Vladimir Tikhomirov of Uralsib -

In the current crisis, Russia has suffered a major slump in fixed investment levels, with total 2009 investment volumes falling to 2007 levels. This was a major factor in the decline in Russia's gross domestic product, and caused a sharp contraction in output in many areas of the economy, from non-residential construction to manufacturing.

Revenues from booming commodity exports, low-interest foreign loans that were easily accessible to Russian businesses, and state funding were the three largest contributors to a rapid increase in fixed investment volumes before the crisis. The spread of the crisis pushed export revenues down sharply and made it almost impossible for the majority of Russian corporate borrowers to restructure their debt. This forced companies to mobilize their resources through cuts to investment plans. It also made it necessary for the government to tap into its reserves and the budget in order to help the struggling private sector avoid mass debt defaults.

In March-April 2010, the investment trend in Russia returned to positive, helped by the base factor effect and continued spending from state companies. While we believe that in the coming months this upward trend will continue, we do not expect to see a fast return to pre-crisis investment levels, as companies remain over-leveraged, banks continue to avoid taking extra risks, global markets are still very volatile, and the prospects of recovery in the world economy remain fragile and uncertain.

GDP hit by decline in exports, investment and manufacturing

Last year, the Russian economy shrank 7.9% on year, the largest annual decline since 1994. While negative dynamics were recorded in many sectors of the economy, the three main contributors to the sharp fall in gross economic output were exports (down almost 36% in 2009), fixed investments (down 17%) and manufacturing (down 16%).

The fall in exports was a direct consequence of a sharp correction in global commodity prices. However, this correction in prices has turned out to be relatively short lived, and already in the first quarter export volumes in Russia had increased to close to their pre-crisis average levels, posting a massive 61% on-year growth.

In the first quarter, the recovery in other key segments of economy was slower but still quite visible, not least due to the low base factor effect. Among the major areas of economic activity in Russia, it was only fixed investment that in the first three months of 2010 continued to demonstrate very weak dynamics. According to Rosstat, fixed investment volumes were down 4.7% on year in the first quarter.

In the years prior to the recent crisis, a rapid growth in investment volumes was - along with booming consumer demand - one of the key growth factors for the economy at large. In the period between the Russian financial crisis of the late 1990s and the spread of the current global financial crisis, fixed investment volumes in Russia increased in real terms by a massive 180%. On the eve of the current crisis, in 2007, the investment growth rate in Russia surpassed 21% on-year - annual growth rates not seen in Russia for almost half a century.

However, as the global crisis deepened, fixed investment was the worst hit. Over the course of just one year (between spring 2008 and spring 2009), fixed investment growth rates in Russia have gone from 20% annual growth to a decline of more than 23%. There were several reasons for such an abrupt shift in investment dynamics, including frozen global and domestic credit markets, sharp falls in export prices, and higher risks of investment in emerging markets - among others.

Foreign funding was the largest driver for investment growth. However, perhaps the biggest contributing factor to such a rapid reversal in this trend was the fact that during the pre-crisis period the bulk of funding for fixed investment came from foreign markets and had a short maturity. A graphic comparison between the fixed investment trend and that of private sector foreign debt illustrates this dependence quite clearly (see below). A protracted period of low rates on global credit markets in 2003-08 prompted many Russian companies and banks to increase their leverage. Thus, in the period between 2003 and 2008 the cumulative foreign debt of Russia's private sector increased by 5.6-times to almost $450bn. This was accompanied by a rapid increase in fixed investment, which rose 4.9-fold to $350bn.

The closure of the global credit markets with the onset of the 2008 crisis forced many Russian companies to reconsider their investment strategies, with short-term foreign loans becoming a vital component.

The big test came in late 2008. In the fourth quarter of 2008, Russian private businesses were scheduled to return over $80bn in interest and principal payments to their foreign creditors. Most of this money was eventually provided by the Russian government and the Central Bank from their reserves. This resulted in a sharp decline in investment volumes in the Russian economy as many businesses were forced to postpone or abandon altogether their plans for expansion. In turn, this affected many related segments of the economy: banking, industrial and infrastructure construction, production output in manufacturing - among others. Driven by these negative trends, Russian GDP followed suit with a sharp contraction from 8.7% annual growth in the first quarter of 2008 to 9.4% decline one year later.

Investment trend turns positive

Rosstat's monthly fixed investment trend data for Russia shows investment volumes bottoming out in May 2009. We have seen signs of investment gradually recovery since November 2009, and fixed investment trends finally turned positive in March. While there is no doubt that the low base effect has played an important role in the recent reversal of the investment trend, other factors contributing to the pick-up in investment volumes were the gradual unfreezing of global credit markets (which allowed private Russian borrowers to successfully restructure their debts), the domestic bond market boom (which was fueled by lower inflation and official rates, as well as excessive ruble liquidity), and continuing (albeit weaker) investment flows from the state, quasi-sovereign companies, and some major exporters.

A closer look at the fixed-investment structure by major sector, based on Rosstat's data, shows three sectors of the economy managing to increase their share in total investment volumes significantly in 2009, namely pipelines, electricity generation, and railroads, with the presence of the state being crucial either directly or indirectly in all of these areas. Ironically, the sector with the steepest decline in its share of the gross fixed investment volume is also state related: this is road construction, where the bulk of funding is provided by local governments whose budgets suffered significantly during the crisis due to decreases in revenues and rapid expansion in social spending.

The above-mentioned fixed-investment trends are also confirmed by regional trends. In Russia, 10 of the country's total 83 administrative regions account for half of all fixed investment volumes. These 10 regions include the largest cities (Moscow and the Moscow region, St Petersburg and the Leningrad region, Ekaterinburg and the Sverdlovsk region, Nizhny Novgorod, and Krasnodar) as well as key mining areas (Tyumen, Tatarstan, Sakha). In the three years before the crisis, investment growth in these areas averaged 16% on year, but slowed to 3.7% in 2008-09. Of the 10 regions, only three managed to retain positive investment growth last year: these were the mineral-rich Sakha republic and Krasnoyarsk, as well as the key agricultural region of Krasnodar. The largest investment volume declines were recorded in areas with developed manufacturing and financial sectors: Moscow and the Moscow region, St Petersburg, and Sverdlovsk region with its capital city of Ekaterinburg. As a result, the combined share of the largest mining areas (Tyumen, Sakha, Tatarstan, and Krasnoyarsk) in gross national fixed investment rose from 18.5% in 2008 to 22.4% in 2009, while that of key manufacturing areas declined from 23% to 20.2%.

State's increasing importance

One commonly held view is that positive fundamental changes in the investment trend in Russia can be expected only after banks and other financial institutions start to resume lending. This is true in a sense, though only to the extent that growth in bank loans would probably coincide with a general rise in economic activity in Russia and worldwide. However, the banks' role as funding providers for fixed investment has traditionally been extremely moderate in Russia. This was due to the lack of 'long money' in the domestic banking system, as high inflation expectations pushed long-term credit rates to prohibitive levels for the majority of corporate borrowers.

Thus, official statistics show the share of bank loans in gross fixed-investment volumes in Russia in the pre-crisis period peaked at 10.7%, in the first quarter of 2008. During the critical stage of the crisis in late 2008 and early 2009, this share increased to 13.4% a year later, but this was more a reflection of the massive government-funded aid that was delivered via state banks with the objective of restructuring companies' foreign debt. As the critical stage of the crisis passed and companies managed to restructure most of their short-term debt, the share of banks in fixed investment fell sharply, to 6.7% in the fourth quarter of 2009.

As Russian banks scaled down their lending activities, the domestic bond market underwent a major revival in 2009. The structure of banks' holdings reflected these changes as portfolios of corporate bonds held by banks rose rapidly during most of last year. However, revenues received by Russian companies from new bond placements were largely directed towards restructuring existing debts rather than investment.

State funding becoming increasingly important. Rosstat data on the structure of fixed investments by funding source reveals that bonds accounted for no more than 0.1% of total investment volumes. Funds from cash flows remained the largest source of fixed investment in the country, but their share decreased substantially from the pre-crisis levels of over 46% (in the first quarter of 2008) to just 29% in the fourth quarter of 2009. Meanwhile, the importance of investment funding received by companies from non-banking institutions and the government (federal and local) has grown immensely, accounting for over one third of all fixed investments in the country in in the fourth quarter of 2009 versus less than 19% in in the first quarter of 2008.