Peter Westin of MDM Bank -

The Russian government should consider investing windfall profits from oil and gas exports into Russian stocks if the market stagnates, President Vladimir Putin said on Monday. However, Finance Minister Alexei Kudrin said such a strategy would fuel inflation and increase speculation on the stock market. And in our view, this strategy runs the risk of transmitting resource price volatility onto the economy and the market.

We assume the president’s statement implies investing part of the Stabilization Fund, which currently holds $113.7bn, into domestic securities, mainly equities (currently, the fund is invested in foreign currencies by the Central Bank). We believe that a more detailed investment strategy will be outlined this year to be ready for the start of 2008. This is because the Stabilization Fund will be split into two at the beginning of 2008: a Reserve Fund, to equal 10% of GDP, and a Future Generations Fund.

The aim of the Reserve Fund is to create a buffer to be used if oil prices drop significantly; thus, the fund’s investment horizon should be limited to only a couple of years (i.e. half the time of the economic cycle). In this respect, we would argue the Reserve Fund should be fully invested in low risk, highly liquid foreign securities. In this case, foreign currency would remain the best option.

For example, consider a sharp drop in the oil price, and therefore a need to draw down the reserve. One would need a liquid instrument so as not to disrupt market conditions. But if these were Russian non-governmental assets, the fund would then transmit resource revenue volatility onto the economy and the domestic market. In downturns, the withdrawal of domestic deposits could have a negative impact on the economy (unless offset by huge open market operations), while in an upturn (with a build-up of reserves) it could fuel aggregate demand. As such, exposure to Russian assets would transmit excess cyclicality onto the economy.

Also, the Reserve Fund, as part of its asset allocation strategy, should probably not invest in Russian government securities. Basically, this would imply the government issuing debt to itself (which makes little sense), with transaction fees probably paid to intermediates. Furthermore, if the fund holds government debt, there is a risk it could become less transparent than if it was invested in non-government securities.

Rainy day fund

The purpose of the Future Generations Fund, as implied by the name, is to save part of the oil windfall for a rainy day, and as such the aim is to maximize returns. Therefore, this fund can be invested in stocks and bonds; at least in theory, this could include domestic securities. However, we still believe the government should limit exposure to Russian risk. If a decision is made to invest in Russian assets, we believe 1) it should be made up mainly of bonds, and 2) it should only involve a fraction of the fund. Thus it will be important to maintain an adequate risk profile for the portfolio, and the fund’s operations must be designed so as not to disrupt financial markets and macroeconomic stability.

Putin said that investments should be made into equity if the market stagnates. This poses another dilemma. Markets normally stagnate for a reason: for example, stocks are fully valued or overvalued, or better opportunities are available elsewhere. Would this mean that whoever manages oil windfalls should invest in underperforming and overvalued stocks or in stocks with potentially better upside? The former would mean the fund was not maximizing its potential; the latter would perhaps be better from a market perspective, but would mean share prices were basically being manipulated. Fund management involves making wise investment decisions and maintaining an optimal risk-reward profile, so the idea of supporting stagnant stocks may run counter to the fund’s very mandate.

The experience of other countries (and one Canadian province and one U.S. state) that have made use of a stabilization fund type of mechanism shows that most have been geared towards investing in foreign assets. Norway’s Government Pension Fund – Global (GPFG, called the Government Petroleum Fund until January 2006), which held USD295 bn as of January 1, 2007, is invested totally in foreign assets. However, some of these equities belong to the emerging market asset class, and thus Russia could allocate funds towards more risky assets without increasing exposure to its own risk. Currently, the GPFG portfolio contains 60% fixed income instruments and 40% equities. In terms of regional allocation, Europe represents 50%, Asia/Oceania 15%, and the Americas/Africa represents 35%.

To conclude; while any support for the domestic stock market is positive we maintain our view that investing Russia’s oil and gas windfall into domestic stocks may not be the best strategy, given the associated risks. If any of the windfall is invested, we believe it should mainly come from the Future Generations Fund (to be established next year) and Russian equities should only comprise a small share of the total investments. At the same time, the Norwegian experience provides guidance for an appropriate investment strategy, where Russia can invest in assets with an array of different risk/reward profiles without necessarily increasing exposure to its own risk.

Peter Westin is chief economist at MDM Bank in Moscow

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