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Source: calculations based on Bank of Russia and RTS trading system data Fig. 30. Trends in the RTS index, loan portfolios, and the corporate bond market in 2009 (January 2009 = 100%) According to Goldman Sachs analysts, Russia belongs to a small group of countries that tightened rather than relaxed their monetary and lending policies as a response to a financial crisis. There was a certain logic behind the decision, since the government feared widespread payment defaults. At the peak of the crisis, from December 1, 2008, to April 23, 2009, the Bank of Russia established a base refinancing rate of 13%, one of the highest among Gcountries, that de facto put a stop to bank loan refinancing. Only starting from April 2009, the Bank of Russia began gradually lowering the rate to its current level of 8.75%. The high refinancing rate was meant to deter banks from the temptation of using government funding to finance ex-ante doubtful loans. In our opinion, this measure served more as protection against fraud than as a barrier to real lending, since even if the rate had remained low throughout the crisis, high demand for funding from responsible entrepreneurs would have been unlikely due to their uncertainty regarding the return on future investment projects. For this reason the ma D. Butrin, Russian monetary policy does not follow BRIC standards //Kommersant, February 9, 2009, page 2.

Section Monetary and Budgetary Spheres jority of countries, with the exception of China, experienced similar lack of loan portfolio growth despite their refinancing rates being close to zero.

The greatest challenge faced by the Bank of Russia after the crisis is to convince entrepreneurs of the need for increased borrowings and of the likelihood of investing borrowed funds in effective investment projects1.

If entrepreneur expectations remain unchanged and demand for borrowed funds is not restored, the banking system will continue accumulating excess liquidity that may channelled into the stock and corporate bond markets. Moreover, as the markets for foreign borrowings recover, banks and foreign hedge funds may revert to the use of carry trading strategies to raise funds for investments in ruble-denominated bonds. According to IMF experts, the involvement of emerging market banks in carry trading to fund consumer lending is one of the principal financial market risks in these countries. 2.

Unlike banking sector loan portfolios, bank investments in corporate bonds have experienced rapid growth. In our opinion, this is due not only to the greater liquidity of bonds compared to loans but also to a number of negative factors, such as less stringent material and moral liability standards for bond market operators compared to lenders, as well as the lack of professionalism among bank staff. Corporate lending requires thorough knowledge of the current financial condition and business prospects of the lenders on the part of bankers. In this case, there exists responsibility personal for the bank specialists who carry out borrower due diligence and approve lending decisions. In the case of bonds, the process is simplified. Bank employees do not need to perform in-depth financial analysis of issuers. Under the provisions of the securities market legislation, bond issuers are required to disclose all relevant information to all potential investors. This largely absolves bankers of the responsibility for the accuracy and completeness of the relevant information considered in investment decisions.

Meanwhile, many issuers default on their bonds, and many investors incur losses, during crises. The responsibility of specific financiers within issuer companies defaulting on bonds and of bank employees who took investment decisions with respect to such bonds is diluted among many people. The greater the number of people involved, the more difficult it is to establish individual material and moral liability. This issue that became evident during the past crisis is no less significant than the too big to fail issue with respect to avoiding the bankruptcy of the largest banks that attract retail deposits.

Ruble devaluation risk The devaluation of the ruble is a continuing risk in the Russian financial market. The data shown in Fig. 31 lead to the assumption that for the past several years, monetary authorities in Russia have followed an informal rule that the nominal exchange rate of the ruble to the US Dollar be in line with its notional exchange rate estimated by dividing the M2 money supply aggregate by the amount of foreign exchange reserves 3. This rule in essence is reminiscent of The Governor of the Bank of Russia stated in his speech to bank representatives on February 4, 2010, that given the recent trends for increasing stability of the national currency, its moderate volatility and the growth of the M2 money supply aggregate in the economy, bank loan portfolios are expected to grow by 20% in 2010.

Moreover, a lending rally is expected by the end of the year that may even need to be curtailed in the interests of combating inflation. S. Dementieva, Russias glorious rally// Kommersant, February 5, 2010, page IMF. Global Financial Stability Report. Financial Market Turbulence: Causes, Consequences, and Policies.

September 2007 P. 2225.

The author has not encountered admissions by officials with regards to following this rule.

RUSSIAN ECONOMY IN trends and outlooks the foreign exchange reserve standard whereby the ruble money supply must be backed by a certain amount of gold and foreign exchange reserves. In cases when the public initiates large-scale purchases of US Dollars, the exchange rate in rubles is in line with the coverage of the ruble money supply by such gold and foreign exchange reserves; thus in these situations, an increase in the notional dollar exchange rate is an early indication of an impending ruble devaluation.

Source: calculations based on Bank of Russia and Ministry of Finance data.

Fig. 31. Relationship between the nominal and notional (calculated) US Dollar exchange rates In late 2009 the growth rate of the notional dollar exchange rate significantly exceeded that of the nominal exchange rate, with the former rate reaching 35.6 rubles in December versus the official nominal exchange rate of 30.24 rubles. This was due to the faster growth rate of the M2 money supply indicator, especially in December 2009 due to increased pension payments, the customary year-end completion of construction projects and payments for government contracts, the attempts of entities financed from the state budget to fully utilise their annual budget allocations, and year-end bonus payments at private companies. These factors jointly contributed to the significant growth of ruble cash in public hands and on bank deposits. The likelihood of increased state spending from the Reserve Fund as a way of financing pension payments, the expected increasing monetisation of the GDP, the slower growth of oil prices, all point to the growth rate of the notional dollar exchange rate continuing to outstrip the growth rate of the actual nominal rate, which in turn translates into a higher ratio between the ruble money supply and the foreign exchange reserves and will push government in the direction of further devaluation of the ruble.

In addition, the policy of weakening the ruble exchange rate is advantageous for the state from the point of view of fostering the growth of value-added sectors of the economy and reSection Monetary and Budgetary Spheres stricting the influx of speculative foreign capital. For these reasons the gradual devaluation of the ruble in the post-crisis period is considered highly probable.

Risk of excessive foreign borrowings by banks and real sector companies The foreign indebtedness of the private sector is practically equal to Russias total foreign exchange reserves (see Fig. 32) and remains a significant risk for the national financial system. The fact that the amounts of foreign exchange reserves and foreign corporate borrowings have practically coincided throughout the 2000s points to a relationship between these categories. On the one hand, the concentration of a portion of value added created by business in foreign exchange reserves creates a necessary safety cushion for the financial system and checks the excessive strengthening of the ruble. On the other hand, the removal of such funds from business revenues in the global economic context has a negative impact on and creates complications for sustaining and fostering the national businesses that generate such revenues. To keep their operations at a sustainable level, entrepreneurs need to compensate for the deductions channelled into the national foreign exchange reserves by obtaining foreign borrowings. Therefore, despite the crisis and government pressure to decrease the foreign borrowings by large state-owned companies, it has so far been impossible to bring about a significant reduction in foreign borrowing volumes.

Source: balance of payments data.

Fig. 32. Growth in private sector borrowings and state reserves Fig. 33 shows separate data for foreign borrowings by banks and corporates. As of September 2009, foreign borrowings by banks decreased from US$166.4 billion to US$135.9 billion, while corporate foreign debt increased from US$281.4 billion to US$299.0 billion. As shown previously in Fig. 10 and Table 3, the decrease in foreign bank borrowings was only RUSSIAN ECONOMY IN trends and outlooks made possible by substantial lending to the banking sector by the Bank of Russia, the Ministry of Finance, and Vnesheconombank, and by the gradual devaluation of the ruble. In other words, foreign bank debt was partially repaid and replaced by borrowings ultimately derived from the foreign exchange reserves. Unfortunately, it is unlikely that the Russian financial sector will be able to raise of cheap funding in volumes sufficient for its development from the state or from retail deposits. The principal hopes of private banks in this regard are for the resumption of carry trading, which will in turn translate into renewed growth of foreign borrowings by the banking sector.

Source: balance of payments data Fig. 33. Foreign debt of the Russian Federation, 1999-2009 (January through September 2009), billions of dollars The principal risks related to the increase in corporate foreign borrowings are related less to the short-term debt service in the next 1-2 years and more to the long-term perspective. If the assumption that the national foreign exchange reserves are the reverse side of the coin of foreign private sector borrowings is true, it means that in the medium term, banks and corporates will be unable service their foreign debt independently, without recourse to foreign exchange reserves. Meanwhile, channelling reserve funds for these purposes can significantly weaken the ruble and cause other problems in the financial system.

Risk of foreign capital flight The Russian financial market is still highly dependent on short-term foreign capital movements. Capital flight may be triggered by expectations regarding devaluation of the ruble, weak macroeconomic indicators, the decrease in national foreign currency revenues due to Section Monetary and Budgetary Spheres lower prices for raw material exports, and budget and monetary policy restrictions in international financial markets.

As shown in Fig. 34, capital flight from Russia in 2008 amounted to US$132.8 billion.

Since the foreign direct investment (FDI) balance was positive at US$20.3 billion, the actual amount of short-term investments withdrawn from Russia stood at US$153.1 billion. The Bank of Russia estimates capital flight from Russia at US$52.4 billion in 2009, including US$2.8 billion in FDI.

Source:Bank of Russia.

Fig. 34. Capital inflows and outflows: total flows and FDI flows Considering that servicing the needs of short-term foreign investments is an integral component of Russian bank carry trading strategies, it is unlikely that such investments will disappear or will be significantly reduced in the near future. Fig. 35 shows that in 2009, banks channelled the bulk of the outflow of short-term investment amounts. This in turn means that the Russian stock market will continue to remain highly volatile. A more complex challenge for the Russian economy and financial sector is the attraction of foreign direct investments and of portfolio investors by conservative foreign investors (mutual funds, pension funds, insurance companies, investment funds, etc.) RUSSIAN ECONOMY IN trends and outlooks Source:Bank of Russia.

Fig. 35. Capital inflows (+)/outflows () by market segment Attracting FDI and the funds of large instituttional investors requires diligent efforts in improving the institutional environment and business climate and in modernising the economy.

Russian banks and private equity funds could be of great help in this undertaking; however, at present that are not in a position to adequately tackle these challenges (see Section 8 for more details).

Risk in the Russian forward market As shown in Fig. 36, similarly to the stock market (see Fig. 9) and the ruble-denominated corporate bond market (see Fig. 20), the Russian forward market that is primarily concentrated in the RTS trading system has seen a drop in aggregate traded value from August to February 2009, but has started a fast recovery beginning from March 2009. Moreover, the crisis had virtually no impact on the number of futures and options transactions and the temporary drop in aggregate value was due purely to the decrease in the value of underlying assets. The forward market plays an increasingly important role in the overall context of financial markets, not only allowing to broaden the range of assets traded but also offering market participants an opportunity ho hedge risks related to the decrease in the market value of underlying assets.

Section Monetary and Budgetary Spheres Source: RTS trading system.

Fig. 36. Trading volumes and number of transactions at the RTS forward market from Septemeb 1, 2001, to December 31, However, we see a cause for concern in the development of the forward market as evidenced by the decrease in coverage of futures and options contracts, as shown in Fig. 37 that contains data on open positions in the futures and options markets, as well as data on transaction coverage in each market segment that is calculated as the ratio of average monthly open position volumes by the average monthly trading volume for the respective forward contracts.

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