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.RUSSIAN ECONOMY IN trends and outlooks rently with a visible strengthening of the RUB in 2009 served as additional channel for growth in profitability of banking operations as well as incentive to convert a part of banks ruble assets into foreign exchange to reach balance between banks foreign exchange assets and liabilities.

600 National Wealth Fund Reserve Fund Stabilization Fund Bank of Russia Forex/gold Holdings July 2008, USD 597 bln *to support RUB smooth devaluation July 2008, USD 434 bln February 2009, USD 348 bln 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: based on the data published by the Bank of Russia and the Ministry of Finance Russia.

Fig. 22. International reserves of the Russian Federation, bln USD.

In 2010, the Bank of Russia managed to recover a part of the international reserves (i.e. total international reserves net of the Reserve Fund and the National Wealth Fund which is controlled by the Ministry of Finance of Russia) almost at the prerecession level due to repayment of loans owed by banks to the Bank of Russia and a favorable foreign economic situation. The size of the National Wealth Fund stabilized at a level of USD 8590 bln. It was only the Reserve Fund that saw a substantial reduction in funds due to the fact that the state had to finance the federal budget deficit which resulted from a rapid growth in social security expenditures of the Government of Russia. The Fund reduced in size to a maximum of USD 142,6 bln in August 2008, USD 26,0 bln in January 2011. The international reserves totaled USD 484,7 bln in January 2011 while a maximum of USD 596,6 bln was reached in July 2008.

Considerable volumes of international reserves is an important factor for macroeconomic stability in this country. It is important, however, that the method of investing in the international reserves also allow modern competences of Russian financial institutions to be increased, because weak domestic financial institutions fail to allow the existing surplus of finances in the country to be utilized effectively for economic growth. This is why it would be Section 3.

Financial Markets and Financial Institutes reasonable in perspective to engage the largest Russian financial institutions in management of the international reserves portfolios.

3.3.4. Deposit Base Growth and Banks Deleveraging The fact that the state assumed obligations for increasing the amount of retail deposit from RUB 400 K to RUB 700 K which is guaranteed for repayment, as applied to a deposit per bank, was one of the most effective antirecession measures aimed at supporting the banking system . When individual investors began to dispose of risk-bearing assets such as shares, units of unit investment funds and junk corporate bonds, this measure resulted in heavy inflow of retail deposits to banks amidst recession. Retail deposits increased from RUB 5850 bln to RUB 5907 bln or by 1.0% when the recession was in full swing between August 1, 2008 and January 1, 2009. As of the 2009 year-end, retail deposits reached a total of RUB 7485 bln, i.e. increased by 26.7%; in 2010 retail deposits totaled RUB 9818 bln, or grew by 31.2%.

Amidst decline in 2009 and slow growth in the credit portfolio in 2009 2010 (see Table 3) deleveraging of the banking system took place (see Fig. 23), i.e. decrease in the value of banks net claims to individuals and businesses against total bank assets from 19.3% on the eve of the recession on August 1, 2008 to 9.1% in 2009 and 5.2% in 2010. On the one hand, such a rapid deleveraging means lower liquidity risks in the banking system. On the other hand, however, it means that banks became less capable of investing deposits in loans, because borrowings became more expensive than in the prerecession period.

19,317,246,20 13,11,9,8,8 7,5,3,5 0,-2,9 -4,6 -7,0 -6,7 -1,0 -1,-4,0 ----20 30,30,-19,8 19,5,-30 7,7,4,3 3,7 0,-8,5 -6,8 0,-7,-5,8 -2,-40 -Net claims to other sectors (deleveraging) Changes in nominal USD exchange rate in RUB (right-side axis) Source: based on the data published by the Bank of Russia.

Fig. 23. Deleveraging (as % of banks assets (liabilities) value) 3.3.5. The Issue of Converting Liquidity into Loans As seen in Fig. 24 and Table 3, the credit portfolio of banks resumed growth in 2010.

Loans to non-banking businesses increased by 12.8% whereas retail loans by 14.3%. In 2009, the non-banking credit portfolio increased by mere 0.3%, whereas retail credit portfolio reduced by 11.0%. However, it is too early to say that the tool of banking loans recovered. In the period between 2009 and 2010, the credit portfolio recovered at slower rates than after the 1.8.USD exchange RUSSIAN ECONOMY IN trends and outlooks financial crisis of 1998. Corporate and retail loans increased by 48.3% and 37.6% in and 71.5% 61.9%, respectively in 2000. After 1998, devaluation of the national currency resulted in rapid growth in competitive position of Russian businesses, and business environment was more favorable that today in terms of corruption, direct intervention of the state in the business and ownership structure. In 2010, the credit portfolio increased at much slower rates than in the prerecession years. In 2006 and 2007, growth rates of corporate loans accounted for 38.6% and 64.3%, retail loans 75.1% and 43.9%.

Corporate loans Retail loans Source: based on the data published in Credit Institutions Review of the Bank of Russia.

Fig. 24. Loans granted, bln RUB Growth in the credit portfolio in 2010 was less than the monetary authorities expected. For example, as early as May 28, 2010, Head of the Bank of Russia S. Ignatyev said that the credit portfolio was estimated to grow by 15% in 2010. In fact, total growth in the corporate and retail credit portfolios was 13.1%. It should be taken into account that as of the beginning of 2011, the relaxed monetary policy represented by leveled down requirements to reserves, refinancing rates and interest rates on interbank lending, continued in the economy in spite of visible risks of inflation growth.

The reasons for slow recovery of the credit portfolio after the recession of 2008against the recession of 1998 can be found among the factors such as low business investment demand, slow economic recovery and global nature of the recent recession (crisis).

01.01.01.06.01.11.01.04.01.09.01.02.01.07.01.12.01.05.01.10.01.03.01.08.01.01.01.06.01.11.01.04.01.09.01.02.01.07.01.12.01.05.01.10.01.03.01.08.01.01.2011* Section 3.

Financial Markets and Financial Institutes Table Corporate and Retail Loans in 1998 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Loans to nonbanking businesses:

RUB bln 300 445 763 1 191 1 613 2 300 3 189 4 188 5 803 9 533 12 844 12 879 14 % of growth 48,3 71,5 56,1 35,4 42,6 38,7 31,3 38,6 64,3 34,7 0,3 12,against the previous year Share in GDP,% 11,4 9,2 10,4 13,3 14,9 17,4 18,7 19,4 21,6 28,7 31,1 33,2 32,Retail loans:

RUB bln 20 28 45 95 142 300 619 1 179 2 065 2 971 4 017 3 574 4 % of growth 37,6 61,9 111,6 50,2 110,8 106,5 90,6 75,1 43,9 35,2 11,0 14,against the previous year Share in GDP,% 0,8 0,6 0,6 1,1 1,3 2,3 3,6 5,5 7,7 8,9 9,7 9,2 9,Source: the estimates were made based on the data published in the Banking Statistics Bulletin of the Bank of Russia for a period of several years and the data published by Rosstat.

The reasons for slow recovery of the credit portfolio after the recession of 2008 against the recession of 1998 can be found among the factors such as low business investment demand, slow economic recovery and global nature of the recent recession (crisis).

3.3.6. Carry Trading Outlooks as a Growth Driver for the Banking System On the eve of the recession 2008 2009, like the previous financial crisis in Russia, the key driver of bank growth was a speculative strategy called carry trading (CT), when credit institutions were involved in active foreign-exchange borrowings in the developed foreign markets at low interest rates, which were invested in high-yield ruble holdings. On the eve of the financial crisis of 1998, such holdings were represented as public short-term bonds (PSTB), and prior to August 2008 retail loans, ruble cooperative bonds and loans to the largest corporations1.

The CT strategy is a very risk-bearing strategy; should the national currency is devaluated, stock jobbers ruble holdings would devaluate instantly while foreign-exchange liabilities owed to non-residents become hard to discharge. A bank would get into the liquidity trap or become insolvent. According to IMF experts, banks involvement into CT for the purpose of funding growth in retail loans in developing countries is one of the main risks in the financial markets of such countries2.

What are the carry trading strategy threats for Russia First, it provides less incentives for bankers to make lower-yield investments in the real economy. Second, the banking system is exposed to a huge risk which eventually results in misbalance between banks foreign exchange assets and liabilities as an earnest of their liquidity crisis, as was evidenced on the eve of both financial crises. Third, carry trading results in financial bubbles in the market of ruble Carry trading strategies, including their preconditions and risks in the Russian market, were discussed in our previous publications. The Russian Economy in 2008. Trends and Outlooks. (Issue 30) M.: IET, 2009, pp. 524-534; Recessionary Economy in Modern Russia: Trends and Outlooks / A. Abramov, E. Apevalova, E. Astafiyeva [et al.]; sc. editor. E.T. Gaidar. M.: Prospect, 2010, pp. 524-534].

IMF. Global Financial Stability Report. Financial Market Turbulence: Causes, Consequences, and Policies.

September 2007, pp.22-25.

RUSSIAN ECONOMY IN trends and outlooks corporate obligations and overload in the field of retail lending. Forth, the strategy may result in securitization of financial relations thus turning smart lending banks into investors in the bond market and credit factories, where borrowers are qualified by machines rather than human beings. The banking system becomes less experienced in lending which requires skilled personnel and knowing the borrowers. As a result, banks can lose their potential for modernization. Finally, carry trading undermines the internal saving system, making it unprofitable for borrowers which are funded in rubles (individuals, unit funds, nongovernment pension funds, insurance companies, etc.) to invest in ruble bonds, because such investments often generate a negative real yield.

The scope of bank involvement in the CT strategy is well illustrated by the deficit () and surplus (+) figures of foreign assets held by banks against the value of non-residents rights to claim against banks, as compared with total value of bank assets, as shown in Fig. 25. In 1997, on the eve of the banking crisis of 1998, liabilities to non-residents exceeded the value of banks which is equal to 5.0% of the balance-sheet total of the banking system. One-time triple devaluation of the national currency made banks insolvent. The balance was restored through bankruptcy of some of the largest private Russian banks and freezing (or, in other words, default) discharge of liabilities owed to non-residents, which the government had to legalize by adopting a regulation which prohibited banks from discharging their liabilities owed to non-residents. As a result, the balance of foreign-exchange assets and liabilities was restored, an excess amount of banks foreign-exchange assets over liabilities accounted for 1% of the value of banks assets in 1998. However, the reputation of the national banking system remained damaged abroad for years to come.

246,8,9 7,6,4,7 5,Bank default 3,1 2,1,-8,9 -9,1,-1,-1,--2,-5,-4,-30,30,19,8 19,3,5,7,7,2 -10,2,4,-9 0,-7,-5,8 0,-12 --8,-6,Surplus (+) and deficit (-) of bank foreign-exchange assets over liabilities (as % of banks assets (liabilities) value) Movement of nominal USD exchange rate in RUB (right-side axis) Source: the estimates were made based on the data published by the Bank of Russia.

Fig. 25. Surplus (+) and deficit (-) of bank foreign-exchange assets over liabilities 1.8.USD exchange rate movement, % Section 3.

Financial Markets and Financial Institutes As of August 1, 2008, deficit of bank foreign-exchange assets against claims reached 10.7% of the balance-sheet total of the banking system, which is doubled the level preceding the August banking crisis in 1998. The carry trading strategy was booming at Russian banks in the period between early in 2004 and July 2008. Had it not been for the public support to banks, devaluation of the national currency, which began in the fall of 2008 and resulted in a 50% devaluation (see Fig. 9), would have repeated the 1998 collapse scenario of the banking system. Owing to the loans from the Bank of Russia and public agencies, as well as a policy of smooth devaluation of the national currency, banks were provided with the money and time required to restore the misbalance between their foreign exchange assets and liabilities.

This is not to say that all these years regulators, namely the Bank of Russia, have been watching indifferently how the was leading the banking system to a new crisis. In the Bank of Russia introduced mandatory reserves requirements (MRR) for credit institutions ruble and foreign-exchange liabilities owed to non-resident banks (2.0%) and other credit institutions ruble and foreign-exchange liabilities (3.5%) (Fig. 26). As the misbalance in foreign-exchange assets and liabilities increased in the banking system these MRRs increased up to 4.5% each on July 1, 2007, 5.5% and 5.0% on March 1, 2008, 7.0% and 5.5% on July 1, 2008. However, these regulations failed to stop CT growth which in part can be explained by the fact that CT-related borrowings served as main drivers of heavy credit expansion in 2004 H1 2008 and one of the key sources of financial soundness of the banks.

12 10,3,6,0 --2,-11,-12 Net foreign-exchange assets as % of banks assets (left-side axis) MRRs to credit institutions ruble and foreign-exchange liabilities owed to non-resident banks (right-side axis) MRRs to credit institutions other ruble and foreign-exchange liabilities (right-side axis) MRRs to foreign-exchange liabilities owed to non-resident legal entities (right-side axis) MRRs to ruble liabilities owed to individuals (right-side axis) MRRs to credit institutions other foreign-exchange liabilities (right-side axis) Source: the estimates were made based on the data published by the Bank of Russia.

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