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4.4.2. Problems of development of ruble bond market In contrast to the Russian stock market, on which the Russian exchanges could not form in 2002 new significant niches, since 2001 the ruble bond market experiences a pe riod of rapid growth. Development of the market of regional and corporate bonds is recog nized as one of major successes of MICEX for the past years. Using the market of corpo rate bonds, the Russian exchanges for the first time realized their potential for funding real sector of economy. In 20002004, by placing corporate bonds, Russian companies drew from the market over USD 10 bn of investment resources.

The scales of a new segment of the Russian market reached, and for some parame ters exceeded, the indices of GKO OFZ market in the period of its prosperity, which is seen in Fig. 14, 15.

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 - GKO-OVZ Regional bonds Corporate bonds Source: According to MICEX data.

Fig. 14. Volume of bond placement According to the volume of placement in 2004, the market of ruble bonds made up Rb 387.5 bn and almost reached historical maximum of bonds placed for a year, which had been fixed in 1996 on GKO OFZ in the amount of Rb 415.1 bn (with account of de nominations). But, in contrast to GKO OFZ market, which collapsed, the market of ruble bonds is now growing not only because of placement of federal securities, but, primarily, due to issuance of corporate and regional bonds. In 2004, on MICEX there were placed Rb bln .

Section 4.

Institutional and Macroeconomic Challenges OFZ for a total of Rb 192 bn; the volumes of issuance of corporate and regional bonds made up Rb 140.4 bn and Rb 55.1 bn correspondingly, i.e., totally, a little more than the issuance of federal securities.

In 2004, the volume of secondary exchange trade with bonds on MICEX exceeded maxi mum indicators of liquidity of the GKO OFZ market in 19951997, which is seen from Fig. 15.

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Regi - onal bonds GKO-OVZ Corporate bonds Source: According to MICEX data.

Fig. 15. Volumes of secondary trade with bonds on MICEX The maximum volume of secondary trade with GKO OFZ on MICEX had been fixed in 1997 and reached Rb 876.1 bn denominated rubles. In 2004, the total volume of secondary trade with ruble bonds amounted to Rb 1169.8 bn, of which Rb 408.6 bn is accounted for OFZ market, Rb 338.0 bn for regional bonds, and Rb 423.2 bn the corporate bond market.

Despite rapid growth of volumes of the market of ruble bonds, the situation on this segment of the market still differs from that taking palce on GKO OFZ market the day before default. The main differences are in that the present issuers are making borrowings at rea sonable rates, which are often lower than the level of inflation. Increase in the volumes of corporate and regional bond redemption is so far behind the volumes of bond placements.

Moreover, supervising the market of ruble bonds is carried out by FSFM (Federal Service on Financial Markets), i.e. the body that is independent of issuers and market participants.

Though, such a rapid growth of ruble borrowings causes a number of problems. The main problem is in that demand is formed at the bond market from the short term re sources, basically excessive bank liquidity, as balances of correspondent bank accounts and on their deposits in the Bank of Russia. Extra amount of such resources allows to fi nance the public debt, corporate and regional issuers at a negative real interest rate. This, in turn, repels from the ruble bond market non governmental pension funds, unit invest ment funds and citizens who, in contrast to banks, do not possess excess money supplies and cannot afford investments at interest rates lower than the level of inflation.

The structure of investors on the market of corporate and regional bonds is shown in Fig. 16 and 17.

Rb bln .

RUSSIAN ECONOMY in trends and outlooks Others Mutual funds 4% 8% National Pension Fund 12% Commercial banks 76% Source: Calculations according to the data of the Bank of Russia, FSFM and.

Fig. 16. Structure of regional bond investors in Russia in the mid 2004 (estimate) On the regional bond market 76% of securities belong to commercial banks, the share of banks on the corporate bond market accounts for about 50%. Considering that part of the banks make bond investments through subsidiary non bank agencies, the ac tual share of banking groups on the market of corporate and regional bonds still higher.

In conditions of low liquidity market of the government securities and absence of bank refinancing system on the part of the Bank of Russia, the corporate and regional bonds began to act an unusual (for them) part of regulating the volume of money in cir culation and servicing the interbank crediting market. However, involvement in the mar ket of companies long term debts and banks excessive liquidity substantially raised the risks of this market segment in the eyes of investors103. Falls of bank liquidity because of changes in the economic situation, bank crisis or emergence of a new financial instru ment, which is better adapted to regulation of banks excessive liquidity (for example, the Bank of Russia bonds or liquid GKO), may restrict new bond placements and consid erably decrease liquidity of the secondary market. Impossibility of refinancing the do mestic debts will make problems of creditworthiness of individual issuers, and in unfa vorable scenario will provoke a wave of defaults on the bonds of companies and regions.

Therefore, despite differences in the structure of investors on domestic bond and stock markets, both markets incur a deficit in domestic investors ready to invest in the long term bonds of Russian issuers. Major obstacle for the emergence of such investors on the domestic debt market is negative effective yield of the greater part of ruble issuers.

In the opinion of MDM bank analysts, just the use of short cheap liabilities for purchase of long bonds generates the investors profits on the market; however, this is an extremely risky model, which is not for the first time in Russia, in again punished many of investors (bank crisis), as in conditions of credibility crisis on the interbank market many inves tors could not finance their positions in ruble bonds and had to sell them at the bottom of the market. (See: MDM bank In vestment Banking. Debt market. Results of 2004. Strategy of 2005. January 2005. p. 31. www.invest.mdmbank.ru.) Section 4.

Institutional and Macroeconomic Challenges Others 37% Commercial banks 50% Mutual funds National Pension 6% Fund 7% Fig. 17. Structure of the investors on the corporate bond market in Russia in the mid 2004 (estimate) The domestic bond market begins suffering considerable competitive pressure on the part of global markets, where not only more reputable creditors are available, but, in condi tions of falling the real dollar rate credits also become much less expensive than ruble bor rowings. Even now the volumes of external borrowings, made by Russian companies, sub stantially exceed the volume of means attracted by them on the ruble bond market.

In conditions of acute competition with global capital markets the Russian stock market needs finding new niches that will allow it to survive and exercise its practicality for various groups of investors.

4.4.3. New niches for the Russian stock market For the Russian stock market the most actual problem is attraction of mass domestic investor to the market. Despite curtailing the central social programs and failure of pension reform, the most part of Russian population does not take interest, so far, in saving up for the future. According to our calculations, its many years already that the populations sav ings in financial assets are decreasing from 16,1% in 1997 to 8,7% in 2004.

The reasons why population does not invest their means in financial assets in Rus sia are low profitability and increased risks. The main body of bank deposits and ruble bonds may gain negative effective yield. Even if investments in the stock of Russian companies gain positive effective yield, they are often unacceptable for conservative in vestors because of increased risks of considerable volatility of their prices. The services of Russian financial intermediaries are often inaccessible for population because of re moteness of peoples place of residence and high cost of such services.

A serious problem for the growth of schemes of collective investment in Russia is excessive cash resources concentrated in the banks, foreign exchange reserves of the Bank of Russia, and in the Stabilization Fund. Investing such resources in financial in struments of the Russian issuers is impossible without increased risks and negative ef fective yield. In such an environment cannot successfully develop the schemes of collec tive investments that accumulate the resources of private investors.

RUSSIAN ECONOMY in trends and outlooks Shortage of qualitative financial instruments on the domestic stock exchange mar ket is necessary for the formation of diversified portfolios, it may be added by an access of Russian investment funds and other portfolio investors to acquisition of securities of foreign issuers. Calculations show that an increase of the proportion of securities of is suers from the developed financial markets in portfolios of Russian investment funds to 80%, allows to considerably reduce the risks with minor lessening of investment yield.

Such approach requires taking competitive decisions in the sphere of currency regula tion, in particular, authorization for the Russian portfolio investors unhampered pur chase and sale and keeping foreign assets under the supervision of banks as currency control agents. Such deals must be out of requirements on the resource reservation in making transactions in foreign currency.

The advantage of such an approach is in that it provides conditions for competitive ability of Russian financial intermediaries through enhancement of their capability to in vest in assets on global markets. The financial intermediaries in Europe or USA are not confined in possibility of purchasing reliable financial assets abroad, so, to restrict the rights of Russian investment or pension funds in acquisition of foreign assets is unwise.

Another field in development of investment funds and other forms of collective in vesting, where a breakthrough may be achieved, is creation of modern centralized sys tems of financial product distribution, for example, the investment shares of unit invest ment funds. The above can be achieved by orientation of clearing infrastructure of the Russian stock market (depositaries, registrars, clearing organizations and clearing houses) to receiving requests for purchase and repayment of investment shares of the unit investment funds and settlements on deals with shares on DAP terms.

The perspective direction of growth of the exchange market in Russia may become the secondary market of investment shares of the exchange index funds, closed end and interval unit investment funds. On the MidAmerica Stock Exchange in the USA the vol ume of transactions with securities of investment funds reaches 85% of the total volume of trade. On the Tokyo and Osaka exchanges in Japan, Hong Kong exchange, All European Trading System Euronext, German stock exchanges, and on other largest for eign trading floors, deals with the papers of investment funds are a significant segment of the markets served by them. The growth rates of the securities market of the ex change index funds and the stock of closed end investment funds on the New York Stock Exchange and in NASDAQ multiply surpass the growth rates of turnovers on deals with other securities.

In Russia, on MICEX the volume of deals with shares of unit investment funds make up only 0,003% of the total volume of trade with securities. At the same time, revival of domestic investor with the use of efficient collective investments, oriented to the poten tial of exchange infrastructure, would lead to forming additional demand of the domestic investors for securities circulated on exchanges.

Therefore, the future of the Russian stock exchange is concerned with its integra tion into global capital markets. To retain the domestic securities market as an inde pendent competitive institution, it should be reoriented to needs of the countrys popula tion and other Russian investors. It is possible to attract such categories of investors to the market, only if every possible effort is made by Russian financial intermediaries in usage of the advantage of international diversification of portfolio investments and form ing the organized market of papers of investment funds.

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