RTS freefall in the wake of the declining commodity prices. The price of oil has already gone down to below $50 a barrel, with the price of gas expected to follow suit in the first quarter of 2009. Steel prices are also down to a quarter of what they were in April.

“Factors like, say, insider trading are dwarfed by our dependence on the energy market. Our problem is the lack of efforts to diversify the economy; if we look at other countries where energy constitutes about 60-70 percent of the economy, we will see that they’ve also been affected,” said Evgeni Gavrilenkov, the chief economist at the Troika Dialog investment bank.

According to Alfa-Bank’s latest daily market review, shares of the blue chips, particularly in oil, gas and metallurgy have been trading with significant peer discounts in both the emerging and developed markets. LUKoil’s discount to the emerging markets’ EV/EBIDTA average stood at 74 percent, while that of Gazprom was 56 percent. Oil and gas averaged a 58 percent discount to the EM average; telecommunications had a 49 percent discount, steel producers--57 percent and banks--71 percent.

“Right now the Russian market is pricing according to our worst case scenario--$40 oil, a very low GDP growth internally and negative GDP growth externally,” said the Chief Strategist and Head of Research at Alfa Bank Ronald Smith, while arguing that it doesn’t necessarily mean that the worst case scenario is going to come about. “Much of the selling is done by the people that are forced to sell. Those who wanted to sell have long been out, and now very few want to sell. The rest of the remaining stockholders would like to hold out for the rebound,” Smith noted, adding that when the pressure from redemptions and margin calls is relieved, the external picture stabilizes and oil grows to at least $50 a barrel.

And the government has been trying its best to speed up this rebound. New legislation meant to protect investors from stock fraud will be worked out by next summer. The inflows will also continue, as the Ministry of Finance will spend over $6.25 billion by the end of the year to bolster Russian stocks. The total package could eventually exceed $18 billion. Yet, it seems like the market would be better off if the authorities refrained from interfering. Instead of trying to artificially create demand inside the country, it should focus on improving the economic fundamentals, which would make Russian companies more appealing to investors.

“They’ve done some things trying to support the stock market, but the market will go where it wants to go. They’ve been buying stocks trying to support the price, with limited success. Most of the government’s attention should go to improving the economy, and the stocks will follow,” said Smith.

When it comes to rules and regulations, it would actually make more sense to have less. The constant halts in Russian stock market trading, when the indexes fall too sharply, along with the state’s excessive interference in corporate governance, such as Putin’s open conflict with Mechel in July, scare off the investors even more than Russia’s armed conflicts do. “The impact from Mechel is still being felt, and it has been greater than that of the war in Georgia,” said Gavrilenkov. He noted that the decision to stop trading, which at one point was halted for an entire two days, was the most harmful move that could have been made. “Russian shares were still speculated with in London, while Russian investors who were willing to buy at that price level here were cut off,” he said. “You can’t artificially create a strong class of domestic investors. When there will be enough money and people will know that the market is free from outside pressure, they’ll start buying stock,” he concluded.
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