What a difference a year makes.
Conventional wisdom last fall held Russia was ripe for real and sustained economic growth.
Now, the Asian financial crisis has caused a seachange among emerging markets investors as, one by one, the weaker Asian countries were taken to task for years of sweeping fiscal problems under the rug.
The retreat of investors from Russia initially was fueled by foreign institutions hitting the eject buttons on their portfolios, downsizing all of their emerging markets positions. A second retreat took place at the beginning of the year as savvy emerging markets investors booked profits in Russia to increase liquidity for scooping up bargains in Asia. Finally, in May, a renewed spiral in Asian markets, rioting in Indonesia and the volatility of the financial markets raised serious concerns over Russia's financial health.
The skittish mood touched off panic selling of financial instruments on speculation of a possible ruble devaluation, despite the new government's insistence that devaluation was not an option. As Asia sneezed, Russia caught pneumonia.
In mid-August, the Russian market's main share index, the RTS, flopped to a two-year low of 120, multiples lower than its all-time high of 577, set in the first week of October 1997. Equity prices closely tracked the Treasury bill market and were dragged down by persistently high yields on short-term government securities, which returned to triple digits amid devaluation fears and further fueled the fear that government borrowing is unsustainable. By mid-August Russia's external debt had fallen to its lowest levels since its restructuring in 1996.
Russian financial markets have been in a free-fall as investors appear to be absorbing only negative news, such as continuing corporate governance problems and low oil prices that erase hope of healthy profits this year in the oil sector.
Investors have filtered out positive developments such as partial passage of an anti-crisis reform package by an unusually compliant Parliament and subsequent presidential decrees that have filled many of the policy gaps; a $22.5 billion IMF stabilization loan; the government's successful debt swap in July that "reprofiled" about $4.5 billion in short-term ruble debt into longer maturing dollar-denominated Eurobonds; and the government's dogged defense of the ruble.
Analysts in Moscow speak of a "great disconnect" between the terrible mood in the market and the underlying fundamentals in the economy. "The Russian example shows that almost any action an emerging markets country takes will not be enough to persuade risk-averse investors to take the plunge," said Jonathan
Garner, a London-based analyst with Robert Fleming & Co. He has become convinced only a gesture from a developed market, such as a surprise interest rate cut, would spur the market.
The massive financial package arranged by the International Monetary Fund, available in tranches on good government behavior, was supposed to calm the markets and restore investor confidence. Markets rebounded in advance of the announcement, driven mainly by hedge funds that then sold their positions once the IMF loan became a reality.
"There is a sense out there among investors that they have tried Russia, and got burned last year," said Gavin Rankin, head of asset management for Troika Dialog Asset Management in Moscow and manager of the Lexington Troika Dialog Russia Fund. "Now investors want to see progress. I think we could have a runup on implementation of the promised reforms. For long-term institutional money, I think there are great bargains out there. People just need to get comfortable with Russia again."
Most investment analysts in Russia are predicting the market will remain in the doldrums for another few months as investors watch for signs of better tax collection, a lower budget deficit, some success in several major upcoming privatizations and better protection of shareholder rights.
It was a different story last fall. The financial markets had gained nearly 190% in dollar terms in the past two years. Inflation had been tamed to an annualized rate of 11%, half that of the previous year, and was expected to dwindle further. Interest rates had been coaxed to around 20%, allowing the government to borrow relatively cheaply on the burgeoning Treasury-bill market, as yields sank to an all-time low of 17%.
The government enjoyed a healthy trade surplus and only the most sullen analyst could think up a scenario under which the central bank's $25 billion in gross foreign exchange reserves could not support the ruble.
Also, a new tax code that was expected to be adopted this year was to increase tax revenue, relieve the business sector of its unwieldy tax burden and begin to unravel the nonpayments predicament in the economy. A spate of Russian corporations were getting prepped for debut issues of Eurobonds and American depository receipts. Instead of pressing on with the tax code, however, the government presented a series of tax bills and amendments, some of which were part of the original code, to the parliament as part of an anti-crisis program that was developed to impress the IMF enough to grant Russia a $22.5 billion stabilization loan. The parliament adopted some of the tax bills, while rejecting others, and is set to consider more of the government's tax proposals in early Sept. It seems, now, that the tax code will be debated and adopted piecemeal.
Investors and equity analysts were exploring ever more exotic sectors of the economy, having grown tired of the steady growth promised by blue chips. Nearly every week the market was brimming with tales of far-flung regional telecom and utilities stocks, steel mills, fertilizer producers or pipe makers that soared like shooting stars across the financial markets firmament, fueled by peripatetic equity analysts generous with their "buy" recommendations and portfolio investors looking to score big by discovering the next trendy sector or corporate gem in the rough.
Raising capital for a Russia-dedicated fund was a relatively easy exercise in 1997 -- many new funds were launched, while some funds added new tranches to existing ones. The total number of Russia-dedicated funds ballooned to more than 70, spanning a wide range of investment strategies.
Rounding the third quarter of last year, the Russian story was a compelling one that was attracting a wide variety of investors, including most of the top global emerging market funds, dedicated funds, hedge funds, public and private pension funds, European insurance companies, high-net-worth individuals, foundations, endowments, and at least one U.S. senator -- who boasted of making a fivefold return from an early position in a Russian oil company ADR.
While many institutional investors had gotten their feet wet in Russia, widely forecasted economic growth and maturing financial institutions were expected to widen and deepen the pool of foreign and domestic capital in the equity and debt markets, providing plenty of fuel for years of sustained growth.
So, do the fall from grace and the current bargain basement valuations in the Russian market outweigh the risk and tremendous volatility for long-term investors? Opinions differ.
"I think the timing is becoming right again," said Mr. Rankin. Investors "may choose to wait a few more months, but we are seeing extremely attractive valuations now. . . . This is the first real constructive government that we've had. In the Gaidar government and the Chubais period, there were only one or two people that you could call a reformer. With this Cabinet, we have a whole team of reformers. But it's not easy to swing around a super tanker."
"Russia is a very risky market at the moment and is not a place where conservative money, such as pension funds, want to be," said Denis Rodionov, an analyst with the investment firm Brunswick Warburg in Moscow. "This is a good market for speculators, but it is hard to recommend a market with 10% to 15% daily jumps to conservative investors."
