COMMENT: The natural flight of capital

By bne IntelliNews June 16, 2011

Elena Kolchina of Renaissance Asset Managers -

Since my first grown up trip abroad I have dreamed of buying a flat in Notting Hill. My dream has nothing to do with the famous film (apart from the fact that the film made my dream much more expensive). My desire for a flat in London has more to do with being a person born in an emerging market who wants to buy a home and keep money in a developed country for my children.

I first went to London as a student who wanted to learn English and was lucky enough to stay for a month in Notting Hill in a flat belonging to one of the founders of Troika Dialog, the first Russian investment bank. It was 1995, and the difference between life in Russia and the developed world was huge (especially if your first taste of the developed world was one of the prime London residential areas). I promised myself that one day I would have an address here too.

What seemed like a crazy idea then has become mundane today for many Russians, while the same flats in central London are becoming increasingly unaffordable for many Englishmen. According to Peter Rollings, CEO of Marsh & Parsons, there is now fierce competition for residential space in many of London's best locations between foreign investors, which has sparked bidding wars for the very best properties.

Rollings says there was an average of 14.3 applicants per property in January and in some cases prices were pushed well beyond the original asking price. "Demand from international investors has been particularly bubbly in the last month, and is helping to drive activity in London's prime property market. Alongside strong demand from American and Chinese buyers, many foreign buyers have been withdrawing money from more uncertain economies and making long-term, more secure investments instead in the capital's bricks and mortar," says Rollings.

There has been a lot of discussion about the recent spike in capital flight from Russia recently. The latest figures indicate that in the first five months of 2011 the net capital outflow from Russia amounted to $35bn, which roughly matches the total capital outflow for all of 2010.

Capital outflow is a natural phenomenon for most emerging markets as it's simply a prudent move designed to protect wealth accumulated rapidly in an unpredictable world. The fact that emerging market economies now drive global GDP provides an opportunity for many people in these markets to become rich. For example, according to bne, between 2004 and 2011 Russia produced one billionaire for every 1.87m people - you were more likely to become a billionaire in Russia than in any other country in the world in the last ten years.

Capital flight has only intensified following the recent crisis, which is not surprising as crises always worry the newly rich that they might lose their wealth as fast as they got it. As a result we are now witnessing a record number of IPOs from emerging market companies and private banking in London and Switzerland have enjoyed a massive inflow of money.

Although emerging markets have gone a long way in their transformation into developed markets, in many ways - including corporate governance and the quality of daily life - we are still far from the point when someone who grew up in an emerging market and made big bucks wants to keep their wealth at home. On the contrary, we are at a point when we want to realize that old dream and buy a home (or a business) in the developed world.

However, I don't think it's necessary to read too much into the current bout of capital flight from Russia. For example, I wouldn't name the often-cited poor investment climate as the main reason for money wanting to leave Russia. Indeed, FDI inflows to Russia continue to increase at a steady rate and this year may reach pre-crisis levels, which testifies to the opposite. Many global companies continue to operate successfully in Russia and many want to expand their presence here. For every foreign company that has problems in Russia and makes the headlines, there are hundreds that have none and are earning hansom profits. The recent acquisition of the leading Russian diary and juice producer WBD by PepsiCo for $3.8bn is a prime example.

There are two areas however, and here Russia is different from its peers, which affect capital flows.

The first is temporary in our view. The majority of Russian companies prefer nowadays to borrow in the local market rather than internationally, simply because it's now cheaper to borrow at home. For example, a top Russian mobile telecom company can borrow in rubles for four years at about 8%, then swap rubles into dollars at 6%, which makes the cost of dollar funding effectively around 3%. However, if the same company were to borrow in the Eurobond market it would have to pay 4% for the money. This kind of deal is possible thanks to high liquidity and demand from local participants (mainly local banks), which is keeping domestic interest rates low. But this sort of arbitrage will disappear slowly as credit spreads in the Eurobond market keep falling, while in the domestic market the CBR is increasing rates in order to fight inflation.

The second difference concerns portfolio investments, which are very volatile. In the last couple of years Russia has not enjoyed a big inflow of foreign portfolio investments. The herd mentality means foreign investors flooded into Russia pre-crisis during the boom years, but nowadays the herd prefers the other BRICS where economic growth is higher. Moreover, there is no guaranteed one way trade in the Russian ruble as there was pre-crisis - the national currency having become more volatile as a result of the change of the CBR policy from FX targeting to inflation targeting.

Again, these changes have little to do with the investment climate as nothing dramatically changed in Russia in the past few years. The changes have more to do with the trends and changing investment fads. For portfolio investors, Russia is a country where there are no restrictions on foreign capital flows, the market is big and liquid and its infrastructure is well developed both for bonds and equities. The fact that Russia is not overcrowded and overbought only means more upside for the future.

The bottom line is we see the main factor behind continued capital outflow from Russia as flight to security by the wealth accumulated in the country in the past decade in a time of obvious global uncertainties. It is not Russia specific. It is typical for many big emerging markets. It is likely to continue, which will prevent the Russian currency from significant appreciation. However, continued FDI, possible improvement of portfolio flows, and more borrowing by Russian companies abroad should neutralise domestic capital outflow and support the ruble.

And there's the rub: while I sit in Moscow scouting out flats in Notting Hill on the Internet, Englishmen in London are packing their bags with the idea of moving to Moscow as they realise it is their best chance of becoming a billionaire. Both trends are natural, and impossible to reverse.

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