Interviews Alexandr Abromov on the financial markets in Russia. ”Promising but unstable”
Russian financial markets have been a completely new element in the Russian post-Soviet economy. The level of development and the character of the financial market institutions in this country can tell us much about whether Russia will succeed or fail in evolving towards a well-functioning market economy. Professor Alexandr Abramov from the Higher School of Economics in Moscow is one of Russia’s leading experts on Russian financial markets. Ilja Viktorov from CBEES met him in Moscow to pose some questions concerning developments in the field.
Published in the printed edition of Baltic Worlds Pages 44-47, Vol 1 2011
Published on balticworlds.com on april 8, 2011
It has already been twenty years since the first stock exchanges appeared in Russia. In the early ’90s, many exchanges arose. It was like an epidemic, says Alexandr Abramov. In the beginning, Moscow had only five or six exchanges, mostly for commodity trading. They traded very unusual securities; it would all look very amateurish now. Starting with the “voucher” privatization in 1993, stock exchanges got a new jump start, notes Alexandr Abramov. The voucher, or privatization check, Abramov explains, was a bearer security; it was possible to sell and buy the voucher freely. The foundations of the first serious stock exchanges in Russia were laid by the voucher market. The next stage of money privatization made it possible to buy shares from the population in Russian regions and sell them at exchanges in the capital.
The Moscow Interbank Currency Exchange (MICEX) was established as the first modern exchange in 1993. Since 1994, the second exchange, the Russian Trading System, came into existence as a result of cooperation between the largest brokers. RTS arose as a dealer market; it was like a Russian NASDAQ. The RTS index is the oldest and most famous one in Russia.
Abramov describes the emerging commodity market: “What did the 1990s look like in Russia? There was an extremely profitable commodity market where you could find goods at very low prices set by the state and resell them on the free market at much higher prices. It was a very simple business, but the first brokers profited on this trade. The emergence of brokerage houses like Troika Dialog and Aton then meant that a new, more civilized market appeared. These brokers specialized in securities trading; they were a new generation of brokers with a different mentality. Starting in 1993, the state began to issue and trade government short-term discount bonds, so-called GKOs, which involved lots of major banks in the process, like Michail Khodorkovsky’s Menatep.”
Before the collapse of the GKO market in 1998, a rather dynamic market infrastructure had developed, according to Abramov.
“Of course, the government was too aggressive in using this financial instrument to finance the state budget deficit. It pursued too risky a policy, which in the end resulted in a default of the GKOs, which, of course, meant a collapse of the Russian financial market, which lasted for a couple of years. However, the GKO market did have a positive side. It provided a great impulse for the development of the MICEX, where considerable investments were made in the trading system and depositories.”
According to Abramov, the GKO market made it possible for many people to be engaged in the financial market industry. Today, these professionals manage the Russian stock exchanges in a rather effective way. Abramov also believes that the GKO market contributed to the formation of new rules and regulations of the securities market, in particular by creating a business environment that enabled companies to survive even the 1998 financial crisis. “After several years the spirit of trust between participants of the Russian financial market was restored — a rather rapid development.”
Today Russia has two major stock exchanges. This, explains Abramov, is the result of different centers of influence: “There is one group, a very important participant in the securities market, concentrated around the Central Bank of Russia. It is a main dealer in the Russian state bonds market and it now issues its own bonds as well. Thus, as a major and influential market participant, it arose as an important player that invested a lot of money in the formation of the MICEX market. Initially, MICEX was developed as a currency market and as a market for the state-issued securities. Only afterwards did MICEX start to develop its stock market.”
“Another group, RTS, is based on principals that are more self-regulating; it evolved around major brokers which were beyond the direct control of the state. RTS was founded as a stock exchange for transactions with non-residents, which is an important function even today. It also gradually began to involve other participants, mostly from the non-banking sector. Thereafter, both exchanges experienced a process of democratization in terms of the involvement of a broader circle of participants and owners. Today, most of the Russian financial market participants are engaged in both exchanges. However, some specialization on different segments of the market can be identified. RTS is more oriented towards foreign participants; most transactions need to be made in foreign currencies, and are not always conducted on Russian territory. The MICEX market is a ruble market only, and all transactions are made within Russia. Historically, it happened that MICEX won the battle over the Russian corporate bond market, and today RTS is not engaged in the trading of either corporate or regional bonds. This strengthens the position of MICEX, because it has greater liquidity. The state-issued securities are traded here, and the currency market as well is confined to MICEX. All of this is organized under the auspices of the Central Bank. This means that the Russian spot market is organized on MICEX. On the other hand, the derivatives market, including options, futures, and some other instruments, is concentrated on RTS. The latter is also trying to compete with MICEX on the equity market with their new project RTS-Standard, which, surprisingly, has been quite successful. At first glance, only about 5 % of the equity market is controlled by RTS. However, if we look at the market transactions, beyond repurchase agreements and so on, we discover that RTS controls about 30 % of the Russian equity market. In my view, this is a good example of competition between the two stock exchanges which contributes to the development of both.”
Ilja Viktorov: But the government wants to merge them, right?
Alexandr Abramov: The problem is that the decision-making process within the government and the Federal Financial Market Service (FSFR) is not transparent. The process has many unclear aspects. But at the moment, it would appear that the government intends to merge the two stock exchanges, which they believe will contribute to positioning Moscow as an international financial center. Apparently, it is thought that it will be easier to control one stock exchange instead of two. Personally, I do not think that merging the two stock exchanges is a good idea. MICEX and RTS have completely different ownership structures, which would likely lead to conflicts of interests if such a merger took place. MICEX is owned by the Central Bank and other banks that are mainly controlled by the state, while RTS is owned by independent brokerage houses. What should be centralized is rather the infrastructure, namely depositories and clearing houses, not the exchanges themselves.
Viktorov: Could it be that the real explanation of the success of MICEX after the 1998 crisis was the support from the state, which it used to establish its dominant position?
Abramov: To some degree, this factor did play a role, but I do not think it was a decisive one. The major brokerage houses that controlled RTS made a serious mistake in the late 1990s. During this time, a large number of discount brokers arose, like Otkritie or Finam. They offered a more effective Internet-based mechanism of transactions. This made it easier and cheaper for private investors to buy and sell securities. The large brokers rejected this idea, and the Internet-based brokers had to switch their activities to MICEX. This is a key explanation for why MICEX became a leading exchange in the Russian equity market.
Viktorov: As you said, the Russian government intends to create an international financial center in Moscow. Is it realistic, given the short history of the Russian financial market?
Abramov: I believe, with some reservations, that it is indeed realistic. This idea should be approached from the standpoint of manageability. Today we have a very clear concept of this center, with some elements of a business plan elaborated by the Ministry of Economic Development, which has overall responsibility for this program. There is also a governmental group of high officials and business people who are thought to be able to contribute to the creation of such a center. Both stock exchanges in Moscow are positive about this idea as well. Meanwhile, the problem of infrastructure in the city is not so easy to solve. The situation with transport and traffic jams is disastrous; there is not even enough parking space at the MICEX building or the Moscow City business area, to say nothing of taxi drivers who cannot speak English, and will not be able to in the near future. Moscow is quite simply not a convenient place to conduct financial transactions, if you compare it, for example, to Shanghai. And the regime of financial regulation here is too unstable as well. Such problems will not be solvable in the next five to ten years. So I do not believe that the idea of transforming the city of Moscow into an international financial center is feasible. Rather, another option might be more realistic, like creating a local zone in one of Moscow’s suburbs, with good infrastructure, convenient connections to airports, and its own administration. It would follow the same logic as the creation of the Skolkovo Innovation Center outside Moscow, in which the government is now engaged.
Viktorov: At a conference, I heard a representative from one of the leading Russian investment companies claim that the infrastructure of the Russian financial market is well developed, in contrast to the Russian economy, which this infrastructure should be serving. “There is nothing to invest in”, is how he put it.
Abramov: To some degree, this is true, but I think it is an oversimplification. Yes, the infrastructure of the Russian financial market is quite workable, though not ideal. The main problem is that our financial intermediaries, our brokers and investment companies, have a very weak influence on the economy. Unfortunately, they focus their business activities more on the extraction of short-term speculative profits than on the pursuit of a long-term strategy. They do not transfer capital from non-residents, state institutions, and rich clients into the real economy to supply it with investments. That’s why I think that the activities of Russian financial intermediaries should be modernized. Of course, we have a well-developed bond market; there are some initial public offerings (IPOs) that started in Russia. But the fundamental problem is that the Russian population does not trust its money to financial intermediaries. Generally speaking, a household in Russia should earn about 25,000 USD of yearly income to be able to make investments in the financial market. We have about 5.5—6 million such households in Russia. In China there are about 8—9 million such households, and in India about 3—4 million. So, potentially, Russia has a large number of households that could invest in financial instruments — the situation is quite comparable to conditions in China. However, in Russia, only about one million people participate in the market, whereas in China, approximately 220 million are involved in the financial market to some degree, and in India, about 60 million people. To put it simply, the Russian population is not in any hurry to put their money into the hands of financial intermediaries. The main problem of our investment companies and brokers is that they cannot survive and provide effective services for a long time. It is a matter of weakness of the financial institutions in a developing economy like Russia; our intermediaries seem to be incapable of building up a strategy to support long-term, serious investors. This would mean making considerable investments in the whole chain of infrastructure, which the intermediaries are incapable of doing because of a great degree of uncertainty in the Russian economy. It is not clear how “long” money can be accumulated in the economy. The Russian financial companies do not know whether their investments will yield any returns in the future. For example, the future of the Russian pension system is still unclear.
Viktorov: But the reform of the Russian pension system failed, didn’t it?
Abramov: Yes, it failed, but the main problem is that nobody has provided an evaluation of the reasons for the failure and the kind of lessons that should be learned and applied to the creation of a new, effective system. Instead, we are witnessing how the same institutions, almost the same people who were responsible for the previous failed pension reform, are starting to elaborate a new pension reform. This problem is very serious, because a well-functioning pension system is a key element of a developed financial market. That is why the financial institutions do not invest long money in the market. Instead, they are oriented towards making short-term speculative profits, an orientation which contributes to the formation of a thirst for gambling rather than for the cultivation of a long-term savings culture among the Russian population.
Today the future development of the Russian financial market remains at the crossroads. One way forward would be to adopt an approach similar to the Amer-ican model, where the big financial intermediaries are financed by the pension system and other long-term savings, and where a majority of households are clients of brokerage houses. The second alternative would follow the path demonstrated by China and India where people participate in the financial markets as if in a big lottery and where millions of people have been involved in the process as gamblers. Unfortunately, without solving the problem of pension savings, the alternative of the spread of risky financial operations among the population will be quite probable in Russia as well. There are some troublesome signs of this now, first and foremost a great popularity of the FOREX market, different lotteries, and financial pyramids. Unfortunately, the government does not realize the dangers; the state prefers to ignore this problem. Such risky schemes as FOREX are simply not regulated. The main regulator, FSFR, prefers to supervise traditional, respectable participants in the financial market but does not have the responsibility of implementing a long-term strategic policy aimed at developing the financial markets in Russia, nor does it have the resources for such a task. And they prefer to ignore the fact that the population is indeed succumbing to the financial addiction. The authorities think they simply have no responsibility over that and lack a systemic vision of the problem.
Viktorov: And in what way, with such an approach, do the authorities intend to create an international financial center in Moscow?
Abramov: Unfortunately, neither the government nor participants in the financial market realize that such a task presupposes more than simply access of foreign securities to the Russian stock exchanges, or the mere invitation of some foreign participants to the Russian market. These steps would constitute a very narrow approach to the problem. An international financial center cannot be developed without a corresponding well-thought-out policy aimed at the development of the domestic financial market. We should understand how the entrance of non-residents, foreign companies, new technologies, new people, and new laws could be used to create competitive Russian structures that, in turn, would be included in global chains of major foreign financial companies. In other words, the domestic market should also benefit from the development of the international financial center. It is against this background that pension saving could play an important role, because these savings potentially could strengthen some Russian financial companies and make them competitive. But for now, the pension money does not work for those who save or invest. The current system is ineffective.
Viktorov: The Russian stock exchanges are not the only ones where the Russian companies make their IPOs. They often prefer to do it on foreign exchanges, first and foremost on the London Stock Exchange. What’s the reason for this?
Abramov: This depends primarily on the capacity of the Russian domestic market. We may develop technology and institutions whenever we can, but it must be admitted that there is much more money in London or Hong Kong. In other words, to be competitive, Russian financial markets need long money to be raised for the IPOs of Russian companies. And creating conditions for this is a difficult task, though not impossible.
There is another alarming tendency that can be observed in the context of IPOs. Some Russian industrial companies prefer to register their headquarters abroad where they keep all their financial assets while having all the dirty production and technological risks inside Russia. The aluminum giant Rusal, which made its IPO in Hong Kong this year, is one example. Other companies follow the same pattern. There are some doubts concerning the degree to which such companies see their future as connected with Russia.
Viktorov: And why does the Russian state apply such liberal rules for capital transactions? Why is it so easy to transfer capital abroad? The Chinese state, for example, maintains much stronger control over such transactions.
Abramov: This question is a difficult one. In my view, the state in Russia is much weaker than in China. The influence of various power and economic groups is much stronger here. So what is unacceptable in China is quite easy to do in Russia. The corporate interests prevail over the state interest; this is the most important aspect. The state in Russia is weak, and China has the advantage of maintaining a strong statist way of thinking.
The Russian government did try to introduce control over currency transactions after the GKO crisis in 1998. About 5 billion dollars was kept in Russia right after the crisis, and the government strived to prevent immediate withdrawal of this money. A special mechanism of
“C-accounts” was created for this purpose. I worked at the National Depository Center at that time and have very gloomy memories of these transactions, their effective-ness, and their non-transparency. There were so many exceptions to the rule; some transactions were made
after phone calls received from above. Generally speak-ing, a well-thought-through regime of currency control has never existed in post-Soviet Russia.
Viktorov: You wrote a lot about the carry trade mechanism. How did it contribute to the 2008 financial crisis?
Abramov: If we compare this crisis with the previous 1998 financial crisis, we may come to the conclusion that both crises had a similar mechanism. What happened before the crisis? At first, banks borrowed a lot in foreign currency and invested in ruble assets. Before the 1998 crisis, they invested in the GKOs, while in 2008 they borrowed to invest in ruble corporate and regional bonds, as well as in order to provide consumption credits. In both cases, fantastic profits were realized. Then the price of oil started to drop, which made foreign players nervous because they feared a devaluation of the ruble. Even the mere risk of devaluation led to capital flight. In 1998, this devaluation happened in reality, when the ruble was devaluated by about 300%, and the banks faced a very difficult problem. They had enormous liabilities in foreign currency and kept overvalued assets in rubles, i.e. in the GKOs. So, if the 1998 devaluation was about 300%, their assets in foreign currency lost their value by the same 300%. A great imbalance between liabilities in foreign currency and ruble assets arose. This led to a liquidity problem; the banks lacked money and could not pay their debts. And what happened in 1998? The state was poor at that time and lacked money to save banks. It did try to save them by prohibiting bank payments to non-residents; it was an extraordinary measure. At the same time, the state had to place some banks into bankruptcy. These banks pursued too risky a policy. The largest banks of that era disappeared, like Menatep, Inkombank, and SBS-Agro. And the bank crisis occurred because of the devaluation.
The same scenario existed in the 2008 crisis. The difference was that the deval-uation was not as strong as during the 1998 crisis. This time the Russian banks had much greater imbalances between the liability in foreign currency and ruble assets. The banks took a gamble willingly. Even a minor devaluation could cause a great depreciation of the banks’ assets. And non-residents started to withdraw their
money. Basically, the Russian banks were facing the same crash as in 1998, but during the 2008 crisis, the Russian state had much more money. So, first, the state prevented a dramatic devaluation of the ruble by letting the banks exchange their rubles into foreign currency at a very favorable exchange rate. About 220 billion dollars were spent for this purpose. Second, the state spent about three trillion rubles — in the form of temporary credits, of course — to support the banks so that they could survive the crisis. All these dramatic events were the consequence of the uncontrolled carry trading mechanism. The banks and companies borrowed in foreign currency when it was cheap compared to the ruble, and invested this money in ruble assets. Carry trading can be very dangerous where there is a risk of currency devaluation — not to mention that carry trading kills domestic investment: before the crisis, the inflation rate in Russia was about 9%, while the Russian corporate bond yield was about 7%. Nobody would borrow money at 9% interest in order to invest in ruble bonds with a 7% yield, since this would entail an obvious loss. Those who raised their money in rubles could not buy Russian bonds on the domestic market. On the contrary, those who borrowed in foreign currency at 2% interest under the carry trade mechanism could make huge profits, because even a 7% yield was a lot for them. And this meant that the domestic financial market was not developed, there was no reason for Russian investors to invest in Russian bonds. Fortunately, this time, in 2008, the crisis did not end up in disaster as it did in 1998. The state could provide guarantees for Russian banks and Russian investors, but the mechanism of the crisis was nevertheless the same. The Russian state was frightened by this situation, and today the carry trading mechanism no longer works. On the other hand, there is no money in the economy. So there are no investments, and the economy is stagnating. It is unclear where Russian companies can get money to provide economic growth.
Viktorov: But the state has money …
Abramov: Yes, only the state. If you observe the current situation, the only investment programs underway are state-financed. Private money, wherever it may happen to exist, is not invested because of the uncertainty of the general economic situation.
Viktorov: Perhaps economic actors are simply insecure about the stability of the total aggregate demand in the Russian economy?
Abramov: This plays a role, of course. But, generally speaking, there is no well-thought-out industrial policy, no economic strategy, in Russia. I mean not only with respect to financial markets, but as regards general development as well. There are no clear indications where, in what sectors, future growth may occur. The official Russian statistics are prettified, of course, but Russian businesses do not feel good. This especially concerns medium-sized companies; they suffered most during this crisis. ≈