A Maturing Market - Director's Cut

This is the full length version of my piece in today's Moscow Times (click here for the published copy).

This has been an odd year for investors. The market has ultimately managed healthy gains, and bonds have performed excellently, but even so, old Russia hands are probably disappointed. After so many years of astounding out-performance, both up and down, 2012 stands out as the year in which the Russian financial market reached adulthood. No more adrenaline rushes or adolescent tantrums as the Micex turned 20, and promptly entered corporate matrimony with the younger (but more future-oriented RTS). What happens next in this exciting epic of economic evolution?

The first thing to be clear about is that the go-go teenage years are behind us. Annualised index volatility has slumped to 19 per cent, the lowest on record, and 2012 returns will ultimately disappoint many accustomed to fast and easy money. But as sure as the government knows that the easy years of populist politics are gone, so investors need to accept that a new level of maturity will be required to negotiate the market’s challenging third decade of existence. There is good news though: The Russian financial sector is on course to mature into a respectable and productive young adult, efficiently intermediating between investors and companies with a wide range of interests. And, despite some impressive developments in 2012, the high and rising equity risk premium tells us that there is plenty more exciting work ahead.

Less enthralling than the country’s ongoing political saga, financial market developments have often happened out of the spotlight this year, so they deserve a moment to shine, even if only to inspire us for the challenges ahead. 

Technically, the RTS and the Micex finalised their merger in 2011, but the integration has taken place this year, culminating in the upcoming adjustment of the Micex Index to include the same 50 names as the RTS. At last, Russia will have real volume trading in an index that is investable and reflects more than just the biggest blue-chips. The formation of a central depository was an equally important and even less well publicised event. But the infrastructure development of greatest importance is surely the subsequent opening of the ruble debt market to international investors. By early 2013, global investors will have easy access to a diverse array of locally traded ruble bonds. This development will bring immediate benefits to corporations, Russia’s capital account and the global investor community. It may also rapidly have the knock-on affect of improving corporate governance and regulation – managers should quickly notice that the best behaved companies borrow at the best rates. 

Elsewhere, the government won accolades for the decision to reinstate budget constraints against fiscal largesse, talked tough on corruption, implemented impressive dividend policies and defined ambitious modernisation plans with clear milestones to allow independent monitoring of progress. The central bank also rose to the occasion, unerringly pursuing the path to inflation targeting and playing a considerable role in one of the ruble’s most stable years to date. The oligarchs too contributed, with concerted efforts to resolve several long-standing conflicts. Not least, the ending of the TNK-BP saga lifts a substantial blight overshadowing the whole equity market, and the signs are good that Norilsk Nickel will pursue a clear and profit-oriented strategy going forward. Oh yes, and let’s not forget that Russia finally joined the WTO. 

All well and good then, so why is the equity risk premium rising? And why is Russia’s discount to its peers so high? The answer to both these questions is basically because the transition from communist superpower to modern capitalist state is no simple stroll through the park. Russia has come a long way but there is far to go. The key challenges are dauntingly difficult; the government is talking the talk, but next year more than ever it will need to walk the walk. 

Above all else, countries need fair, independent judiciaries to enjoy low costs of capital and sustainable global capital in flows. This will take years to achieve, but prosecutions that took place this year, and are scheduled for 2013 imply that the effort is not likely to begin in earnest any time soon. None should doubt, first and foremost, that without this change, all other efforts are gravely limited in their potential to bring progress. The process of political liberation should also be honoured in full: One-party systems always make investors nervous about long-term projects. 

Macroeconomic policy is perhaps most urgent though. It doesn’t only define the path forward, it is also essential for consolidating the progress already achieved. The government has acknowledged that the old economic model is broken, and it is. Despite the probability of healthy global growth in 2013, Russia runs the risk of missing the party. Commodities prices are unlikely to rise anything like the way they did in the pre-crisis era, and Russia remains a resource dependent economy. Slower retail sector expansion this year, coupled with soaring household borrowing should raise concerns. Next year’s growth will come from investment or nothing. 

It is true that, for now, the government can provide the capital that the private sector is so nervous about deploying (especially as returns on investment appear to be declining whilst risk lingers at an elevated level). But this is not a sustainable solution. First, the state sector is already far too big and struggling to shrink itself, second it is notoriously bad at economically efficient capital allocation, and third it simply lacks the funds to keep palming out year after year. Government projects might get the ball rolling, but for Russia to resume healthy growth, it is going to need to meet its qualitative development milestones. That will require the bureaucratic elite to do more than just talk the talk. 

The Russian financial market is growing up fast before our eyes, but 2013 and the years immediately following will determine whether it becomes an organised and responsible member of the global economic community or whether at this sensitive young age it becomes easily distracted and runs off the rails. We all have a responsibility to play our part in stewarding it to a successful middle age.

James Beadle is a senior investment advisor at Societe Generale Private Bank, with twelve years of experience in the Russian financial market.