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


Master's Thesis, 2005

122 Pages, Grade: 1,25


Excerpt

CONTENT

List of tables

List of illustrations

List of schemes

Abbreviations

Definitions

Executive summary

1. Introduction
1.1. The description of the problem
1.2. The workflow of the research

2. Russia and its current economic and political situation
2.1. What rating agencies believe about Russia
2.2. The industrial sector in Russia
2.2.1. General characteristics of the industrial sector
2.2.2. The Russian commodity market
2.3. The banking sector in Russia
2.3. The banking sector in Russia
2.3.1. Credit granting system in Russia
2.3.2. State owned banks
2.3.3. Private owned banks
2.3.4. Syndicated credits in Russian commodity markets
2.4. SWOT analysis of Russia: overview
2.4.1. Political risks
2.4.2. Economic risks
2.4.3. Legal risks

3. The description of the federal law №173 “on Currency Regulation and Control”
3.1. The old payment flow regime
3.1.1. General characteristics
3.1.2. The structure of the old payment regime
3.1.3. Alternative structure
3.2. The new payment flow regime
3.2.1. Entry into effect and the ‘transitional period’
3.2.2. Basic principles of new currency regulation
3.2.2.1. Transaction passport
3.2.2.2. Resident repatriation of foreign currency
3.2.2.3. Preliminary registration
3.2.2.4. Obligatory sale of proceeds (conversion)
3.2.2.5. Special accounts (SA)
3.2.2.5.1. Special accounts for residents
3.2.2.5.2 Special accounts for non-residents
3.2.2.6. Mandatory reservation of currency
3.2.3. Types of currency operations
3.2.3.1. Regime for foreign currency loans
3.2.3.2. Regime for loans in Russian Roubles
3.2.4. The instructions of Central Bank of Russia to the FZ №173
3.2.5. The new structure

4. The influence of the new currency law on western credit lenders and the risks associated with this law
4.1. Capital flight as a main risk of Russian government
4.2. Offshore accounts as a main advantage for both lender and borrower
4.3. SWOT analysis of the new currency law
4.4. The controversies of the FZ №173

5. Minimizing and preventing the risks associated with doing business in Russia
5.1. Risks Overview
5.1.1. Offshore risks
5.1.2. Onshore risks
5.2. Dealing with risk
5.3. Hedging the risks
5.3.1. Derivatives
5.3.2. Barter
5.3.3. Documentary collection
5.3.4. Letter of credit (L/C)
5.3.5. Credit insurance (CI)
5.3.6. Sureties and guarantees
5.4. The explanation of risk categories on the example of OJSC Rosneft
5.5. Inspection and monitoring

6. Conclusion

Literature

Attachments

Confession

List of tables

Table 2.1-1. Comparing the country ratings of Russia

Table 2.2.2.-1. Russian Energy Overview

Table 2.2.2.-2. Overview of Russian Commodity Market

Table 2.3.2-1 Ten Largest Russian Banks by Customer Deposits

Table 5.1.1-1. Roots of currency risks

List of illustrations

Illustration 2.2.1.-1.Russia – GDP growth and Oil-prices correlated

Illustration 2.2.1.-3. Russia – Foreign debt decreases (%-age of GDP )

Illustration 2.2.1-4 The Development of Russian Economy (in USD Bn)

Illustration 2.2.2.-1.Rough Sketch of Russia’s Oil Balance 2002

Illustration 2.3.2-1 Domestic credit to private sector (2001)

Illustration 2.3.3.-1. Russia – Low FDI by international standards (%-age of GDP)

Illustration 3.1.1-1. The Russian passporting system

Illustration 5.1.-1. Potential clients as carriers of credit risk

List of schemes

Scheme 3.1.2.-1. The steps of the old payment regime.

Scheme 3.1.3-1. The alternative payment regime

Scheme 3.2.3.1-1 Regime for foreign currency loans

Scheme 3.2.3.2-1 Regime for loans in Russian Roubles

Scheme 3.2.5-1. The new payment regime

Scheme 4.2.-1. The functioning of offshore accounts

Scheme 5.3.1.-1. Implementation of currency derivatives

Scheme 5.3.1-2. A commodity swap for oil

Scheme 5.3.3.-1. The implementation of documentary collection

Scheme 5.3.4-1. The implementation of the letter of credit

Scheme 5.3.5-1. The implementation of credit insurance

Scheme 5.4-1. The assignment of export proceeds

Abbreviations

illustration not visible in this excerpt

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 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.

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.

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 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.

1. Introduction

1.1. The description of the problem

‘Credit is trust[9] in business life,

so trustworthiness is the key principle

when doing international business’,-

Wolf B. Kersten

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 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 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.

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

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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 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 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 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 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

illustration not visible in this excerpt

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

(d) Table 2.2.1.-1. Russia’s Key Economic Indicators

Source: Ministry for Economic Development and Trade[30]

illustration not visible in this excerpt

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.

Illustration 2.2.1.-2. Russia – Public debt is reduced (%-age of GDP)

Source: EIU 2004; HSH Nordbank; * = Forecast

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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

illustration not visible in this excerpt

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.

Illustration 2.2.1-4 The Development of Russian Economy (in USD Bn)[34]

Source: United Financial Group in: www.ufg.com

illustration not visible in this excerpt

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.

A high economic risk (50-75%) in Russia is caused by the high dependence on commodities, in particular oil and gas. The increase in the share of fuel export in total exports (50% in 2000) is not healthy for Russian economy: it makes export vulnerable to fluctuations of world oil prices and may cause the RUR appreciation against USD, which would cause a ‘Dutch disease’- a tendency to rely upon a single export instead of diversifying[36]. The concentration of economic activities on extract and export of natural resources makes the Russian economy vulnerable to commodity prices. In the last 5 years commodity prices have appreciated by four times and in October, 2004 oil prices have reached a record of 55,67 USD/barrel[37]. On April 13, 2005 the oil price is still quoted on NYMEX at 50,22 USD/barrel[38].

The biggest challenge for Russian commodity market is the domination of extraction over processing of natural resources. This is one of the characteristics of a developing country. How large are Russian reserves in natural resources? How long will they supply the country?

The former CEO of Russian oil company Yukos, Mr. Michael Khodorkovsky estimates the reserves at 150 Bn. barrels: ‘If you simply summarize proven oil reserves of Russia’s 10 largest firms, audited by international auditors, you get a much higher figure than British Petroleum’s modest estimate.[39] ’In Russian energy overview, the Energy Information Administration (EIA) estimated the proven oil reserves at 60 Bbl. and oil production at 8,44 million bb/d.

Table 2.2.2.-1. Russian Energy Overview

Source: EIA, Russia Country Analysis in: http://www.eia.doe.gov/emeu/cabs/russia.html stand 14.04.05

illustration not visible in this excerpt

This short overview of Russian energy can be completed with a sketch of national oil balance. The illustration 2.2.2-1 shows the distribution of Russian crude oil among its international buyers.

Illustration 2.2.2.-1.Rough Sketch of Russia’s Oil Balance 2002

Source: EIA in: http://www.eia.doe.gov/emeu/cabs/russia.html

illustration not visible in this excerpt

This table shows that 46% total crude oil will be exported to eastern and western European countries. At present, Germany is the biggest export and import partner for Russia. In 2003 the export to Germany consisted of 7,8% and import 14% of Russia’s total export and import amount[40]. Between 1994-200, among Russian trading partners, Germany was in first place, with Ukraine and Belarus alternatively in second and third place, and USA and Italy respectively in fourth and fifth places[41].

Having such sufficient hard commodities, energy and oil resources, creditors would be definitely interested to find out the situation in a soft commodity market. Soft commodities are produced in Russia as well, but their international export is limited to the CIS countries. The fact that hard commodities prevail over soft ones and the extraction and export of hard commodities prevails over their processing is a characteristic of the developing country. The Table 2.2.-4. gives a short overview over the commodity market in Russia.

Table 2.2.2.-2. Overview of Russian Commodity Market

illustration not visible in this excerpt

Thus, table 2.2.2.-4 shows that the main soft commodities exported from Russia are croups, timber and beef. The imported products include machinery and equipment, medicine, consumer goods and sugar, just to name a few. If a commodity is considered to be the strategic resource of the country, it receives a favourable treatment from the perspective of foreign exchange availability and political risk standpoint. Such strategic commodities for Russia are oil, gas, precious metals, iron, copper, zinc and timber.

In the opinion of Elena Bolkhovitina, the Russian economist, the isolation of the financial sector from the physical sector is a major problem that hinders economic development in present. Therefore, after seeing the present situation in the Russian industrial sector, let us take a look at the banking sector and find out if the Russian banking sector is oriented to industrial needs.

2.3. The banking sector in Russia

(i)For western creditors Russian banks often stand up in a borrower category. They take a loan either for their own needs or to finance certain producers/commodity exporters. This is why it is important for any financial institution, which aims to do business in Russia to have a basic knowledge of the Russian banking structure.

The modern banking system is a very important pillar of a national economy for any country. In the last years the banking system of the world and especially the system of Russia has changed dramatically. The specifics of the Russian banking system lie in poor capitalisation, unequal territorial distribution, low financial stability and poor coordination with the industrial sector[42]. Recently, all components of the banking system have been modernized and the year 2004 was a year of progressive changes in banking legislative sphere. To see how the Russian banking system is organized please take a look at illustration 2.3-1.

Illustration 2.3.-1: The structure of Russian banking system

Source: ‚Bankovskoe delo", Moscow, Ekonomika, N 9, 2001

illustration not visible in this excerpt

The above illustration shows that after the modernization of the Russian banking system it became very similar in its structure to systems of many western countries. This illustration also shows that commercial and special banks often belong to some financial institution group, which is a specific characteristic of Russian banking system.

The Banker Magazine stated in January 2004 that Russian banks dominate the top ranks in the fastest growing European banks. The leaders were Vuz-Bank, CentroCredit Bank and IBG Nikoil Bank. However, despite positive economic growth in the last ten years, Russia still doesn’t have a properly functioning banking sector. The disclosed non-performing loans of Russian banks usually understate the potential problems that a bank experiences. Even though the banking sector has recovered from the crisis of 1998, around 1,200 Russian banks are still technically insolvent because they are highly undercapitalised[43].

Progressive development of Russian banking sector shows the transformation from RAS to IFRS, which was provided by CBR guidelines in December 2003. The first transformed accounts had to be presented by the end of 2004. The national standard, RAS, will continue to exist in parallel. CBR has set no time frame for complete transition to IFRS as a reporting standard. Before this regulation was issued, 15% of Russian banks were already producing their reports either under IFRS or US-GAAP[44]. Accrual accounting, net income, differed taxes, consolidation and other issues make a difference between RAS and IFRS.

The banking system of Russia can be better understood through the analysis of its ownership structure and credit granting system.

2.3.1. Credit granting system in Russia

Credit granting system in Russia is characterised by the licensing regime, where Russian residents must apply for the CBR licence to open the offshore account. This regime will be abolished by the FZ №173 in June 2005.

The main characteristic of a credit granting process is, however, a fact that most credits from Russian banks go to SME’s. The reason for that is that most Russian banks are simply not capable of high credits. Due to the over-banked situation in Russia, 10% of 1300 registered banks have own funds of less than USD 10 Mio.[45]. Because of their limited capital, most Russian banks are not ready to borrow more than USD 100 Mio. State banks prefer to lend to state companies; that is why private owned companies often need to search financing abroad, raising syndicated credits if necessary.

Since Russia is considered to be ‘over-banked’ some experts suggest that the CBR might use the Retail Deposit Insurance Law as a means of ‘weeding out improper bank owners, as well as the hundreds of marginal banks in the sector’[46]. From the beginning of June 2004 there were information in the Media about the possibility of eventual new bank crisis. This crisis may supposedly be caused by the intensification of regulatory revision of different Russian banks by the CBR. The revision is made because of the strong declining liquidity and as a preparation for the introduction of the deposit insurance funds. Thus, Sodbusinessbank and Credittrust supposedly haven’t met the requirements and the CBR took their operating licences away. After that event many small Russian private banks started to panic because they thought that this may happen to them as well. However, after the meeting of CBR with 25 leading Russian banks on 04.06.2004 and after the meeting of Mr. Ignatjev, the acting director of CBR, with Mr. Putin, rumours of a ‘closing list’ with new names of small banks have quieted down[47]. Recently the situation has started to change and separate Russian banks could demonstrate their ability to attract syndicated credits on the amount of more then USD 100 Mio.: Alfa Bank (USD 120 Mio.), Vneshtorgbank (USD 200 Mio.), Gazprombank (USD 275 Mio.)[48]

The Russian banking structure can be divided into state owned banks and private banks. The following section describes the ownership structure of Russian banks.

2.3.2. State owned banks

State owned banks dominate the market: they often grant credits either to state owned companies or to private SMEs. Most of state owned banks are also authorised banks, in other words, they hold a licence of CBR for the performance of certain operations like the opening of special accounts, reservation or the issuance of transaction passports[49]. This is why it is easier for the state owned banks to receive a licence from the CBR than for small and medium private banks. Large companies often get loans from foreign creditors, whereas private SMEs are staying behind with no or very poor commercial lending. Compared to other eastern European countries like Hungary, Czech Republic, Slovak Republic and Poland, Russia had the lowest percentage of the domestic credit granted to private sector in 2001, which is shown on the illustration below.

Illustration 2.3.2-1 Domestic credit to private sector (2001)

Source : European Bank for Reconstruction and Development in: www.ebrd.com

illustration not visible in this excerpt

The domestic credit granted to private sector is approximately 13% of the GDP. The credit to SMEs are very often granted by the four leading state banks – Sberbank, VTB, Gazprombank and the Bank of Moscow.

The state owned Sberbank (Saving Bank of Russian Federation)[50] comprises a market share of 63% of total deposits and 43% in retail deposits[51]. It dominates in commercial lending (30%) and it is the only Russian bank, which is quoted on the Russian Stock Exchange. Sberbank possesses over 20.000 branches and successfully implements IAS standards since 1996.

The second largest state bank is VTB (the Bank of Foreign Affairs), which is specialized for servicing Russian state debts. With its USD 2,2 bn. it possesses about 10% of the banking sector’s total capital[52]. Other large state banks are Gazprombank (Joint-Stock Bank of Gas Industry) and Bank of Moscow. According to the S&P[53] report, the four above-mentioned banks represent 55% of deposits and 45% of loans within the Russian banking system.

Table 2.3.2-1 Ten Largest Russian Banks by Customer Deposits

Source: Standard & Poor's and company reports.

illustration not visible in this excerpt

In comparison to foreign banks, which possess less then 10% of all banking assets in Russia, the state banks possess more than 50% of these assets. The government wants to keep ownership in large profitable banks like Sberbank, VTB, the Russian Bank of Development but it intends to sell its shares in smaller banks[54]. This way the government can still have an influence on the economy and the banking sector will be less over-banked.

2.3.3. Private owned banks

The Russian private banking sector is extremely fragmented and controlled by financial institution groups (FIG), which are organized mostly as holding companies and account for 80% of export. FIGs are interchangeably called Integrated Business Groups (IBG)[55].

During the process of privatisation the 1996 program ‘loans for shares’, the Russian elite acquired titles to enterprises that generated tremendous financial flows. This capital allowed the elite to finance further purchases of conglomerate. In the opinion of James Millar, an American economist, having a ‘captive bank at the core of the conglomerate compensates for Russia’s weak commercial banking and financial sector’[56].

Only 15 private banks possess a share of deposits or loans between 1-4%[57]. Hence, it is economically profitable to do business within a FIG, because the member support is guaranteed. Bank Imperial, for example, was supported by its minority owners – LUKoil and Gazprom[58]. Therefore, it is an advantage for foreign creditors to receive support not only from government, but also from a FIG in order to mitigate its country risks. Joint Venture with a Russian partner could be another chance to mitigate sovereign risks.

Already at the year-end 1997 the positioning of Russian FIGs has shown Gazprom, Lukoil, Interros-Oneksim, Yukos, Inkombank Group, Bank ‘Rossiysky credit’, Consortium ‘Alfa-group’, Group ‘Most’, AFK ‘System’ as leaders in major economic sectors [59].

Due to the lack of transparency it is hard for foreign creditors to obtain objective information about small FIG. Despite the laws in taxation and funding during the 90s, the efficient regulation of FIG has still not been achieved. FIG are often characterised as high risky concentrations. It is caused by the fact that these firms concentrate their activities in resource extraction and exportation sector. The estimated risks of FIGs are in monitoring, unclear nature of ownership and the lack of transparency. However, the increase of retained earnings and high growth rate of state banks and some private banks helped to reduce this risk element.

Foreign investments go into the natural resource sector and the investments in the banking sector are extremely small. Thus, foreign banks account for less than 10% of the total banking assets[60]. The market is ready for a change and one large investment may lead to solid structural changes.

Illustration 2.3.3.-1. Russia – Low FDI by international standards (%-age of GDP)

Source: EIU 2004; HSH Nordbank; * = Forecast

illustration not visible in this excerpt

The largest foreign bank in Russia is the International Moscow Bank with total banking assets of USD 2,4 billion in 2002[61]. Referring to the Bankscope statement, the next largest foreign banks are Citibank and RZB. Other banks like ING Bank, Deutsche Bank and Credit Suisse First Boston remain important credit grantors to private companies.

The present economic situation shows the lack of coordination between banking and industrial sectors. Industry is concentrated on extraction and export of commodities and Russian banks are undercapitalised to grant credits to private SMEs, who do business in other industrial sectors. To change present situation, long-term FDI are highly desirable.

2.3.4. Syndicated credits in Russian commodity markets

For foreign creditors syndicated credits represent a convenient way to finance the export of commodities. A syndicated credit presents a credit granted by a certain consortium and has a very complex structure[62]. Its first advantage is that it brings relatively cheap money for the borrower. Second, it is easier to get such an amount of money from a syndicate then to collect it from private investors. Third, syndicated credits allow a bank to finance large projects. Fourth, syndicated credits are good for risk mitigation, where the risks will be mitigated among syndicate participants[63].

[...]


[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

[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

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

[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

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

[12] Standard and Poors: www.standardandpoors.com

[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

[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

[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

[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

[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

[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

[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

[36] Millar, James: Normalisation of the Russian economy: obstacles and opportunities for reform and sustainable growth in: National Bureau of Asian Research, Seattle. Washington, 2002, p. 13

[37] Handelsblatt, 06.03.05

[38] Financial Times, 13.04.05

[39] BradyNet, Online Magazine: How large are Russia’s oil reserves in: www.bradynet.com/bbs/russia/100228-0.html, stand 14.04.05

[40] EIA, Russia Country Analysis in: http://www.eia.doe.gov/emeu/cabs/russia.html stand 14.04.05

[41] Millar, James: Normalisation of the Russian economy: obstacles and opportunities for reform and sustainable growth in: National Bureau of Asian Research, Seattle. Washington, 2002, P. 37

[42] Smulov A.M.: Industrial and banking firms: interdependence and resolution in critical situation in: Finansy i Statistika, Moscow, 2003. p.435

[43] Bank industry analysis: Russian Federation, Scott Burgie, Standard& Poors from 16.06.04

[44] Burgie, Scott: Bank industry analysis: Russian Federation in: Standard & Poors, 16.06.04

[45] Hishow, Ognian N.: Das Bankensystem der Russischen Föderation in: Berlin, 2003

[46] MoodysRating Agency: www.moodys.com

[47] Pravda newspaper: ‚Whats the deal with taxes’ from 06.08.04

[48] Dyatchenko, O: Syndication in Russian way: Syndicated Credits need more Trust in: Banking Review magazine №9, September 2004

[49] the terminology is covered in chapter 3

[50] according to www.sbrf.ru/ruswin/invest/affilcur.htm the Russian state possess 64% of Sberbank; the rest belongs to private shareholders

[51] Savings Bank of Russian Federation (Sberbank): http://www.sbrf.ru/eng/

[52] Bank of Foreign Trade (VTB), annual report 2002 in: http://eng.vtb.ru/ias2002.pdf stand 14.04.05

[53] Standard and Poors: www.standardandpoors.com

[54] Government decree No. 454 of April 2002

[55] Millar, James: Normalisation of the Russian economy: obstacles and opportunities for reform and sustainable growth in: National Bureau of Asian Research, Seattle. Washington, 2002, P. 23

[56] Millar, James: Normalisation of the Russian economy: obstacles and opportunities for reform and sustainable growth in: National Bureau of Asian Research, Seattle. Washington, 2002, P.21

[57] Bank industry analysis: Russian Federation, Scott Burgie, Standard & Poors from 16.06.04

[58] ‘Imperial’ Joint Stock Bank in Encyclopedia ‘Golden Book’: http://enc.ex.ru/cgi-bin/n1firm.pl?lang=2&f=486 stand 14.04.05

[59] Millar, James: Normalisation of the Russian economy: obstacles and opportunities for reform and sustainable growth in: National Bureau of Asian Research, Seattle. Washington, 2002, P.22

[60] Bank industry analysis: Russian Federation, Scott Burgie, Standard& Poors from 16.06.04

[61] International Bank of Moscow, annual reports 2002 and 2003: http://www.imb.ru/en/about/finance/international/balance2002/ and http://www.imb.ru/off-line/about/reports/annual_2003_en.pdf stand 14.04.05

[62] www.investorsworld.com

[63] MacNamara, J: Structured Trade and Commodity Finance in Emerging Markets in: Oxford 2001 p. 30-33, 46

Excerpt out of 122 pages

Details

Title
The Influence of the new russian currency law FZ ¹173 on western Creditors: avoiding risks when doing Business with Russia
College
University of Hamburg
Grade
1,25
Author
Year
2005
Pages
122
Catalog Number
V43858
ISBN (eBook)
9783638415590
File size
1312 KB
Language
English
Notes
To make it easier for western creditors to conduct a profitable business in Russia and hedge their risks, the creditors need to understand the new Russian currency law ¹173. The purpose of this work 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. This is a very genuine topic, because it increases the understanding of international finance as well as ...
Tags
Influence, Creditors, Business, Russia
Quote paper
Yelena Russakova (Author), 2005, The Influence of the new russian currency law FZ ¹173 on western Creditors: avoiding risks when doing Business with Russia, Munich, GRIN Verlag, https://www.grin.com/document/43858

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