Russia's capital market reforms take hold just in time

By bne IntelliNews August 1, 2012

bne -

With a new financial storm in the autumn looking increasingly likely, the Russian government's push to reform its capital markets will likely make a big difference to Russia's survival chances in the next meltdown.

The crucial part of the government's changes is making it easier for foreigners to buy the OFZ - the main domestic bond used by the state to cover any budget deficits.

Under the current regime, foreigners already own about 5.5% of all the outstanding OFZ, or RUB3.1 trillion, ($103bn). But to do so means these investors need to hire a local broker and negotiate the tax code. And because of certain regulations abroad, some gargantuan would-be investors, like US pension funds, can't buy OFZ even if they wanted to: under US rules, Russia would need to have a Central Securities Depository (CSD).

That is all changing. The centrepiece of the reforms has been to set up a CSD; in June, the biggest depository in the country NSD formally applied to take over the job as CSD, a bit later than planned, meaning Russia is on course to have a CSD this autumn that will open the gates to a new pool of capital worth trillions of dollars. "The exact timing of the liberalisation depends on completing the standard process of approving and certifying the Central Depository. Our upbeat expectation is for this to have been completed by November. Therefore, the Russian local bond market might be fully liberalised for non-residents by late autumn 2012," VTB Capital said in a note.

Long-term horizons

The OFZ bond has been developing since 2009 when bond market reforms began and is used by the state to cover the deficits that appeared after the last financial crash. For 2013-2014 the budget allowed the government to borrow RUB1 trillion ($33bn), though the actual borrowing by the government has been a lot less than in the plan thanks to the economic recovery and the rising tax take. This year the government has only borrowed the equivalent of 1.5% of GDP - far more than the 0.1% of GDP budget deficit the state is running, according to VTB.

So the government has the money it needs to cover the deficit, right? Yes... but the problem with the bulk of the current breed of foreign and domestic investors - such as banks and hedge funds - is that they have short-term horizons. Most investors in the Russian capital markets are and always have been speculators. The real appeal of the new foreign investors is that they will have a longer-term perspective; pension and insurance funds tend to buy-and-hold for decades, taking the bond through to maturity, as their liabilities come due only when a worker retires or that rare catastrophe hits. This will give some crisis stability to the Russian markets that they so badly need and was so palpably missing in 2008.

The reforms should make increased inflows a self-fulfilling prophecy. The changes mean the OFZ will have to be included in the indices (the GBO-EM index family) that track emerging market bond funds, as they are now more readily investible. Hence most investors will be forced to re-balance their portfolios and buy some OFZ to match the benchmarks. VTB are predicting just this re-balancing process will see the foreign share in the OFZ jump from 5.5% now to 15% within only a few months of the changes being put in place. And this technical increase is before investors start thinking about how much more these bonds pay compared with the rock bottom yields currently offered by most developed countries (in Germany the returns are already negative.)

"The relative attractiveness of OFZs compared with [emerging market] peers will likely push other classes of global investor (global pension funds, real money accounts) to include OFZs into their portfolios. Hence, a 20-30% share of non-residents in the OFZ market looks achievable within 18 months following liberalisation. In absolute terms, this translates into potential additional demand of RUB500bn-800bn from non-residents, which covers up to 70% of the total OFZ net issuance in 2010-11," says VTB

Will it be a success? All the ducks are lined up. Given the macroeconomic imbalances in the world today - you are locked into losing money on German bunds; you make a decent profit on Russia OFZ by any standard - everything points to the reform being a huge success.

No withholding tax

In addition to the creation of the CSD, the Kremlin has put several other key changes in place. The 15% withholding tax that used to be charged on foreign OFZ holders will effectively disappear once the new rules are in place. More importantly, the Central Bank of Russia has more-or-less finished its transition to a floating exchange rate - in mid-July, the CBR widened the exchange-trading band against the dollar in anticipation of a meltdown in Europe. "Is the Russian local bond market fundamentally attractive for non-residents?" asks VTB. "Our answer is a firm 'YES'."

VTB says Russia's fiscal position is one of the strongest among the G20 countries. It has a very conservative debt/GDP ratio, with the finance ministry forecasting 10-14% for 2012-2015, with a maximum sovereign external debt share of only 20% for the next three years. It has the third largest reserves in the world, more than $500bn. And a flexible exchange rate policy makes Russia's budget revenues less vulnerable to global shocks.

The ability of the ruble to fall in value in a crisis is what provides the cushion for external shocks and the ruble exchange rate is now as flexible as it has ever been in the last two decades. VTB predicts that up to half of all the demand for new issues of OFZ from this autumn could come from international investors, which will have the effect of driving down yields by 100 basis points and making the cost of borrowing for the Russian government even cheaper.

The end result of the changes? Much more, much cheaper, much long-term money for the Russian government. Sounds like a good deal.

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