Who's afraid of the bear?

Originally published in the September 2007 issue

Global investors seem to have a thing about Russia. They seem to expect a country just 15 years old, with vivid memories of the Soviet communist system, to behave like a Western European country and operate to the same standards. Too often the phrase “Russia risk” is quoted as a reason not to consider investing in the region.

On closer examination many of these purported risks turn out to be legacy memories from the 1990’s or simply the normal risks one might expect in any emerging market. Investors blithely allocate to China and India where standards of corporate governance, access to the legal system, administrative transparency, state involvement in industry, protectionism, democracy deficits and so on are all live issues. This is not to mention corruption and, in China’s case, a mercantilist policy that tends to reduce return on equity.

Investors seem to turn a blind eye to problems in Romania and Bulgaria, even post- EU accession, expecting these will be favourably resolved over time. But Russia is different; it’s bigger, brasher, not wholly European, an ex-superpower and still largely a natural resource economy. And it did go bust in 1998. When coupled with a seemingly relentless news flow such as witnessed in the last 12 months then investors’ minds focus on the risks not the opportunities. Russia is not expensive as a stock market, relative to other emerging markets or its own recent past. The Rouble is cheap and, the Central Bank and Finance Minister indicate it will continue to be allowed to appreciate in real terms and maybe nominal terms as well. Plenty of Russian assets are cheap too, whether they are power stations or oil and gas deposits.

There are, of course, risks in investing in Russia but they are not the ones that most investors focus on. In 2007 Russian real GDP growth may exceed 8% in Rouble terms and this may reach 20% in US$ terms, depending on the amount of Rouble appreciation – impressive even by Asian standards. Foreign exchange reserves exceed US$400 billion. The current account surplus this yearwill be around 4-5% of GDP. The government has no net debt and will enjoy a fiscal surplus even if the oil price falls back to US$40 per barrel. Macro-economic risk is not only minimal but the excellent economic outlook is based on domestic demand-led growth, not commodity prices. Consumption is growing at 10-12% real and capital investment by 15-18% real, largely independent of commodity prices. Wealth is spreading out: the Gini coefficient is improving and real wage growth is significant.

A few other myths are worth debunking. An owner of Russian equities today has good title; can settle a trade; and will enjoy reasonable disclosure as 75% of major companies now publish IFRS data. The relative importance of foreigners (and thus their skittishness) has much diminished as over 80% of trading is by domestic investors. Turnover averages around US$3.5 billion per day or better. There is a thriving and liquid derivatives market. Over 50 names can be borrowed for shorting in reasonable size and price.

Whilst natural resources are still over 65% of market capitalisation, the new issue flood has vastly increased the investable universe in terms of sector diversification, number of names and liquidity. Attractive exposure to the consumption theme can be had via the financial sector, where bank balance sheets are growing at 50% rates given the prevailing low levels of debt in the economy.

Russia did assert its legal authority to regain control of Sakhalin-2 and the Kovytka field. The process was not elegant and the PR handling was poor in the extreme. The Strategic Assets Bill will become law later this year and as in many emerging (and developed) economies this will exclude foreigners from controlling key assets. This is not so much a nationalisation process, rather a final sorting-out of the immediate post-Soviet era. While Russia is no longer a super power, it still has plenty of missiles and there is a sense of loss of empire. Russia’s conventional forces are not a threat but Russia does seek to make clear its own foreign policy, and one that is distinct from NATO or G8 with different strategic concerns. It is likely that Russian foreign policy will continue to raise hackles in Washington, as Russia pursues its own interests and asserts its sovereignty. It seeks respect from the G8 and to be accepted as an equal partner for negotiations. Where Russia perceives its interests to be affected, such as in Kosovo, it will make its views felt. Thus further incidents should be expected, as NATO continues to move East (missiles in the Czech Republic) and Russia resists. However, economically, Russia is on a path to converge with the mainstream global economy and capital markets over the next 5-10 years and is well aware of the rules of the game. Expect more tail-tweaking (Chavez, Hamas, etc) and maybe even repeats of the cyber attacks on Estonia but probably little of real consequence. The diplomatic tit-for-tat over Berezhovsky and Lugovoi should die down in time. Russia has learnt in the last 9 months that there is still some housekeeping to do. Deputy central bankers should not get shot in capital cities. Lethal radioactive materials should not be available for freelance foreign assassinations.

Compared with the 1990’s, lawlessness has vastly improved and big city streets are mostly as safe as in the West. Russia is busy making money and in many cases travelling to the West to spend it. It is brash and rich and getting richer. The West just needs to get used to this.

President Putin enjoys 80% popularity ratings; aggressive statements on foreign policy do not hurt him or the United Russia Party, especially ahead of upcoming elections. In fact the strict content of his notorious Munich speech – telling the Americans that unilateralism in world affairs was a non-starter- was not materially different from comments made by Chirac or even Blair. Putin’s delivery was a little harsh and the reporting of his remarks was worse.Putin’s policies have generally been good for the Russian economy and for the stock market. It is likely that the next President will be elected with at least tacit approval from Putin, perhaps even selected by him, and will pursue similar policies. Political risk to the stock market in Russia does not appear to be material. The constraints on democracy in Russia may be occasionally unattractive but compared with most Asian countries in the 1980’s and several today, Russia is considerably more open.

The risks that investors should perhaps be considering are different. In the short term, there are still corporate governance risks at individual companies. Securities and Company law still have lacunae which some companies exploit, but risks to investors can often be on the upside as management alter their behaviour, mindful of the benefits of better governance. Some aspects of the administrative decision-making are perhaps less transparent than they could be. Access to the legal system for redress can sometimes be difficult. But again these are on a par with other emerging markets.

In the short term investors should worry more about interest rates, inflation rates, growth and earnings. They should focus on the oil price, Chinese demand and the US consumer. Recent global credit wobbles will not impact Russia unduly – there is extraordinarily little leverage in the Russian economy and Rouble corporate bond yields rose by only 50 bps or so. Any material impact would only arise indirectly via a slowdown in G7 and Asian economies. In the medium term, it is worth keeping in mind some other concerns. Is the longer term trend towards more or less democracy? Will the creation of very large state champions (Gazprom, Rosneft, etc) lead to inefficient allocation of capital and suppress entrepreneurial activity elsewhere? Will the decline in state spending on education be reversed? Will the size of the state bureaucracy continue to grow rapidly?

Overall Russia seems to have chosen an economic model which is relatively investor friendly, provided that the position of minority shareholders receives reasonable respect. There are risks: certainly in particular companies. But while the Russian market is no longer obviously cheap, it is not yet expensive and the economic background is excellent. Investors might do well to learn to conquer their fears of the Bear.