Roland Nash of Renaissance Capital -

Russia is in the odd position of having both a large excess supply of capital and an equally large amount of excess demand.

The corporate debt market and the ballooning money supply amply illustrate the excess supply, with Russia’s largest corporates able to borrow the liquidity at 6-8% in roubles, several percentage points below inflation.

Excess demand for capital is even easier to illustrate. One way is to measure the average age of Russia’s capital base, which by 2004 was estimated at over 20 years.

A more graphic way is simply to attempt to drive between any two spots within central Moscow after 14.00. Or, more disturbingly, to read the headlines of air crashes, power sector failures and apartment block infernos.

In many ways, Russia has survived transition thanks to the capital base it inherited from the Soviet Union. As important (arguably) as cash generated from hydrocarbons and more important (certainly) than money borrowed from the IMF, has been the ability to run down the roads, pipelines, gas fields, schools, housing and hospitals erected during the Soviet period. While a lot of it wasn’t very good, investment in the Soviet Union was at times running in excess of 50% of GDP – a remarkable transfer of wealth from that generation to the current one.

Not maintaining a capital base is, effectively, a one-off transfer to new owners as underinvestment runs infrastructure into the ground. Much of that one-off went to the private sector through privatization. But equally a great deal went to the government as they focused on current obligations (pensions, debt service, public sector wages etc.) and trusted that public infrastructure would survive with only relatively minor maintenance payments. Eventually, of course, any infrastructure reaches the end of its useful life-span and begins to crumble.

Generally speaking, the vortex created by large excess demand and large excess supply of the same resource in the same economy generates the incentive structure that encourages its own solution. Unfortunately, in the Russian context the situation is prevented from clearing by equally enormous logistical barriers. In the private sector, the logistical log-jam is the financial sector, which is still incapable of intermediating between demand and supply effectively. In the public sector, it is Russia’s bureaucracy that has so far proved incapable of taking the tens of billions of dollars of resources the government raises from the hydrocarbon sector and deploying it to regenerate Russia’s public infrastructure.

What is perhaps the most exciting trend in Russia today is that both of these barriers are being dismantled simultaneously. The success of that project will determine the shape of Russia’s medium-term future, certainly economically, and possibly also politically. If the blockage is cleared and capital can be deployed successfully, then Russia will move from oil dependence to the sort of dynamic economy that will allow it to achieve the economic success enjoyed in South East Asia or post-war Germany. If not, then inflation and an appreciating rouble will eventually choke off recovery and leave Russia surviving on the few industries not dependent on a competitive economy. The political incentive at that point could be to find more administrative means to encourage domestic industry.

Private sector intermediation

In the private sector, much of the news (though not all) is very good. While the banking sector is still small, it is growing extremely rapidly.

The incentive created by largely unleveraged households willing to borrow at 14% in roubles to finance mortgages, small and medium-sized enterprises able and willing to borrow at 15%, and consumers prepared to borrow at up to 30% to bring forward growing wages, is driving banks and investment funds able to finance at 6-8% to build out infrastructure at an incredible speed. A scalable spread of 1000-plus basis points in a rapidly growing economy where sovereign risk is measured at 100 basis points in a world where risk is priced at its lowest level in decades can incentivise some pretty ambitious expansion plans. There remains a log-jam in the private sector, but it is being removed at an astonishing speed. Everything from home improvement loans to venture capital is booming, driven by financial institutions from Sberbank to Citigroup.

Unfortunately the rate of growth carries its own inefficiencies. Increasing financial intermediation by in excess of 80% per annum requires a very robust financial infrastructure. First-rate personnel, state-of-the-art IT systems and reliable information are required for efficient decision making. In Russia, much of the financial build-out is being done on the run. The price being paid for branch networks (4-6 times book value) and qualified personnel (ask Goldman Sachs) amply illustrates how valuable parts of the financial infrastructure are becoming.

In this kind of environment, when financial intermediation is growing so rapidly through relatively weak systems, mistakes are inevitable. Some of this can be seen in the growing non-performing loans of the increasingly competitive consumer finance organizations. Less obviously, is the likely short-cuts being made on risk systems and liquidity measurement, which will only become visible should liquidity dry up.

Despite the inevitable teething troubles, the financial revolution currently engulfing Russia’s private sector is an incredibly powerful force for improving the economy. SMEs are becoming less capital constrained from expansion and can therefore grow. The wealth generated from lowering the cost of capital by 1000 basis points for much of the non-traded economy will be enormous. After all, much of the trillion dollars of value created in the equity market since 2000 was because of falling spreads. Already in 2006, the average Russian increased his wealth by roughly $8,000 because of housing price increases. The average annual income during the same period was $4,000.

Public sector intermediation

What is less clear is the benefit of intermediating the value created by commodity producers through the public sector. Perhaps the biggest single surprise success story of the Russian government since the reforming of the tax system in 2000-2003 has been the rules-based, efficient accumulation of the $100bn stabilization fund. But not spending money, while politically difficult, is logistically a lot easier than spending it effectively. Now, perhaps because of elections, but at least as much because of the obviously crumbling public infrastructure, the government is beginning to spend it.

There are four principal strategies through which the public sector will intermediate funds – through the budget, through the stabilization fund, through public-private-partnerships (PPPs) and through state dominated national champions.

Budget

The most obvious, but least ambitious is directly through the federal budget. Expenditures are set to grow from $157bn in 2006 to $275bn in 2008 (16-18% of GDP). Within this increase, a proportion will be spent on four heavily publicized "National Projects" orchestrated by First Deputy Prime Minister Dmitri Medvedev and another part allocated to an Investment Fund to be run by the Ministry of Economics, Development and Trade. The four national projects have been allocated RUB217bn ($8bn), much of which will be spent on health. The Investment Fund receives RUB70bn ($2.5bn) per annum to be spent on projects accepted by the Economics Ministry and is generally parcelled out in the form of public-private-partnerships.

Stabilisation fund

So far, the stabilsation fund is invested in much the same way as are international reserves, in short-dated non-Russian government securities (for the most part euro and dollar treasuries). However, this year it was decided that when the fund reaches the equivalent of 10% of GDP (roughly $125bn), it will be split into two. The accumulated fund will be effectively renamed the ‘reserve fund’ which will continue to be invested in the same way. Any additional funds above 10% of GDP (roughly $3bn a month) will be placed into a second fund called the ‘fund for future generations’. Currently there is debate about whether such a fund should be invested internationally (Finance Ministry proposal) or domestically (just about everybody else). The fund should reach 10% of GDP some time in the third quarter, roughly six months before presidential elections, creating a considerable political imperative to spend the money domestically.

Public-private-partnerships

PPPs are the great white hope of the government in the quest to regenerate infrastructure. Private groups tender projects to the Economics Ministry, which throws in some public money, largely from the Investment Fund, to the successful applicants. So far, 10 projects have been accepted ranging from tunnels under the Neva in St Petersburg to toll roads between Moscow and Novorossisk. Other plans include reconstructing sewerage plants in Rostov-na-Danu, and more ambitious schemes to upgrade local urban infrastructure across Russia. From the ten projects so far chosen, the official target for private money to be invested is RUB770bn ($30bn), leveraging the public sector allocation roughly 20 times. Aside from the sums involved, the most hopeful aspect of the PPPs is that there is at least some market discipline at work. While inflationary pressure from the spending is inevitable, PPPs may well prove to be the most effective means of allocation public money.

Investment by national champions

The largest element of public sector spending could well come from the country’s national champions. The investment targets of public entities are sky-rocketing. Between 2006 and 2008, Transneft plans capex of $14bn compared with $6bn over the three previous years as it builds out its pipeline network. Between 2007 and 2009, Gazprom plans capex averaging $20bn a year compared with $12bn over the previous three years. As UES raises funds through the IPO process, the power sector should see investment grow from $3bn and $7bn in 2005 and 2006 to $20bn and $29bn in 2007 and 2008. As investment switches from brown field development to green field, the oil sector should see investment grow from a total of $8bn and $10bn in 2005 and 2006 to $17bn and $18bn in 2006 and 2007. The increase in total capex among the national champions is clearly in the tens of billions per year starting this year. Changes of this magnitude will have a substantial macroeconomic impact.

The numbers involved in the expansion of public sector investment are clearly large. State plans are not always fully executed, but even so, the increase in investment will be several percentage points of GDP per annum. Given the rather mammoth social problems facing Russia, from a declining population to power sector shortages, it is very clear that funds have to be allocated to the public sector. The problem is that Russian state run institutions do not have a particularly good track-record at spending money effectively. Pumping several percentage points of GDP into the economy in the midst of an already roaring domestic economy risks inflation and asset price bubbles.

What is encouraging is that there appears to be rather more imagination and care going into spending plans than we had feared. While there are dangers with PPPs, national projects and investment by national champions, they are considerably less than if the federal budget and stabilization fund were simply allocated to pre-election popular spending. Although there may well also be some of that, the majority of the funds appear to have allocation strategies which are remarkably sensible given the constraints of the justifiably infamous Russian bureaucracy.

Investment, both public and private, is set to boom as the financial sector and the state seek to intermediate the funds being generated by the natural resource sectors into the rest of the capital constrained economy. The investment is eminently necessary. As a percentage of GDP, total investment in Russia is still only around 19%. When Korea, Japan and Germany went through their restructuring, investment was between 25% and 40% of GDP. Investment at that level was enough to compensate for an appreciating currency and underpinned multi-decade high growth rates.

If Russia is to maintain its impressive recovery and to allow the diversification of its economy, it needs to improve investment rates towards these levels. As the financial and public sector logjams are being dismantled, that investment is beginning to take off. Because of the inefficiencies inherent in a rapid build-out, risks exist in both the financial and (particularly) public investment programmes. But, at the very least, the economy is going to enjoy a large investment boost in coming years, with particularly positive implications for all firms involved in infrastructure development from steel to cement.

Roland Nash is Head of Research at Renaissance Capital in Moscow

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