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Brooks R., Del Negro M. The Rise in Co movement across National Stock Markets: Market Inte gration or IT Bubble. Federal Reserve Bank of Atlanta. Working Paper 2002 17a, September, 2002.

Section Institutional Problems Table Beta Coefficients for Russian Blue Chips in 2003Beta Coefficients 2003 2004 2005 2006 2003Aeroflot (ao) 0.57 0.25 0.46 0.40 0.AvtoVAZ (ao) 0,64 0,52 0,40 0.76 0.RAO EES (United Energy Sys 1.14 1.00 0.98 1.07 1.tems) RAO EES (United Energy Sys 0.95 1.00 0.86 0.99 0.tems) Norilsk Nickel (ao) 0.87 1.19 1.04 1.06 1.LUKoil (ao) 0.91 0.86 1.03 0.98 0.Mosenergo (ao) 1.04 0.66 1.28 0.48 0.Rostelekom () 0.98 0.82 0.87 0.65 0.Sberbank (RF Savings Bank) 0.75 0.71 0.79 1.07 0. 0.54 0.60 0.99 1.00 0.Gazpromneft (former Sibneft) 1.29 0.85 0.91 0.73 0.() Surgutneftegas 1.22 0.90 1.13 1.21 1.Surgutneftegas 0.97 0.70 0.97 1.11 0.Tatneft () 0.77 0.80 1.32 1.12 0.Gazprom () 0.75 0.65 0.71 1.03 0.Mean value 0.89 0.77 0.92 0.91 0.Standard deviation 0.23 0.23 0.26 0.25 0.Source: Russian stock exchanges data For most of the issues Beta coefficients are close to 1, which is an evidence of high correlation between changes of their prices with MICEX profitability index. The average Beta coefficient for all issues of stocks made 0.92 in 2005 and 0.91 in 2006, which reflects the domination of synchronized dynamics of blue chips prices at Russian stock exchange119.

The synchronized dynamics of stocks does not only impede institutional in vestors and the public from using the advantages of portfolio justification at the domestic market, but also reflects the problems of management efficiency in major corporations. Portfolio theory evaluates the efficiency of managers through Alpha coefficient reflecting the deviation of actual profitability of portfolio from its poten tial profitability under the pre set profitability of the basic portfolio (e.g., index) and Beta of the given portfolio. Table 19 represents application of this approach to evaluation of management efficiency in Russian companies.

It will be fair to emphasize that a number of analysts (e. g., A. Vernikov from Anton Line), state that in early 2006 the trend of gradual destruction of synchronized stocks dynamics became notice able, which is related with emerging new generators of the market growth represented by energy companies and banks (commentary in Quote. ru of January 29, 2007).

RUSSIAN ECONOMY IN trends and outlooks Table Alpha Coefficients for Russian Blue Chips in 2003Alpha Coefficients 2003 2004 2005 2006 2003Aeroflot (ao) 0.13 0.22 0.06 0.06 0.AvtoVAZ (ao) 0.07 0.01 0.03 0.06 0.RAO EES (United Energy Sys 0.,05 0.05 0.06 0.12 0.tems) RAO EES (United Energy Sys 0.12 0.05 0.04 0.15 0.tems) Norilsk Nickel (ao) 0.27 0.13 0.04 0.04 0.LUKoil (ao) 0.05 0.06 0.04 0.09 0.Mosenergo (ao) 0.07 0.25 0.31 0.00 0.Rostelekom () 0.01 0.09 0.11 0.31 0.Sberbank (RF Savings Bank) 0.06 0.22 0.21 0.11 0. 0.05 0.10 0.37 0.12 0.Gazpromneft (former Sibneft) 0.18 0.02 0.12 0.11 0.() Surgutneftegas 0.02 0.05 0.11 0.15 0.Surgutneftegas 0.04 0.09 0.02 0.17 0.Tatneft () 0.04 0.07 0.02 0.13 0.Gazprom () 0.03 0.26 0.21 0.04 0.Mean value 0.02 0.06 0.00 0.01 0.Standard deviation 0.11 0.13 0.16 0.14 0.Source: Russian stock exchanges data The average Alpha coefficient for 15 major companies in 20052006 was 0, which shows lack of their managements contribution into deviation of their stocks prices dynamics from index (the average market indicator). In 2006 several com panies (Norilsky Nickel, LUKoil, Gazpromneft, Surgutneftegaz, Tatneft and Gaz prom) had negative Alpha coefficient.

Interaction between stock exchange and banking system During 11 months of 2006 banks increased their investments into stocks by RUR 65.6 bln (or $2.4 bln), which is a pretty modest figure in the context of growth of capitalization and capital market liquidity. At the same time the gap between the level of capital market development and banking system potential continued to grow. Figure 12 represents the data about the share of bank loans, capitalization and direct foreign investment in Russian GDP .

In 2006 the capitalization share in GDP increased up to 92.7% vs. 61.5% in the previous year. This was the year when Russia became one of the world leaders with regards to direct foreign investment. In this context the share of bank loans in GDP after having decreased in 2005 from 25.9% down to 20.6% in 2005 remained prac tically on the same level. The gap between capitalization and internal loans indica tors is an evidence of serious disparity between the level of banking system devel opment and growth dynamics of Russian companies.

Section Institutional Problems Source: data received from Central Bank of Russia, Statistical Agency of Russia, World Bank and UN Conference on Trade.

Figure 12. Share of bank loans, direct foreign investment and capitalization in GDP of the Russian Federation, % Growth of external debt of Russian companies Lack of internal credit resources forced the banks and non financial compa nies to borrow internationally. The banks were much more active in doing that, than non financial companies. This led to significant changes of external debt of Russia and Russian companies in 2006 (see Figure 13).

Source: data provided by the Figure 13. Foreign Debt of the Russian Federation in 1999 2006, USD bln RUSSIAN ECONOMY IN trends and outlooks In 2006 external debt of non financial companies and commercial banks made $135.4 bln and $78.5 bln respectively. During one year the debt of non financial companies increased by 8.4%, of banks by 56.7%, i.e., the debt of banks was growing much faster than external debt of non financial companies. As a result in 2006 serious disparities in the banking system assets and liabilities pro file continued to build up, which is reflected in Figure 14.

Source: calculations based on data provided by the Central Bank of Russia.

Figure 14. Excess (+) and shortage ( ) of banks foreign assets vs. liabilities (share, % of the value of assets / liabilities) In 2006 foreign liabilities of Russian banks significantly exceeded the share of respective assets. That resulted from the banks implementing their strategy tar geted at facilitated formation of their liabilities in foreign currency and their further re investment into Ruble assets. For banks this policy is risky because in case of serious fall of Ruble, decrease of Ruble assets profitability or appreciation of for eign currency borrowing the banks may face the liquidity problem. The misbalance between foreign currency assets and liabilities of the banks was one of the main reason for 1998 crisis of major Russian banks in the conditions of abrupt devalua tion of Ruble. In 2006 the misbalance between assets and liabilities of the banks exceeds the scale of similar misbalance before 1998 crisis. In 1997 it constituted 5.0% of the value of banks assets (liabilities), and in 2006 it reached the level of 7.7%. This is an evidence of increasing risks associated with banks liquidity and of vulnerability of their financial status in case external factors change significantly at both foreign currency and credit markets.

Low level oof savings of the population in securities As was shown in Figure 11, the share of individual citizens in stock exchange transactions at MICEX in 2006 was 20% (as for the total value). The public is one of the main drivers of e commerce, the citizens are actively employing the possibili ties of marginal debt financing to increase profitability and scale of capital market transactions. According to MICEX, the number of individual market players at the Section Institutional Problems end of 2006 made 250 thou persons, which exceeded the level of the beginning of the year 2.5 times.

However, the statistics of individual private investment into securities during 11 months of 2006 reflected in Figure 15 show that the publics contribution into capital market development was pretty modest in 2006.

Source: calculations based on data provided by the Central Bank of Russia and by Federal Statistics Agency.

Figure15. Public inclination towards savings 1997 The share of citizens income invested into securities in made 0.6% 3 times below the level of 1998 (prior to the crisis). According to the RF Statistics Agency, the increment of net citizens investment into securities in 2006 reached RUR 87.bln ($3.2 bln), which is 1/3 more than in the preceding year. Individual savings in securities in 2006 exceeded the increment of banks assets in the form of stocks, however, in the context of annual capitalization increment in the amount of $426 bln and liquidity of stock exchange increment in the amount of $397 bln, these savings look pretty modest. The overall value of securities accumulated by the public in 2006 reached $20 bln.

It is also necessary to note that the preliminary 2006 data represented in Fig ure 15 show two negative trends with regards to the public inclination towards in vesting in financial assets in 2006: the indicator of the overall inclination towards savings fell from 11.7% of total revenues in 2005 down to 8.0% of income in 2006;

at the same time the overall citizens debt on bank loans, increased significantly in RUSSIAN ECONOMY IN trends and outlooks 2006 and reached 5.3% of individuals income practically equal to the amount of bank deposits in Rubles.

Heavy growth of capital market, attracting resources by way of corporate bonds float and IPO of shares in an ideal situation should promote the growth of in vestment and economic upswing. However, in order to make this correlation work, the investment attracted by companies through capital market need to become real investment, i.e., be utilized for creating new production capacity, fixed assets and production reserve. Emphasizing this kind of correlation between investment and economic growth, the Nobel Prize winner in economics neo Keynesian P. Samuelson marked that investment are materialized only in case real capital is created120. In other words, fixed assets are real generators of economic growth.

With this regards, the puzzle of Russian capital market with its heavy growth of IPO and of corporate bonds float in 20052006 is in the fact that all this does not lead to real capital growth. Figures 16 and 17 show consolidated data on capitaliza tion, liquidity and issue of Russian companies stocks and corporate bonds.

Capitalization ($ 908 000 MM; 100%) Secondary market redistribution of Capital input through IPO property ($ 17 040 MM; 1.9%) ($ 881 920 MM; 97.1%) Investment into fixed capital by way of issu Russian stock Foreign stock ing shares ($ 2 500 MM; 2.8%) exchanges exchanges ($ 596 964 MM; ($ 284 956 MM;

65.8%) 31.3%) Note. * Evaluation takes into consideration 2006 market exchanges data and Russian Statistics Agency Report for 9 months of 2006.

Figure16. Russian Companies Equity Securities Market Parameters in 2006* Paul E. Samuelson, William D. Nordhaus, Economics: translated from English.: 16th edition. Wil liams publishers, 2005. p. 389.

Section Institutional Problems Market value of floating corporate bonds ($ 32 800 MM; 100%) Secondary market redistri Primary market bution of property Corporate bonds float ($ 133 300 MM; 406,4%) ($ 16 921 MM; 51,5%) Investment into fixed capital through corporate bonds ($ 60 MM; 0,2%) Note. * Evaluation takes into consideration 2006 market exchanges data and Russian Statistics Agency Report for 9 months of 2006.

Figure 17. RUR Corporate Bonds Market Parameters in 2006* In 2006 within the framework of IPO Russian companies attracted about $bln, and by floating their Ruble bonds another c. $17 bln. According to the RF Statistics Agency, only $2.5 bln out of $17 bln received from floating stock (14.7% of the raised funds) were invested into fixed assets. The statistics about utilizing $17 bln received from floating corporate bonds is even more paradoxical. Only $MM out of this amount (0.4%!) was used to increase fixed assets. Of course, it is possible to refer to the inaccuracy of official statistics data, however, overall it is unlikely to change in any way the key conclusion: the funds received from issuing stocks and bonds are not re invested into fixed capital, respectively they do not have any impact on the economic growth.

One can speculate on the areas in which these resources are used. The major flow might be spent on re financing of debt and acquisition of assets from their ef fective owners. The processes currently taking place at Russian capital market are similar to those in the USA in late 1980 s when LBO (leverage buy out) deals were funded at the expense of issuing junk bonds and IPO. The essence of such deals was massive borrowing at capital market using credit facilities to buy companies and acquire their assets. The key risk in such type of deals is poor efficiency of the acquired companies which may turn out insufficient to pay out the debt incurred to buy these companies. In the US the junk bonds market was finished with a loud col lapse of the borrowers in 1989.

* * * Thus, the Clod Frollo dilemma which foreign investors are currently facing when deciding about investment into Russian securities may be worded in brief.

During the last several years Russian capital market has demonstrated remarkable RUSSIAN ECONOMY IN trends and outlooks results as per its profitability, liquidity and capitalization growth. This cannot be left without attention of the investors making them pretty excited. However, each time they need to make their decision about investment, they need to understand that when buying financial instruments from Russian issuers they are not acquiring managerial talent and skills, but the capacity of the government to assure high pro ceeds of the corporations it controls due to speculative demand for energy and other primary resources. At the same time the growth of securities yield is often heated by new liquidity supply rather than by improving efficiency of the corpora tions activities.

There are two ways out of such situation for major investors. One is an opti mistic scenario. It stipulates transformation of the share of foreign strategic and portfolio investors in Russian issued stocks and bonds into a positive corporate governance model, which eventually will facilitate establishing fair market competi tion in Russian economy. The second scenario is a pessimistic one and implies repetition of the LTCM story.

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