The best model for developing the Russian stock market: a strong domestic market of investment resources supplemented by foreign capital

Alexander Potemkin, General Director, MICEX

Forty Russian companies have already issued ADRs. Three Russian issuers—MTS, Vypelkom, and Wimm-Bill-Dann—have third-level ADRs, the highest level, and are traded on the NYSE. The rest have first-level ADRs traded on the OTC market in the US or on markets in Europe, or have ADRs traded under Rule 144A, which can only be traded by qualified institutional investors with at least $100 million in securities. Russia is currently number six in the world in trading ADRs for shares in domestic companies. It is worth noting that worldwide, ADRs are usually traded at stock exchanges. Russian ADRs, however, are most frequently found on the OTC market in America. According to data from the Bank of New York, $11 billion in deals involving the ADRs of the most liquid Russian companies were conducted last year, and $14 billion in the first eight months of this year. By means of comparison, trading in receipts for Russian stock on NYSE, LSE, and Deutsche Borse reached around $77 billion from June 2003 to June 2004. These numbers testify to the significance of exchange trading of ADRs. The fact of the matter is that only ADRs traded on exchanges are capable of positioning a company as a transparent issuer with serious strategic plans to participate in the world capital market.
Leaders in OTC trading for the first eight months of this year were MTS, LUKoil, YUKOS, Norilsk Nickel, and Surgutneftegaz. These companies make up 96% of the trading in Russian ADRs within this system. On the market, the leaders in ADR trading were Sibneft, YUKOS, Norilsk Nickel, LUKoil, and Tatneft. If we take a look at changes in the share of ADR trades conducted on the foreign market compared to the total volume of trading in Russian stocks, we see a tangible increase in the foreign market’s share from 24-28% in 2001-2 to 40% in 2003. To all appearances, this notable increase is connected to the dramatic expansion of Western operators working with Russian securities after Moody’s assigned Russia an investment-level rating in October 2003. Now, Russia is among the top ten countries with high ratios of foreign to domestic markets. To be fair, we should mention that several relatively weak developing countries such as Peru and Mexico were also among the top ten, as well as some of the world’s leading economies, such as Canada. A country’s size seems to have little effect in principle on the share of the foreign market, which is the same in Luxembourg and Brazil.
The important difference between the foreign and domestic markets for Russian stocks is that different categories of investors operate on them. The foreign market is to a great extent oriented toward major institutional investors that include securities from countries with high credit ratings in their portfolios. These large investors do not review their portfolios often. As a rule, this only occurs in connection with major political or corporate events. The investors on the domestic market are far more diverse. Securities operations are conducted by small brokerages and banks, as well as by numerous individual investors responsible for a large number of operations each day. However, just because there are no big investors does not mean that the domestic market is ruled by speculation. In recent years, institutional investors—banks, mutual funds, private pension funds, insurance companies—have played an ever larger role on the domestic market. For instance, the top twenty biggest operators on the stock section of MICEX for August 2004 included Alfa Bank, Gazprombank, Probiznesbank, and other leading Russian banks.

ADR: Pro and contra

The further integration of Russian into the world economic system, in particular as Russia joins the WTO, will be accompanied by an increase in the share of the foreign market sector. According to analysts, ADRs will become more popular in Russia. Five Russian companies are already planning in the next two years to issue third-level ADRs. In the next four years, if the Russian economy and the world financial market remain stable, around twenty Russian companies will be in a position to issue ADRs.
Despite the growing popularity of ADRs and other financial instruments traded abroad, opinions differ as to their effect on the Russian stock market. On one hand, the development of a foreign market for Russian securities serves as a catalyst for the domestic stock market and helps integrate the domestic market into the global stock exchange community. On the other hand, expanding ADR issues by Russian companies is hampering the domestic capital market’s expansion, as liquidity is pulled from the domestic to the foreign segment of the market. Thus, increasing the size of the foreign market not only means rapprochement with the Western financial community, but at the same time threatens to drain liquidity from the domestic market. From time to time, regulatory agencies have expressed their concern that the stock market is moving abroad and have implemented various legislative limits. Russian authorities are paying particular attention to controlling ownership rights in the banking industry. According to Russian legislation, foreigners need the Central Bank’s permission to acquire any shares at all in Russian banks.

Airlock or center of gravity?

The market for ADRs and corporate eurobonds has traditionally been dominated by major corporate issuers. Leading Russian corporations, hoping to attract large-scale, one-time investment, will continue to look to world capital markets in the future for investment resources.
There is little point in debating that when market conditions are good, the foreign market allows companies to attract a large amount of resources. At the same time, the domestic market is always an important indicator for corporate events such as mergers and takeovers. If market conditions worsen, the domestic market could always become a source of capital.
The domestic capital market will develop actively thanks to small and mid-sized companies entering the market. For smaller companies whose capitalization at placement does not exceed $300-500 million, entering the Western market makes little sense. High costs make an ADR issue unviable. For these companies, the domestic market will become the sole good source of capital. For this reason, IPOs of their stocks will take place on the Russian stock market, and not elsewhere.
We can thus conclude that the best model for developing the Russian stock market is a strong domestic market for investment resources supplemented by foreign capital and not vice versa. The local financial market should be accessible at any time and should help Russian companies attract new capital in any situation. With this model in mind, the development of the Russian depositary receipt market might be a very promising project. Some of the major companies in the NIS could potentially issue this kind of security. In addition, the Russian stock market also needs to develop as much as possible the institution of the IPO in order to increase domestic liquidity and investment efficiency. This could be accomplished via the collaborative effort of both regulatory agencies and professionals on the market.
First and foremost, the costs associated with deposit and accounting services should be decreased by creating a special central depository for the shares of companies conducting IPOs. Time and organizational costs also need to be reduced.
Guided by the logic of the development of the world depositary receipt market, we can determine two ways the Russian stock market could evolve. The first is positioning Russian exchanges as a kind of an airlock for Russian issuers in the process of entering the global capital market. The second way is for the market to attempt to become a major nexus of the world stock market by accumulating, much like the NYSE, LSE, and Deutsche Borse, operations involving both the capital of domestic companies and financial instruments, including depositary receipts, from other countries, most likely from the NIS.
The creation of such a center would to a great extent block the movement of Russian stock operations abroad. However, we should not forget how difficult the tasks are that would have to be solved in the process of this transformation. In addition to regulatory issues for monetary authorities, there are technical problems that Russian exchanges would have to deal with. These problems include creating the conditions that meet world standards for accounting and clearing.

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