Russia’s hopes of creating a global financial hub come back earth

Financial News at Sibos

September 16, 2008


A series of setbacks has raised questions over whether Moscow could rival other centres and whether the rouble could become a reserve currency, writes Jason Corcoran


The credibility of Moscow's ambition of becoming a global financial centre within five years has been called into question following a summer of systemic shocks to investor confidence and the arrested development of its market institutions.

Highly liquid domestic markets, strong economic growth and a position at the heart of a booming region have contributed to the rapid growth of Russia's capital markets over the past decade.

The dual government of President Dmitry Medvedev and Prime Minister Vladimir Putin have a blueprint in place for building Moscow's position as a financial hub. Some institutions, especially the Federal Anti-Monopoly (FAS) commission, have grown in stature due to its recent high profile investigations into price fixing. The
administration is now adding to the institutional pillars brick by brick but some of the foundations appear shaky.

Russia's five-day war with Georgia over Southern Ossetia, along with a selling spree sparked by allegations of price fixing at miner Mechel, left domestic stock markets nursing 35% losses and two year lows at the end of August.

Analysts at French bank BNP Paribas estimated the conflict with Georgia could have triggered capital flight worth $25bn of outflows, while Russia's gold and foreign currency reserves fell by $16.4bn since the beginning of military operations on August 7.

Alexander Kotchoubey, head of international development for Russia and Eastern Europe at Swiss private bank Lombard Odier Darier Hentsch, believes Moscow's goal of becoming a financial centre had been pushed back to 2015-2020.

"The credibility of making Moscow a financial hub and transforming the rouble into a reserve currency has been hit," explained Kotchoubey, who was until recently a managing director at Moscow-based Renaissance Investment Management, an emerging markets fund manager with $7bn under management. "Investor confidence and the perception of stability in Russia depends on what people are thinking in London and
Frankfurt and neither one is present at the moment."

Foreign investors have highlighted the lack of corporate governance, the respect for the rule of law, uneven property rights and an abused taxation regime, as obstacles towards the development of domestic markets. Recent cases cited by investors include the price fixing probe of miner Mechel, allegations of tax evasion by fund manager
Hermitage Capital and the separate shareholder wrangles at the
Anglo-Russian TNK-BP and mobile group Telenor.

Yet Alexei Fedotov, head of securities and fund services at Citigroup's global transaction arm in Russia, believes the market reform process kick-started in 2005 is irreversible.

He said: "Russia is a unique BRIC market created as a result of mass privatisation of huge number of companies within extremely short period of time. Since 2005 the speculative growth of the market has been gradually replaced by growth caused by serious changes implemented by the government."

"Changes included liberalisation of banking stocks, Gazprom shares, liberalisation of Russian currency and huge unprecedented IPO growth. As a result the growth has attracted to the market investors and market players of a higher calibre."

Market makers have mixed views about the prospects of the rouble becoming a reserve currency, which is one of the central planks of President's Medvedev's plans to develop Moscow into a global financial centre.

One senior Western banker in Moscow said: "People have been slow to adapt to the Euro currency as a reserve. It's a good goal to have the rouble as a reserve currency but there needs to be much more done to achieve it."

Maxim Baklunov, head of equity sales at Russian investment bank KIT, fees the rouble could be a credible alternative to the dollar.

He said: "The plans of the Russian government to turn Moscow into an international financial centre and the rouble into a major regional reserve currency will make the Russian financial system more competitive. Taking into account the government policy seeking to increase the significance of the Russian currency and to reduce the
risks associated with fluctuations of the US dollar's exchange rate, we think that rouble has a good chance of becoming a major regional reserve currency."

A deepening liquidity, with volumes on domestic bourses recorded of up to $7bn a day, has lured leading US and UK investment banks to set up local brokerage subsidiaries over the past three years.

Citigroup has been a pioneer in Russian wholesale and retail banking and Fedotov argues the Russian growth story remain intact in spite of the recent volatility.

He added: "The volatility is not able to change improvements in the market and did not create reasons for a serious capital outflow or did it make the market fundamentally unattractive or risky. In view of that, there is a certain optimism that the market will continue to develop in coming years and foreign investment will grow.

"This, however, does not stop us from focusing on market improvements and working closely with local market participants and regulators to introduce such important changes as a central depository, foreign nominee concept, RUB RTGS settlement, which in our view will be able to further support market growth and make it irrevocable."

Citigroup is one of the few foreign brokers to be involved in the reform process with other bulge bracket rivals complaining of being left out in the cold.

The Russian government's plans to create an international financial centre in Moscow are based on a competitive taxation system, simplified registration and more permissive procedures for issuers and investors.

The Federal Financial Markets Service (FFMS), the main Russian market regulator, submitted a draft strategy to the government in March for the development of domestic capital over the next four years.

The report, entitled "Measures to Improve the Regulation and Development of the Securities Market in 2008-2012 and a Long-Term Horizon," is a blueprint for the development of the domestic capital market and outlines measures to revamp laws tax law, improve corporate governance, lower administrative barriers and simplify procedures, prevent manipulative practises and the use of insider information.

The domestic capital market plays a vital role in the government's plans for Russia's continuing economic revival. The new administration intends to tap domestic capital for the investment needed to revive Soviet-era industrial assets rather than rely on foreign capital.

Among some of the provisions proposed in the report are radical changes to the tax rules. Under discussion is the possibility of cutting the capital gains tax and a reduction in the tax on income from securities to zero.

One aim of these proposed changes is to make Russia a more attractive place to list shares than the offshore havens companies currently use. The FFMS is worried about losing capital market functions to foreign exchanges and has already introduced administrative controls to encourage companies to list onshore.

Its success has been only partial, as Russian companies that float IPOs now almost always list simultaneously in Russia and abroad.

Additional measures introduced by the FFMS in July restrict companies engaged in oil exploration or mining from selling no more than 5% of their shares abroad, a cut from the previous blanket level of 35% for all companies listing abroad.

The regulations limit foreign stakeholding in industries related to national security and defence to no more than 25%, while those making public offerings in other sectors may sell a maximum of 30% of their stock abroad.

After a slow start to the year for Russian equity issuance, some analysts argued that these rules could hamper Russian equity issuance and liquidity. "In the short term it will have no effect, but in the medium term it could slow down the pace of the IPO pipeline, says Chris Weafer, chief analyst at the Moscow-headquartered UralSib bank.

There were just 13 IPOs in the first half of this year - about half the volume over the same period last year - according to Russian data provider Offerings.ru.

The report, which is being debated in government circles, also suggests developing a futures market and a pooled investments market.

The regulator has drawn up a proposal for increasing the free float. The free float in Russia is currently about 20-30% percent of total outstanding shares. "The free float of securities in Russia should be increased to not less than 40- 50% in the nearest two three years," the document says.

There are currently no foreign securities listed on Russian bourses due to a lack of legislation and appropriate regulation. This could change later this year, however, because a draft law is already in the Duma, the lower house of the Russian parliament. Once new laws are passed, Russian investors will be able to invest via a domestic exchange in foreign companies' shares and depositary receipts.

Key figures within the government and the regulator are actively pushing for the creation of a central depository and a merger of two the main stock exchanges, the rouble denominated MICEX and the dollar-denominated RTS. Some market participants, who are shareholder and members of both exchanges, have privately complained of the pace of the integration of the two platforms.

After all these amendments are made, the regulator estimates the capitalisation of the Russian financial market will increase by $40-50bnm and Moscow will have a chance of evolving into a pan-CIS and Central European hub for capital markets.

However, Lombard Odier's Alexander Kotchoubey feels legislative reforms and institutional change will not mean much without the "intangible concept of investor confidence and market stability."

He said: "Russia was on the cusp. It had entered the top ten in market capitalisation and it had become essential to have Russian equity allocation in global portfolios. It is now facing a tremendous headwind from the war with Georgia and the blow-up at TNK-BP with investors now being very cautious about making any sort of allocation to Russia."