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Lots of volatility and anemic growth lie ahead

The Russia Forum 2010, organized by Troika Dialog Group, took place between February 3 and 5 in Moscow.

Ruben Vardanyan Troika Dialog Manager

Date: 15 February 2010

Source: Kommersant-Dengi magazine

The Russia Forum 2010, organized by Troika Dialog Group, took place between February 3 and 5 in Moscow.

Offering his summary report on the investors’ congress to Dengi special correspondent Petr Rushailo is Ruben Vardanyan, Chairman of the Board of Directors of Troika Dialog.

How do the overall moods of participants at this year’s Forum compare to those of previous Forums, last year’s in particular?

Last year’s Russia Forum also took place at the beginning of February. At that time, everyone had a sense of total collapse, and no one was ready to discuss any kind of investment prospects. Everyone was thinking about other questions: how deep will the crisis be, how long it will last and how it will affect Russia. The illusion that Russia would remain an island of stability and would manage to avoid the crisis had dissipated. We also found ourselves swept up by the crisis, so a rather dismal mood prevailed over last year’s Forum. This year everything was much more positive: the apocalyptical scenarios didn’t pan out, and people saw that everything was far better than previously believed and discussed. The second outstanding feature at this year’s Forum was the large number of participants from China, Africa, India and Brazil, allowing us to discuss not only and not so much Russia’s problems, but problems affecting emerging markets overall.

What if instead of last year’s Forum we compare this year’s to calmer time periods?

In 2008 we called ourselves an island of stability and it seemed that Russia would be able to avoid the crisis entirely, since we had good reserves, since we didn’t have the kind of distressed debts the American banks had… Basically, it’s hard to compare. But if we’re serious, I would first of all point out the change in attitudes toward discussions, since what’s important isn’t only the caliber of speakers, but also the caliber of listeners. And this year’s The Russia Forum was attended by many top-caliber participants: businessmen, officials, and regional leaders who came not to speak, but to listen. I can’t remember that kind of thing happening before in Russia.

In your opinion, which type of speeches elicited the greatest interest?

Included in the Forum were numerous speeches as well as 25 panel discussions on the widest range of topics. And, in my opinion, the greatest amount of interest was elicited by the speeches given by Igor Shuvalov and Aleksei Kudrin, as well as by the panels devoted to currencies, entrepreneurialism, geopolitics, the BRIC countries, problems of investing and alternative investments, for example – investing into works of art and wine.

What’s that – corporate CEOs and officials thinking about “soaking the national reserves with wine?”

Everyone is looking into alternative investments these days, including very serious investors: the situation in the world has changed drastically. Whereas before conservative investors purchased certificates from the biggest Western banks confirming that they have gold, after which they purchased gold bars, now they are buying up gold coins as an asset allowing them to secure a liquid exchange, meaning investors aren’t certain of anything – they’re afraid of anything and everything. And precisely because of this, investors searching for new investment targets are showing interest in what is happening with the oil, banking and retail sectors of the Russian economy. And precisely because of that, discussions of geopolitical problems elicit some rather fervent interest. For me personally, it was a great pleasure to listen to the speech by Michael Milken, Chairman of the Milken Institute, who outlined the major world trends over the past 150-180 years; it struck me as incredibly interesting.

Is this the same Milken who made his fortune on junk bonds and was put in jail? So a person who up until recently was considered a con artist has become an economic guru?

Yes, the same Michael Milken. But I would like to point out that he was never considered a crook, on the contrary, he was always considered a financial genius. Incidentally, the story regarding the accusations made against him to this day isn’t entirely clear – in terms of whether or not he broke the law and what these exact violations were. Either way, Mr. Milken created the largest currently-existing institute conducting research in medical trends, education and economics.

And what kinds of interesting things did he say?

He said that in the 21st century changes are occurring in key trends in the fields of medicine, education and migration. In particular, according to data at the Milken Institute, Russia in the 1990s lost $1 trillion due to the large number of highly-qualified specialists who left the country. No less interesting are the data cited by the Milken Institute regarding the problem of obesity. It was discovered that 46% of women in America as well as 37% of men carry extra weight, whereas 9% of the Russian population suffers from obesity, and just 1.5% in China.

Is it possible to draw any firm economic conclusions from these discussions?

Absolutely, and very firm ones at that. The first conclusion is that in the next 30-50 years Asia will become the key region in terms of the number of educated people, the quality of education and the size of the economy. Incidentally, it was very interesting to learn that in 1820 India and China accounted for 41% of global GDP, while Russia accounted for 2.5% and America – 1.7%. The situation has changed since then, but right now the light tower has shifted in the other direction. And in the near future we could see the center of decision making and the center of the world economy shift from Western Europe and America to the Asian regions – China and India primarily – despite all the problems and difficulties existing in these countries.

Why would it have to shift? Is it because they have greater potential, speaking relatively, for additional weight per capita? There are also a lot of hungry people in Africa…

In the 21st century, the primary focus won’t be purely economic indicators, but human capital. And judging by the current dynamic, Asia by 2015 will already hold a greater number of well-educated people than America. Right now there are more children in India than in all of Western Europe. The generation currently coming of age in China will be able to compete with the Europeans and Americans in terms of their level of education. And to top it off, India and China will soon take the top two spots in the world in terms of education. All of this fundamentally changes the picture of the world. In spite of problems involving medical care, unemployment and a number of other difficulties faced by these countries in terms of energy and capability to influence global processes, they will acquire a number of levers. And in the next 20 years, this trend will only intensify.

Nevertheless, the economic sources of growth are not very clear. Up until now, growth in China was provided by successful realization abroad of all of its manufacturing output – in other words, through growth of consumption in the West. Where will China realize its manufacturing output in the new world model you have described?

I think the level of domestic consumption in China will change drastically in the near future. Roughly speaking, if China at one point was eating meat once a month, and then started eating once a week, this would create a many-fold increase in global demand for meat. And although China has shown the entire world that it is growing faster in heavy industry than in light industry, internal demand is bound to take on greater significance. Given the number of Chinese living in the interior who are currently excluded from the consumption process, the growth reserves here are immense.

Based upon your description, the timeframes for these changes aren’t that large. What are we talking about – decades?


What are the implications of this for Russia in terms of the economy, primarily from an investment standpoint?

Russia must competently construct its relationships – economical and financial ones included – with these Asian countries, and try to understand how it can make use of the situation. Russia could be a vital and highly interesting country for both China and India, and not only as a natural resources provider, but as a neighboring country. In terms of investment processes, the trend of shifting emphasis to the east is evident even to the layperson’s eye. In particular, Rusal just recently completed its listing on the Hong Kong Stock Exchange. Could you imagine someone 10-15 years ago seriously thinking that Hong Kong, rather than New York or even London, would serve as a world capital-raising platform? Everyone simply would have laughed. So lots of things have changed over the past decade.

OK, let’s return to Russia’s prospects. What should we do with regards to the described change in the geopolitical situation?

Russia should utilize the crisis-related matters to implement the changes that everyone recognizes are necessary. This includes diversifying the economy, creating added value to final products and implementing various kinds of innovations. All of this will become possible in one case only: if the political elite, state and private business make earnest steps in this direction.

You have to admit, those are general words. What steps in particular? Are political changes needed?

Political change is also a general expression. I will cite a simple example: Russia’s current taxation system is far more attractive for both individual investors and corporates than many western countries, where taxes are rising. But we have other flaws. And very simple ones. For example, it would be nice if a businessman wishing to visit us were able to obtain a visa in two hours, rather than waiting in line for an indefinite amount of time. This is a question of politics, but solving such problems does not require changing the political system. This is a minor but very illustrative example. A more complicated issue is the justice system. And even more complicated is the application of law in general. And the entirely intractable issues are a quality education system and quality medical care. These things require investments as well as real actions on the part of both federal and local power. But they do not require any kind of drastic overhaul of the political system. No one expects corruption to be vanquished and the entire country to change in a matter of months. Nevertheless, there are things that can be done quickly. Even the small things: if our cab drivers are able to speak English, this will also enable investment inflows – foreigners will have a simpler and better time working here.

The prospects are clear. But if we analyze the current situation, what awaits the Russian market in coming years?

All in all, everyone at The Russia Forum agreed that the world economy will experience growth for the next two-three years. However, growth in the developed countries will be absent outright or highly anemic, while the world economy will grow by means of the emerging markets, including by means of Russia. Furthermore, investors are taking an optimistic view on Russia in the short-term, since our corporate borrowers are cheaper and significantly more stable in comparison with analogous companies in emerging markets. Furthermore, our country doesn’t have a great amount of outside debt, and in this sense Russia is more attractive than, say, Greece or many other countries. At the same time, the problem lies in the fact that these factors are of principal importance when we are talking about short-term and medium-term investments. But for long-term projects, 10-20 years, Russia is a rather risky country in terms of possible changes in the rules of the game, particularly instability of currency market regulation and the particulars of the justice system. But investors have been talking about this for years and years.

You mentioned Greece, which together with a number of other European countries has found itself in a difficult situation with sovereign debt and fiscal spending. How has this influenced investors’ views of the relative risks of investing into emerging and developed markets, as well as the risks of investing in the government and corporate sectors?

I have to say that over the course of the crisis, not only have these kinds of estimations changed, but the very concept of economic growth has changed as well. The crisis showed that the world has become highly diverse. Before it was straight-forward: America sneezes and everyone contracts pneumonia. As it turned out, America sneezed, got sick, and even contracted pneumonia, while in Brazil, a country that used to be entirely dependent upon the U.S. and was by no means the most stable of countries, the growth temps didn’t even fall; the same can be said for China. Canada, one of the countries bordering the U.S., hasn’t experienced any kind of banking crisis. In South Africa, New Zealand and Australia, everything is calm. So, the hub of the universe used to be called Western Europe and the U.S., where everything was determined. The main current of money as well as people used to go in that direction, and it was redistributed from there as well. But suddenly everything has changed: it turned out the debt burden in the U.S. was greater than in other countries, even the emerging market countries, and servicing the budget in developed countries raises more questions than in emerging markets, and the protectionism that was previously used by weaker countries began to be actively used by developed countries… Given all this, it became clear that both government and corporate debts have to be viewed differently. The idea that sovereign debt is more reliable is illusory. On the one hand, you have Argentina announcing default every 20 years, and this has become a normal part of the country’s development. I think a new fragmentation of the debt market will occur in coming years – precisely based upon the level of debt burden of corporate borrowers. And this fragmentation will be very precise even within single industries and will carry greater significance than the industry to which the borrower belongs. Furthermore, greater emphasis will be placed on the amount of information about borrowers available to the markets, as well as on the role of various kinds of guarantees. And of course, operations involving lots of leverage can be forgotten about entirely.

And how long will this last – I mean in terms of policies limiting leverage as well as the market’s fear of a new crisis in general?

A long time I think. At the very least, in terms of regulatory policies. It’s already clear that regulation will strengthen at the national and global levels, and since all of this will be formalized into the corresponding normative acts, this will last a long time. I think we are going to experience a certain period of reaction to recent events, primarily in terms of serious restrictions on the risks of financial institutes, and even of nonfinancial corporations.

In this regard, it’s clear that the profitability of operations on financial markets will be reduced, right?

Overall – yes. Although we have to admit that in Russia this was astronomical. In our industry, returns of 30-35% were considered the norm, while nowadays 12-15% annually is considered a very good result.

Has your company reached any conclusions for itself? For example, to what extent are investment companies facing serious competition from classical banks with deposits?

They aren’t becoming competitors, nor will they. The reason is that these are two different types of business, exhibiting different levels of risk and requiring different levels of professionalism in decision-making. I think we will return to a division of banks between classical banks primarily serving the population and investment banks. Because, otherwise, this problem will arise again, and it will be far more serious if it is discovered that as a result of the banks’ overly risky policies on capital markets they are unable to make payment on deposits.

And how deep could such a process of dividing risks reach? For example, why only banks? Brokerage activity could also be separated into a separate category…

We will see several trends: unification of overall standards and unification of reporting. Furthermore, we are going to see major fractioning: each will be involved with one business area and will not put their hands in another basket. Regulation over everything will be performed by a single, central national regulator, who will start keeping track of all risks in terms of geography and products. I anticipate the appearance of precisely this kind of model.

Is there space for national interests inside such a model? Say, for example, a country such as Greece doesn’t want to pay – how can it be compelled?

This was the main question discussed at Davos: who will do everything, and in case of conflicts, how to determine who is right and what will happen with those who do not fulfill the established rules.In terms of what needs to be done, a lot is already more or less understood – last year facilitated a great deal of progress in this area of knowledge. A number of serious questions were discussed both in Davos and at our Russia Forum, including in one-on-one meetings. The question is, where are the leaders who will say “This is how to do it!” so that “those who don’t agree will have the gas turned off,” to quote our outstanding movie.

So, will such leaders be found? And when?

Right now we are placing a great deal of hope in the G20: that the G20 will replace the G8. This is a serious geopolitical change, and I think the results will become apparent this year. In reality, the politicians don’t have much time. And if they don’t take immediate action, the appearance of new financial bubbles in the near future appears entirely possible. From this standpoint, working during the crisis is good. Because everyone, politicians included, understand: if one thing or another isn’t done, it will be very bad. That is, they are forced to do the thing that they wouldn’t have done before. You hear the Americans saying: the bankers turned out to be financial swindlers, building a pyramid, etc. My answer to them is: wait a minute, William Donaldson, Head of the Federal Securities and Exchange Commission, back during calmer times tried to create order on the market, and all of you raised a fuss and immediately had him removed. And this person was actually trying to prevent the appearance of some of today’s problems, which even then were starting to appear. During good times it is difficult to change anything; during the bad times it’s easier.

OK, so Milken was imprisoned in his time. OK, so last year there were continuous attacks against the ‘fat cats’ – financial sector representatives – who had lost all sense of shame. Have you personally been affected in any way by the new trend?

In Russia, thank heavens, this doesn’t seem to be happening, since we have a different problem in terms of the financial market. Our problem isn’t with the major companies, but with the small ones, in the fragmentation of the market, which is especially obvious in conditions of financial crisis. In Russia there is too large a number of small banks, brokerages and insurance companies, while in crisis conditions, reliability is the top priority. The undercapitalization of Russia’s financial market is one of our main difficulties. It’s a separate matter that overall we, of course, see the change in attitudes toward financial sector representatives, but it seems to me that here we have a number of excesses largely created by the desire to turn back the clocks. The problem is far deeper and more serious; it isn’t with financiers’ appetites, but with the very system of approaches to risk assessments. The same Michael Milken, for example, cited a very interesting example. There are five million companies in the U.S., of which 500 are S&P rated. And of these 500, only four have a AAA-level rating. Meanwhile, by the start of the crisis, 16 thousand securities of various kinds were rated AAA. And all of them were bound to real estate.

And what are your overall forecasts for the Russian market this year? What are you telling clients?

I have a feeling that everything will be challenging: we are going to see high volatility and a lack of significant growth. However, no particular cataclysms are in the forecast. In 2010, both Russia and the world in general will experience a search for a new growth model and new growth points. In addition, I anticipate the opening of new markets and the appearance of new instruments that investors will purchase in order to diversify their risks.