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Fig. 26. Regulation of carry trading by the Bank of Russia The banking crisis which began in August 2008, made banks and the Central Bank of Russia balance assets and liabilities which happened because solution of this issue was the matter of survival for each bank amidst the crisis rather than introduction of any new regulations and requirements. To avoid collapse of the banking system, executive authorities and the Bank of Russia had to create economic conditions so that banks can resolve the issue. Nevertheless, liabilities as % of bank assets 1.1.1.7.1.1.1.7.1.1.1.7.1.1.1.7.1.1.1.7.1.1.1.7.1.1.1.7.1.1.1.7.1.1.1.7.1.1.1.7.1.1.as % of foreign-exchange RUSSIAN ECONOMY IN trends and outlooks upon the crisis the state adopted a whole system of economic countermeasures against CT.

Three new MRRs to foreign-exchange liabilities owed to non-resident legal entities, to ruble liabilities to individuals and other foreign-exchange liabilities, each 2.5% of the value of liabilities, were adopted on November 1, 2009 instead of the two previous MRRs.

On October 13, 2010 the Central Bank of Russia extended the floating operational corridor for the value of the dual currency basket from RUB 3 to 4 and reduced the amount of accumulated interventions (symmetrically, by 50 kopeks for the lower and upper limits), which shifted by 5 kopeks the limit of operational interval, from USD 700 mln to USD 650 mln.

This meant that a wide fixed currency rate corridor of RUB 26 to 41 per dual currency basket was officially abolished. On March 1, 2011, the Bank of Russia expanded the limits of the dual currency basket to RUB 1, setting the lower and upper limits of the corridor at RUB 32,45 and RUB 37,45, respectively. These measures were aimed at making foreign exchange rate less predictable whereby making it hard to apply CT.

On July 16, 2010, the State Duma adopted an amendment to Article 269 of the Tax Code of the Russian Federation which was intended to make external borrowings less attractive for companies and banks. In 2011 2012, the upper limit for foreign exchange loans which are regarded as costs incurred on reducing the profit tax, will be reduced from 15% to 0.8% of a refinancing rate set by the Bank of Russia (6.4% p. a. from February 28, 2011)1. The upper rate on ruble loans is planned to be increased from the current 1.1 to 1.8 of the refinancing rate, i.e. up to 14.4%. Lawmakers and executive authorities believe that this would increase the private business demand for ruble loans and limit application of the CT strategy. It should be noted, however, that in applying the CT strategy in practice, borrowings from nonresidents are obtained at an interest rate less than 6%. In 2010 a system of monitoring over external liabilities owed by state-owned corporations was launched, and today decisions on large borrowings from foreign entities by state-owned companies should be made subject to approval by public representative participating in management bodies of such companies.

Realizing the threat of carry trading, but due to changes in their previous opinion on that developing countries must not prevent inflow of foreign capital, IMF experts recommended that these countries apply different tools designed to limit inflow of short-term foreign investments in order to prevent financial bubbles in the stock market and real estate market2.

Among other countermeasures against CT, the IMF recommends to apply a flexible foreign exchange rate policy, accumulate foreign exchange reserves in sovereign national wealth funds, reduce interest rates as adjusted to inflation, harden the fiscal policy, strengthen prudential supervision3.

Russian financial and monetary authorities followed in part these recommendations. On the one hand, after the crisis a range of CT countermeasures was markedly widened. However, no effective measures such as reduction of inflation and hardening of fiscal policy were taken. The higher internal inflation, the wider the spread between internal loan rates and the value of borrowings from foreign countries, and the more effective is CT for financial specu Visloguzov V. The State Duma Suggests to Obtain Ruble Loans; Foreign-Currency Loans Will be Made Less Attractive for Companies. July 16,2010.

Osty J., Ghosh A., Habermeier K. Capital Inflows: The Role of Control. IMF Staff position note. February 19, 2010, SPN/10/04. http://www.imf.org/external/pubs/ft/spn/2010/spn1004.pdf.

IMF. Global Financial Stability Report. Chapter 4. Global liquidity expansion: effect on receiving economies and policy response options. April 2010, p.1.

Section 3.

Financial Markets and Financial Institutes lations. A trend towards strengthening of the national currency amidst growth in oil prices which emerged at the end of 2010, will also encourage this process.

Even if the Ministry of Finance and the Bank of Russia manage to effectively resist , an equally knotty problem arises as to what should replace cheap foreign borrowings, even riskbearing, short-term, but still popular in promoting lending and economic boost. A new, third wave of became more visible in the economy as early as mid-2010. In spite of the already existing debt load, Rosneft borrowed RUB 52,5 bln from China Development Bank in Q2 2010 thus increasing its total outstanding debt to RUB 346,3 bln. The oil company pays 3.62% p. a. on the Chinese loan and generates a substantial profit from financial speculations by allocating the money to bank deposits at 6.228% p. a. According to the US GAAP reports, Rosneft held 3,12 bln USD on bank deposits as of June 30, 2010.1 Another example is related to subsidiaries of foreign banks, which, according to the bank deposit market review in H1 2010 published by , reduced interest rates on ruble and foreign currency retail deposits to 45% p. a. and 0.6% p. a., respectively. According to a manager from Nordea Bank, financing by the parent company is much cheaper than retail deposits2.

Hence the risk that the financial system may go back to CT remain very high. As shown in Fig. 25, the banking system avoided this strategy for 5 years after the crisis of 1998. As early as 2002 the value of bank foreign-exchange assets exceeded liabilities owed to non-residents by a factor of 5.1% of the value of assets of the banking system. After the recession of 2008, the excess amount of foreign-exchange assets over liabilities was found to be much less. As early as 2010, this indicator decreased to 1.9% of the total bank assets against 3.1% in the preceding year. These changes demonstrate that the banking system is ready to go back to the previously applied risk-bearing forms of funding and growth.

Another potential source of growth in the financial system is increase in the level of monetization of the Russian economy. Money growth in the economy promotes lending and economic growth. According to the concept of long-term socio-economic development of the Russian Federation for a period till 2020, which was approved by the Order of the Government of the Russian Federation on November 17, 2008, No. 1662-r (Long-Term Development Concept 2020), monetization of the economy is supposed to increase from 28.3% in 2006 to 6065% in 2015 and 7075% of GDP in 2020. As a result, credit expansion of banks would increase, enterprises would generate more money as net profit and amortization, savings and investment potential of the state and households would increase. This implies transition to new monetary tools designed to provide economic demand for money which is based on growth in liquidity through refinancing of banks by the Central Bank of the Russian Federation. According to the Scenario-Based Conditions-2030, it is retail deposits growth as well as refinancing operations that are going to be the main resource base for banks3.

The advantage of CT is that it is habitual for the financial system, offers less inflation risks, because it provides short- and medium-term investments at interest rates better than inflation rate. However, CT will not offer long-term resources sufficient for modernization. Fur Derbilova E. Bankers from Rosneft. Vedomosti, August17, 2010.

Dementiyeva S., Deventiyeva K. A Back-Breaking Contribution: Subsidiaries of Foreign Banks Need no Retail Deposits any More. Commersant, August 16, 2010.

The Ministry of Economic Development and Trade. An explanatory note on scenario-based conditions and basic parameters of the long-term forecast of social and economic development of the Russian Federation for a period till 2030. Posted on the website of Vedomosti as an attachment to the article Grow and Save published by Kuvshinova O., Tovkailo M. Vedomosti, February 10, 2010.

RUSSIAN ECONOMY IN trends and outlooks thermore, it results in regular, serious financial crises and hampers the development of internal financial institutions and personal investments. Though the accelerated monetization strategy implies orientation on internal resources, it is exposed to serious inflation risks which can be avoided by adopting a policy aimed at developing business environment and improving rapidly the quality of state governance. CT is likely to be resumed with renewed vigor unless a clear development strategy appears in Russia in a year or two.

3.4. Ruble Bond Market Fig. 27 shows monthly data on volumes of issues and turnovers in the secondary market of ruble corporate obligations in the MICEX from 2001 till January 2011. The figure also shows data on bank liquidity as bank balances on correspondent accounts and deposit accounts with the Bank of Russia, as well as shows how the onset of the financial crisis of August 2008 resulted in visible decrease of bank liquidity, stock market trading volumes and placement of corporate obligations. In September 2008, the lack of risk management system for REPO deals in the MICEX resulted in a temporary crisis caused by defaults on REPO deals by a few large players. Nevertheless, the bond market managed to avoid a system crisis, because the Bank of Russia intervened in settlements and rehabilitation of the banks which were found to be insolvent.

The market of corporate obligations recovered in full in 2010. Floatation of corporate obligations in the domestic market totaled RUB 917 bln in 2009 and RUB 854,9 bln in 2010, thus exceeding substantially the prerecession levels: RUB 465,3 bln in 2006 and RUB 457 bln in 2007. During the recession period and post-recession recovery, corporate bonds allowed the non-financial sector to compensate for stagnation and slow growth of the corporate loan portfolio in 2009 and in 2010 (Table 3). The number of new defaults in the market of corporate obligations decreased from 26 in 2008 and 76 in 2009 to 9 in 20101.

In 2010, volumes in the secondary market of corporate obligations increased up to RUB 23,0 t against RUB 9,3 t in 2009 and RUB 11,3 t in 2008. Given the restrictions imposed on application of the CT strategy, this means a new factor of rapid growth in liquidity in the ruble bond market. In 2010, rapid growth in short-term liquidity of the banking system as a result of accelerated growth in monetization of the Russian economy became such a factor.

A share of banks in the structure of sources of financing of corporate bonds increased from 31.9% in 2008 to 41.5% in 2009 and 41.4% in 2010. However, further growth in the market of long-term ruble bonds through short-term internal liquidity seems to be a very risk-bearing strategy. Should the monetary authorities have to reduce monetization of the economy due to inflation, it may cause serious problems in the corporate bond market.

The fact that most players use the corporate bond market to invest idle cash or obtain short-term loans rather than make long-term investments makes itself evident in the structure of deals with corporate bonds in the MICEX (Fig. 28). From the beginning of 2005 till August 2008, a share of REPO deals grew rapidly to reach 84% of the trading turnover. Due to the crisis in the REPO market in September 2008 February 2009, the share reduced markedly but then began to grow as the securities market recovered, to reach 83% in February 2011. A share of market deals accounted for mere 5%.

Department of Surveys and Information of the Bank of Russia. Financial Stability Review. 2010, p.13. Posted on the webside of the Bank of Russia: www.cbr.ru.

Section 3.

Financial Markets and Financial Institutes 3 000 000 1 Crisis and recovery 2 800 Secondary trading 1 2 600 Public offering 2 400 1 Bank liquidity 2 200 2 000 000 1 1 800 1 1 600 Period of liquidity growth and carry trading boom Moderate liquidity 1 400 zone 1 200 1 000 000 800 600 400 200 - Source: based on the data published by the Bank of Russia and the MICEX Stock Exchange.

Fig. 27. Corporate bond operations and bank liquidity in 2001 Jan. 2005 2006 2007 2008 2009 2010 Auction (market) mode Negotiated deal mode REPO deal mode Source: based on the data published by the MICEX Stock Exchange.

Fig. 28. Structure of deals with corporate bonds in the MICEX Stock Exchange, % Bond deals, RUB mln Bank liquidity, RUB bln Jul-Jul-Jul-Jul-Jul-Jul-Jul-Jul-Jul-Jul-Jan-Jan-Jan-Jan-Jan-Jan-Jan-Jan-Jan-Jan-Jan-Oct-Oct-Oct-Oct-Oct-Oct-Oct-Oct-Oct-Oct-Apr-Apr-Apr-Apr-Apr-Apr-Apr-Apr-Apr-Apr-RUSSIAN ECONOMY IN trends and outlooks Even more eloquent are the figures in the structure of stock-exchange deals with regional securities, as shown in Fig. 29. In February 2011, 91% of all the deals with regional securities were accounted for REPO operations in the stock exchange. With REPO deals, multiple pledge of bonds banks can use a credit leveraging of nearly 1:1 or 1:2, i.e. per RUB 1 of initial investments in bonds they can borrow from RUB 1 to RUB 2 of loans secured by bonds.

10 2005 2006 2007 2008 2009 Auction (market) mode Negotiated deal mode REPO deal mode Source: based on the data published by the MICEX Stock Exchange.

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