The Influence of the new russian currency law FZ ¹173 on western Creditors: avoiding risks when doing Business with Russia

CONTENT

  List of tables  V

  List of illustrations  VI

  List of schemes  VII

  Abbreviations  VIII

  Definitions  X

  Executive summary  XIII

1.  Introduction  1

1.1.  The description of the problem  1

1.2.  The workflow of the research  2

2.  Russia and its current economic and political situation  4

2.1.  What rating agencies believe about Russia  4

2.2.  The industrial sector in Russia  6

2.2.1.  General characteristics of the industrial sector  6

2.2.2.  The Russian commodity market  11

2.3.  The banking sector in Russia  15

2.3.  The banking sector in Russia  15

2.3.1.  Credit granting system in Russia  16

2.3.2.  State owned banks  17

2.3.3.  Private owned banks  20

2.3.4.  Syndicated credits in Russian commodity markets  22

2.4.  SWOT analysis of Russia: overview  24

2.4.1.  Political risks  24

2.4.2.  Economic risks  25

2.4.3.  Legal risks  27

3.  The description of the federal law 173 “on Currency Regulation and  

  Control  28

3.1.  The old payment flow regime  28

II

3.1.1.  General characteristics  28

3.1.2.  The structure of the old payment regime  31

3.1.3.  Alternative structure  33

3.2.  The new payment flow regime  36

3.2.1.  Entry into effect and the transitional period’  36

3.2.2.  Basic principles of new currency regulation  37

3.2.2.1.  Transaction passport  38

3.2.2.2.  Resident repatriation of foreign currency  39

3.2.2.3.  Preliminary registration  39

3.2.2.4.  Obligatory sale of proceeds (conversion)  40

3.2.2.5.  Special accounts (SA)  40

3.2.2.5.1.  Special accounts for residents  41

3.2.2.5.2  Special accounts for non-residents  41

3.2.2.6.  Mandatory reservation of currency  42

3.2.3.  Types of currency operations  44

3.2.3.1.  Regime for foreign currency loans  44

3.2.3.2.  Regime for loans in Russian Roubles  46

3.2.4.  The instructions of Central Bank of Russia to the FZ 173  47

3.2.5.  The new structure  48

4.  The influence of the new currency law on western credit lenders and the  

  risks associated with this law  50

4.1.  Capital flight as a main risk of Russian government  50

4.2.  Offshore accounts as a main advantage for both lender and borrower  51

4.3.  SWOT analysis of the new currency law  52

4.4.  The controversies of the FZ 173  55

5.  Minimizing and preventing the risks associated with doing business in  

  Russia  56

5.1.  Risks Overview  56

5.1.1.  Offshore risks  59

5.1.2.  Onshore risks  62

5.2.  Dealing with risk  65

5.3.  Hedging the risks  66

III

5.3.1.  Derivatives  66

5.3.2.  Barter  70

5.3.3.  Documentary collection  70

5.3.4.  Letter of credit (L/)C  72

5.3.5.  Credit insurance (CI)  75

5.3.6.  Sureties and guarantees  77

5.4.  The explanation of risk categories on the example of OJSC Rosneft  78

5.5.  Inspection and monitoring  82

6.  Conclusion  84

  Literature  86

  Attachments  92

IV

  List of tables  

Table 2 1 1.  Comparing the country ratings of Russia  4

Table 2 2 2 1.  Russian Energy Overview  12

Table 2 2 2 2.  Overview of Russian Commodity Market  14

Table 2 3 2 1  Ten Largest Russian Banks by Customer Deposits  19

Table 5 1 1 1.  Roots of currency risks  59

V

  List of illustrations  

Illustration  2 2 1 1 Russia - GDP growth and Oil-prices correlated  8

Illustration  2 2 1 3. Russia - Foreign debt decreases ( age of GDP )  10

Illustration  2 2 1 4 The Development of Russian Economy (in USD Bn)  11

Illustration  2 2 2 1 Rough Sketch of Russia’s Oil Balance 2002  13

Illustration  2 3 2 1 Domestic credit to private sector (2001 )  18

Illustration  2 3 3 1. Russia - Low FDI by international standards ( age of GDP)  21

Illustration  3 1 1 1. The Russian passporting system  29

Illustration  5 1 1. Potential clients as carriers of credit risk  56

VI

  List of schemes  

  Scheme 3 1 2 1. The steps of the old payment regime.  31

  Scheme 3 1 3 1. The alternative payment regime  33

  Scheme 3 2 3 1 1 Regime for foreign currency loans  45

  Scheme 3 2 3 2 1 Regime for loans in Russian Roubles  46

  Scheme 3 2 5 1. The new payment regime  48

  Scheme 4 2 1. The functioning of offshore accounts  52

  Scheme 5 3 1 1. Implementation of currency derivatives  67

  Scheme 5 3 1 2. A commodity swap for oil  68

  Scheme 5 3 3 1. The implementation of documentary collection  71

  Scheme 5 3 4 1. The implementation of the letter of credit  73

  Scheme 5 3 5 1. The implementation of credit insurance  75

  Scheme 5 4 1. The assignment of export proceeds  82

VII

Abbreviations

ABS - Asset Backed Securities

Art. - Article

BIS - Bank for International Settlements Bn. - Billion Bbl/d - Billion barrels per day CDS - Credit Default Swap CI - Credit Insurance CBR - Central Bank of Russia CRM - Credit Risk Mitigation CRO - Chief Representative Officer D/P - Documents against Payment EH - Euler Hermes EU - European Union EWS - Early Warning System FATF - Financial Action Task Force FIG - Financial Industrial Groups FDI - Foreign Direct Investments FCR - Foreign Currency Rating FZ - Federalny Zakon.(rus. Federal law) GDP - Gross Domestic Product GPA - Gross Problematic Assets IFRS - International Financial Reporting Standards IBG - Integrated Business Groups IMF - International Monetary Fund IRMA - Integrated Risk Management Approach ISDA - International Swap and Derivatives Association JV - Joint Venture LCR - Local Currency Rating L/C - Letter of Credit Mio. - Million

VIII

MICEX - Moscow International Currency Exchange MNC - Multinational Corporation NATO - North Atlantic Treaty Organization NPL - Non-performing Loans

OECD - Organization for Economic Cooperation and Development OJSC - Open Joint Stock Company OTC - Over The Counter RAB - Russian Authorized Bank RAS - Russian Accounting Standards RF - Russian Federation P/h - Policyholder PS - Passport System RUR - Russian Roubles RZB - Raiffeisen - Zentral Bank SA - Special Account SC - Structured Commodity SCTF - Structured Commodity Trade Finance SME - Small and Medium Enterprises S&P - Standard and Poors

SWOT - analysis of Strengths, Weaknesses, Opportunities and Threats Tcf - Trillion Cubic Feet VAR - Value at Risk WTO - World Trade Organization UFG - United Financial Group USD - United States Dollars

US GAAP - United States -Generally Accepted Accounting Principles YNG - Yuganskneftegaz YOY - Year On Year

IX

Definitions

The FZ №173 contains definitions and extends issues like authorized bank, special account, currency valuables, local and foreign securities 1 .

Authorised Banks - credit organisations, which were created according to the law of Russian Federation and have a right based on a licence of Central Bank of Russian Federation to conduct banking operations in a foreign currency. Currency valuables - foreign currency and foreign securities. Domestic securities - now defined as securities payable in Russian Roubles and the issuance of which is registered within the Russian Federation.

Foreign securities - securities, including those in a non-documentary form, which are not domestic.

Special Account - banking account in any authorised bank or a special part of depot account.

Other then the new definitions from the currency law, there are some general definitions that are important to know in order to better understand the topic.

Banking risks - the most important banking risks are (1) market risk, (2) credit risk, (3) liquidity risk, (4) operative risks, (5) strategic risks ² . Barter - is the exchange of products and services without the use of money ³ . Creditor - a person or organisation, which grants credits to others. Credit derivatives -an over-the counter, off-balance sheet instrument the value of which is derived, directly or indirectly, from the price of a credit instrument ⁴ . Credit risk - the risk of loss arising from default by a creditor or counter-party. Commodity - a product that is traded in stock exchanges and futures markets, for which a publicly quoted price is available, and a product that is recognized or referred as such. Soft

¹ Definitions taken from the FZ №173 Ch.1 Art.1

² Gabler Bank-Lexicon in: 13th Edition, Wiesbaden, 2002

³ Definitions taken from http://www.investorwords.com are: barter, industrial risk

⁴ Definitions taken from HWP Hamburg, International Finance, WS 2003/04, W. B. Kersten: commodity, credit risk, credit derivatives, economic/ commercial risk, guarantee, rating

X

commodities usually include cocoa, sugar, coffee, cotton and grains, where metals and chemicals represent hard commodities.

Confirmed letter of credit - . L/C to which the advising bank has added its own, independent undertaking to honor presentation of the required documents, i.e., pay the beneficiary at -A-7 -sight or at maturity, as specified by the L/C. The opposite to confirmed L/C is the unconfirmed L/C ⁵ .

Country risk - possible political or economic instability of the country as well as shortages in foreign exchange.

Economic/ commercial risk - possible fluctuations in demand, natural disasters, bad economic conditions in buyer’s country.

Exporter -the person or company who sends goods or commodities to a foreign country, in a way of commerce ⁶ .

Guarantee - to accept responsibility for an obligation if the entity with primary responsibility for the obligation does not meet it. Importer -the merchant who brings goods into a country or state.

Industrial Risk - is a risk associated with business of manufacturing products; it excludes utility, transport and financial companies.

Investment grade - obligations with a rating of AAA, AA, A or BBB ⁷ . Lender - individual or firm that extends money to a borrower with the expectation of being repaid, usually with interest. Lenders create loans.

Political risk - risk in a sale of goods that the government in the buyer’s country may take some action that prevents the buyer from paying. This covers possibilities such as the imposition of foreign exchange controls and expropriation as well as non-payment due to war or insurrections.

Price risk - a risk from fluctuation of commodity prices according to supply and demand in the marketplace; can be mitigated either through securing fixed price contracts, or by hedging in the future market.

⁵ ABN Amro Bank, Trade Service Premier: http://www.maxtrad.com/pdf/trade_services_primer.pdf. All definitions of L/C were taken from this source, as well as political risk, transfer risk, pre-export financing

⁶ Online Economic Dictionary: www.hyperdictionary.com

⁷ HWP Hamburg, International Finance, WS 2003/04, Wolf B. Kersten

XI

Product risk- risk attached to a commodity itself, but in terms of the possibility that the commodity may be destroyed or damaged either during storage or in the transportation process.

Pre-export financing - specific form of working capital lending in which the borrower is given funds needed to obtain or manufacture goods that have been ordered by a buyer in another country.

Rating -is the means of grading, scaling; a natural behaviour; is a floating, dynamic process; is always individual and cannot be neutral or objective, depends on the point you stand and what you want to achieve.

Participation - participation in the funding of an advance (advanced part of the loan) accepted by each participant under a certain agreement.

Revocable letter of credit - is a L/C that can be amended or cancelled at any time without notice to or consent of the beneficiary. A L/C that is subject to the UCP500 or to U.S. law is revocable only if it clearly specifies so. The opposite to revocable L/C is irrevocable L/C.

Revolving letter of credit - is a L/C that reverts to its original amount at specified intervals,

e.g., monthly, thereby preventing drawing too much in any one period. Speculative grade - spreads from BB, B, CCC, CC, to D.

Standby letter of credit as opposed to a commercial L/C, a letter of credit that does not cover the direct purchase of merchandise, so called because it is often intended to be drawn on only when the applicant for whom it is issued fails to perform an obligation. Structured Commodity Trade Finance - financing of short- or medium-term business transactions of commodities or semi-finished products ⁸ . Syndicated credit - a credit granted by a certain consortium of lenders. Syndication - granting of credits or the emission of the stocks and bonds with the participation of a certain consortium.

Transfer risk - risk incurred by the seller of goods that, due to the fact that his country has a negative balance of payments, no foreign exchange (U.S. dollars or other ‘hard’ currency) may be available to the buyer when he is ready to pay for the goods.

⁸ Büschgen, H.E./ Graffe, F.: Handbuch für das Auslandsgeschäft in: Bonn 1993 p.104

XII

Executive summary

When doing business in Russia, foreign companies face a number of risks, mainly: economic, political and legal risk. However, the rapid economic growth during the last four years and a new progressive legislation have created favourable conditions for foreign direct investments (FDI) to the country. This fact was also noted by rating agencies like Moody’s, S&P and Fitch who gave Russia an investment grade and stable outlook this year.

A need of modernization of the Russian banking sector was an incentive for the initiation of the federal law (FZ) №173 “on currency regulation and currency control”, which came in force in June 2004. This law has replaced the old currency regulation law from 1992. The new currency regulations in Russia shall ease the trade between Russian residents and non-residents, bringing more flexibility to western credit lenders - banks, insurers and other financial institutions. However, the FZ №173 does not only provide the liberal opportunities to financial institutions, but also presents new risks. Doing business abroad, investors face sovereign risks: economic, political and legal ones. Despite the stabilization of Russian economy in the last few years, there is still a need for foreign investments in industrial sector and a need of reforms of the banking sector. At present there is a very poor coordination between industrial and banking branches: the commodity export dominates over its inland processing in industrial sector and the banking sector adjusts to the industrial needs very slowly. The sectors are ripe for changes and any big merger or foreign investment may trigger their restructuring.

After the breakup of the Soviet Union, the government took several measures to strengthen the exchange rate of RUR, which had a large influence on currency market and foreign trade. Changing the normative threshold for the compulsory sale of exporter’s currency profit is a tool the Russian government used in order to regulated the currency flows. In November 2004 the normative threshold was decreased to 10%, when just in 1998 the maximum normative stood at 75%. The new FZ №173 makes a clear distinction between the roles of the Central Bank of Russia (CBR) and the government in currency regulation: CBR will be responsible for foreign trade and government for credits and securities. Both the CBR and the government cannot interfere in transactions unless the currency law explicitly specifies it. The basic achievement of this law is the possibility for Russian

XIII

residents to open offshore accounts and so conduct the whole transaction offshore. The new currency law allows to avoid repatriating export proceeds back to Russia, which are meant for credit re-payment abroad. Similarly, there is no further need to convert the proceeds in RUR or make reservation from export proceeds on special accounts. However, the transaction still has to be registered preliminarily with the issuance of according transaction passport. Some requirements of the FZ №173 like special accounts, mandatory reservation, conversion and repatriation are temporary and will stay in force until January 2007.

After the law came into force, there was no currency revolution and the fear of capital flight has cooled down. The new currency law is quite liberal; however, the numerous instructions of CBR might restrict the control and regulation of currency operations. FZ №173 has a large influence on creditors since it determines the new ways of currency flow; thus, it determines a new approach to estimate the business profitability. As a disadvantage, many analysts see the fact that the purchase of internal securities and the payment the insurance premium by the policyholder can be conducted in RUR only. Similarly, Russian residents, if they are not banks, cannot lend loans in foreign currency to other residents. With these measures Russian government tries to protect the country from its biggest risk - capital flight.

There are many classifications of risks. When doing business in a foreign country, creditors face two types of risks: onshore and offshore ones. The possibility to conduct transactions completely offshore provided by the FZ №173, allows creditors to eliminate Russian onshore risks. However, the remaining offshore risks like price-, political-, transport-, delivery- and credit-default risk have to be considered by creditors in international trade. Typical instruments to hedge the credit default risk in Russia are letters of credit, sureties and the assignment of export proceeds. By assigning export proceeds from offtakes directly to creditors, the risks associated with the default of Russian borrowers are minimized. This form of financing is very typical for the structured commodity trade.

Credit default remains the biggest risk that creditors are facing when financing an export transaction. In order to change the situation there are additional legal reforms to be made and the FZ №173 is the one of them. The export sector needs to switch from developing to processing, create conditions for better competition and attract foreign direct investments.

XIV

1. Introduction 9

1.1. The description of the problem

Today bananas from Honduras will be sold in Novosibirsk, coffee from Brazil will be sold in Moscow and Russian oil will be sold in Zurich. To make this trade possible, new financing techniques like structured commodity trade financing are needed. Behind these transactions, reliable tools are inevitable.

It is an understatement to say that doing business with someone in another country is more complicated than just finding ways to transport goods over long distances. One of the most obvious differences from doing business domestically is the fact that companies face new risks such as country risks, industry risks and especially credit risks. To make it easier for western creditors to conduct a profitable business in Russia and hedge their risks, lenders need to be aware of the economic, political and legal situation in the country; particularly, the creditors need to understand the new Russian currency law №173. The intention of the new federal law is to ‘create a single government currency policy and to increase the stability of the Russian Federation and its internal currency market’ ¹⁰ .

The purpose of this master thesis is to describe the pros and cons of this law, the risks that western creditors face when they engage in financing export transactions and the ways to prevent these risks. The influence of the federal law “on currency regulation and currency control” on western creditors is a very genuine topic for this master thesis, because this work shall increase the understanding of international finance as well as the interest for its

⁹ Due to the complexity of this new Russian law and its importance for German exporters and banks it is agreed with the tutoring professors that the scope of the pages of this master thesis exceeds the average, normal number of pages as agreed in the exam guidelines.

¹⁰ FZ №173, introduction

1

practice in Russia. The absence of a deep research and the freshness of the topic make it especially interesting for investors.

Is the recent situation in Russia friendly to western creditors? What aspects of the FZ №173 are necessary to know when financing Russian exports? What impact will this law have on western creditors? What are the ways to hedge risks associated with the FZ №173? These questions will be discussed in this paper.

1.2. The workflow of the research

The sharpening competition between financial institutions evokes the necessity to understand the complexity of the FZ №173 and use the positive experience of risk management in practice.

This work applies descriptive, comparative and statistical methodology. The objects of this work are the Russian Federal Law №173 and the risks associated with this law. The subjects of this master thesis are lenders, borrowers and other structural organizational units, which are directly or indirectly touched by the law. The tactics of my work are to reflect the impact of the FZ №173 on western lenders and to suggest the effective methods to hedge credit risks.

My master thesis consists of introduction, four body chapters, conclusion, attachments and a literature list. After a short introduction of the topic in the first chapter, the second chapter will present the recent economic and political situation in Russia. Understanding the present situation in Russia is extremely important for creditors because it helps them to better estimate the risks connected with the country, industry and the borrower. To estimate the above-mentioned risks I will present a SWOT analysis, where the economic, legal and political risks of Russia as a sovereign will be analysed. Furthermore, an analysis of credit risk connected with the transaction itself will be conducted. The description of the current situation in Russian banking and industrial sectors as well as the opinion of the leading rating agencies will help potential lenders to build a qualified opinion about the borrower and the risks associated with the transaction.

The third chapter will present the currency flow regime under the FZ №173 as well as the implications under the new law. The FZ №173 stipulates that everything that is not

2

forbidden is allowed. However, is the abolishment of repatriation, sale and reservation of export proceeds the major achievement of the new currency law? What are the steps of the old and new currency regimes? The answer to these questions, along with the explanation of issues like special- and mirror accounts, transaction passports, and preliminary registration will be given in the third chapter.

Chapter four will show the consequences connected with this law and the way the new law may affect western financial institutions. The chapter will present the differences between old and new regimes and some practical examples of transactions will be given.

At the end, in the fifth chapter, I will describe the measures a creditor needs to take in order to minimize and prevent risks, which were not prevented by the currency law №173. For this purpose I will describe the ways the risks are analysed and dealt with on the example of the firm OJSC Rosneft. Chapter five will also describe the ways of monitoring and hedging the risks, which are associated with the currency law.

3

2. Russia and its current economic and political situation

Knowledge of the current economic and political situation in Russia is a first step to understanding which reforms and changes in legislation are needed for the economic development of the country. The SWOT analysis of Russia as a sovereign, as well as the analysis of risks connected with business transactions will help lenders to better estimate credit risk in trade finance.

2.1. What rating agencies believe about Russia

Russia has great potential on the international trade market: investments in domestic sector are increasing and the retail sector is booming. When doing business with Russia the best way to evaluate the country is to make a comparison of its credit rating from different rating agencies. Thus, credit rating is a prediction of a rating agency on an ordinal scale after the assessment of the creditworthiness of the debtor and its ability to completely fulfil all short and long term financial liabilities based upon its economic ability, willingness and legal binding ¹¹ . There are four main steps in a rating process: a) sovereign ceiling (country rating); b) sector of the industry; c) rating of the company or d) type of the credit/ liability ¹² .

The first step to estimate country risks is to find out the opinion of the leading rating agencies like Standard and Poors (S&P), Moody’s and FitchRatings on Russia. Table 2.1-1. Comparing the country ratings of Russia

Source: Internet sites of these agencies, stand 23.08.2004

This table shows that all three agencies gave Russia a stable outlook; however they have a different opinion in characterising the Russian economy. In the opinion of the S&P

¹¹ HWP Hamburg, International Finance, WS 2003/04 Wolf B. Kersten

¹² Standard and Poors: www.standardandpoors.com

4

specialists, for example, the Russian foreign currency rating (FCR) is characterised by satisfactory foreign policy, insufficient social, political and external economic conditions. The local currency rating (LCR) is characterised by unsatisfactory fiscal conditions and insufficient internal economic conditions. The credit strength of Russia includes a large current account surplus, strong primary budget surplus and reduced external vulnerability ¹³ .

Each agency has its own methods and rating grades. Moody’s rating scale goes from Aaa to B3 in 16 intervals. The most used grading/ scaling, also used by S&P and Fitch Ratings, splits between AAA to D, where D stands for default. Since the S&P is the largest rating agency, I decided to use its scale to describe the economic and political situation in Russia. BBB/BBB- in S&P practices shows the adequate protection, however it also means that weak economic conditions may lead to a weakened capacity of debtor to meet his financial obligation. BBB rating and the ratings above (A, AA; AAA) refer to the investment grade, whereas the grades between BB and C refer to the speculative grade. Plus and minus show the relative standing within the rating category. After comparing these grades in the transformation table ¹⁴ we will find that all agencies had a similar impression about Russia: it deserves an investment grade ¹⁵ . S&P and Moody’s awarded the investment grade to Russia in January 2005 and Fitch in November 2004.

Even though the economy in Russia is growing, the weak economic situation and political instability do not guarantee investors a profitable return. Until recently the country was overfilled with speculative investments, where short-term investments have dominated. For many creditors the investments in risky countries are associated with high returns. Thus: appetite for profit goes similar with risk. However, when sovereign risks are too high, a country may become insolvent very easily. The main reasons for such insolvency are a share markets crash, exchange currency rates crisis, bank crisis, domino effects ¹⁶ , government mismanagement and overreaction of neighbours ¹⁷ . The S&P analysts suggest

¹³ Standard and Poors, Russia country rating, updated on 12.07.04 in: www.ratingsdirect.com

¹⁴ the transformation table of HSH Nordbank is shown in the attachment 2.1-1

¹⁵ www.standardandpoors.com, www.moodys.com, www.firchratings.com

¹⁶ ‘A cumulative effect produced when one event sets off a chain of similar events’ in www.thefreedictionary.com

¹⁷ HWP Hamburg, Credit Risk Management, WS 2004/05 W. B. Kersten

5

that the key for a positive rating change is in solid fiscal and debt management policies. “If not slow reforms and bad practices, the future of Russia could look even better” ¹⁸ .

Country ratings present a composition of financial and industrial environment. After comparing country ratings of Russia, the next step that should help western creditors to make their decision about credit granting is a description of chances and challenges of Russian economy.

2.2. The industrial sector in Russia

The imbalance of the Russian economy lies in separation of the single economic market in two: financial- and industrial sector, which are poor coordinated with each other. In the opinion of Russian well-known economist Mr. Alexey Smulov, banking and industrial sectors have to be well connected for the further positive economic development. Previously, after the crisis of 1998, the Russian banking system became isolated and concentrated on its own problems and ignored the problems of the industrial sector. Credits to the real sector of economy made up only about 1/3 of the total assets of the Russian banking system. In order to keep the success in economic growth, it is necessary to activate the banking system and the industrial sector ¹⁹ .

2.2.1. General characteristics of the industrial sector

After the breakup of the Soviet Union in 1991, the Russian economy started to change. The presidential decree №213 from November 15, 1991 ‘on the liberalisation of external economic activity’ was crucial for the liberalisation of economy, since it provided that ‘the rate of the Rouble against foreign currencies shall be formed on the basis of demand and supply in auctions, exchanges, the interbank market and in the purchase/sale of currencies by commercial banks, other legal entities and citizens’ ²⁰ . However, Russian economy never experienced an investment boom like Asian and Latin American countries and

¹⁸ Burgie, Scott: Bank industry analysis: Russian Federation in: Standard & Poors, 16.06.04

¹⁹ Smulov A.M.: Industrial and banking firms: interdependence and resolution in critical situation in: Finansy i Statistika, Moscow, 2003. p.5

²⁰ Korolenko, N: Currency market in Russia: trends and prospects in: Euromoney in association with Moscow Interbank Currency Exchange, 1997. p. 70

6

Russian banks were not largely involved in borrowing possibilities, which opened in 1990s. Thus, Russian banks received only USD 2 Bn. of Eurobonds and syndicated loans during 1997-98 and their assets remained small ²¹ . The common assets of the Russian banks in spring 1998 were around 35% of GDP, where Brazil had 72%, Poland 60% and many developed countries more than 100%. 35% of all banking assets were invested in government paper in 1998 and very little in financing the public deficit ²² . A poor economic climate in Russia in 1997-98 caused a deep economic crisis.

The consequences of this crisis were the devaluation of national currency (by 250% by December 1998), monthly inflation rate of about 45%, collapse of all financial markets, dollarization of national economy and capital flight. Dollarization is used to describe the extent, to which foreign currency substitutes for domestic money in its three traditional functions (unit of account, medium of exchange and store of value), with the impact assumption that the substitution process is symmetrical and responds to changes in the determinants in both directions ²³ . By the end of September 1998, the Rouble had only kept about 35% of its value before the crisis and GDP was forecast to decrease 6% for the 1998 ²⁴ .

The reasons behind the Russian crisis of 1998 are macroeconomic imbalances, the absence of a balanced economic strategy and incompleteness of institutional reforms ²⁵ . The crisis of 1998 was also caused by a continuous budget deficit that was thoughtless financed by sale of government short-term securities at high interest rates ²⁶ . The fixed exchange rate implemented by the Russian government in the beginning of transformation showed itself as an effective stability anchor ²⁷ . Another reason was the underdevelopment of the banking sector, the lack of a legal framework and regulation and supervision by CBR. In Russia’s case inconsistencies were stemming not from a fixed peg and monetarisation of the public

²¹ Komulainen, Tuomas: Currency crisis theories in: Potsdam University, 1999. p. 21

²² Komulainen, Tuomas: Currency crisis theories in: Potsdam University, 1999. p. 4

²³ Buchs, Thierry D.: Currency substitution in the Russian Federation (1992-97) in: Most. Bologna, Dordrecht, 2000. p. 95

²⁴ Komulainen, Tuomas: Currency crisis theories in: Potsdam University, 1999. p. 1

²⁵ Bolkhovitina, Elena: An analysis of the currency and financial crisis in Russia in: Tokyo, 1999 p. 1

²⁶ Millar, James: Normalisation of the Russian economy in: Seattle. Washington, 2002, P. 7

²⁷ Quaisser, Wolfgang: Foreign trade strategies and export development in Eastern Europe, Russia and Ukraine’ in: Osteuropa-Institut München, München, 1994 p.i

7

deficit, but rather from a fixed exchange rate and debt-financed fiscal deficit, that was getting out of control, in a context of liberalized capital flows ²⁸ . In 1999, thanks to the default and devaluation, more realistic government budgeting and a general rise in the world price of oil, the principal Russian export, the economy subsequently returned to the path of growth established in 1997 ²⁹ .

The strong development of Russian economy in 2000-2004 was caused by the increase of oil prices. This led to a budget surplus in the last three consecutive years to 2004. Since the economy depends on the energy sector, the government diversification measures were only partly successful. Recently, the dependence of GDP on oil prices has tremendously grown.

Illustration 2.2.1.-1.Russia - GDP growth and Oil-prices correlated Source: EIU 2004; HSH Nordbank; * = Forecast

% - change, yoy

Due to a high dependency of Russian GDP on oil prices, the Russian state started to use oil prices to regulate economic limits. In the Russian industrial sector the domination of commodity market is quite obvious. Natural resources are extremely abundant, but they will be exported abroad and not processed in Russia.

In order to understand the present economic situation, let us take a look at the table 2.2.1-2, which shows a successful development of major economic indicators. According to this

²⁸ Chapman, Sheila: Explaining Russia’s currency and financial crisis in: Most, Bologna, Dordrecht, 2001 p.23

²⁹ Millar, James: Normalisation of the Russian economy in: Seattle. Washington, 2002, P. 9

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table, in the real GDP growth between 2001 and 2004 constantly increasing due to the increase in Russian oil prices.

Table 2.2.1.-1. Russia’s Key Economic Indicators

Source: Ministry for Economic Development and Trade 30

This table shows that in the trade balance of each year between 2000 and 2004, the export volume was approximately twice as high as import volume; where the major part of export belongs to hard commodities. Often local goods will be exported without proper processing, which make them less competitive on international market.

In the year 2004 inflation (14% yoy) has fallen slower than planned mainly due to the income dynamics, the growth of money masses, fiscal expansion and the growth of administrative prices (rent, etc.) Russia became efficient in its debt management and its external debt has noticeably decreased ³¹ .

The illustration 2.2.1-2. shows the reduction of foreign debt in Russia as a percentage of GDP between 2000 and 2005.

³⁰ Ministry of Economic Development and Trade in: www.economy.gov.ru, stand Januar y 2005

³¹ see attachment 2.2.1.-2. for Russian public debt and attachment 2.2.1.-3. for Russian foreign debt

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Illustration 2.2.1.-2. Russia - Public debt is reduced (%-age of GDP) Source: EIU 2004; HSH Nordbank; * = Forecast

Similarly to the development of public debt, the foreign debt has reduced in the last few years. Moderate foreign debt (40% of GDP) is covered to 43% through currency reserves ³² . The analysts forecast that Russian foreign debt will continue to decrease in 2005.

Illustration 2.2.1.-3. Russia - Foreign debt decreases (%-age of GDP ) Source: EIU 2004; HSH Nordbank; * = Forecast

The reduction of foreign and public debt has contributed to the economic growth in Russia. In the recent 2000-2004 years, economic growth can be characterised by the average of 4-5% ³³ . Based on economic growth indicator and historical data, the analysts of United Financial Group were able to give a forecast for the development of Russian economy through 2016.

³² EIU country profile

³³ Smulov A.M.: Industrial and banking firms: interdependence and resolution in critical situation in: Finansy i Statistika, Moscow, 2003. p.14

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Illustration 2.2.1-4 The Development of Russian Economy (in USD Bn) 34 Source: United Financial Group in: www.ufg.com

1 6 0 0

1 4 0 0

1 2 0 0

1 0 0 0

8 0 0

6 0 0

4 0 0

2 0 0

0

2 0 0 3 E 2 0 0 4 F 2 0 0 5 F

Despite high economic growth and sound financial management, the role of small and medium enterprises remains minimal. The banking sector makes large investments in heavy industry and IT. In order to keep the sustainable growth at 5%, Russia will need to take some extra measures. For instance, it will have to improve productivity, create conditions for the increased competition and attract FDI. To become more attractive for FDI, Russia needs to implement efficient government regulation and public spending, reduce the scope of government financing, cover its budget deficit and restructure national monopolies ³⁵ .

2.2.2. The Russian commodity market

A difficulty for western banks in financing a commodity transaction may occur when a producer of commodity originates from a country with an unstable economy like African countries, South America or Russia. These countries have limited means and limited access to finance needed facilities and projects. The reason for that is high costs associated with equipment and labour as well as the cost of production process itself. Rich natural resources present a main advantage for Russia; the disadvantage, on the other hand, is presented by the domination of extraction over processing of resources.

³⁴ In this illustration E stands for estimated and F stands for forecasted

³⁵ Bolkhovitina, Elena: An analysis of the currency and financial crisis in Russia in: Tokyo, 1999 p.10

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