This Selected Issues paper examines the potential costs of faster disinflation in Russia, drawing on the experience of European transition countries. The paper analyzes this experience, discusses factors contributing to the persistence of moderate inflation, and quantifies the disinflation costs in these countries. It compares the Russian economy with the sample countries. The paper concludes that a relatively rapid reduction of core inflation from above 10 percent in 2002 to less than 5 percent in 2004 would be beneficial for the Russian economy.

Abstract

This Selected Issues paper examines the potential costs of faster disinflation in Russia, drawing on the experience of European transition countries. The paper analyzes this experience, discusses factors contributing to the persistence of moderate inflation, and quantifies the disinflation costs in these countries. It compares the Russian economy with the sample countries. The paper concludes that a relatively rapid reduction of core inflation from above 10 percent in 2002 to less than 5 percent in 2004 would be beneficial for the Russian economy.

VI. Russia: Capital Market Developments and Issues1

The strong gains in Russian debt and equity markets in 2002 were underpinned by robust macroeconomic performance, prudent fiscal management, strong oil prices, high ruble liquidity and expectations of a sovereign credit rating upgrade. This chapter discusses recent developments and prospects for Russian financial markets as well as related policy issues. Drawing on the experiences of other emerging markets, it highlights some structural weaknesses of Russian financial markets that need to be addressed in order to avoid potential vulnerabilities going forward. The main conclusions are: (1) given that most of the public debt stock is foreign currency denominated, there is a need to speed up the re-development of the government ruble bond market in order to reduce the debt roll-over risk in the event of an unexpected terms of trade shock and/or a temporary loss of access to the international bond market; (2) although the recent pick-up in corporate borrowing (both domestic and external) does not represent a major systemic risk, local investors’ credit risk assessment capabilities need to be strengthened and rapid growth of corporate leverage and foreign exchange exposures should be monitored.

A. Government Bond Market

1. In 2002, Russia’s external debt remained, for a second consecutive year, one of the best performing assets in the emerging debt market (EDM) asset class, with the EMBI+ Russia subindex returning 36 percent (compared to a 13 percent return on the EMBI+ Composite Index). These gains were underpinned by the continued robust macroeconomic performance, due in part to strong oil prices, and expectations of sovereign rating upgrades, which were partially validated when Moody’s and S&P raised Russia’s long-term foreign currency rating to just two notches below investment grade in late 2002. At the same time, Russia’s external debt demonstrated relative immunity to the EDM spill-over effects from the developments in Brazil and Turkey (Figure 6.1). At present, the Russian benchmark eurobonds are trading at yields that are below those of many similarly rated sovereigns.

Figure 6.1:
Figure 6.1:

Emerging Debt Market Spreads

(in bps)

Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A006

Source: JPMorgan

2. Yields on ruble denominated government bonds continued to decline last year in tandem with external bond yields, largely owing to the stability of the ruble and declining inflationary expectations, but also to the abundant banking sector liquidity on the back of strong petrodollar inflows. In addition, the steep decline of sovereign eurobond yields in the second half of 2002 prompted investors to consider long-dated ruble bonds as an attractive alternative to sovereign eurobonds of similar maturity. As a result, the nominal yields of the most liquid 2006 and 2008 ruble bonds fell from 17-17.5 percent in September 2002 to 14 percent in December 2002, while real yields on shorter-dated bonds remained negative. The government ruble debt duration and market liquidity improved, with the daily turnover in ruble government bond market increasing by 4 times during the last year. These trends have continued into 2003, with the Ministry of Finance placing 15-year bonds at an average yield-to-maturity of only 9.7 percent in February.

3. Near-term technical conditions are likely to remain supportive for both ruble and foreign currency denominated bonds. In 2003, the sovereign external debt repayment will significantly exceed external borrowing.2 An additional eurobond issuance on the order of $2 billion with respect to the second tranche of the FTO/IIB/IBEC debt exchange is expected later this year. However, it is unlikely that the Russian government will have a fiscal need to issue a new eurobond in 2003, though the budget includes a provision for up to $1.25 billion of new eurobond issuance. The demand for Russian sovereign dollar bonds is expected to be strong due to the likely reinvestment of $5.5 billion to be received by investors after the redemptions of Russia’03 and MinFin IV bonds and as more foreign investors receive mandates for investing in Russia. As for the ruble bond market, the new demand for government securities from local investors is estimated at around Rb80-100 billion in 2003, which, given that the planned net issuance is less than Rb60 billion, will put additional downward pressure on ruble bond yields.

Government Bond Market Structure and Investor Base

Foreign Currency Denominated Bonds

Russia’s public foreign currency denominated debt amounted to around $120 billion (35 percent of GDP) as of end-2002, of which roughly $45 billion was in the form of government securities denominated in dollars (eurobonds and MinFin bonds).

At the end of 2002, the investor base for Russian eurobonds and MinFins was almost equally split between foreign and domestic investors. According to market sources (Troika Dialog, 2002), almost 60 percent of all outstanding eurobonds and MinFin bonds were held by foreigners (which may also include some Russian money invested through off-shore accounts) and about 40 percent by Russian residents. The largest share of foreign investors in Russian dollar bonds are the dedicated emerging debt market (EDM) funds. Going forward, an upgrade of the sovereign foreign currency credit rating even by one notch (which would still leave Russia below the investment grade rating) is likely to increase the demand for sovereign bonds from cross-over investors, i.e., global fixed-income and investment grade funds. Also, Russian institutional investors are likely to become more active buyers of sovereign eurobonds as capital account liberalization moves forward. At present, local institutional investors who wish to invest in foreign currency denominated securities are required to obtain a license from the Central Bank of Russia (CBR).

Ruble Denominated Bonds

The total value of ruble denominated public debt was Rb680 billion or $21.4 billion (6.3 percent of GDP) as of end-2002. Most of this debt is in the form of non-market instruments held by the CBR. The size of the ruble denominated government bond market was around Rb217 billion as of end-2002 (2 percent of GDP). This is small in absolute terms and by comparison with other emerging markets; for example, the total value of tradable local currency denominated government debt is around 15 percent of GDP in Poland and 25 percent of GDP in Hungary. There are two types of instruments in the government bond market—-T-bills (GKOs) and Treasury notes (OFZs). The planned net government bond issuance in 2003—Rb50-60 billion, of which at least half is expected to be placed with the State Pension Fund—is likely to lead to only a modest increase in the amount of tradable bonds available to market participants.

The GKO/OFZ market is dominated by two large players: as of end-2002, Sberbank held 52 percent of tradable debt and the State Pension Fund held 14 percent. The share of Sberbank in the longer-dated bond market segment is smaller, around 20 percent, and it is notably absent from the secondary market. All transactions between the State Pension Fund and the Ministry of Finance are carried out outside the market, at an average market price. According to the Ministry of Finance, the State Pension fund acquired Rbl4-16 billion of the ruble denominated government paper in 2002 (by comparison, the total value of tradable bonds increased by about Rb57 billion in 2002). Going forward, the introduction of new pension legislation is expected to significantly increase the potential investor base for government paper, with private pension funds likely to become important players in the government bond market in 2004. The government is currently not looking to attract foreign investors to the ruble denominated government bond market.

4. Russia’s ability to service its debt in the medium-term is seen by market participants as virtually assured under any plausible oil price assumptions, and some of its external vulnerability indicators (such as gross financing requirement to reserves ratio) are already close to the levels observed in the investment grade countries.3 S&P, for instance, took seven positive rating actions affecting Russia’s sovereign credit rating during December 2000-December 2002 and currently has a stable outlook on Russia, which implies that the agency does not expect major improvements in sovereign creditworthiness in the near future. Furthermore, S&P’s recent reports suggest that an early and steep upgrade (one notch in 2003 and one more notch in 2004) is unlikely without a visible renewed structural reform effort. In particular, the agency noted that “the absence of a viable banking sector, low labor mobility, slow progress in demonopolizing the economy, and weak institutional structure make Russia vulnerable” (Hessel, 2003).

5. As near-to-medium term debt sustainability has become less of a concern, the government has shifted its attention to ways of improving the public debt structure and lowering debt service costs. According to the recently published medium-term debt management paper, the authorities’ strategy will be to decrease the non-market portion of public debt (including via conversion of some of the Paris club debts into tradable securities) and to increase the ruble debt stock while reducing the foreign currency denominated debt stock.4 Indeed, since the bulk of Russia’s public debt is foreign currency denominated (Box 6.1), a relatively more aggressive ruble-denominated bond issuance with the proceeds used to retire some of the external debt would help to achieve a more balanced (in terms of the currency composition) public debt structure within a shorter time frame and to develop domestic bond market into a stable financing source. The latter would help to significantly reduce the roll-over risk in the event of an adverse terms of trade shock and/or an unexpected temporary loss of access to the international bond market.

6. Given that there is no fiscal need for larger local debt issuance, the Ministry of Finance may experience some difficulties in balancing the objective of developing the domestic bond market with the objective of minimizing the cost of borrowing. However, if the government takes a longer-term view of the problem (and also takes into account the fact that the development of a deep and liquid market takes time), it is likely to be more willing to accept somewhat higher short-term costs associated with promoting the domestic government securities market. In fact, some countries, such as Chile, Hong Kong SAR, and Singapore made a considerable effort to develop their domestic government bond markets notwithstanding fiscal surpluses (IMF, 2002). The recently approved medium-term debt management strategy indicates that the authorities’ thinking is evolving in that direction. Separately, the experience of some emerging markets showed that, for instance, setting up an independent debt management agency (like the AKK in Hungary) could be an effective way of achieving better coordination between these objectives.

7. The development of the money market and the longer-dated government bond market will also increase the number of liquid local currency instruments available to the central bank for conducting open market operations. In November 2002, the Central Bank of Russia (CBR) introduced several new refinancing and liquidity-management instruments. In particular, the CBR began to conduct daily repo (collateralized lending) operations with the banks (GKO/OFZ dealers) for the purposes of temporary liquidity injections, which increased the demand for government paper and contributed to the decline in government bond yields late last year. More recently, the Ministry of Finance restructured the CBR’s portfolio, increasing the portion of tradable instruments to about Rb30 billion, in order to raise the effectiveness of the CBR’s open market operations. However, the tradable portion of the CBR’s portfolio remains below 10 percent.

8. In many emerging market countries, the development of the local currency-denominated government bond market was motivated by the need to establish a benchmark yield curve for corporate bond issuance. In Russia, the benchmark functions for private bond issuance were performed at different points in time by various instruments, such as GKO/OFZs, the CBR’s refinancing rate, TNK or Gazprom bonds as well as sovereign eurobonds. However, most of the reference rates had the same shortcomings—high volatility and high sensitivity to supply factors. In addition, the real yields on the ruble denominated government bonds were often (and currently are) negative, which implies that they cannot serve as an effective benchmark for corporate bonds. While in some emerging markets, where the size of the outstanding government bond issues is relatively limited (such as Hong-Kong SAR and Czech Republic), the interest rate swap curve constitutes a more liquid benchmark than the government yield curve, in Russia, the swap market is unlikely to become a viable alternative benchmark in the near future. Firstly, the derivatives still do not have the same legal status as other securities and secondly, most market participants expect a continued decline in yields, implying that an interest rate swap market is likely to remain one-sided/illiquid for a while, as everyone would want fixed-rate assets and floating-rate liabilities.

9. Finally, it appears that many of the pre-conditions for a successful re-development of the local government bond market in Russia are already in place. In particular, since the 1998 crisis, the government has made considerable progress towards macroeconomic stability and established a track record of fiscal prudence, while significantly improving the overall fiscal framework. In the area of monetary policy, both transparency and coordination with fiscal policy have increased as well. In some structural areas, however, the progress has been slower. The recent passage of the pension laws and other securities markets related legislation is expected to stimulate growth of the local institutional investor base, which is currently fairly narrow. The banking sector remains highly concentrated and dominated by state banks, while other institutional investors’ (insurance companies and pension funds) development has been constrained by the lack of comprehensive regulatory framework and the dearth of the fixed-income investment opportunities. Separately, the envisaged gradual pace of capital account liberalization, with the government intending to maintain certain restraints on capital flows over the medium-term, means that local bond market is likely to be shielded from the impact of volatile foreign flows at least until it becomes sufficiently deep and liquid. However, this also means that foreign investors will not be able to play a role in increasing the diversity of investor base or improving the liquidity of the government bond market in the near future.

B. Corporate Bond Market

10. Corporate borrowing from both domestic and international bond markets rose sharply in 2002, reflecting pent-up demand and favorable costs of borrowing. The ruble-denominated corporate bond market experienced phenomenal growth, albeit from a very low base. The total value of all outstanding bonds (not including the non-market issues) increased from Rb25 billion ($0.8 billion) as of end-2001 to Rb63 billion ($2 billion) as of end 2002 and is expected to increase by at least 50 percent in 2003. Along with some positive developments, such as improvements in pricing efficiency and lengthening of maturities, the market continued to experience “growing pains.” In particular, its rapid pace of expansion led to the perceived deterioration of the average credit quality of corporate issuers last year, with more medium and small size companies tapping the market in 2002 compared to 2001. External debt issuance by Russian corporates rose as well. While a lot of it was linked to refinancing and liability management operations, the total net external borrowing reached almost $6 billion in 2002, approaching the pre-1998 crisis level. Gross eurobond issuance was $3.4 billion, compared to the previous peak of $2.2 billion in 1997. This trend is expected to continue. According to market estimates, eurobond placements by Russian companies in 2003 may exceed $5 billion, with more than $2 billion already issued since the start of the year.5 The majority of Russian eurobond issuers are large exporters, who prefer to finance themselves in the eurobond market because their funding needs (both in terms of the amounts and maturity) cannot be met domestically.

11. A notable compression of the ruble denominated corporate bond yields during 2002 was generally attributed to the continued decline in government bond yields and a relative shortage of corporate paper, compared to the abundant banking sector liquidity.6 At the same time, the average local corporate bond spread over GKO/OFZ tightened to about 300-400 bps at the end of the year. The latter is difficult to square with the perceived increase in the overall credit risk and could be either due to a correction of the previous pricing anomalies (i.e., the re-rating of corporate risk premiums for some borrowers) or due to high ruble liquidity, which might have pushed corporate bond yields below the levels that are consistent with credit fundamentals. Similarly, the spreads on corporate eurobonds continued to decline in line with sovereign spreads (Figure 6.2). More recently, BP’s decision to invest $6.75 billion in a venture with TNK (one of Russia’s largest oil companies) announced in February 2003 has led to a more rapid compression of corporate spreads, possibly reflecting a re-rating of the corporate credit risk premiums.

Figure 6.2:
Figure 6.2:

Sovereign and Corporate Eurobond Yields

(in percent)

Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A006

Source: Bloomberg

12. Notwithstanding the busy issuance calendar, the technical conditions in the corporate bond market are likely to remain supportive in the near term. In the local market, the negative real yields on government paper are likely to prompt investors to place more money in corporate bonds. The technical position of corporate eurobonds is likely to remain strong as well, as the government’s strategy of gradually reducing the external public debt stock will leave more of the foreign institutional investors’ money seeking Russian exposure (including the new mandates) to be allocated to corporate eurobonds.

13. At their present levels, corporate leverage and foreign exchange exposures do not represent a major systemic risk for the following reasons: Separately, for the municipal and regional governments, the amount of external borrowing each year is currently capped by the amount of repayment.

  • corporate leverage in Russia is still fairly modest and according to analysts, the debt-to-capital ratios in most Russian companies are below the optimal level (i.e., the level that minimizes the weighted average cost of capital);7

  • given the small size of the ruble corporate bond market, a potential default, even if it triggers a wide-spread liquidity crunch, is unlikely to have systemic implications, and, as some market participants argue, might even be “healthy” for a market that needs to strengthen its credit risk assessment capabilities. However, some analysts believe that the widespread use of put options increases the refinancing risk in the ruble corporate bond market because it effectively creates an additional transmission mechanism of contagion, i.e., an “accidental” default by one company can prompt investors to exercise all puts that expire shortly after the credit event regardless of the credit quality of the underlying bonds;

  • the creditworthiness of the major Russian oil companies is unlikely to be seriously affected by oil price swings unless long-term average Brent crude falls below $15/bbl, which is considered to be the “break-even” price for most Russian oil producers;

  • a lot of external borrowing last year was driven by refinancing or liability management, which actually improved corporate debt profiles, according to credit rating agencies;8 going forward, the refinancing motive will continue to be an important driver of external borrowing since most of the outstanding corporate eurobonds mature during 2003-07;

  • the majority of the Russian firms that tapped the eurobond market are the top-tier companies from the oil and gas sector that are “naturally” hedged by having dollar revenues.9

14. Despite its rapid growth, the domestic corporate bond market remains very small—0.6 percent of GDP, compared to an average of 5 percent of GDP for emerging markets. The recent surge in domestic corporate bond issuance in Russia was due to favorable interest rate environment, high ruble liquidity, the dearth of bank financing and at the same time, a growing number of banks providing brokerage and underwriting services.10 Further growth of the market may be constrained by the existing regulatory restrictions, relatively high cost of issuance, the lack of a diverse institutional investor base and developed credit culture. Separately, it should be noted that in many emerging market countries, most notably in Latin America, Hungary and Poland, the “crowding out” by government bond issuance was one of the main impediments to the continued expansion of the domestic corporate bond market (IMF, 2002).11 Thus, the latter may have to be taken into account in the design of the medium-term government bond issuance program.

15. The elimination of taxes and transaction costs impeding securities transactions, subject to a review of the impact on government’s fiscal revenue, can promote more efficient functioning and further growth of the corporate bond market. A proposed reduction of the bond registration fee from 0.8 percent to 0.2 percent will be discussed in the Duma later this year. While it is unlikely to have much impact on the budget, this measure will help to accelerate the conversion of the ‘veksel’ market into the corporate bond market,12 and to reduce the incentives for the Russian companies to use certain financial instruments that are non-transparent and difficult to price (i.e., bonds with put options and variable-rate coupons, where the coupon rate is determined unilaterally by the issuer and announced shortly before the put option expiration date).13

Corporate Bond Market Structure and Investor Base

Foreign Currency Denominated Bonds

The total value of all outstanding corporate eurobonds is about $7 billion, with most of the bonds denominated in dollars and maturing during 2003-2007, The longest-dated Russian corporate eurobond is currently the one issued by Gazprom in February 2003, which matures in March 2013. As for sector composition, about 81 percent corresponds to the oil & gas sector bonds, about 15 percent to the telecom sector and about 4 percent to banks and other financial institutions.

Corporate eurobonds are mainly held by dedicated foreign investors (emerging debt market funds) and Russian banks. The recently issued Gazprom eurobonds were distributed evenly between the US, European and Russian investors. Some of the demand, reportedly, came from foreign institutional investors, that had only recently received mandates for investing in emerging debt markets, and therefore, were looking to increase their exposure to Russia (which accounts for about 22 percent of the EMBI+ index). Going forward, further credit ratings upgrades of sovereign and corporate bonds will lead to further expansion of the institutional investor base, with more cross-over investors (global fixed-income and investment grade funds) seeking exposure to the Russian corporate eurobonds.

Ruble Denominated Bonds

The total value of all outstanding ruble-denominated corporate bonds (not including the non-market issues) was Rb63 billion ($2 billion) at the end of 2002. The industry structure of ruble bond market is more diverse, with the oil and gas sector companies accounting for only about 40% of the market. In contrast with 2001, the majority of the ruble bond issuers in 2002 were medium and small-size firms, since many of the large exporters gained access to cheap trade credits abroad as global interest rates fell to new lows. In the second half of 2002, 3-year bonds with a fixed-rate semiannual coupon and imbedded put options at 12 month intervals, became the most commonly used instruments. The average ‘investment period’ of the ruble corporate bonds increased from 123 days as of end 2001 to 440 days at end-2002 (according to Bank Zenit, see footnote 7). The majority of issuers are unrated and most of the bonds are relatively small and illiquid.

According to local market sources (TIB, Alfa-Bank, Bank Zenit, Troika Dialog), the current structure of the investor base for the ruble corporate bonds is as follows: 45-50 percent - Moscow based banks (most of which are also the underwriters), 20-25 percent - regional banks, 20 percent - insurance companies and non-government pension funds, 10 percent - other (including about 3 percent - retail investors). The top 20 banks are also the main liquidity providers in the secondary bond market, deriving part of their trading income from buying/selling corporate bonds, while most of the medium and smaller-size banks typically hold bonds to maturity. Regional banks that have relatively expensive liabilities typically seek higher-yielding paper. Foreign investors can invest in the ruble denominated corporate bonds using N-accounts (rubles are not freely convertible into foreign exchange) and K-accounts (rubles are freely convertible into foreign exchange for coupon payments). Although until recently foreign investors remained on the sidelines, their participation in selected primary placements (eg., the UES bond issue) was notable. Asset management companies that invest on behalf of mutual funds are currently not allowed to participate in primary bond placements, because mutual fund regulations explicitly prohibit their managers from investing in securities that do not have a history of quotes. Some buy side market participants note that a relaxation of this restriction would significantly increase their interest in the domestic corporate bond market.

16. The design of foreign exchange regulations should also take into account their impact on corporate borrowing and financing of productive investment. For instance, the existence of a surrender requirement makes collateralized borrowing by Russian exporters more difficult and expensive: because of a possibility that the requirement can be adjusted upward at any time, borrowers have to pay a higher risk premium. Moreover, the draft Federal law on Foreign Exchange Regulation and Foreign Exchange Control, which will be discussed in the Duma later this year, proposes the introduction of Chilean-style capital controls on inflows. Although these controls may be a useful policy tool for reducing speculative short-term flows and the probability of a liquidity crisis, it is important to determine carefully their parameters and scope to limit potential negative impact on trade financing and borrowing costs (both externally and domestically) of Russian firms (Box 6.3). In particular, there is some evidence that the imposition of encaje (the URR in Chile) made it substantially more difficult for medium and small size firms to obtain external financing for productive investment (Forbes, 2002). For many Russian companies, neither the local banking system, nor the rapidly expanding but still small ruble bond market can yet serve as a viable alternative source of financing, implying that they are already more financially constrained than most other emerging market firms.

17. The development of a credit information infrastructure is important for improving the overall credit culture of the corporate bond market. Very few local borrowers are currently rated: S&P has recently introduced a national scale of credit ratings for Russian companies, but has so far awarded such ratings to only a handful of corporate bond issuers. There is currently no correspondence between these ratings and corporate bond spreads. Some analysts noted that increased investor discrimination was manifested in a more pronounced tiering in the corporate bond market last year compared to 2001, with the difference between the yields of the top quality and “junk” bonds actually increasing to a minimum of 5 percentage points (for instance, one of the small/“high-risk” issuers reportedly placed a bond at 40 percent in 2002).

The Cost of Unremunerated Reserve Requirement (URR) For Corporate Borrowers

The implied cost of URR can be calculated as follows (see Appendix 1, Box 4 in Ariyoshi et al):

t=r(i*+s)T/(1r)D

where t is the implied URR tax rate (in percent of loanable funds), r is the URR rate, i* is the nominal interest rate in the currency in which the URR is constituted, s is the premium applied to the investor when borrowing funds to cover the URR (country plus borrower specific risk premium), T is the duration of the URR, and D is the duration of the foreign investment/borrowing.

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Memo: Corporate risk premium = 400 bps

The URR is aimed at discouraging short-term flows: the URR implied tax rate increases with URR rate/duration and decreases with borrowing duration. It is also increasing in the international interest rates and the sovereign/corporate risk premium, meaning that whenever the cost of dollar funds goes up or the sovereign/corporate spread widens, the URR rate/duration have to be adjusted downward in order to maintain the same implied URR cost.

C. Equity Market

18. During 2002, the Russian stock market significantly outperformed the emerging equity markets asset class, with the MSCI Russia index up 14 percent and the MSCIEMF Index down 9 percent. The local benchmark RTSIS Index, which is more diversified than the MSCI Russia index and has more medium- and small size non-oil stocks, returned 38 percent for the year.14 By comparison to the bond market, the scale of primary market activity in the Russian equity market was fairly modest—only $1.3 billion (mainly ADRs/GDRs), of which $775 million accounted for by the privatization IPO of the government’s 6 percent stake in Lukoil in December 2002. Market analysts believe that primary market activity in equities is not likely to pick up significantly until Russian companies achieve their optimal leverage levels and/or equity valuations become sufficiently ‘rich’ for the original owners to have incentives to sell their stakes.

Equity Market Structure and Investor Base

Total capitalization of the Russian equity market is currently $78.3 billion (according to the MSCI), with oil and gas sector stocks accounting for more than 70 percent of the market. There are two main organized exchanges for trading equities in Russia—the Russian Trading System (RTS) and the Moscow Interbank Currency Exchange (MICEX). Stock market liquidity is fairly low, due to large block holdings and cross-shareholdings, with the free-float (tradable shares) amounting to less than 30 percent of market capitalization. In addition, many Russian companies have active ADR/GDR programs, with the total value of all outstanding ADRs/GDRs estimated at about S3 billion (BEL/Capital data). The most widely held ADRs are those issued by Lukoil, Surgut, VimpelCom and MTS (around 50 percent of the total). According to legislation introduced last year, Russian companies are required to be listed locally for at least 180 days before they can issue ADRs/GDRs.

The investor base for Russian stocks is dominated by local investors (more than 60 percent, including individuals, large corporates and banks). Even a significant part of ADRs/GDRs is reportedly held by off-shore accounts that invest on behalf of their Russian clients. Some 30 percent is almost equally split between European and US dedicated emerging equity market funds. There is no general regulation that limits foreign investor participation in the local equity market, but there are some special cases—Gazprom, UES and Sberbank shares—where the government has imposed limits on foreign ownership. The much anticipated entry of global equity funds into the Russian stock market has not happened yet, as many global equity funds were unnerved by the increased risk of the emerging equities asset class, high geopolitical uncertainty and increased redemptions last year. As a result, they were forced to retreat from high-risk assets (including those that are oil-sensitive). Also, contrary to market expectations at the start of 2002, hedge fund activity has not picked up in any significant way either.

19. Despite a significant run-up in equity prices since the 1998 crisis, average equity valuation measures for the Russian stock market are still below those of its asset class (emerging equity markets) or industry (oil) comparators. For example, the price-earnings ratio (P/E) of the MSCI Russia index (6-7) is still only about a half of the P/E ratio of the MSCI EMF index.15 Even if one takes into account the quality of business environment and governance, Russian equity valuations do not appear to be excessively high (Figure 6.3).

Figure 6.3:
Figure 6.3:

Emerging Market Equity Valuations and Governance

Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A006

Sources: MSCI, World Bank Staff Estimates
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Note: Governance Score is an average or 6 WB governance indicators: Voice and Accountability, Political Stability, Governance Effectiveness, Regulatory Quality, Rule of Law and Control of Corruption.

20. The oil price is viewed as the main risk factor driving investor sentiment in the near term. Indeed, since early 2003, the correlation between the Russian stock market index and oil has risen (Figure 6.4). However, the Russian equity market may decouple from oil as soon as the Iraq-related volatility in oil spot and futures markets declines. This is because the probability that the long-run average level of Brent crude will dip below $ 15/bbl (the level at which the Russian oil companies are said to break even) is low, both as seen by most analysts and as implied by futures prices. Also, the equity market performance in the second half of 2002, with only telecoms and Sberbank posting positive returns, suggests that when gains in oil stocks are capped by high oil price volatility, the domestically-oriented stocks can drive the market.

Figure 6.4:
Figure 6.4:

Russian Stock Market and Oil

Citation: IMF Staff Country Reports 2003, 146; 10.5089/9781451833065.002.A006

Source: Bloomberg

21. The slowing down of structural reforms ahead of the elections is seen as the second most important risk factor for the Russian stock market outlook. Slow progress in the energy and gas sector reform is constraining much needed corporate restructuring. At the same time, there have been fewer improvements in corporate governance last year compared to 2001.16

22. Going forward, key changes that are needed to lift the constraints on further growth of the stock market capitalization and free float in Russia include the diversification of the economy and decisive improvements in corporate governance that would reduce high equity risk premiums and increase enthusiasm on the part of foreign institutional investors. The ongoing “chaebolization” of the Russian economy, with many large oil companies reportedly using their excess cash reserves to acquire local energy distribution companies (‘energos’), also limits growth of market capitalization. Finally, the introduction of enabling regulations to allow securitization of real estate and establishment of real estate investment trusts (REITs) will help to increase the capitalization of Russian stock market as well.

D. Local Institutional Investor Base

23. The development of a diverse institutional investor base will help to create a stable demand for sovereign and corporate bonds as well as to improve the “credit culture” of the local corporate bond market. At present, the investor base for ruble-denominated bonds remains very narrow and includes mainly large and medium-size banks. In many emerging markets, banks dominate the short-end of the government bond market, as they often hold short-term government paper to meet liquidity requirements. However, mainly the pension funds and insurance companies represent a stable and in many cases steadily growing source of demand for longer-dated government securities (for instance, pension funds hold 10 percent of all outstanding government bonds in Hungary and 25 percent in Mexico (IMF, 2002)). In Russia, the on-going pension reform is expected to result in a significant inflow of pension money into the government bond market starting from 2004. At present, the total investible resources of pension funds and insurance companies are fairly small (Table 6.1).

Table 6.1:

Investment Potential of Local Institutional Investors, as of July 1, 2002

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as of January 1,2002

for Q1 2002; Rb32.1 bn for 2002

Source: Federal Commission for the Securities Markets, Russian Federation

24. A consistent and comprehensive legal and regulatory framework is one of the necessary conditions for stable growth of various collective investment schemes. To this end, the Federal Commission for the Securities Markets (FCSM) and other regulatory bodies that currently oversee the activities of unit trust funds, asset management companies, pension funds and insurance companies should be encouraged to work together. The FCSM has recently published its medium-term strategy for the development of local securities markets (FCSM, 2002), where, among other things, it expressed concern about the potential impact of pension reform on the development of the investment fund industry. The law on investment of pension contributions in securities, which was approved by the Duma in July 2002, envisages that a limited number of asset management companies (that are to be appointed in an open tender) will be managing the investment of a portion of mandatory contributions into financial markets starting from 2004. The FCSM is concerned that this will limit competition in the investment management industry going forward.

25. Other issues related to investor protection deserve some consideration as well. For example, the appropriate regulatory bodies have to establish and enforce clear rules preventing a potential conflict of interest between asset management and investment banking arms of local banks. In addition, since many large corporates in Russia run their own pension funds, going forward, regulators should put in place safeguards to avoid the situation when the owners of largest institutional investors (pension funds or trust funds) are also among the most active issuers of corporate bonds. In Korea, for instance, corporate bond issuance picked up sharply in 1999-2000, but was mainly concentrated in the Big Five chaebols, which also owned the largest investment trust companies (ITCs). The subsequent collapse of one of the chaebols resulted in a run on ITCs and a sell-off in the corporate bond market, forcing the Korean authorities to introduce market stabilization measures to prevent spill-overs into other sectors of the economy (GFSR, 2002).

References

  • Ariyoshi, A. et al, “Capital Controls: Country Experiences with Their Use and Liberalization,” IMF Occasional Paper 190, Washington DC, 2000.

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  • Forbes, K., One Cost of the Chilean Capital Controls: Increased Financial Constraints for Small Firms,” 2002, MIT-Sloan School of Management and NBER, unpublished.

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  • Hessel, H., Russia: Is the Future Investment-Grade?,” Standard and Poors, January 16, 2003.

  • International Monetary Fund, 2002, Global Financial Stability Report,Emerging Local Bond Markets,” Chapter IV, September (Washington: International Monetary Fund).

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  • International Monetary Fund, forthcoming, The Role of Local Securities Markets, IMF Occasional Paper (Washington: International Monetary Fund).

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  • International Monetary Fund, forthcoming, Russian Federation: Financial Sector Stability Assessment, (Washington: International Monetary Fund).

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  • Kudrin, A. and J. Fenkner, Corporate Bonds: Russia’s New Revolution,” Troika Dialog, December 2002.

  • “The Main Objectives of the Medium-Term Debt Management Policy of the Russian Federation: 2003-2005,” Moscow, Ministry of Finance, March 2003 (in Russian).

  • “The Development of the Securities Markets in the Russian Federation,” 2002 (materials for discussion), Moscow, FCSM, (in Russian).

  • World Bank and IMF, 2001, Developing Government Bond Markets: A Handbook (Washington, World Bank).

1

Prepared by Anna Ilyina (ICM).

2

Debt service of the Russian government is expected to total around $17 billion or less in 2003, which is much lower than previously estimated due to the decline in global interest rates as well as to the active liability management operations conducted by the Ministry of Finance during 2001-02, including the buybacks of the Russia’03 and MinFin IV bonds, bilateral debt reschedulings, and arrears-for-bonds offsets with local entities.

3

For a detailed discussion of Russia’s sovereign rating and credit fundamentals see Chapter VII.

4

“The Main Objectives of the Medium-Term Debt Management Policy of the Russian Federation: 2003-2005,” Moscow, Ministry of Finance, March 2003 (in Russian).

5

This includes the Gazprom’s $1.75 billion 10-year bond sate completed on February 21, 2003.

6

According to Bank Zcnit, the average yield on a bond with the investment period of 1 year fell from 21.1 percent a.s of end-2001 to 15.8 percent as of end-2002, where investment period is defined as the time to the first put option expiration date or to maturity, depending which yield (yield-to-put option expiration or yield-to-maturity) is the highest.

7

According to S&P, as of end-2001, the three-year average total debt-to-capital ratios of Gazprom (23 percent) and Sibneft (13 percent) were significantly lower than industry medians (41 percent in Europe, 49 percent in Asia and 43 percent in Latin America for oil sector, and 46 percent for the global gas industry). Analysts believe that even if one takes into account the issues of transparency and corporate governance, there is still room for Russian corporates to increase leverage.

8

One notable exception was Sibneft that borrowed to finance its acquisition of Slavneft.

9

While several analysts expressed concerns about the debt structure and inefficient management of Gazprom, these concerns, however, did not appear to have had much impact on the recent SI.75 billion bond issue (February 21, 2003). The size of the issue was increased from the originally planned $750 million and, after having been more than three times oversubscribed, the bonds traded up in the aftermarket. In addition to other factors (Box 6.2), the Gazprom issue was, apparently, well timed, as it shortly followed BP’S acquisition announcement.

10

Many Russian companies prefer bonds to bank loans because the latter (but not the former) often require posting a collateral and are on average 2-3 percentage points more expensive.

11

The average size of the corporate bond market in Latin America is only 1.5 percent of GDP, while it is around 7.4 percent of GDP in emerging Asia. In Eastern Europe, the largest and most liquid corporate bond market is in the Czech Republic, around 4.8 percent of GDP (IMF, 2002).

12

A ‘veksel’ is similar to commercial paper but, unlike a standard commercial paper, its legal status is not well-defined and, unlike a corporate bond, it does not have to be registered with the Securities Commission. The capitalization of the veksel market was around $10 billion as of mid-2002, compared to the corporate bond market capitalization of around $3 billion (including the non-market issues).

13

These instruments appear to be similar to the Brazilian long-term debentures with repactuacion clauses that allow for a renegotiation of the terms and conditions of the securities every year (IMF, 2002).

14

However, the reasons for the diverging performance of these indices in 2002 appear to have been stock specific, i.e., related mainly to different weightings of large stocks in the MSCI Russia and RTSI$ Indices.

15

For detailed discussion of the Russian equity valuations, see The Role of Local Securities Markets, IMF Occasional Paper, forthcoming.

16

For detailed discussion of the corporate governance and market infrastructure issues, please see Russian Federation: Financial Sector Stability Assessment, (Washington, IMF), forthcoming, and “The Development of the Securities Markets in the Russian Federation,” 2002 (materials for discussion), Moscow, FCSM (in Russian).

Russian Federation: Selected Issues
Author: International Monetary Fund