Russian Capital Markets

The objective of this paper is to describe the composition of the three major capital markets in Russia: Public Equity, Debt, and Private Equity. Our study focuses on the most critical issues that these markets must successfully confront to move forward and validate the renewed interest they have recently garnered. Rather than relying upon subjective opinion and conjecture, we employed a variety of quantitative metrics from data collected on each market to support our conclusions. Our in-country meetings helped us in augmenting our analysis with information that is not in the public domain and provided insight and primary commentary to current and future market tendencies.

Public Equities

The Russian equity market began to take shape in the second quarter of 1994 following the peak of the privatization program, which was launched in 1993 and aimed at making most of the Russian enterprises public in a short period of time. In the first round of privatization in 1993, each Russian citizen received a free privatization voucher valid for use (either directly or via privatization funds) in privatization auctions. As a result of these auctions, shares in Russian businesses were thinly distributed throughout the population, with virtually everyone suddenly a shareholder.

However, it was the second phase of privatization launched in the second half of 1994 that shaped the equity market as it is now. It involved the sale of thousands of sizable stakes in the Russian enterprises to both domestic and foreign strategic investors via various auctions and tenders. The most common mechanisms included investment tenders and commercial auctions, which usually included significant investment conditions, with little revenue actually generated for the budget.

In late 1995, control over many of the largest Russian companies was transferred away from the government to influential financial-industrial groups (FIGs) and in some cases to the companies' management, through the controversial shares-for-loans scheme. Shares were given in trust in exchange for loans to the federal government: none of these were repaid, and the lenders took ownership of the stakes. The scheme involved controlling stakes in major Russian companies such as Lukoil, Surgut Holding, Norilsk Nickel, Sidanco, Yukos, and SibNeft.

In 1996 privatization went up a gear, and the government announced the third phase concentrating on "targeted" sales of sizable blocks in Russia's largest companies. The sale of a 25% +1 stake in Sviazinvest to the Mustcom consortium for $1.9Bn in July 1997 is the most notable example, and was the largest privatization deal in Russia so far.

The August 1998 crisis led to the privatization process being postponed. Nevertheless, as the market has since started to recover, interest in those stakes still in government hands has returned and there are calls for a continuation of privatization.

Market Structure

Secondary market trading got off to an immediate start after the first stage of privatization was completed. Market infrastructure—including the establishment of registrars, stock exchanges, and brokerage companies—developed steadily over the next three years. Initially exporting industries (oil & gas, metals, and pulp & paper) and utilities (power generation and distribution, telecoms) attracted the most attention, although another group, consisting of consumer goods and retail companies, was later discovered. This second category still makes up a small part of the market, but the number of newcomers continues to grow.

Exhibit 1.1: Breakdown of the Russian Market Capitalization by Sector, April 2001[1]

Exhibit 1.2: Breakdown of the Russian Market Capitalization by Company, April 2001[2]

The majority of trading in Russian shares continues to be on an over-the-counter basis, with organized exchanges gradually gaining popularity. The RTS and MICEX are becoming the two main rivals to become the primary Russian equity exchange. The electronic Russian Trading System (RTS) is a dealer-driven market modeled on the American Portal system, established by the Professional Association of Equity Market Participants (PAUFOR) at the end of 1994. Russia's most successful market infrastructure project, the RTS has raised liquidity and improved market transparency. Currently it includes 372 stocks representing 239 listed companies, covering virtually the entire Russian equity universe with the exception of GazProm. The Moscow Interbank Currency Exchange (MICEX) originally specialized in currency and debt trading. Since March 1997 it has also been trading equities, although initially it accounted for less than 5% of total registered equity trading volume. A favorite platform for many domestic investors (nonresidents still prefer to use the RTS), MICEX has managed to increase volumes significantly, thanks to the rebound of domestic interest in the equity market and the active use of leverage by Russian brokers. MICEX trading is mostly concentrated in the more liquid shares, with LIES accounting for about 90% of total turnover. GazProm domestic shares are not listed on RTS or MICEX and the majority of the trading in this company is conducted on the Moscow Stock Exchange (MFB), essentially a one-stock exchange.

Foreign investors are able to trade in Russian securities within the U.S. or Europe without the need to deal directly in unknown foreign capital markets through American Depositary Receipts (ADRs) or Global Depositary Receipts (GDRs). Using ADRs, an investor in the U.S. who is interested in buying shares in, for example, Gazprom, may do so by simply calling any local broker dealing in ADRs, rather than having to place his order on a stock exchange in Russia. ADRs and GDRs allowed Russian companies to access previously unavailable international capital markets, and over 50 companies have issued ADR or GDR (primarily OTC) so far. Currently all of the Russian ADRs are trading at par with corresponding domestic issues, with an exception of Gazprom [3] for the reasons explained below.

The Russian government imposes certain restrictions on the acquisition and ownership of Russian companies by foreign investors. For example, foreign participation in Russian banking (both foreigners holding bank shares and setting up their own structures) is regulated by the Central Bank of Russia (CBR), based on a sector-wide ownership ceiling of 12%. Apart from banks, only a few companies place restrictions on foreign participation. The most prominent example is GazProm, which limits nonresident holdings to 9% of Charter capital. In effect this limit is actually lower, as foreigners may only buy shares through a depository receipt and do not have access to the underlying shares. The depositary receipt currently accounts for about 2% of the company.

Indices

Among the multitude of indices tracking the Russian market, the six listed below are the most actively used. All are capitalization weighted, with the major differences being the number of companies included and adjustments made for liquidity and free float.

Exhibit 1.3: Overview of key Russian Equity Indices[4]

Index	Provider	No. of stocks	No. of issuers	% of market covered	Starting date	Treatment of Gazprom
RTS	RTS, Interfax	77	60	94%	1-Sep-95	Not included
Moscow Times	Skate-Press	50	50	87%	1-Sep-94	Domestic price
ROS	CSFB	30	30	76%	1 -Dec-93	ADS price
MSCI Russia	MSCI	11	8	68%	30-Dec-94	ADS price
RTX	OETOB	8	8	65%	8-Oct-97	Not included
IFCI Russia	IFC	9	9	48%	3-Feb-97	Not included
AK&M	AK&M	49	49	-	-	Included

The manner in which GazProm is included leads to significant distortions, both because of the company's size and its peculiar two-tier market structure, where foreign investors only have access to the approximately 2% of the company that trades in the form of ADSs. The remaining Charter capital trades domestically at a large discount to the ADS. Some indices (e. g. the IFCI) have strict requirements on the free float available for investors, and thus exclude GazProm. Others include it based either on the domestic or ADS price. Given the low liquidity of many stocks included in the indices, pricing methodology can also have a key impact. The most commonly accepted method is to take the average between the best bid and best ask on the exchange. The RTS is an important exception, as it is based on the weighted-average price of actual deals registered in the system. Russia's weight in the emerging markets universe is 2.7% according to the MSCI EMF index and around 2-3% under IFCI methodology.

Regulation

The Russian government put in place a general legal framework for the market in place, and it is governed by both the Law on the Securities Market and the Law on Joint-Stock Companies. The Federal Securities Commission (FSC) acts as the market watchdog and has the authority to fine companies and to nullify any improper securities issue. However, to date many other kinds of violation by issuers are only subject to civil proceedings.

The National Association of Equity Market Participants (NAUFOR) has started to play an important role in improving corporate governance through court cases against companies that abuse regulations, by initiating legislative actions, and by establishing transparency and information dissemination standards. Working closely with NAUFOR, the Russian Trading System (RTS) has introduced a set of requirements for being listed, including regular financial results according to IAS or US CAAP and timely public announcements of corporate actions.

Given the basic framework was in place, it was expected that securities regulation would become much more effective. However, poor enforcement and legislative loopholes remain, highlighted by several high-profile corporate governance violations. In response, the FSC has outlined measures that would ensure stricter enforcement and set in motion legislative reform that would further improve shareholder protection. However, we believe significant political effort is still required, and analyzing the corporate governance culture at any particular company remains a crucial part of making investment decisions in Russia.

Current situation

Since the financial crisis of 1998 when foreign investors withdrew their money from emerging markets in a “flight to quality”, the market slowly recovered during 1999, as prophecies of doom (hyperinflation, social unrest and renationalization) turned out to be exaggerated.

Exhibit 1.4: Russian market performance, RTS Index, March 11, 1996- April 6, 2001 [5]

Improvement in the economy was helped by oil price recovery from record lows, and things were looking significantly better by the end of the year. GDP grew by 3.2% in 1999, inflation was 36.5% and the trade surplus amounted to $33.5bn. The federal budget deficit was much improved at 1.7% of GDP. The market also recovered, rising by a massive 252% on the year. The RTS index gained 35% in December alone thanks to results of the Duma elections were the communists lost their control of the Russian parliament. President Putin and the Government led by Prime Minister Kasyanov have shown that they are indeed committed to deep reforms. Among other achievements, they have managed to get the long-awaited new Tax Code through the Duma in just 5 months, something previous governments have failed to do in 7 years. The government economic team, led by German Gref, the Minister of Economic Development and Trade, has developed a long-term economic plan, which calls for accelerated economic reform and targets economic growth of at least 5% a year for the next decade.

Despite the relatively healthy macroeconomic situation and the reform-oriented government, the market has not been as strong as expected: the AK&M domestic issues index declined 15.5% in 2000, while AK&M ADR index declined 39.5%[6]. Public equity market in Russia is currently almost inactive, with daily trading volumes of $5-15 M down from a pre-crisis level of $50-100 M, on a total market capitalization of about $50 Bn [7]. With only 9 companies accounting for more than 90% of the volume, it is clear that most of the trading represents short-term speculation.

Exhibit 1.5: Trading Volumes Compared with Other Eastern Europe Countries [8]

The absence of strategic investors and lackluster performance of the market can be explained by a number of factors. First of all, investors want to be sure that this is the right time to invest in Russia. Having experienced so many false starts, a lot of investors are wary about investing in Russia again and want to see some concrete results before committing any money. Secondly, recent instability on world markets has dampened growth prospects for the Russian market, which closely follows NASDAQ: correlation coefficient between NASDAQ and AK&M’s domestic issues index was as high as 0.93 in August 2000[9]. It's hard to see a strong Russian market in the short term when the US market is showing such volatility and relative weakness. Additionally, Russian companies continue to demonstrate lack of transparency in operations and reporting, being slow to adapt GAAP/IAS reporting standards. Most market participants are short-term driven, and institutional investors such as insurance companies or pension funds are still not present [10].

However, the most important issue investors are focused on is the corporate governance concern (minority shareholder rights, renewed government activism by the tax police, etc) rather than political instability or slow-motion macroeconomic collapse loomed on the horizon of the Russian equity market. Now that neither of these two issues is any longer at the top of the list of worries about the market, investors have instead shifted their focus to corporate governance issues, which encompass minority shareholder rights, as well as renewed government activism by the tax police, general prosecutor and Audit Chamber. Managers have not developed the habit of making decisions based on shareholders’ interests, and courts do not often protect shareholders’ rights. The unfortunate result of this problem is that the Russian companies are trading at levels below or only barely above those at which it opened for the year, with few prospects for significant improvement in the short term.

Currently, companies comprising well over half of the total market capitalization of the Russian market are under corporate governance clouds:

UES: The restructuring program of Russia's monopoly power provider, which is also the Russian equity market's most liquid stock, continues to plague United Energy Systems (UES). Repeated attempts by CEO Anatoly Chubais to reassure minority investors that their interests will be respected in the restructuring process have resulted only in escalating skepticism on the part of minority shareholders. The dissolution of a committee whose aim was to facilitate dialogue between minority shareholders and UES management means that there is now no formal vehicle for communication between the two groups. Calls from minority shareholders for the resignation of Chubais – who, until only months ago, was widely perceived as their savior – are steadily growing louder. Meanwhile, pressure on Chubais is also rising from the government, which has been conspicuously quiet about the restructuring program – although the Duma didn't hesitate to condemn the restructuring program in a nonbinding resolution recently. The investigation into the early 1990s privatization of UES, while highly unlikely to yield any concrete result, adds yet another layer of uncertainty.

LUKOIL: The recent announcement of an investigation into tax evasion at LUKoil is – in some ways – precisely what many investors in Russia hoped for when Putin promised to crack down on the oligarchs to decriminalize the corporate sector and improve the investment environment in Russia. While the arrest of Media-MOST head Vladimir Gusinsky badly misfired (insofar as it was intended as a measure to trim the power of the oligarchs), the raid of LUKoil (and, similarly, AvtoVAZ) sent the signal that the Putin administration will take no prisoners in trying to bring about higher levels of law-abiding behavior and transparency. But in the meantime, minority investors in LUKoil are left to wonder whether they are receiving a fair return on their money – which was already in question even before the launching of the tax police investigation.

Norilsk Nickel: The office of the general prosecutor recently launched an investigation into the privatization of Norilsk Nickel. A number of reassessments of the famously crooked privatizations of a collection of Russian companies have taken place over the past several years with virtually no practical implications. But while the specter of renationalization remains extremely remote, any examination dampens sentiment and gives the market another cause for worry.

Although the long-term benefits to minority shareholders of a true cleansing of the Russian business environment are clear, increased volatility and uncertainty will likely be the key short-term implications. Companies targeted by the general prosecutor's investigations or tax police raids suffer from significantly increased uncertainty – and when many of the traded companies of the Russian equity market are potential, or even likely, targets of governmental inquiries, there are few places for portfolio investors to put their money confidently. As a result, dedicated Russia investors should, in the short term, focus on those companies that are relatively clean (i.e., solid tax payment record, few skeletons in the closet, low profile), such as Surgutneftegaz (Oil & Gas), SeverStal (Steel), Golden Telecom (Telecommunications). On the other hand, global investors who can afford to wait until the dust settles in the Russian equity market, and for investigations to run their natural course, will likely remain on the sidelines.

Yukos, one of the largest Russian Oil&Gas companies, may serve as a good example of the dramatic effect of the corporate governance issues on the value of companies in Russia. Prior to 2000, the company had been known as one of the worst in terms of investor relationships. Last year Yukos took a number of steps to improve: it has consolidated its affiliated structures, increased transparency by implementing GAAP reporting, improved its dividend policies, invited foreign investors to serve on the board of directors, and changed its corporate charters to prevent share dilution. Yukos was included in the MICEX stock exchange and RTS trading system, and is planning to issue ADRs. Following the implementation of these initiatives the company’s market value increased 8 times during year 2000. [11]

Fixed Income

This section of the paper examines the development of the Russian corporate debt market. In general, businesses can raise money: by borrowing money from a bank, by selling equity, and by issuing bonds. It is important for a country to have developed all three capital market options so that entrepreneurs and corporations can have assured access to capital. This so-called “three-legged” approach disperses risks more widely and enhances the financial system’s ability to cope with shocks. Currently Russia is making progress towards establishing a well functioning corporate bond market. This progress is seen in two areas of the corporate debt market, Veksels and corporate bonds.

Veksels

Veksels are promissory notes issued by enterprises, banks, and governments with specified maturity and discount rates[12]. They are the main money surrogates used in Russian and the EBRD estimates that the face value of the stock of outstanding Veksels is approximately 10% of GDP, or up to US$ 20-25 billion in 2000[13]. The Veksel market, although still relatively immature, provides issuers with a short-term capital source that provides relief for working capital fluctuations. Several market professionals see the market evolving over the future and continuing to provide short-term finance to Russian companies.

Along with equities they are the only standard registered securities in Russia[14]. There are two main types of Veksels, commodity and financial:

· Commodity Veksels are promissory note that cannot be redeemed for cash, and instead can be redeemed for the production of the issuer. For example, Irkutsenergo Veksels, promissory notes issued by the power company in the Irkutsk Region, can only be redeemed for energy.

· Financial Veksels, as the name implies are more similar to Western promissory notes and are redeemed n cash upon maturity.

Although there are many types of Veksel structures, they typically have maturities ranging from 6 months to 2 years, may or may not pay a coupon, and are sold at a discount to face value. The discount to face value represents several factors of the Veksel: underlying issuer credit risk and general market benchmark yield.

There are three main types of issuers, enterprises, banks and municipalities. In 1998 it was documented that approximately 80% of the outstanding Veksels were issued by enterprises, a fact that was verbally verified by several traders of Veksels in March 2000[15]. Banks are the second largest issues of Veksels, with between 15-20% of the total outstanding Veksels. Municipalities also issue Veksels and make up the remainder of the Veksel market.

Veksels are issued for two primary reasons: First, and until 1998, they were issued to manage seasonal working capital variations and liquidity problems. For example, agribusinesses would issue Veksels to finance seed purchases and use either the crop and cash generated from the crop to repay the Veksel at harvest time. Second, and primarily a function of the 1998 financial crisis, Veksels are used when enterprises are in severe liquidity crisis or close to financial insolvency. Many Veksels were issued during the crisis by enterprises and used to pay suppliers.