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Source: calculations based on data from the IMF Financial Statistics Database.

Fig. 40. Growth of energy prices and of excess liquidity in Russia (4Q 1999 = 100%) Source: calculations based on data from the IMF Financial Statistics Database.

Fig. 41. Preconditions for carry trading in Russia RUSSIAN ECONOMY IN trends and outlooks The prerequisites for a renewal of carry trading from the point of view of exchange rate policies and the cost of funding are analysed in Fig. 41. Despite the current strengthening of the ruble exchange rate to the yen and the dollar, the instability of the ruble significantly increased during the financial crisis. The ruble was devalued relative to the dollar and, to an even greater extent, relative to the yen. This instability of the ruble continues to be an obstacle to carry trading. Moreover, as was shown in Fig. 31, the so-called notional ruble exchange rate grew much faster than the nominal exchange rate in December 2009 due to the significant growth in the M2 indicator set against a decrease in the foreign exchange reserves which, in our opinion, is indirect evidence of the expected devaluation of the ruble.

As regards the difference between the interest rates in Russia, Japan, and the USA (see Fig. 41), it remains significant despite the fact that Russia in 2009 kept inflation at a moderate level of 8.8% and continued lowering the refinancing rate. This means that the second precondition for carry trading is being met. The same can be said of the third precondition, i.e.

the existence of a liquid and relatively stable foreign exchange market and of financial assets denominated in national currencies.

Thus the majority of the preconditions for the renewal of carry trading in Russia are being met. However, such a renewal remains limited by the relative instability of the ruble. Another important obstacle to carry trading activities is the remaining lack of confidence in the global financial markets.

Their risks of carry trading for Russia are several. First, such strategies leave few stimuli for the financiers to make riskier and often less profitable investments in the real sector. It is much easier and more profitable to raise short term funds than to take upon oneself the risks of economic modernization. Second, such strategies imply a huge inherent risk for the banking system, ultimately leading, as has already been seen prior to both financial crises, to a currency gap between bank assets and liabilities denominated in foreign currency that entailed a bank liquidity crisis. Third, carry trading needs to the emergence of bubbles in the rubledenominated corporate bond market and leads to overheating in the consumer lending segment. Fourth, this strategy leads to the securitization of financial relationships that transforms banks from smart lenders and investors in the bond market into lending factories where lender due diligence is performed by computers instead of people. The banking sector loses credit appraisal skills that require high professional qualifications of staff and an indepth knowledge of the borrowers business. As a result, the banks potential for aiding economic modernization is lost. Finally, carry trading undermines the domestic savings system, making investments in ruble denominated bonds unprofitable for the borrowers that use ruble funding (general public, mutual investment funds, private pension funds, insurance companies, etc), due to the fact that such investments often have negative real rates of return.

The state must decisively oppose carry trading. The greatest effect in this respect can be achieved by measures to curtail inflation. The higher the domestic inflation, the higher the spread between domestic ruble borrowing rates and the cost of raising funding abroad, the more effective carry trading strategies are for speculators. Fig. 42 shows data on inflation levels in Russia compared to other G20 countries. It is obvious that, despite inflation being lowered from 14.1% in 2008 to 8.8% in 2009, its level remains practically the highest among Gcountries. This in turn points to the need to combat inflation and, above all, to combat the factors contributing to its domestic growth as one of the key priorities for the government and for the Bank of Russia.

Section Monetary and Budgetary Spheres Source: IMF data and national statistics.

Fig. 42. Inflation in G20 countries in 19992.4.7. Attracting conservative institutional investors The Russian stock market remains unattractive for the most highly capitalized and conservative investors, above all for foreign pension funds. In order to understand the reasons for this, we can use the experience of the largest U.S. pension fund, the California Public Employees Retirement System (CalPERS), with reserves of approximately US$200 billion. For many years until 2007, CalPERS rated emerging markets as potential investment targets for its assets. The CalPERS methodology was publicly disclosed and based on studies by authoritative agencies such as Freedom House, the World Economic Forum, Oxford Analytica, The Heritage Foundation, Wall Street Journal and many other research bodies.

The CalPERS methodology involved an assessment of emerging markets investment attractiveness based on two groups of indicators, country risks and the inherent risks of specific financial markets.

Country risks were evaluated by CalPERS according to the following criteria:

Political stability, i.e. the state of civil liberties, the extent of independence of the judicial system, and political risk;

Information transparency, including freedom of the press, disclosure of information on the monetary policy and budget, quality of stock exchange listings, and the effectiveness of application of International Financial Reporting Standards (IFRS) The compliance of labor legislation with the international standards that regulate labour relations, such as the ratification of the ILO convention, the compliance of labour legislation with ILO standards, the effectiveness of law enforcement..

RUSSIAN ECONOMY IN trends and outlooks In other words, evaluating country risks entailed an assessment of the investment climate and investment institutions as the foundation for financial markets.

The second group of indicators entailed the assessment of quantitative and qualitative parameters of emerging capital markets, including the following indicators:

Stock market liquidity and volatility, the assessment of market capitalisation and its growth rates, the ratio of monthly trading volumes to market capitalisation, the growth in the number of listed companies, stock market volatility and the risk/return ratio;

assessing the effectiveness of banking supervision and legal practices in the stock market, the degree of protection of creditor and shareholder rights;

Assessing the degree of openness of the economy to foreign investment, bank and financial institution regulatory regimes, restrictions on the purchase of securities;

Assessing the effectiveness of the stock market settlement mechanisms and the levels of transaction costs, predominantly tax expenses, related to securities market transactions and to the remittance of profits to beneficiary owners.

The maximum score for any market equals 3. Countries that scored 2 and above were included in the list of markets approved for investing CalPERS assets. Otherwise a country market was considered off limits for investment by CalPERS.

In 2007 CalPERS modified its decision taking methodology with regard to investments in emerging markets. Portfolio managers were given the right to independently choose emerging markets companies as investment targets taking into account the inherent risks of different countries and stock markets. However, even given the changes in the investment decision process in 2007-2009, CalPERS never invested in Russian securities. This means that the de facto approach taken by this fund to analyzing the Russian stock market has remained unchanged and is still relevant for understanding the deficiencies of this market from the point of view of conservative foreign investments.

In 2007, the Russian stock market received the CalPERS score of 1.91, i.e. below the investment threshold score of 2, which precluded CalPERS from investing in this market. Fig.

43 analyses the principal obstacles that prevented the Russian market from obtaining the maximum score according to CalPERS methodology.

Country risk factors, including political stability, information transparency, and compliance of the labor laws with international standards together accounted for 66% of the missing score for Russia. Political stability in the country received a score of one out of three. The principal reasons for such scores are the low assessment of civil liberties, of the independence of the judiciary system, and the degree of protection of ownership rights, as well as political system stability. The level of information transparency in Russia received a score of two, sufficient for the market to be designated as an investment target. Within this category, the higher scores for information disclosure concerning monetary policy, the budgetary system, and stock market listing were counterbalanced by low scores for freedom of the press in the effectiveness of applying IFRS (IAS or US GAAP). The degree of compliance of labour laws with ILO standards received a score of 1.7 out of three.

Against this background of conservative assessment of the effectiveness of institutional factors, the quantitative and qualitative characteristics of the Russian stock market appear quite adequate. However, Russia still failed to reach the threshold score of two by 34% for this indicator. The quality of market regulation of the banking sector and stock markets received the average rating of two; a higher score was made impossible by the insufficient effectiveness of banking supervision and legal practices in the stock market, as well as deficienSection Monetary and Budgetary Spheres cies in the protection of creditor rights. Capital market openness received a low score of 1.Dees the entry barriers for banks and insurance companies.

Source: www.calpers.ca.gov Fig. 43. Obstacles that prevented the Russian market from obtaining the maximum score according to CalPERS methodology (US) in The Russian market received a relatively high score of 2.3 for settlement efficiency and the level of transaction costs. Settlement efficiency and the securities market in particular received the top score of 3.0, even despite the absence of a central depository and of a system of settlement guarantees without the ex ante securities deposits.

Changes in the Russian economy and political system in 2008-2009, even apart from the crisis, exacerbated the situation in the areas where Russia had received the lowest CalPERS scores. This is evidenced by Table 5 that shows the scores for the relevant areas assigned by the agencies whose ratings were used by CalPERS, or, if firsthand information was not available, alternative assessments by authoritative agencies, over the past three years.

Table Changes in the problem areas of Russian economic and political life as seen by conservative foreign investors, 2007CalPERS scores Subsequent scores Information Weight, Information 2003 2004 2005 2006 2007 2007 2008 source % source 1. Political stability 16,7 1,0 1,0 1,0 1,0 1,Freedom House 1,0 1,0 1,0 1,0 1,0 Freedom 5,0 5,0 5, Civil liberties House*** Global 1,0 1,0 1,0 1,0 1,3 Global 106 109 Independence of the judicial system Competitivenes Competitivene s Report ss Report* and legal protection 2. Transparency 16,7 1,0 3,0 2,0 2,0 2,(openness) Freedom of the Freedom House 2,0 2,0 1,0 1,0 1,0 Freedom 75 78 House press RUSSIAN ECONOMY IN trends and outlooks CalPERS scores Subsequent scores Information Weight, Information 2003 2004 2005 2006 2007 2007 2008 source % source Oxford 1,0 2,0 2,0 2,0 2,0 Global 118 119 Transparency of monetary and fiscal Analytica Competitivene ss Report* information eStandards 2,0 1,5 1,5 Global 95 108 Compliance with IFRS Forum Competitivene ss Report* 3. Compliance of Verite 16,7 1,0 1,0 1,0 1,7 1,7 Global 33 27 labor laws with inter- Competitivene national standards ss Report* 4. Investor rights 12,5 2,0 2,0 2,0 2,0 2,0 Global 45 67 protection Competitivene ss Report* 5. Openness of capital The Heritage 12,5 1,0 1,0 1,0 1,3 1,7 The Heritage 49,8 50,8 50,markets Foundation's Foundation's Index of Eco- Index of Economic Freedom nomic Freedom ** The Heritage 1,0 2,0 2,0 1,5 2,5 The Heritage 44,2 60,8 68, Trade barriers Foundation's Foundation's Index of Eco- Index of Economic Freedom nomic Freedom ** The Heritage 2,0 2,0 1,0 1,5 1,5 The Heritage 30,0 30,0 25, Foreign Foundation's Foundation's investment Index of Eco- Index of Economic Freedom nomic Freedom ** The Heritage 1,0 1,0 1,0 1,5 1,5 The Heritage 40,0 40,0 40, Banking and Foundation's Foundation's finance Index of Eco- Index of Economic Freedom nomic Freedom ** S&P Global 2,0 2,0 2,0 2,0 2,0 Global 129 127 Stock market Stock Markets Competitivene openness **** Factbook ss Report* * Russias ranking among 125 countries in 2007, 134 countries in 2008, and 133 countries in 2009 according to the global competitiveness index.

** using a maximum score of 100. In 2010, of Russia ranked 143rd among 183 countries in terms of the index of economic freedom and confirmed its status as an non-free economy.

*** using a reverse score of 7; the higher the score, the worse the civil liberties situation. Russia has the status of an non-free country.

**** the maximum participation of foreign investors in corporate equity in general, and in the equity of insurance companies and banks..

Source: calculations based on CalPERS data and ratings by the World Economic Forum www.weforum.org, Heritage Foundation www.heritage.org/index/ and Freedom House www.freedomhouse.org/ The vast majority of the Russian economic and political areas analysed are witnessing either a deterioration of the scores or the persistence of low scores. Thus the unfavourable institutional environment, labor laws that are out of compliance with international standards, especially as regards hiring qualified foreign staff, the low level of investor rights protection, barriers to trade and capital movements, and a weak financial system of the main reasons that prevent the influx into Russia of the long-term funds of major international institutional investors.

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