Putin’s First Six Years.
Vladimir Putin became president of Russia at the end of 1999 following Boris Yeltsin’s resignation. The new presidency brought hope of sweeping reforms and prosperity, which was boosted by international economic recovery and an increase in the price of oil at the end of 2001. These factors gave Putin’s economic policy a head start. Since the start of his presidency, annual real economic growth amounted to 6.7 per cent. Private consumption contributed 60 per cent to the GDP growth. While capital investments and exports recorded double digit growth rates, the growth rate of imports exceeded them all. This underlines the big problem Russia faces: that overall production and export structure is too small and highly dependent on natural resources. On the import side Russia is very dependent on imports of capital goods and consumer products. The oil price hike generated substantial surpluses on the trade balance and current account. The Russian state also profited from the oil price developments by skimming off some of the oil revenues. The government surplus amounted to 2.4 per cent of GDP (annual average) and the current account to 10.3 per cent of GDP on average in 2000-2005.
The huge surplus on the current account put great upward pressure on the rouble. At the same time the strong domestic demand kept inflation at a relatively high level. Due to the relaxed monetary conditions, interest rate policy is not very effective. In real terms interest rates were negative. In nominal terms the interest level stayed at a substantially higher level than in the euro or dollar area. This situation gave companies an incentive to play the financial markets game. Companies in Russia borrowed substantial amounts of money outside Russia to temporarily invest in the Russian capital market. Thanks to the expected currency appreciation against the US dollar, profits were good. Companies who played and are still playing this game without hedging their positions are running a big risk in case the rouble suddenly depreciates. This could be triggered by a sudden fall in oil prices. The combination of high inflation rates and a strong currency had a very negative impact on the competitive position of the non-natural resources sectors.This substantially reduced the opportunities for domestic productive investments in Russia and reinforced the outflow of capital.
What Has Been Achieved?
GDP per capita in PPP increased from US$6,417 in 1999 to US$11,209 in 2005 (forecast by the IMF). The OECD wrote in its working paper, ‘Russian industrial restructuring’ (22 October 2004), that a lot of improvements in productivity have been recorded since 1997. Unfortunately these improvements were mainly registered in the natural resources sectors, and the sectors with a high participation of foreign companies.
Only a few sectors have reached a degree of international competitiveness that would enable them to export on a significant scale. Russia’s major advantages are in oil, oil products, gas, wood, pulp and paper and energy intensive products such as non-ferrous metals, steel and fertilizers. On the other hand, Russia still has a major competitive disadvantage in industrial machinery and equipment, electronic consumer goods, cars, and medicinal and pharmaceutical products. While Russia has the potential to develop a comparative advantage in other sectors, this is likely to remain a difficult process.
The progress of the reform process is often criticised. One should bear in mind that the first reform attempts were started by General Secretary Gorbachev in 1985 and ended with the USSR splitting into 15 independent republics in 1991. Since then, Russia has struggled in its efforts to build a democratic political system and a market economy.
Business is still cautious of the government’s policies. Any negative trend adversely affects entrepreneurial investment activities. The European Bank for Reconstruction and Development (EBRD) wrote in its ‘Transition Report 2004’, that the business environment has continued to benefit from general political stability and sound macro economic policy. However, events surrounding the Yukos case have increased uncertainties about property rights and the overall rules for the private sector. Positive changes have included a reduced tax burden, streamlined regulations for small businesses and an improvement in corporate governance. However these have been constrained by uneven implementation and remaining weaknesses in state institutions, notably the public administration and the judiciary. Because of the necessity of accelerating the reform process, the federal authority gained more power over the regional authorities. This made foreign investors, who ideally would like to see Russia with a fully functioning democracy, reluctant to invest.
Limited Risks in the Short Run
In the short term, however, risks are limited. Economic indicators clearly show a slowdown in economic growth in the first five months of the year. The growth rate of industrial production decreased to 3.6 per cent compared with the same period in 2004. Annual growth rate in 2004 was 6.1 per cent. Inflation amounted to 13.4 per cent in the first five months. The government’s target of 8.5-10 per cent for 2005 is unrealistic. Nevertheless even a sudden dramatic fall in oil prices could trigger a rapid but temporary depreciation of the rouble, having limited negative impact on the economy.
Currently the Central Bank of Russia (CBR) accumulated US$142bn in its reserves and the Ministry of Finance accumulated US$22bn in the stabilisation fund (SF). However, a sustainable lower level of oil prices is not expected in the near future. Funds from the oil stabilisation funds will be used to pay off part ($15bn) of the Paris Club debt. Even after this debt repayment, total amount in the SF will be around $33bn by the end of 2005, enough to pay off the entire $43bn debt to the Paris Club. The early debt repayment of Russia combined with the decreasing debt burden in per cent of export revenues has a positive impact on the country rating. A further improvement of the current rating (BBB-) is only possible when the reform process shows clear results.
The Challenges: Reforms and Attracting Foreign Investments
Repayment of debt is probably the second best allocation of oil revenues by the government. The best policy for the long term is to improve the infrastructure to smooth the possibilities for foreign investors. Russia lacks the highly demanded improvements in its production capacity and the ability to develop new products. As a consequence the very valuable, well-educated Russian workforce, especially in the technical area, has partly dropped out.
In its report, ‘Fifteen years of economic reform in Russia’ (13 May 2005) the Organisation for Economic Cooperation and Development (OECD) wrote: ‘Tremendous knock-on effects can be generated by real steps to strengthen the independence and probity of the judiciary and a reform of the civil service. The reduction in official corruption would itself represent a major improvement in the business climate. Further reductions in licensing and other regulatory burdens would reduce bureaucrat’s opportunities to intervene in private businesses… The Russian authorities understand and are committed to these priorities and important steps have been taken towards realising them. Russia’s long term growth depends on reform that aims at creating not merely a strong state but one which is law-based, accountable and efficient. The proposed increase for the next three years of the incomes of civil servants bringing their salaries in line with private sector salaries will certainly help’.
With its high market potential, Russia should be a natural recipient of foreign direct investments. Unfortunately, statistics show that the outflow of FDI in 2003 was higher than the inflow. To be able to attract more FDI, the government must show progress in its reform process and convince the foreign investors of its trustworthiness. Latest figures on FDI show a net inflow of US$2bn in 2004 and the first half of 2005. We expect total net FDI inflow for the whole year 2005 of US$4bn.
Currency Developments
The CBR still juggles with the aims of trying to stem inflation and to prevent excessive real appreciation of the rouble. For its policy the central bank uses a currency basket of euro (30 per cent) and US dollar (70 per cent). These goals will continue to create uncertainty towards the conduct of monetary policy. If the CBR is serious about the inflation target of 8-10 per cent this year it has to allow the rouble to appreciate in the short run.
The real effective exchange rate reflects the development of the rouble against the currencies of the most important trade partners, adjusted for differences in consumer price developments. This variable is often used as an indicator of the international competitiveness of a country. Supported by the oil price development and the policy of the CBR, the rouble stabilised against the US dollar and depreciated against the euro. This was not enough to compensate for the inflation in Russia, which was substantially higher in that period. President Putin promised to make the rouble fully convertible from 1 January 2007. According to the law on currency regulation and currency control, all restrictions on capital flows must be removed from this date. This, however, is not very likely to happen as recent restrictions on capital flows will be operational till 2007.
Foreign Direct Investments
Due to its well-educated, cheap labour force, the vast reserves of natural resources, the large domestic market and the infrastructure in need of modernization, Russia should be a natural recipient of FDI. Between 2000 and 2003, the total incoming foreign investment was almost the same as the outgoing investment.
President Putin reduced the period in which privatization deals can be legally re-examined from 10 to three years. This is an important step in ending the re-examination of the privatizations during the 1990s.
The government defined some restrictions on foreign participation in strategic sectors, which means that non-residents will be excluded from or limited to minority participations in some areas of infrastructure, defence and extractive activities.
There are no restrictions for foreign companies in setting up shop in Russia in one of the well-known legal structures, like the limited liability company or the joint stock company. The choice for a legal structure has fiscal implications. In particular the designation of resident versus non-resident operation is critical in terms of impact on the movement of cash and the application of Russian tax.
The thin capitalisation rules states that if a Russian subsidiary is funded by a foreign parent (20 per cent or more ownership of the subsidiary), interest is only deductible for tax purposes if the ratio of debt to equity is 3:1 or lower.
Payment Systems
In Russia, payments are processed through a variety of systems. Due to their coverage across the country, the central bank’s payment system and the Sberbank (the Russian savings bank) network are the two most popular methods of transmitting funds within Russia. Together both systems cover 94 per cent of the payment traffic in value. The correspondent banking system adds 5 per cent and 1 per cent is left for non-bank credit institutions. The CBR system is a gross settlement system that affects all payments through customer accounts on an individual basis in roubles. To complete settlement, the CBR grants overnight loans. The CBR has 78 regional branches all with operating regional settlement centres. This is a highly decentralized system with each branch responsible for determining its own rules for processing payments. The clearing time depends on the distance (number of time zones) between payer and payee. It is estimated at three working days within the country and one day within the same time region. The Bank of Russia is currently developing a real time gross settlement system.
Sberbank operates the most widely used proprietary countrywide settlement system. The bank has 20,000 branches all over the country, operating the only nationwide bulk retail system in Russia. Many banks use Sberbank instead of the CBR to process payments.
The correspondent banking arrangements are still very important mechanisms for making inter-bank payments. The share of electronic payments, by value, increased from 75 per cent in 2001 to 89.5 per cent of all payments in 2004. Cheques are rarely used and there is no inter-bank cheque clearing system.
Cash is still the main instrument of making retail payments. In contrast to Central European countries more than 90 per cent of all transactions are still made in cash. The number of plastic cards issued continues to grow. The majority of these payment cards are debit cards, issued within the framework of salary payments. Credit cards are still relatively new in the markets. The use of these cards has only grown since 2001.
Cash Management
With restrictions on cash management still relatively tight, it is difficult for treasurers to standardise Russian cash management to the same degree as in Western Europe. One of the difficulties is incorporating Russian activities in a wider cash pool. Russian law is somewhat unclear on the accounting and tax treatment of physical pooling arrangements. Generally these arrangements do not create enough potential benefit from savings on overdrafts and the repayment of loans. However, single-currency notional pooling is more straightforward, giving clients a chance to save on interest charges. Cross-border pooling is difficult under the present currency control regulations, which will be in place until 2007. Effective from June 2005, Russian resident companies are allowed to open accounts in OECD countries without permission of the Russian Central Bank. However, 15 days before transferring a certain amount of money to the foreign account, 25 per cent of that amount must be deposited in a non-interest bearing account with the Russian Central Bank. This obligation severely reduces the advantages of cross border pooling.
The treasurer may seek to fund the Russian subsidiaries separately, the challenge is then to ensure the subsidiary has sufficient cash for its activities, while not investing too much capital locally, as it may be more difficult to repatriate. The treasurer can decide to arrange funding locally or from outside the country. In general, funds are locally available through loans, domestic bonds or securitisation. When it is decided to deal with a local bank it is important to consider the status of that bank. Russia is still in the process of restructuring its banking sector after the small-scale banking crisis of 2004.
One of the problems for multinationals operating in Russia is the limited local opportunity for investing cash. Most of the cash is invested in short-term deposit accounts up to six months. Although there are other investment opportunities in local bonds, the treasurer needs to understand the credit risk. Given the current high rouble liquidity, there are frequent bond issues from the account of municipalities and from the Ministry of Finance (T-bills) with a maximum tenor of 10 years and bond issues from corporates with a maximum tenor of five years. Corporates and the Ministry of Finance also issue bonds in hard currency (US dollar) with a maximum tenor of 10 years.
Managing the FX exposure is an important task for the treasurer given the lack of convertibility of the rouble and the subsequent limited possibility to hedge local currency investments. There is only an on-shore liquid market for FX forwards up to six months. On a case-by-case basis, deals can be structured with a tenor up to three years. Offshore there exists a market for hedging up to five years.
The efficiency of the risk management and funding strategies of companies is greatly affected by the lack of local derivatives (both infrastructure and legal framework). Derivatives are still viewed as gambling contracts not protected by courts.
In practice most multinationals need to operate some form of dual banking strategy. Because the international banks do not have a wide branch network, companies operating in several cities in the country need to employ local banking services by domestic banks. Good co-operation between the international bank and the local bank will improve the payments flows.
Sources:
Treasury Today, ‘Banking and Cash Management in Russia’, June 2005.
OECD, ‘Fifteen Years of Economic Reform in Russia’, May 2005.
OECD, ‘Russian Industrial Restructuring’, October 2004.
ING Financial markets research, several publications.