Financial system and economic development (Tacis project of Assistance to the Ministry of Economic Development and Trade) - Russian News

Targets of financial reform in emerging economy may be formulated in a different way; therefore, conclusions and recommendations of the Paper may depend both on actual material – macroeconomic (institutional) scenario and analysis of sectors and instruments – and on objectives of reformer. It is clear that there exists considerably developed discussion about bank reform, many materials about other sectors, especially about pension reform and development of insurance sector. However, common approach and target of development of financial sector eludes observation and is sufficiently expressed neither in scientific works nor in government documents. Discussing of private financial sphere takes place with regard to separate instruments and laws and not in the general context of country development and a role of financial sector.
Let’s formulate two possible approaches to development of financial sector in Russia which might influence both understanding of the Paper and its usage. The first approach doesn’t require actions assuming that Russia undergoes in a natural way all phases of industrial development and development of financial sector without any considerable interference of the state as a reformer. The state concentrates on formulation of common laws, and, as far as possible in emerging economy, supports ownership rights, financial control over enterprises belonging to financial sector, avoids budget deficit. Naturally, filling “gaps” in legislation takes place. However, complex reforming of the sector and its adequacy to the needs of development of country economy are not under consideration. State gives to private business (and its organizations, if possible) full initiative in credit development, choice of financial servicing in bank sector and on financial markets (home and abroad), in working out new instruments, while applying, if possible, common international norms for ensuring necessary (according to standards) level of capitalization and financial indicators. This approach is coherent and implies maximal liberalization of currency control and capital flow, all parts of financial sector both in control and ownership and in operations.
This policy carried out to certain extent at present resulted in 1998 default which focused efforts of Government on solving budget and debt problems and practically excluded possibility of scale intervention by government into savings process, intermediation of financial sector and savings. At some moment government had insufficient financial and organizational resources for large scale reforms in this sphere. Apparently private interests also played its role, for example, in the situation that large scale restructuring of bank sector had not been carried out. Reforms in conditions of budget-debt crisis have to bear structural and institutional character, being at the most cost saving for the budget and convenient for those players who have stable position on existing economic stage. Having such approach, no ambitious targets on capitalization, volume of operations or parameters of financial sector can be formulated. If we are satisfied with existing financial sector or we are expecting its independent accelerated development, there is always possibility to revert to this approach.
Considerations concerning bank system may be applied with the same commonness but more critically actually to all other segments of financial institutions: “…. Lack of radical reforms predetermined present weakness of the Russian bank system, making to speak that it needs not in reform but in creation anew.” The main problems which Russia bank sector faces at the beginning of a new century and which requires immediate solution are as follows:

This Paper is an example of different approach – it’s try to view development of the sector of private finance in general, basing on the ground that (it will be shown further) majority of its segments are small and cannot adequately implement their usual role of financial intermediaries. Year 2002 is presumed to be the right time for the following reasons:

Protection of financial sector stability in developed countries reflects its outstanding role in development of economy, and in accumulation most of all.. It is clear that the issue is not in justifying budget injections in Russia, but rather in financial sector development being inadequate for the problem of national development. International comparisons show that Russian banks and other financial enterprises are at the level of transitional economies which do not have such a significant export, are not characterized by such a high non-uniformity of branch-specific industrial and regional development, and have not suffered, probably, such a deep crisis of accumulations in the 90-ties (four-fold decrease) as Russian economy.

Fig. 1.1. Long term sovereign currency credit ratings of Russia.
Rating diagram – Group of economic experts.

By the fall of 2002 sovereign ratings of Russia (Fig.1.1) have nearly achieved the 1997 level . This fact indicates that macroeconomic and debt stabilization will make possible for the Russian issuers to reenter international credit markets. Portfolio capital has already started to inflow into Russia and it needs adequate financial institutions and instruments for participating in the process of accumulation. Complicated law evading forms increase financing costs making financing of big infrastructural objects especially complicated, which will be in increasing demand in the course of time, in particular due to expected reforms in natural monopolies.
Inflow of direct investments to Russia didn’t increase in 2002, and in 2000-2002 it was equal to absolute value of inflow to Hungary, being two times lower than in Czech republic and three times lower than in Poland. At the same time Russia stays first among European countries with emerging economy in respect of direct (legal) outflow of capital in 2001: USD 2,6 bln. against USD 337 mln. of Hungary which is the second in this respect. Outflow of direct capital exceeds inflow. It also indirectly indicates that by setting up joint-ventures, projects’ financing or financing against guarantee (for example, by bilateral credit lines), it is not possible to ensure sufficient inflow of foreign (including Russian) capital into the country.
Inflow of portfolio capital resulted in double reduction of banks’ international position from July 2001 till July2002 (from USD 11,9 to 5,7 bln.). This trend demonstrates the beginning of massive inflow of portfolio investment capital but in the form which is characterized by its fluctuations. The latest review of the situation in bank system shows: “ Credit boom typical for the last two years is abating. A specific “credit pause” is about to happen, which is characterized by reduction of credit growth rate in economy, though real threat of big scale “bad debts” crisis is quite far away”.

Fig. 1.2. Savings and accumulation in Russia in 1996-2001. (in % GNP).
Source – “Review of economic policy in Russia for 2001», M., 2002, TEIS, Appendix 1 «Accounts of capital flows», p. 325.

The overall use of savings in Russian economy is illustrated in Figure 1.2 Actually it shows that after 1998 crisis Russia managed to mobilize savings for servicing external debt and continued export of capital, while accumulation rate increased from 15% in 1999 to 22% in 2001. It is true, however that in the recent time the growth was due to reconstitution of reserves while the rate of investments as such remains within 18%. Big positive value of current payment balance represents a theoretically inevitable capital outflow along several budget items: servicing and pay off of external debt, legal and semi-legal export of capital, purchase of currency by the Central Bank. In any case, Russia undoubtedly demonstrates one of the highest rates of savings in the recent history – nearly exceeding 30-32% saving rates in South-Eastern Asia and Japan (33% in 1961-1973) during the accelerated growth period. However, in those cases both savings rate and accumulations were correspondingly high, like the growth rates. World general saving rate is about 23% of GNP .
Naturally, due to stabile status of low rate of savings within three years after 1998 default, problem of modernization is still open especially because according to preliminary assessments growth of investments in 2002 is slowing down (lower than GNP growth rates). Russian situation is different due to necessity to serve high debt while being in tremendous need of capital investments into infrastructure, transport, manufacturing industry and research after a decade of “investment pause”, and at the same time exporting capital. The necessity and possibility of rational use of national savings lies within peculiarities of internal process of accumulation and the role of financial sector.

A) Annual average GNP growth rates during the period, %;
B) Ratio of average share of investments in GNP to average GNP growth rate within the same period, times.
Calculations based on international statistics.

International experience shows that for each 1% of annual average growth of GNP, average rate of accumulations increases by 3 to 6% (see Table 1.1) during the same period (the only exclusion being Japan during the length crisis in the 90-ties). This index is somewhat lower at the earlier stages of industrial modernization. In principle, it can be expected that in modern Russia accumulations will be slightly more effective, but this implies higher share of equipment in investments and use of the state of art technologies. In general, growth of accumulation rate in official governmental projections is based on expectation of gradual growth of accumulation rate and GNP growth rate with the factor of ultimate capital capacity 4 to 5 times, while current level is also about 4-5% at the rate of accumulation being 15-18% . Evidently, without effective financial sector it is very difficult both to raise accumulation rate and to increase efficiency of accumulation through creditor’s control over borrowers and quality of their projects.

Fig. 1.3. Savings of the national economy sectors (% of GNP).
Source – “Review of economic policy in Russia for 2001” , Ì., 2002, TEIS

Specific feature of Russian situation is concentration of major savings in the hands of enterprises. This fundamental fact should strengthen attention given to the problem of financial sector and its tools since it is highly profitable companies which should solve the problem of choice between investment in their own companies, acquisition of other companies inside the country, investments outside the country, or acquisition of financial tools which would allow them to finance capital investments of other companies, in particular, of other sectors. Growth of state savings during the last two years did not affect the accumulation process since it reduced state capital investments. Reduction of state lending did not have any significant influence on financial sector resources, since they remained low. Actually in 2000 amount of government investments in the country dropped lower than median level in OECD (about 4% of GNP). After default government borrowings cessation undoubtedly was a benefit for real sector as a whole. However it didn’t considerably change the situation in financial sector – discontinuation of resources “raking out” by the government having weak financial sector didn’t dramatically improve possibilities of external investments’ funding.

Fig. 1.4. Net credit position of enterprises in respect of other sectors of economy (in % of GNP).
Source – “Review of economic policy in Russia for 2001” , Ì., 2002, TEIS

Figure 1.4 shows a more complicated picture. It shows that during the last years non-financial sector was actively crediting “other world” (foreign countries) and financial sector. Only in 2001 the enterprises were able for the first time to obtain financing from the financial sector, which proves positive tendencies in national economy. Capital outflow or annual funding of other world equal to USD 15-20bln. (capital outflow equals to approximately 5-6% of GNP) actually represents the reserve of financing which could have been redistributed inside the economy through more powerful, efficient and trustworthy financial sector.

Comparing with 2001 important changes took place in the following spheres:

The major reason for credit inaccessibility is not vulnerability of prosperous creditors, but rather inability of most borrowers to provide liquid collateral which would attract creditors. As Russian experience demonstrates, when liquid collateral is available, banks are actively providing credits, i.e. against export contracts. Figure 1.5 shows credit dynamics in recent years. It should be noted that in 1999-2000 relative reduction of credit took place and only in 2001 it shifted upwards along with GNP. It should be noted that it was mostly provided by private sector: the share of Central Bank in the total credit represents low percentage. It can be seen from the chart that private credits increased significantly in 2001 (from 11,9% of GNP to 15,4% of GNP). However, it follows from Table 1.2 that its level remains comparatively low. At the same time the share of private credit in the internal credit has grown significantly, which in mid-2002 amounted to 67% (as compared to 31% at the end of 1998). However, the share of bank credits to enterprises for the term over 1 year is 29%, and for the term over 3 years – only 7%.

Own resources	50,3
Regional budgets	2,6
Federal budget	5,8
Credits of other organizations	4,9
Bank credits	3,5
Non-budgetary funds	2,6
Stock issue	0,1
Miscellaneous	20,2

Source: MDM - Bank

Situation in Russia is very typical for the countries with emerging economy. According to L.Bokrosh : «After 10 years of transitional period financial sector in Central and Eastern Europe is characterized by the following:

Finally, time factor which was spent during ten years crisis of transitional period makes to search for ways of ensuring growth and development. Actually, insufficiently active investing process and slow improvement of the situation is a sound basis for considering prospects of financial sector development with specific prerequisites: two scenario of institutional development on which two scenario of macroeconomic conditions are laid on (approximately according to official forecasts).
Assessment of financial market development in the perspective, in transitional economies presents a significant problem. Strictly speaking, there are too many variables, too many institutional factors of critical importance, which affect the process. For a whole number of reasons, it is impossible to create a closed system to forecast demand and offer of financial market tools:

Function of financial markets can be described in different ways but we shall consider Noble prize winner G.Stiglits’s work who gave this description in a specific work on emerging economies in the beginning of 90-s (in narration):
1. Transfer of the resources (capital) from saving agents to borrowers and investors.
2. Capital agglomeration as the projects need more capital than one or group of savings agents may offer.
3. Projects selection.
4. Monitoring of project funds usage.
5. Ensuring of projects fulfillment (pay back).
6. Risk transfer, split, aggregation.
7. Risk diversification.

Existence of a close relationship between the level of financial system development and intensity of development of any country is a well-established fact. At the same time, the nature of this relationship is still discussed by economists. Some believe (for the first time this opinion was clearly formulated by I.Shumpeter) that financial institutions have active influence on economy due to more effective transformation of savings into investments. Other influential economists attribute rather passive role to financial system, believing that its mere role is to satisfy the demand in broker services. Thus, Noble prize-winner R.Lucas stated that “significance of financial sector for economic growth is grossly overestimated”.
An important development in this area was achieved due to recent studies conducted by World Bank experts (R.Levine, A.Demirguc-Kunt, V.Maksimovic et al.), where relationship between financial system parameters and economic growth rates was studies empirically on a vast material. The influence analysis was conducted at several levels: by comparison of parameter levels and dynamics in a large number of countries, branches and individual enterprises. Of great importance are recent publications in which interrelation between financial system development and institutional environment (including the type of legislative system, its orientation to protection of investors’ rights, provision of contracts right, etc.) is reviewed. These works have proved that the parameters of financial system development not only correlate with long-term rates of economic growth, but there is a stable cause and effect relation between these two. Along with that, new important data was obtained on the mechanisms through which financial institutes influence economy. Relative importance of various mechanisms determines the angle of view, under which it is reasonable to review the perspectives of Russian financial system development.
The view on these mechanisms largely depends on the discipline within which they are discussed. Thus, in the frame of economic development theory, fundamental importance is attributed to capital accumulation process. According to world-wide experience, production investment at the companies (at operating enterprises) are mainly made through own funds (profit and capital charges). Since even in the most developed countries the leading role in investment financing belongs to the banks, financial system is largely equaled to banking system and the analysis is reduced to the discussion of the latter.
The advocates of “banking” approach believe that banks primary importance is determined by conduction of focused analysis of credited businesses and significant control over their managers. On the other hand, a number of researches consider capital markets to be a more important part of financial system. This point of view is reasoned by importance of markets as a unique source of free-for-all signals on investment attractiveness of particular branches of industry or businesses. Significant positive contribution of market-driven assessments into growth of economic efficiency has been proved empirically.
In terms of corporate finances, since classical work by Modigliani-Miller it is believed that various ways of financing are of equal significance for a company. Clearly, this is true for more developed and efficient markets at rather strict prerequisites . As for transitional economies, the conditions for market formations are still being formed. Actual roles of banks and markets in different countries vary within a very wide range.
Recently, “functional” approach has become most pronounced, according to which it is no longer important whether brokerage is based on a bank or on a market, as long as it performs its fundamental functions successfully, namely:

Stressing the importance of financial services does not mean undermining the role of financial institutions. In fact, within the frames of this approach big importance is given to relationship between institutions, markets, and tools in the process of broker activity. Higher quality of broker services in principle can influence economy through increase of savings rate, more active accumulation of main capital and its more efficient distribution (in particular, more active innovation activity).   However, it should be remembered that theoretically, some of these effects can be both positive and negative. Thus, availability of developed financial system along some channels provides positive effect of the level of savings in economy, while along the others it leads to reduction of this level, so that the summary result of such an influence remains uncertain.
Capital accumulation (even at constant level of savings) may increase because risk separation (including provision of liquidity of invested resources) and additional control over the use of these resources by the managers, decrease transaction costs and through this, cost of capital.
A number of recent studies   showed that when analyzing investment formation it is critically important to take into consideration imperfection of financial markets, as a result of which a significant gap exists between the cost of internal and external sources of accumulation. It is well known that theoretically availability of own investment sources should not influence investment decisions in any way. However, this is true only in “ideal” situation when all market participants have equal access to capital and credit interests are strictly related to investment risks. In real life, access to credit resources varies significantly between sectors and countries as a result of which development of many industries is in critical dependence to the access to external financing sources. In Russian conditions, access to credit remains segment-related. This problem cannot be solved by globalization of international markets of capital to which there is a lot of evidence: extremely strong correlation between the level of savings in different countries, significant inter-country differentiation of investment profitability, etc.
In the sectors where such access is limited, the volume of investments depends significantly on the amount of own resources. In particular, availability of external financing is especially important for development of small and venture businesses in which potentially most promising but highly-risky innovation projects are usually concentrated. One of the most important results of financial system development is greater access to external financing.
World Bank studies in 87 countries of the relation between financial depth (private credit as percentage of GNP) and market capitalization of stock, and the level of per capita income have demonstrated direct and stable correlation It follows from the above that developed financial markets are of special importance for such an economy or such sectors which are in particular demand of external financing, not having own sufficient sources of accumulation. As applicable to Russia, this is particularly true for machine building and agriculture. Thus, the state of financial broking can affect not only the rates of economic growth, but also the structure of economy. Strong financial system provides equal development opportunities to those sectors where own financial sources are insufficient. In particular, it facilitates the process of market penetration by new businesses, which increases competition and by that contributes to the growth of economic efficiency.

Inset 1.1. Spanish experience.
Let’s consider similarity of the situation in Spain and Russia: starting development of bank sector, lagging of stock market. Constructive aspect in the Spanish financial history consisted in explosive increase in shares’ circulation and acquisition (up to 40% of taxpayers) due to privatization of natural gas and power supply monopolies in the middle of 90-s. In general, during privatization period in Spain within 1993-2000, about Euro 30 bln. has been generated, and additional share issue in 1999-2000 produced extra Euro 25 bln. Considerable tax concessions (on capital cost growth) were given to the families which would keep shares within more than two years after purchase. Thus, a considerable stimulus was given to stock exchange development, improvement of financial “literacy” of the population and trustworthiness of the people to financial institutions. Involvement of the broad masses in stock acquisition, including improvement of the support by population and mobilization of home savings, considered as an important objective of the reforms.

Clearly, the role of external financing drops in stationary conditions and increases abruptly when the structure of economy by any reasons (i.e. under the influence of external shocks) undergoes significant changes. This proves the importance of external financing for transitional economies. On the other hand, the gap between the cost of internal and external financing sources is largely determined by institutional factors such as asymmetry of information possessed by insiders and investors, adherence to contract law, etc. In Russia, transformation process is evidently accompanied by the strongest structural shifts, while institutional environment is unfavorable even in comparison with majority of other transitional economies. This determined the special acuteness of the problem of external financing in our country.

The above studies of the World Bank allowed us to test empirically the hypothesis on possible channels of influence of financial system on economy. Traditional analysis is based on indicators, which are used to assess the degree and structural features of financial system development in various countries. These indicators are used in current work and allow us to compare quantitative parameters of Russian financial system with that of other countries, as well as assess possible effect of the further development of financial sector in our country:
Financial development. Is defined as a sum of internal credit (which does not include inter-bank credit) and capitalization of securities market in percent to GNP. Thus, this measure unites the parameters of banking system and capital market development.
Liquidity parameters. Most common in this category is the parameter called “financial depth” which characterizes the size of financial-broking sector and is defined as its summary liquid liabilities (including cash and liabilities of banking system and non-bank institutions) in percent of GNP. Table 3 shows that in most wealthy countries the liquidity is roughly two thirds of annual income while in the poorest countries it is only one fourth.
Financial activity. This indicator is similar to the previous one with the only difference that instead of capitalization parameter, stock market turnover is used.
Private sector crediting. Represents credit to private sector as a percentage of GNP. Potential importance of this parameter is determined by the fact that it shows in what degree the system provides transformation of savings into private investments. As a rule, this should be backed up by financial sector activity aimed at selection of efficient companies and investment projects, insurance and separation of risks and provision of transactions.
Private crediting of private sector. This indicator is similar to the previous one with the only difference that it does not include Central Bank credit. Thus, it reflects the activity of broking sector to a greater degree.
Share of private sector in crediting. Represents a share of credits given to private sector in the total volume of internal credit. This indicator is important since the efficiency of crediting private and state sectors differs significantly.
The role of commercial banks. Represents proportion between internal credit provided by commercial banks, and the sum of internal credit provided by commercial banks and Central Bank. It can be expected that commercial banks are more efficient in selection of investment projects and risk diversification, thus the high proportion is indicative of more developed financial system. In the wealthiest countries this proportion exceeds 90%, while in the poorest it is around one half.
In some studies the named variables were used in logarithmic form. All the above parameters correlate well with parameters of economic development. The table below shows correlation between major parameters of financial system with GNP value and variations of these parameters in four groups of countries (by GNP per capita).

Table 1.3 Relation between financial system parameters and per capita GNP value (1985)

	Groups of countries with per capita GNP:				Correlation with per capita GNP
	High	Above average	Below average	Low
Financial depth	67%	51%	39%	26%	0.51
Crediting of private sector	53%	31%	20%	13%	0.70
Role of commercial banks	91%	73%	57%	52%	0.58

Source: R.Levine, Financial Development and Economic Growth. World Bank, Policy Research Paper 1678, 1996.

One should realize that these parameters are conventional to a very large degree, since their construction involves aggregating of essentially heterogeneous elements. For example, the result showed that increase of stock market capitalization (measured as percentage of GNP) by 1 percent item is equivalent in terms of influence on the growth of financially dependent companies to increase of internal credit by only 0,4 percent item. Comparatively lesser influence of capitalization parameter can be explained by the fact that its increase as such does not mean additional financing of investments.

Main general conclusions of the econometric analysis of different countries, industries and companies can be formulated as follows:

In application to Russia it means that strengthening of financial system serves as a necessary prerequisite for diverse from “raw material” model of development and creation of conditions for expansion of critically important sector of dynamically growing small and medium enterprises. The reverse relation was also revealed: high demand for external financing creates demand for broking institutions, thus stimulating their development.
The absence of clear relation between financial system structure and its efficiency proves fruitlessness of old discussion on advantages of particular architectures. However, in-depth studies show that the issue of advantages of a certain structure is relevant but it should be formulated in a more concrete manner: under what conditions is banking or marketing broking system more advantageous? S. Tadesse concluded that efficiency of financial architecture depends on the structure of economy and its institutional environment. In particular, he found that in the countries with developed broking sector, its “market” orientation provides a positive effect on growth, while in the countries with weak broking system, on the contrary, positive effect on the growth is provided by “banking” orientation. The authors of the study are of the opinion that in the basis of the revealed relationship lies action of institutional factors: markets can function productively only under the condition of high degree of property protection and law observance. Fulfilling of these conditions stimulates development of financial system in general and capital markets in particular. Bank activity is less sensitive to the “quality” of institutional environment. In other words, the presented results confirm the consideration voiced by many economists that strong banks have relatively more possibilities, even in unfavorable institutional environment, to collect information on enterprise performance, control use of borrowed money, and oversee contract fulfilling. This conclusion explains why at the early stages of transition to market economy the burden of financial broking is laid on banks. In the future, countries with more developed legislative base and strong market institutions may receive additional impulse for development with the help of capital markets.
A relation was also found between financial architecture and structure of economy. Namely, it was found that banking system has advantages in the environment where small businesses prevail, while market system works better under the dominance of large companies. Thus, according to one indicator (weak contract legislation), banks should be more efficient in Russia, but according to other (high concentration of production) – markets should have an advantage. This leads to the conclusion that it is necessary to develop both main directions of financial system. In development logics a certain succession is observed – from banks to markets.
Inter-country studies have also shown that if the overall structure of financial sector has no decisive significance, the fastest growing countries generally use the whole range of financial tools . In other words, the solution to the problem of bringing our economy to the stable high rate of economic growth (not less than 5% per annum) requires vigorous development of all elements of financial system, not just of one of its parts.
Even more important difference was revealed for direction of investments. One of conclusions made in above mentioned work by Rajan, Zingales (1996) states that investments into state sector produce negative, and not positive effect on the rates of economic growth. However, this results needs additional verification. World Bank studies demonstrate that there is no strict correlation between government investments and development –among courtiers that spend on these purposes more than other countries one can find: Germany, Italy, Portugal, Czech and Hungary. Usually it is considered to be connected with such factors like: difference in starting condition (quality and quantity) of physical capital, amount of private investments in transport and natural monopolies connected with regulating reform, size of public sector as a whole, nature of population distribution.
An important characteristics of mature financial system is its ability to provide long-term investment resources. It is well known that the shortage of “long money” is one of the main weaknesses of Russian financial system. Caprio, Demirguc-Kunt showed that the share of long-term credit in the overall assets has positive influence on development by increasing the share of companies which growth exceeds the rates achievable only through own capital sources. Readiness of investors to provide “long money” to a great extent depends on the degree of macroeconomic stability, and on general institutional factors.
Authorities may promote development of long-term investments by decreasing associated risks, for example, by developing mortgage legislation. Serious positive effect on expansion of long-term credits can be made by introduction of accumulative pension system (through efficient management of its resources). At the same time, the attempts to increase long-term crediting through direct involvement of the state (for example, by subsiding) give opposite effect. Increase of the share of long-term credits at the account of state subsidies hinders production growth rather than accelerates it.
The relation between development of financial system and general market institutions has been studied in most detail by Levine, Loayza, Beck . They showed that critically important conditions for successful development of broking sector are:

In particular, such measure of financial development as capitalization of securities market has high (0,39) and significant positive correlation with the quality of financial reporting which is evaluated on a regular basis by the Center of international financial analysis and research.
The effect of capital market liberalization should also be mentioned. Bekaert, Harvey, Lundblat concluded that transition from complete closeness of internal securities market to its complete openness for non-residents causes (other conditions being equal) increase (by about 1% a year) of the rates of economic growth during the next 5 years. Thus, partial opening of the market has proportionally lesser effect (for example, making 50% of all stock available to foreigners, during five year period will result in additional growth by 0,5% a year). It is true that such liberalization somewhat undermines economic stability, which is especially dangerous on the background of existing institutional weaknesses.
World publications, especially those by international financial organizations indicate the important role of developed, balanced, institutionally mature and sufficiently liberal financial sector for accelerated economic growth. Existence of simple success formulas is quite unlikely, but in principle, the directions of activity are clear. They consist in search of harmonious development of financial sector, transition from relying on bank sector to ensuring development of financial markets.

Before referring to the Russian economy and its financial sector, it’s necessary to determine what numbers are spoken about with reference to world financial markets. It’s worthwhile to remind that according to IMF assessments, in 2002 world GNP equals to USD 32 trillion according to current exchange rate and USD 48,9 trillion by purchasing-power parity. USD10,5 trillion falls to the share of the USA, i.e. 21,4% by parity or 32,7% by current exchange rate . From 1994 to 2000, net volume of international debt securities (i.e. without internal issue) increased by five times: from USD 251 to 1246 bln. Within the same period of time borrowings of corporations increased from USD 13,5 to 181,1 bln., which is close to the issue of interest, regarding external financing of accumulation and possible capital inflow .
World Bank calculations demonstrate considerable decrease of portfolio investments into developing countries with emerging economy in 2000-2001. Direct investments growth practically stopped. UNDP assessments of 24 October 2002 (regarding 85 countries for the first half of the year) predict total world direct investments inflow decrease by 27%, up to USD 534 bln. Though investments inflow decrease in countries with emerging economy are expected to be inconsiderable, competition for investments is strengthening, in spite of recovery of economic growth in the world. In this respect status of Russia regarding direct investments stays unchangeable . IMF assessment of total investments of global investments’ funds in 2001 amounted to only USD 108 bln. which indicates serious potential competition for these investments.
Let us characterize Russian financial system on the basis of the above indicators. We will compare Russian parameters with those of other developed, developing and transitional economies from World Bank representations. The data of Table 1.4 shows that Russia has a relatively high share of external financing. In principle, it can be indicative of higher demand for external capital, and of availability of external financing. Taking into account the level of development of our financial system, the first option seems more likely. Thus, the data prove higher dependence of our economic development on the “quality” of broking system.
However, both major “civilized” methods of capital attraction are exceptionally poor developed in Russia; bank credits and stock issue jointly account for only 3,6% of the total financing which is 7 times less than in the average in World Bank representation. Consequentially, the share of “other” sources, including budget financing, trade credits, etc., is abnormally high. In 2001 Russian market of corporate bonds demonstrated 75% growth and continues its forward development, though its volume (about USD 2,5 bln. for the end of the first half of the year) is twice lower than of stock market.

Table 1.4 Inter-Country comparisons of the structure of financing investments into main capital (Russia – 2001, other countries – 1995-1999)

	Total external financing	Bank credit	Stock issue	Other
Russia	49.7	3.5	0.1	46.1
WB representation average	41.0	19.0	5.5	16.5
Argentina	42.9	30.1	2.5	10.3
Bulgaria	25.3	6.4	1.4	17.5
Brazil	54.1	25.6	5.5	23.0
Czech	26.9	10.2	0.8	15.9
Hungary	34.8	15.1	6.0	13.7
Germany	47.4	14.3	19.9	13.2
Indonesia	20.5	16.1	0.0	4.4
Mexico	39.3	10.8	4.4	24.1
Malaysia	57.6	16.3	10.9	30.4
Poland	58.3	13.2	30.5	14.6
Rumania	24.0	10.3	2.4	11.3
Turkey	42.2	20.9	8.3	13.0
Ukraine	24.0	6.4	2.2	15.4
USA	46.5	20.3	3.0	23.2

Using the assessment of the effect of private crediting of private sector obtained in Beck, Levine, Loayza on the basis of inter-country comparisons, we can determine expected effect of the improvement of financial development parameters, which took place in 2001 (assuming that it will preserve). Other conditions being equal, this improvement should cause increase of growth rates by 0,6% a year. The parameter describing relation between financial sector volume and GNP rather accurately defines the position of Russia among other countries . The sum of issued bonds, securities, bank deposits and market capitalization in proportion to GNP is less than 25% (1998). For comparison: among OECD countries the lowest ratio is observed, strictly speaking, in developing Mexico (over 50%). Even in Spain, which has started to develop its financial markets not that long ago, this indicator is nearly 150%. Term instruments and derivatives are not covered by the analysis as their role in the Russian economy is absolutely inconsiderable.
At that the Russian stock market, even after lengthy growth, seems under-capitalized, at least in comparison to developed markets. Thus, in percentage of GNP, capitalization of Russian securities market by the end of 2001 was about 26%, while capitalization of European zone stock market was 66,1%, that of USA was 128,7% of GNP, and that of Japan – 73,9% of GNP (at the end of 2000) . however, the market participants are still optimistic about the future growth in mid-term and long-term plan. This optimism is grounded, with account of uneven growth of stock market capitalization in 2001-2002 (mainly it was provided by abrupt burst of several large companies): one can still hope that with “dragging along” of second- and third echelon companies further growth of securities market will occur. In particular, the improvement of corporate culture level should play its positive role, along with higher transparency of companies and acceptance of individual corporate management codes.

State	Ð/Å ratio	Russian company 27 May, 2007	Ð/Å ratio
Taiwan	21,7	-
Argentina	18,1	-
Philippines	17,8	-
Malaysia	17,1	-
Chili	15,3	-
Thailand	13,3	-
Poland	13	-
China	13	-
Mexico	12,7	-
“Developing markets”	11,9	Sibneft	11,7
India	10,9	RAO ES	11,6
South Korea	10,9	UKOS	9,6
Czech	9,3	LUKOIL	9,4
Russia	8	Surgutneftegas	9,1
Brazil	7	Gazprom	6,5
Indonesia	6,9	Sberbank	4,2

Major problem of Russian stock exchange is dominance of either oil companies or natural monopolists (RAO ES and Gazprom, Rostelecom). The latter makes the growth of stock rates dependent on tariff policy of the government and plans for restructuring of natural monopolists.
In summary volume of trading and other parameters of liquidity our market is far behind the leading stock exchanges, not only American (turnover of NASDAQ in 2001 – 11 trillion of USD, NYSE – 10,5 trillion of USD), but European as well (see Table 1.6).

The scenario of “dominance of financial-industrial groups” is characterized by higher capacity of debt market in comparison to “liberal economy” scenario. Thus, the relation between internal private securitized debt and GNP for the countries with “chaebol” orientation is 0,43 for South Korea and 0,54 for Malaysia. In more liberal countries with Anglo-Saxon influence, this proportion is 0,08 for Brazil, 0,15 for Hong Kong, 0,05 for South Africa, India and Singapore, 0,11 for Czech and 0,02 for Hungary .

Table 1.7 Distribution of household savings by the types of assets (%)

Asset State	Cash + deposits	Bonds + Stock	Stock and shares of open IF (UCITS)	Insurance and pension funds
Belgium	30%	46%	15%	12%
Finland	39%	50%	4%	8%
France	40%	12%	15%	33%
Germany	39%	22%	10%	29%
Italy	21%	47%	21%	11%
Spain	34%	39%	16%	11%
Sweden	19%	29%	20%	32%
United Kingdom	21%	18%	4%	57%

In spite of the inconvenience of combining stock and bonds into one category, the table gives an interesting material for deliberation (Table 6). In particular, despite the long history of investment funds in Great Britain, their popularity among public is low (4%). And on the opposite, such countries as Italy and Sweden, which has only recently started to develop such institutions, demonstrate very high interest of households to investment funds – about 20% of all savings.
International comparisons demonstrate the way which Russian financial system faces to go along for approaching median index common for the countries with emerging economy. For assessment of the influence which could be made by growing financial sphere it is necessary to keep in view the fact that level of accumulation in Russia, savings level and need in renewal of physical capital happened to be, at the least, in serious lack of correspondence. Time has come to answer a principal question – either we continue to observe natural process of formation of financial system or we want to find the ways of development acceleration.

Institutional issues of financial sector functioning are not among the main issues covered by this Report. However, it is difficult to assess properly real status of the sector and outlooks for its development without basic idea about legal situation, regulation and surveillance. Therefore Appendixes to this paragraph contain materials on distribution of regulating and surveying powers (Appendix 1), situation in current legislation process for the beginning of autumn 2002 (Appendix 2). In general a short list of proposals of institutional nature is given which could become a basis for further development of the proposals on financial sector development in the future. Development of such measures, complex approach to sector development is a matter for future work.
Structure of regulation of financial markets’ participants in the Russian Federation carried out by government bogies is very incoherent. Due to historical reasons many countries have complicated control system. One could expect more wisdom in such system in the situation with Russia which has recently started to form its financial institutions. For example, in respect of the policy on financial markets, Spain has chosen a way of coordinating mixed bodies by creating a special Committee comprised of representatives from Central Bank, Ministry of economy (Treasury and Pension and Insurance Inspection Department) and a body equivalent to Securities Commission. We don’t have possibility to analyses all these materials in details; it’s a topic for another similar Report. Let’s outline some evident issues:

The Report starting point, and after corresponding analysis final point is: the existing financial system does not provide for the Russian economy growth acceleration. The international comparison materials show that the Russian financial system is much weaker than in other transitional economies and such medium-developed countries, which follow a complicated way of building financial markets and institutes: Spain, Central and Eastern European countries.
Overcoming the direct (mostly debt-based) consequences of the 1998 collapse and the three-year upsurge of economy allow putting up a task to evaluate and forecast the financial institutions’ development and reform and the financial market development. The main reason for such close attention to the financial sector problems is the low level of accumulations in the country (18% of GDP during the whole after-crisis period). The country needs for modernization cannot be provided with the low growth rate, especially in the accumulation sphere. That is why conversion of the population and company savings and foreign investments into real investments in the country economic development is inevitably in the focus of attention when the matter is not in overcoming the crisis but in growth and modernization.
It’s high time to move away from partial reforms of separate sectors, from adopting basically correct but isolated laws on certain sector branches and to the complex assessment of the situation and search for ways to enhance the financial sector as an investment funding source. Strictly speaking, adopting a new legislation in the sphere of insurance and especially pension reform makes the legislators give a broader look at the possibilities of investing the pension funds into financial instruments. Particularly an assumption on compulsory investment of the pension funds into state securities envisages the emergence of such securities of relatively high quality, with particular features and in the amount providing for the law requirements fulfillment.
One should realize that the financial market development covers both for the institutional and instrumental sides, supply and demand for financial assets by both the non-financial (real) sector, the state, the outside demand and by all financial market segments in the interbranch competition.
The approach adopted in the current report is based on the assumption that the chaotic processes in the financial sector formation do not necessarily bring satisfying results at reasonable time from the point of view of the Reformer-Government. This is proved by the international experience in the banking system reform. In any case most Governments incurred considerable costs trying to secure the financial institute sustainability (see Table 1.8). What is important for us here is the decisiveness of Governments (including Ronald Reygan’s) of such an unlike group of countries rather than the enterprise success. Thus in the USA the extra budget inflows made up to $200 bln. in course of paying compensations for depositors’ losses during the bank crisis of 1980-1992 and the crisis of loan and saving associations in the 80s .

Table 1.8 The total expenditure on resolving the bank sector problems in % of the annual GDP during restructuring

Country	Period	Expenditure estimation, %
Argentina	1980-82	13-55
Chili	1981-85	19-41
Mexico	1995	15-17
Venezuela	1994-95	17
Bulgaria	90-s	14
Hungary	1992-95	10
Finland	1991-93	8-10
Japan	90-s	3
Spain	1977-85	15-17
Sweden	1991-93	4-5
USA	1984-91	5-7

Source: “Financial Transition in Europe and Central Asia”, World Bank, 2001, p.80.

The main bulk of savings in the Russian economy is accumulated not with the Russian population (which is due to the higher development stage), but with enterprises. Respectively by creating the accumulation conditions we first and foremost mean the conditions for accumulating temporarily surplus capitals inside but not outside the country and setting up a system of long-term instruments. It also indicates that importance of attracting money from population – “under mattress money” – for accumulation is obviously exaggerated. Increase of population savings rate is important for the future during savings redistribution; up to now, efficient usage of enterprises’ savings on the territory of the country is the most important issue.
The 4 scenarios suggested above give a general idea of possible differences in the financial market development in the country in the nearest future. It should be noted that the official reform concept in the 90s was traditionally liberal and to a great extent Anglo-Saxon being supported by massive technical aid from the respective sources. At the same time the large Russian business has been persistently and knowingly implementing a more closed, “Asian” or “Chaebol” option for business organization both in practice and in the legislation. Recently significant steps have been made towards more transparency, compliance with the international standards of corporate management. At the same time the fight between two tendencies – liberal legislation designed for free competition among the mass-scale medium-size and large business with the strengthening financial-industrial groups in their new forms – does not allow making a well-defined forecast of institutional changes.
Thus the choice from the development point of view still depends on the complexity of legislators’ approach to a great extent. In particular if we omit quite a few aspects of the financial market development, we will emphasize on two or three major ones, which create uncertainty in projecting financial markets. These are the method of the bank system accelerated development, solutions to the problem of future for state and regional banks. The second problem of the same caliber is the pension reform development, particularly additional pension provision being the social insurance appendage or a powerful drive in the share and bond market development. The same pertains to the insurance and investment fund development. At last, a crucial choice should be made in the long-term debt instrument development area for the purpose of funding large objects under the condition of high commercial risks: guarantees, issue by banks (German model) or by other institutes (American model).

A whole range of general purposes does not cause any doubt at the current stage:

At the same time a whole set of problems remains unsolved for some historic and conceptual reasons. For example, materials on bank system say the following "……even available capital does not always mean real investments. In some cases charter capital of the banks is increased artificially which doesn't result in adequate growth of rally working bank assets." One can identify some problems as follows:

Among the problems raised in the Report there is a topical issue of matching between the demand and supply of financial instruments to fulfill the acting law requirements to the instrument quality. There is a serious problem of future discrepancy between the (low) supply of federal securities with maintaining surplus and legislative requirement to invest the pension funds into state securities. Inside the matter of financial market balanced development a sub-system was formed, which has to be balanced in compliance with the law. In particular, we might need to move from initial compulsory pension (insurance) funds investments into state securities to a reverse order: initial investments into foreign securities with gradually toughening requirements to investments into Russian securities.
The measures on resolving these or those problems mentioned in the report are sometimes practical and sometimes conceptual. They cannot exhaust the world experience or all possible directions in the financial market development. The largest and most significant are:

No set of separate important measures and development of “partial” legislation can replace a unified program. As mentioned before: "It is necessary to deliver active government policy targeted at setting capacious efficient stock market which represents a qualitative investment mechanism" . We suggest that the “Program of Financial Institutions reform and Financial Market Development” should be prepared, discussed with the stakeholders and adopted at the governmental level during 2003. This Program would cover all market segments and instruments and would start in 2004-2005. It is time to proceed from solving narrow legal issues, which nowadays create problems, to strategic approaches. Such program should answer the conceptual questions that were put up in the 90s but failed to be answered:

1. Liberal or close-end system of ownership and control, which can otherwise be called Anglo-Saxon or Asian (Chaebol);
2. Ratio and distribution of the role between banks development and financial markets – issue of harmonic development;
3. Future state banks’ development, particularly the issue of their evolution (Sberbank in particular), in course of which they all act more like development banks;
4. Unity of legislation and development complexity (balance) of various market segments, instruments and financial institutes;
5. Definition of the system of aims and measures in building trust to the contract system and reliability of savings institutions;
6. Definition of a long-term policy in selection criteria for reliable financial instruments for investments in financial institutes that accumulate the population savings’ Sberbank, pension and private insurance funds;
7. Identification of the legislator’s attitude to the desirable role played by foreign financial institutes in the Russian market in the WTO context;
8. Identification of the legislator’s attitude to the role played by Western financial markets (banks and stock-exchanges inside the country) in the Russian business funding;
9. Definition of an approach to the private (voluntary) pension provision (and insurance) as a key issue of the financial market formation and reorganization of the savings system in the country, but not as a secondary element of social security;
10. Developing approaches to building a non-degenerate matrix of financial instruments by type and urgency and derivatives;
11. Provisions of adequate divisibility of financial instruments with low transaction costs of issue for personal ownership;
12. Definition of outside funding methods of long-term (commercially risky) projects, possible state involvement into this process (power engineering, transport etc.) and the role of specialized financial instruments;
13. The role of bankruptcy legislation: protection of companies from financial turmoil or a property re-allocation method;
14. The role of self-regulating organizations in adding to the state control bodies to maintain stability in the financial markets;
15. Identification of rates and content of transition to the International Standards of Financial Accounting (ISFA), enhancement of internal and external audit and control over financial institutes both in the interests of depositors and for the sake of the financial system sustainability;
16. Identification of aims and development indicators of the market segments, methods and means to achieve them, monitoring and correction;
17. Setting up a Coordination Committee consisting of the control bodies’ representatives to develop and pursue a single policy and control over the financial market various segments;
18. To determine need in body responsible for general development and regulation of financial markets from point of view of development.

5. Scenarios of Financial System Development

It has been shown above, that state of financial system has two-way connections with general economic tendencies. It determines the necessity of mutual estimation of prognoses of the financial sector development and macroeconomic prognoses. Scenarios suggested reflect the experts’ appraisals, which follow the successive approach to the development of financial markets not as just a result of economic growth, but as an instrument for increasing of its tempos, creation of more harmonious financial infrastructure adequate to the industrial development of the country.
In the conditions of transit economy with underdeveloped structure and non-established dynamics long-term tendencies are under the influence of a number of factors of indefiniteness. So the prognosis can be only variant in its character. This work specifies 4 possible scenarios of long-term development received by possible combination of two characteristics.
The first one represents the “quantitative” measurement, it differs active development (with high funding norm, and correspondingly with rapid growth) from inertia development , where investments remain relatively low. Which of these variants will turn to be realised will depend on the degree of government efforts effectiveness in the sphere of improvement of investment climate. If successful one can rate both at big foreign investments and at relatively quick decrease of Russian capital outflow, and consequently, rapid increase of investment resources.
The second measurement represents “qualitative” way of development. Its variants may be conditionally called “open” (or “liberal”) and “closed” (or “monopoly”). The first alternative presupposes:

Necessary conditions for the implementation of this scenario are: increase of property structure transparency, strengthening of corporate management mechanism, of property owners’ control over managers’ activity, real increase of transparency and trustworthiness of enterprises’ financial indices; active development of competition at financial markets, elimination of barriers for new participants (including foreign) to enter the markets.
The second alternative means preservation of non-transparent structure of property and obstacles for enlarging the number of owners, weakness of mechanisms of corporate control and management. Actually one can speak of the fact, that financial-industrial groups (FIGs) will prevail in such conditions.
Implementation of this scenario will result in relatively smaller role of external sources of investment financing, limited re-distribution of resources between the branches and, consequently, significantly smaller role of financial-intermediary system. In this case financial resources will be re-distributed primarily within the FIG, i.e. practically without participation of intermediary system.
From the point of view of perspectives of financial markets and instruments development, three variants of FIG development are possible:

At present most of the FIGs contain more or less big banks. These banks may develop in one of the following ways:

«Open» scenario would let significantly decrease interest rate on financial markets because of providing more information for the investors, and consequently, decreasing their risks.
Which of these ways economy would go depends on the combination of fundamental economic and institutional factors. The first include preservation and elimination the abovementioned unevenness of profitability and distribution of own investment resources between the sectors. With preservation of available priority of raw resources sectors over processing ones on these indices further strengthening of FIG is the most probable. The key institutional factor, determining the way of development, is the progress in creation of effective protection mechanisms for the rights of owners and investors. Development of FIG is mainly determined by the necessity, in the conditions of lack of transparency and non-protection of investors rights, to control the enterprises with significant investments.
At present there are some changes in both the first and the second directions. On the one hand, in some companies the priority of the task of market capitalisation increasing has become higher lately, and as a main instrument for implementation of this goal openness of companies was greatly increased, some measures were taken to improve relations with share-holders and investors, payment of dividends was abruptly increased.
Process of establishment control of big enterprises over enterprises of both their and some attached branches is going on parallel, i.e. horizontal integration of FIG is spreading all over.
Development of financial sector has a many-sided connection with realisation of this or that scenario. On the one hand, in the “open” variant there is an increasing necessity of financial-intermediary system development, i.e. this way of development gives rise for the financial sector. On the other hand, the very variant is impossible without efficient mediation. At last, it should be taken into consideration, that a turn towards the “open” scenario and rapid development of the financial system need mainly the same conditions.
Basing on the above (section 1.2) results, we considered the “open” way to provide higher general output of industrial factors because of more effective distribution of the resources and providing more complete financing of innovation projects. Besides, we considered “liberal” scenario to include active continuation of structural reforms, and on this basis, reduction of expenses after 2005 ã., when results of reforms start to be visible. Profits of the budget in GDP percent were taken approximately the same, though they were reached on different basis: in “liberal” scenarios more decrease of taxation rate was supposed to take place alongside with reduction of tax evasion. As a result in “inertia-closed” scenario after 2005 extended budget is implemented with certain deficit, and in “active-open” during the whole period surplus is supported. So, the scenarios differ with their interest rates on financial markets.
The two changes cannot be regarded as completely independent. So, strengthening of basic market institutions simultaneously improves investment climate (increasing chances of the “active” scenario implementation and helps the development of financial system, investing into formation of open economy. Nevertheless these two changes are connected only partially, and chances of implementation of any of the four variants are rather high. Received results can be presented in the form of the following matrix.

Significance of main macroeconomic tendencies of Russian economy development in long-term perspective should be estimated from the point of view of conditions for the transformation of savings into investments. The first thing that attracts attention is a gap between a rather high level of savings in Russia and not so high level of funding (see figure 1.2 in section 1.1). The leading role here belongs to private savings. So, in 2001 the level of savings was equal to 33% GDP, including 24% GDP of private savings. To compare, we should point out that in 63 countries analysed in the work Beck, Levine, Loayza , average level of private savings is equal to 19% GDP. Such a high level of savings can be partially explained by extremely favourable for Russia trade conditions (according to the economic theory the level of consumption shouldn’t significantly react to short-term positive and negative income departure from the expected long-term level). Nevertheless, even taking into consideration a certain correction on probable returning of trading conditions to “normal” long-term level (which corresponds to the price of “Brand” oil about 20-21 USD per barrel, i.e. “Urals” would cost about, 19 USD per barrel) one can expect, that the level of savings will remain rather high according to international standards.
The funded part of pension system introduced beginning with 2004 will support the high level of savings. Practically availability of funded component has not a simple influence on the level of savings. But, in our opinion, it won’t influence decisions of working population, but it will decrease consumption of generations, that are already retired or going to be retired in the nearest future, for which the amount of pensions will decrease . Chilli may serve as an empirical proof of it, where introduction of the funded pension system let to the increase of savings level. In a long-term plan it does make difference for the country, which of the economic agents and in what form will keep their savings. Of great importance for the development of pension system, as a means of financing of long-term investments by means of accumulation of debt instruments, will be legislative decisions, rules and regulations of the Government, which were the subject for wide discussion in the autumn 2002.
Assuming preservation of the high level of savings in the country, taking into consideration all the above mentioned factors, the level of gross internal savings, according to our estimations will lay between 26-29% GDP in 2005 and 24-26% GDP in 2010. Gross funding in 2001 was 22% GDP. This index is close to midlevel if compared to funding in other countries. But it doesn’t mean that its amount has reached the acceptable level. Firstly, a significant part of funding (4.3% GDP) consists of accretion of material working capital stock, which followed the reduction of its level in 1998 and the changes close to zero in 1999. One can expect that in the future the amount of stock will grow correspondingly to the growth of production and the average share of this component in the structure of GDP using will be much lower then in 2001.
The physical amount of the fixed assets was growing faster than the ecnomy on the whole in 2000/2001. Its amount as percentage of the GDP had grown from 14.3% in 1998 to 17.8% in 2001 over the post-crisis period of 1999 to 2001.