Ben Aris in Moscow -
Russia is the cheapest major equity market in the world, and was before the European sovereign debt crisis drove prices down even further in May. At some point Russian equities will re-rate, catch up with their Bric peers, making you a packet in the process, right?
It remains a difficult question to answer, mostly because a lack of domestic capital makes the Russian markets so unpredictable. The Kremlin is hoping to put that right, by encouraging more institutional investors, but the route to building Moscow into an International Financial Centre is proving tricky.
"What was the p/e ratio in the 90s?" asked East Capital's founder and CEO Peter Hakansson at a recent dinner in Moscow to celebrate the Swedish-based fund's decade of investing into Russia to become the best performing in the world. "It was a bit more than 6. What is it now? More or less the same. This market is due a re-rating."
Russian stocks currently have a price to earnings average rating of about 8-times, compared to China's 16-times and India's 20-times. Yet analysts are now predicting that they'll get even cheaper this year, thanks to rapidly improving earnings. A Bloomberg consensus forecasts p/e ratios in Russia will fall to 6.4 in 2011.
"Russia is the cheapest market in the world," Florian Fenner, CEO of UFG Asset Management, told investors in Hong Kong earlier this year. "The trouble is Russian equities have always been the cheapest in the world. They never catch up."
There are many reasons why investors are reluctant: worries over corporate governance and political risk and Russia's dependence on oil prices, to name but a couple. However, amongst the biggest is the sheer unpredictability of the market: in the last 13 years Russia's stock market has either been amongst the best performing in the world - or the worst.
In bne's annual funds survey last September we asked funds to report their returns year-on-year, and most reported they were down by 50%. But we also asked for year-to-date results, and most were up by about 50%. A difference of three months turned massive loses into massive gains.
"The Russian stock market is still too reliant on foreign investors and the main domestic investors like brokers, banks and private individuals," says Alexei Fedotov, head of custody at Citi Group. "The total capitalisation of Russia's pension funds in 2008 was $40bn, against a total market capitalisation of $1.4 trillion - miserable. And the mutual funds (known as PIFs in Russia) are worth peanuts. Almost all of the investors in Russia are speculative, and sell at the first sign of trouble."
This is why the financial reforms the Kremlin is currently proposing are so important. If the Kremlin can pull it off, then an entirely new class of institutional investor will be created, that will add massively to market capitalization. Not only that, but such investors will typically hold stocks rather than trading speculatively, and these long-term investors should then give the market some stability, flattening out the wild swings that Russian stock prices usually exhibit.
The Kremlin launched a big push to deal with these problems in April 2008, aiming to turn Moscow into a (confusingly named) International Financial Centre, or IFC. In practice, this means setting up the infrastructure of a fully functional financial sector, but so far many of the reforms have been fluffed.
Currently Russia occupies a meager 68th place in the Global Financial Centres Index. Finance Minister Alexei Kudrin said in May that, "if divided into global, transnational and local markets, our potential is on a par with global financial centres such as Dubai, Beijing and Shanghai. It means that we are on top of the list in terms of potential."
The bureaucracy to fulfill the president's orders for action has been stymied by the need to cater to vested interests. In April Russian president Dmitry Medvedev ordered the regulators to draw up a comprehensive plan by the start of June, but Kremlin officials missed the deadline. The plan is to get the major pieces of legislation ready for parliament's autumn session, when they should sail through the vote.
The devil is very much in the details. The core of the new system will be a central depository, or CSD, that can clear and settle all trades. Currently Russia has two major depositories: DCC - owned by market participants; and NDC - controlled by the Micex exchange. Talk of merging them has been going on for more than a decade, but now it looks like a CSD could appear by the autumn.
"We are supposed to be very close to [the creation of a CSD]," says a senior custodian at a major Russian bank. "There has been a lot of lobbying and the regulator [Federal Service for Financial Markets or FSFM] said publicly that it expects the necessary laws to be passed this summer."
The reason a CSD is so important is it removes a lot of risk. The creation of an IFC is essentially a technical challenge that involves the day-to-day workings of a stock market. The problem a CSD solves is if an investor sells a stock to a trader then the money for the stock should be transferred at exactly the same time as the shares are reregistered - known as DVP, or delivery vs payment -- otherwise at some point in the deal one of the two parties has both the stock and the money, and could renege on their side of the bargain. Currently deals can take up to three or four days to finalize (known as T+3, T+4, etc in the trade); traders simply have to trust that their counterparty will pay for the stocks bought, even if the market tanks in the meantime - which it does regularly.
Setting up the law to create a CSD hit the buffers in the past, however. One draft actually got through its first reading in the Duma earlier this year, but got binned after the registrars, who actually record who owns what stock, objected to it.
"The [latest] model is a compromise between various interest groups. The registrars in Russia are still very powerful: we don't just have the babushki fill out the register. There's a lot of oligarch money involved; they use control over registrars to protect their companies, and they have been lobbying strongly, so the authorities had to find a compromise," says one senior custodian who preferred to remain anonymous.
The compromise CSD model - a 'Crest' model - means that deals can be done both on the CSD and at the level of the registrar, who can also accept money.
"What I am afraid of is that we will split the liquidity of the market," says another custodian with a major international bank that also didn't want to be named. "It means that you have some trades going through the CSD and some through the registrar, and that's without counting the [Over The Counter] deals."
Most of the drafting of the new legislation has fallen to the FSFM, which is working with the Central Bank of Russia. However custodians say that the FSFM doesn't have the resources to do the job properly and is rushing it.
Another reform, already in place last year, created Russian Depository Receipts (RDRs), a proxy share that allows companies listed elsewhere to be traded on a Russian exchange. With foreign companies not allowed to list on the Micex and RTS, the point of this reform was to make it easy for companies that are essentially Russian - i.e. that have all their assets in Russia - but are listed in tax havens such as Cyprus (and so technically "foreign") to come home.
However, this move was also fluffed. "It seems to me, the imperfections of RDR legislation produced the situation where the risks of the Russian RDR issuing depository are much higher that its possible rewards," says Marina Ivanova, head of custody services at Deutsche Bank in Moscow. "We looked at these instruments and couldn't see how to work with them. There are too many contradictions with international law."
Two further bills have also been largely drafted and are due to be read in the autumn: one that defines clearing processes and another that will finally ban insider trading. However, no one is sure how well these laws will work until they see them. Custodians interviewed for this article are nervous, afraid that the regulator is going to set in stone a flawed infrastructure that will take another decade to repair. Others are happy to see some progress and are lobbying like mad to get the best fix possible.
"The devil is in the details and today the model [for the IFC] is not 100% clear," says Mathieu Maurier, head of Rosbank's security services. "But I am optimistic. After a decade of discussion we'll probably have a CSD by the end of this year and that will be the cornerstone of the new market infrastructure. We can take it from there."
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