The Russian economy is showing signs of decreased investment activity. The main reason for the instability is Russian authorities’ increased pressure on business.

Yana Galukhina, Tatyana Gurova, Maxim Rubchenko

The week before the May holidays, investors saw an impressive decline on the Russian stock market. Between April 12th and April 30th the RTS Index fell by almost 18% from 781 to 631 points. Naturally, the fluctuations of the stock market do not have any direct negative impact on Russia’s economy, if only because of the stock market’s limited size. However, there is no reason to brush it off, either, as even in its current state, the stock market indicates investor mood. A panic on the market is merely the first, clear sign that investors have doubts about Russia’s attractiveness and about Russian stocks as a means of capital investment.

Believing the bad news

The RTS began to fall on April 12th after six months of confident growth. The first push toward decline, analysts believe, came from Russian banks, which occupy an important place on the stock market. “The stock market decline was connected to the short-term deficit of banking system resources,” argues Vasili Ivanov, Director of the Investment Department at Petrokommerts. “With the current peak in tax payments by the clients of credit institutions, a noticeable decrease in the supply of resources on the inter-bank market occurred and led to an increase in inter-bank credit rates”.
At the same time, China’s prime minister announced that the Chinese authorities, disturbed by rising inflation and excessive investment, plan to take decisive measures to cool down the economy. This announcement led to a sharp decline in prices for natural commodities, stocks, and currency practically worldwide, and Russia was no exception.
However, short-term problems with bank liquidity and the “China factor” alone are not capable of causing such a strong negative reaction on the stock market. Everybody knows the liquidity problem will be resolved fairly quickly. The “China factor,” moreover, was first of all to be expected, and second of all it has both positive and negative effects on the Russian market. One of the largest and most attractive borrowers is temporarily withdrawing from the world financial market, which will leave investment resources open…why not invest in Russia? This question is easy to answer.
April 23rd, Vice-Premier Alexander Zhukov order Minister of Development German Gref “to arrange for the Sayano-Shushensky Hydroelectric Plant to return to state ownership in accordance the court’s ruling.” Stock market investors perceived this unexpected move, which did not have any direct relationship to financial markets, as a promise to start de-privatizing one of Russia’s largest power stations. The result: RAO EES Rossiya stock prices plummeted by 10% in one day.
On March 12th, the Arbitration Court of the Eastern Siberian Federal District declared the privatization of the Sayano-Shushensky plant invalid and ruled that the plant’s assets had to be returned to full state ownership. Representatives of RAO EES immediately announced that they will dispute the Siberian court’s decision. It is very possible that Zhukov’s order was merely meant to remind the energy holding that it needs to either appeal or carry out the court ruling. However, as criticizing the results of privatization has become all the rage among high-level Russian officials today, the Russian market reacts to any hint at de-privatization of assets quite badly, to put it mildly.
Rumors on April 29th that Vladimir Potanin would soon be arrested troubled the market even more. The price for Norilsk Nickel shares, already falling due to the news from China, fell by more than 10% in one day. In two days, the company lost more than two billion dollars of its market value, falling from $14.67 to $12.57 billion.
The “Potanin factor” hit the entire market. The RTS Index lost more than 5% in a single day, April 29th. Inter-bank credit rates also skyrocketed that day from 10% to 40%. The price of Russian eurobonds on the international market fell from 92% to 89% of face value in a matter of minutes, which meant Russia’s foreign debt grew by several tens of millions of dollars.
When both Interros and the Prosecutor General denied the rumors, the situation improved somewhat, but in the week before the May holidays, the world’s biggest producer of nickel lost 15% of its capitalization.
The Sayano-Shushensky plant and the imagined arrest of Potanin both point to the same thing, namely how easily the market believes bad news. Even if the goal of all these rumors is to manipulate the market, it must be admitted that the people behind them have found a fool-proof method. Many observers believe that the next political target will be the head of Interros himself, especially after Potanin strongly condemned Finance Minister Alexei Kudrin’s “London theses” regarding “socially responsible” business practices. It no longer matters how fanciful his hypotheses were. There is no denying that the YUKOS Affair exacerbated the stock market’s vulnerability to rumors and made it easy to manipulate. Perhaps the market’s sensitivity increases its attractiveness for speculators, but without a doubt it reduces the interest in Russian stocks of investors thinking about the long term.

The point of no return

The hopes improving Russia’s sovereign credit rating are intimately connected to how the courts sort out the YUKOS Affair, and hearings began May 7th. Unfortunately, an unfavorable ruling for YUKOS looks very likely. Let’s not forget that only two days before the trial began, Alexei Kudrin referred in an interview with the newspaper Kommersant to the example of LUKoil, which once upon a time registered a company in Baikonur. Tax officials, according to Kudrin, were able to prove that this company “was merely a vehicle for reducing taxable capital. LUKoil agreed with this conclusion and decided to pay up.” Immediately after this statement by Kudrin, YUKOS shares fell by nearly 7%. “Investors took Kudrin’s words as an unambiguous order to the court about how it should rule on the YUKOS tax payment case,” noted the United Financial Group in an analytical overview.
Naturally, it is not the fate of YUKOS itself that so worries financial market players. The bad thing is that it is so easy to bankrupt one of the largest and most successful companies in Russia. The YUKOS ruling will mean open hunting season for tax collectors on entrepreneurs across Russia. If YUKOS will be declared guilty of illegal use of domestic off-shores, thousands of other Russian companies doing the same thing will also come under threat. For both domestic and foreign investors, this means extra risks that reduce the attractiveness of Russian assets. Under such conditions, it becomes less and less likely that Fitch or Standard & Poor’s will raise Russia’s sovereign credit rating to the investment level.

Risky times

Many market players know that all is not well with the Russian economy and that it is under powerful negative pressure, pressure which could at some unknown point turn economic growth into decline. This is because state authorities, by attacking Russian big business, are disturbing the mechanism of investment that has supported economic growth for the last two years.
According to our calculations, beginning in 2002, invest became the main factor behind economic growth in Russia. Last year, when investment growth rates reach 20% p.a. in certain months, the majority of analysts recognized investment’s influence. According to the shared view of market players, the rapid investment growth last year came predominantly due to direct and portfolio investments by large domestic entrepreneurs, who considered it advantageous and possible to reinvest both current profits and previously exported capital back into Russia. What has changed today? A lot.
Obviously, when business comes under political pressure, there is less motivation to return capital from abroad and reinvest profits. That’s the first issue. The second is that business’ demand for cash increases, in case companies have to pay the tax man. In this context, TNK-BP’s request that British Petroleum pay $3.75 billion for assets handed over to the joint company ahead of schedule seems completely symptomatic. Analysts explain this move on the part of TNK-BP’s Russian shareholders (a move which does not benefit either party) as stemming from both the desire to invest in a television station and a misunderstanding between the company’s Russian and British management teams. In our opinion, it makes sense to assume that Mikhail Fridman and other TNK-BP co-owners are simply hording money in case they are forced to obey the demands of the tax authorities.
Obviously, under such conditions, the price for borrowing funds on the international market will increase for Russian companies, or at least cease to go down as it has up to now. In the end, this chain reaction could lead to a reduced money supply in Russia, higher prices for money, and then to a slowdown in the investment process. As the American economy gets back on its feet and the price of money worldwide is expected to rise, these negative developments will only get worse.
For the moment, we are seeing the first signs of a decline in investment activity in real fixed assets. Investment figures for March turned out more modest than anticipated, based on last year’s investment pattern. Last year, February and March were filled with announcements of new investment projects, while this year they are noticeably fewer. Of course, this is not enough for us to start talking about a slowdown in investment growth. But taken along with what is happening on the stock and bond markets, there is reason for concern.
Does the government feel this concern? More likely than not, it does, and it is preparing a set of compensatory measures. Shoving aside independent big business and the stock market as institutions difficult to manage from above, the government to all appearances is placing its bets on large-scale investment and socially significant projects in three areas, namely innovation, transportation, and construction. In order to expand investment in the high-tech sector, the president convinced the Ministry of Finance to privatize intellectual property. In addition, the government now has a stabilization fund that can also be used to make investments.
This is all well and good. But how is this being accomplished? The government has yet to discuss its strategic sketches with the already existing Russian business community. It is only asking—both directly and indirectly—for money. When business talks back, the government remembers those off-shores. Why are the authorities acting this way? Possibly they can’t and don’t want to work with independent entrepreneurs. They think that by coming up with some new projects, they can surround themselves with new, reliable partners who will be completely dependent on the government. However, this approach could lead to another division of property, and the very suggestion of this is sending the financial markets into a panic.

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