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RUSSIAN ECONOMY IN trends and outlooks were able to lend funds to their clients in an amount equal to the amount invested by such clients (1:1 leverage). Qualified investors, i.e. liquid and experienced brokerage customers, were able to borrow up to three times the amount of their investment from brokers. The above sanction by the regulatory body limited debt leverage for margin transactions for all types of investors to a ratio of 1:1. The right to use 1:3 leverage for qualified investors was reinstated with a number of additional restrictions starting from June 15, 2009.

The regulatory rationale behind the measures to ban short sales and limit margin trading was apparently to prevent speculative traders from exacerbating the market slump by short sales (where market participants sell securities borrowed from a broker using falling market expectations), as well as to limit the risk of a new market bubble and to protect the investors using margin trading strategies from significant losses. The introduction of such restrictions requires the effective and constant monitoring of all broker operations by the Federal Financial Markets Service, which is still missing1. Despite sanctions imposed on two major brokerage companies, Brokercreditservice and Finam that breached the short sales ban while it was in effect, and despite their managers and owners having their market participant qualifications annulled, there can be no certainty that all other market participants followed these regulations. These restrictions on the debt leverage that could be made available to brokerage clients could also be legally sidestepped.

The question remains as to the appropriateness and effectiveness of these measures in the stock market. The restriction on margin trading had little sense in a falling market, as such strategies are only profitable for investors in growing markets. Therefore, the 1:1 leverage restriction for margin trading for all market participants did not hinder the operations of most participants and may have aided certain less experienced investors in avoiding losses. During the acute phase of the crisis up to February 2009, as well as later, most market participants avoided margin transactions of their own account due to fears of a crisis relapse. This in turn significantly affected broker revenues that are mostly made up of interest income on margin loans to clients. A. Shemetov, Director General of ATON, one of the leading brokerages, whereas 60-70% of pre-crisis broker revenues derived from margin lending, and the rest was made up of brokerage commissions, during the acute phase of the crisis the situation was reversed, with brokerage commissions accounting for 60% of revenues. Indirect confirmation of general market participant compliance with margin lending restrictions starting from mid-September 2008 until the middle of June 2009 is provided by the date are shown in Fig. 25 regarding the number of repo transactions involving Sberbank ordinary shares that are the most liquid traded instrument at the MICEX stock exchange. Repo transactions involving shares are a popular instrument used by brokers at MICEX to raise The authors of the Report on the results of the 2008 study of the effectiveness of the legislative and regulatory framework for financial market and securities market operations with a view to stabilising the financial system, carried out at the Federal Financial Markets Service and the Ministry of Finance (upon request) by the Audit Chamber of the Russian federation, there is no analysis being systematically carried out with regards to monitoring and evaluating the stock market situation by government agencies, while the stock market activities of large financial institutions are not being monitored or analyzed, which leads to the absence of comprehensive and accurate information concerning the situation in the Russian stock market for the Russian government and top officials. Audit Chamber Bulletin, No. 1, 2010, page 100. Published at http://www.ach.gov.

ru/userfiles/bulletins/05-buleten_doc_files-fl-1855.pdf V. Kudinov, Short sales transactions are coming back, Vedomosti, June 15, 2009.

Section Monetary and Budgetary Spheres funding in the financial markets for further on-lending to fund margin transactions by their clients.

By way of evaluating the impact of regulatory measures on trading activity for the most liquid MICEX traded stocks as exemplified by Sberbank shares that were the most actively traded blue chip stock at MICEX in 2009, Fig. 25 shows that while the restrictions on margin lending remained in effect from September 16, 2008 to June 15, 2009, the number of repo transactions in the stock market was significantly lower than in other periods.

Source: MICEX stock exchange.

Fig. 25. Repo transactions with Sberbank ordinary shares The issue of appropriateness of the short sale transaction ban is less clear. Unlike margin trading, interest in which naturally dropped in the falling market, short sale transactions were in demand by market participants at that time. Short sale transactions and are investors to derive profits from a falling market. Playing on falling market expectations entails natural limitations for investors in terms of managing risks, which limits their potential of further exacerbating the market drop. For this reason, regulator fears that such trading strategies could seriously affect the extent of the Russian stock market downfall have questionable grounds.

The above downfall was primarily caused by the flight of short-term foreign investors from the Russian market that was not affected by the restrictions imposed by the Federal Financial Markets Service.

The economic expediency of short sale transactions set against a weak regulatory background led to frequent breaches of such restrictions, as evidenced by the sanctions imposed on the top managers of two major brokerages mentioned above. Such breaches are also indirectly evidenced by the number of market transactions involving Sberbank shares at MICEX prior to the introduction of the ban on short sale transactions, during its validity, and following its lift RUSSIAN ECONOMY IN trends and outlooks ing (Fig. 26). The imposition of the ban on short sale transactions in mid-September 2008 had no impact on the number of transactions with the most liquid securities. Moreover, that number grew steadily up through the middle of June 2009 when the ban was lifted. In all likelihood, market participants found other legal means of enabling their clients to enter into short sale transactions.

Source: MICEX Stock Exchange.

Fig. 26. Market transactions with Sberbank ordinary shares 2.4.5. Principal financial market risks Based on the outcome of the 2008-2009 crisis so far, principal financial market risks are to do with the excessive dependence of the economy and stock market on oil prices; the growth of new market bubbles in the stock market and ruble-denominated bond market due to excess liquidity, fast rates of growth for foreign borrowings by banks and real sector companies, risks of foreign capital flight, devaluation of the ruble, growth of forward market trading volumes given insufficient transaction coverage, growing risks in the repo market, and the low capacity of the financial services market that stands in the way of increasing the capitalisation of financial intermediaries.

Dependence of the stock market on oil prices Similarly to the economy as a whole, the Russian stock market is highly dependent on oil prices. This is clearly shown in Fig. 27 that traces the correlation (R2 regression ratio) between absolute monthly RTS index values and Brent oil prices throughout the existence of this stock market index and up to December 2009. The R2 ratio between these sets of data equals 0.86, which points to a close correlation between these parameters. Given the low diSection Monetary and Budgetary Spheres versification in the economy, the oil price plays a key role in determining the prices of Russian blue chip stocks and thus the value of portfolios underlying stock market indices.

Source: calculations based on IMF IFS and the RTS trading system Fig. 27. Correlation between the RTS stock market index and Brent oil price from September 1995 to December The link between oil prices and stock market indices is also evidenced by data in Fig. that shows the changes in the correlation coefficient between the relative monthly changes in the RTS index and Brent oil prices in a 12-month period. The sliding correlation curve is characterized by the 12-month delay in showing the strengthening or weakening of the link between the two indicators. However, superimposing various data on the data sets in Fig. shows additional relationships. Immediately preceding the peak index values prior to the 1997-1998 and 2007-2008 financial crises, the correlation coefficient fell sharply, to reach 0.67 in September 2007 and -0.53 in October 2007. After reaching bottom in October 2007, the correlation coefficient rose abruptly to reach near-maximum levels (approaching 1). Thus with the onset of a crisis, stock market indices and oil prices move simultaneously and in the same direction. The correlation ratio then decreases several months later as the stock market recovers.

RUSSIAN ECONOMY IN trends and outlooks Source: calculation using IMF IFS and RTS trading system data.

Fig. 28. Correlation between RTS stock market index changes and Brent oil price changes from September 1995 to December The above cyclical fluctuations of the sliding correlation curve are due to economic reasons. RTS index values are largely determined by the oil price. Furthermore, the Russian market is highly sensitive to the behavior of short-term foreign investors. The onset of a financial crisis is generally preceded by euphoria on the part of such speculative investors.

Several years of Russian stock market growth fueled by oil prices tend to lead to the mass influx of foreign portfolio investments (see Fig. 34 below for more details), which in turn leads to rapid growth in stock prices and high yields that attract yet more investors. Stock market growth accelerates regardless of oil price dynamics. In this case the sliding correlation curve moves into the negative zone. The market per se lacks the prudence to stop the growth euphoria, and a strong external impulse is needed to stop the investor rally, which is effectively provided by the oil price shock. Faced with falling oil prices, foreign investors become aware of the Russian economy and the stability of the national currency are anchored on energy sector export revenues. Speculative capital flees the country, and the close relationship between oil prices and the RTS stock market index is restored until the next instance of foreign portfolio investor euphoria.

The current level of Russian stock market dependence on oil prices is one of the principal risk factors for investors. Estimates by international financial institutions, in particular the World Bank and the IMF, shown in Fig. 29, do not foresee significant growth in oil prices similar to that seen in the 2000s. World Bank data estimate oil prices at 76 dollars per barrel in 2010, 77 dollars per barrel in 2011-2012, 78 dollars per barrel in 2015, and 80 dollars per barrel in 2020. Based on the regression equation describing the relationship between the RTS Section Monetary and Budgetary Spheres index and annual oil prices, it is possible to determine the average annual values of the RTS index for the coming decade. In this case, average annual values of the RTS index (see Fig. 1) shall remain at their present level of 1,500-1,600 points for several years, which means that, unless the Russian economy undergoes modernisation and becomes more diversified, the internal stock market will stagnate for 10 years, which does not rule out high volatility. In this case, the recovery of the RTS index, unlike the present V-shaped scenario, can take place under an L-shaped scenario lasting several years, similar to that for the DJIA index following the Great Depression, the Japanese Nikkei 225 index after its collapse in 1989, or the NASDAQ index after the Internet bubble crash in the early 2000s.

Source: calculations based on price change forecasts for goods published at the World Bank web site www.worldbank.org, and RTS trading system data.

Fig. 29. RTS index forecast up to 2020 based on World Bank oil price forecast Emergence of new market bubbles in the stock market and ruble-denominated bond markets due to excess liquidity in Russia and globally Another risk in the Russian stock market that may lead to the emergence of new market bubbles in the stock market and ruble-denominated bond markets despite the expected oil price stagnation forecast by international financial institution experts is represented by the excess liquidity accumulated in financial markets. The principal reasons for its accumulation in the domestic market include the funds injected into the banking system by government crisis mitigation policies have not yet been channelled into lending, as well as the renewal of foreign funding for domestic stock market operations using carry trading strategies.

Provided that the Russian economy does not become more structurally diversified the relationship between oil prices and the indices remains unchanged RUSSIAN ECONOMY IN trends and outlooks Fig. 30 shows the growth rates for equity market capitalisation and corporate bond market value indicators compared with the trends in bank loan portfolios. From January to December 2009, the RTS index grew by 170.0% and the aggregate market value for ruble-denominated corporate bonds increased by 40.1%. At the same time, bank corporate loan portfolios decreased by 6.3% over the same period and consumer loan portfolios decreased by 11.5% while bank investments in corporate bonds grew by 115.4%.

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