Another Look

I just completed a class called "Economies in Transition" about all the former communist countries and their respective paths to market-based capitalism. This was a very challenging course, a sense of uphill battle against time made all the more pressing by voluminous readings and long lectures listing the hurdles that these countries faced. The impediments to not just success, but a state of 'non-failure', are so many that the current economic condition in most of Eastern Europe seems almost miraculous.

At the end of the course, we were required to submit a paper. Of course, my interest being what they are I strayed back into looking at equity markets. Here's what came of it. (footnotes didn't convert to the blog. If you really have to know, I'll send you the full text on request!!)

Emerging Economies, Emerging Markets:
Equity Markets in Russia and Kazakhstan

Russia and Kazakhstan Are Getting More and More Attention
Russia and Kazakhstan are two of the more prosperous former Soviet states. Despite their comparatively authoritarian political systems, the governments are relatively benign compared to successor regimes in most other soviet republics. As such, economic prosperity sparked by strong global natural resources demand has translated into better domestic prosperity and increased attention from Western investors. Indeed, equity markets in both countries have surged over the past few years. There are two principal reasons for examining these markets in the context of their domestic economies: First, understanding how these economies in transition have reached this point is important in characterizing expected, or continued, interest from overseas investors; Second, understanding the status of nascent equity markets in such emerging economies will determine whether those same investors will be able to participate in an historically rare opportunity.

The Oil Boom Has Changed These Countries
Natural resources in general and oil in particular have lifted the fortunes of both countries in the recent past. Russia and Kazakhstan are important producers of energy assets in an increasingly energy starved world. In fact, Russia is second only to Saudi Arabia in net exports of oil, and first in natural gas. Kazakhstan, meanwhile, ranks 14th in net exports of oil and has an attractive natural gas sector. Not surprisingly, such large export volumes of an increasingly valuable commodity mean that the energy sector represents a significant percentage of national accounts. For example, the World Bank estimates that the petroleum industries in Russia and Kazakhstan probably accounted for 25% and 30% of GDP, respectively, in 2006. Indeed, the impact of rising global oil prices certainly has been a significant factor in the strong GDP growth in both countries in the beginning years of this century.

The Macroeconomic Backdrop is Very Positive
Recent oil prices have certainly provided a favorable tailwind for both Russia and Kazakhstan. Thanks to those exports, both countries now run significant current account surpluses, with Russia’s at about 8% of GDP. A persistent effort by the central banks to “sterilize” the foreign currency inflows means that foreign currency reserves have skyrocketed. Russia’s hard currency reserve of $305 billion is third only to export powerhouses China and Japan. Kazakhstan’s meanwhile, topped $15 billion at the end of 2006.

While certainly an encouraging external environment, both governments have exercised notable internal fiscal restraint in the face of a huge cash infusion. In an effort to forestall a case of “Dutch Disease”, both governments have attempted to segregate the inflows by setting up funds where the oil windfalls can be isolated and kept out of the annual budgetary process. These “stabilization funds” have been earmarked for special infrastructure and social expenditures in the future. Russia’s stabilization fund is now about $88 billion and Kazakhstan’s topped $13 billion at the end of 2006. Tax rates on natural resource extraction and the legislation creating the stabilization funds lead observers to believe that the windfall accounts will continue to grow as long as the price of oil stays over $27 per barrel.

With the bulk of oil revenues isolated in these special windfall funds, the governments have still exercised good fiscal management. Russia runs consistent budget surpluses as high as 8% of GDP while Kazakhstan usually maintains a net neutral budget process.

Both Countries are Moving Beyond Oil
The oil revenues, and the positive outlook for prices in the near term, have certainly been a welcome windfall. This is especially true given the rocky road to global economic integration that both Russia and Kazakhstan may have faced as transition economies if they had not had such desirable natural resources to rely upon. Future growth, however, will likely depend more on how quickly these countries diversify their economies. While economists don’t generally oppose resource abundance as a path to growth, resource dependence is often considered an impediment to meaningful long-term economic expansion.

As a legacy of the centrally planned Soviet economy, neither country has any other significant export industry where it exhibits a comparative advantage. This has made the economies very reliant on revenues from oil. Indeed, despite efforts to sterilize the influx of oil-based tax revenue, Russian GDP in 2005 may have increased as much as 0.4% for every dollar that the prevailing oil price exceeded a baseline of $24 per barrel.

Revenue diversification is a major topic in both Russia and Kazakhstan. Each government intends to deploy assets from the stabilization funds into national infrastructure of both a human and fixed capital nature. More specific Russian ideas to boost research and development spending as a percentage of GDP through grants and tax credits aims to spur growth in the high technology and small business sectors.

Inadequate Domestic Financing Leads to Foreign Financing
A key characteristic of most emerging economies is that they lack sufficient capital to fund internal development. This is certainly true in both Russia and Kazakhstan. Despite burgeoning foreign direct investment, capital inflows to industries outside of the oil and gas sector remain rather inconsequential. Indeed, even FDI with gas and oil investments is still lower in these countries than in other emerging economies.

While Kazakhstan has a relatively robust banking system that extends credit to commercial enterprises even in its neighbor Russia, Russia is still hobbled by its relatively weak banking infrastructure. This is evident in the number of cross-border transactions that Russian natural resource companies are initiating. That is, there remains no effective mechanism for the ample capital generated by natural resources companies to circulate back into the domestic economy. In fact, commercial loans account for only 17% of GDP there when they usually account for more than half of GDP in developed countries.

The net effect of this is that companies often have to consider overseas investors for at least some part of their financing needs. As a result, the domestic capital market is heavily financed by foreign investors. Indeed, Russian and Kazakh companies often list at least some portion of their shares outside of their home markets. Current Russian legislation dictates that new issuers list at least 30% of their shares on domestic markets, leaving companies free to raise significant amounts of capital in London and New York. While the tightened US regulatory environment in the post-Enron era has led to a lack of new Russian issues on US exchanges, there are still some 60 securities listed either directly or through ADR programs. London has become a more desirable destination since, and the LSE alone has 70 listings between its main exchange and its AIM board .

There Are Other Factors Contributing to Economic and Market Growth
Increased foreign interest and involvement on the domestic equity markets in Russian and Kazakhstan, however, are only a contributing factor to the explosion in those indices. Each country has important domestic trends that are also significant contributors.

Both countries are inheritors of the Marxist legacy of underinvestment in consumer products and services. For example, services accounted for only 35% of Russian GDP in 1990. Now that the prevailing ideology is no longer hostile to providing personal services, that sector of the economy is free to grow. The World Bank estimates that, as a result, services topped 57% of GDP in 2005 .

The centrally planned economy was faced with chronic housing problems thanks, at least in part, to its allocation of resources to military and heavy industrial projects. Now, market forces are rushing to compensate for the longtime underinvestment in both commercial and residential real estate. In 2005, for example, construction and retail trade accounted for almost 50% of the expansion in GDP .

Both countries, as mentioned, have plans to use the stabilization funds for increasing R&D spending. Some officials look to boost the participation of small businesses in the economy by using the oil windfall as a sort of national venture fund . While plans are not certain and implementation may be questionable, any effort to create a meaningful small business sector should add to the economic vitality and diversity of both countries.

Other forms of support for market growth can be found in financial reform. In Russia, for example, the government is converting the national pension system from a pay-as-you-go system to a system with at least some portion of self-directed investment accounts. The PIF, or mutual fund, industry has seen steady inflows from middle-income Russians as they shift a portion of their salaries into the capital markets.

As a result of strong growth in other parts of the economy, oil has become proportionally a bit less important. That is, oil related companies accounted for 66% of the Russian stock market in 2005, but only 60% in 2006 . Given a relatively stable to declining outlook for global oil prices, the energy industry’s representation in the Russian market is likely to decrease further still in 2007.

Equity Markets Look Poised for Continued, and Balanced, Growth in 2007
Russia, with its 6 initial public offerings raising $17.4 billion, ranked among the top IPO markets in the world in 2006 . This tally was certainly helped by the placement of the enormous Rosneft flotation. Indeed, Rosneft was a watershed in other ways. The strong domestic demand for the shares has led to contemplation of a regulatory change. Instead of offering 30% of shares domestically, Russian regulators now believe that the home market may be able to absorb as much as 50% of new issues.

In any event, strong domestic market demand has prompted other companies to announce their intentions for public offerings. In late December, the tally of announced flotations stood at 10 companies intending to raise $21.2 billion . The list includes state-owned financial giants SberBank and Vneshtorg Bank as well as retailers and a technology company. Notably, about two-thirds of the total funds would be raised by companies not in the natural resources sector.


Market Structures are Well Developed, But Still Evolving
Capital markets in the former soviet states have gone through several incarnations already since their founding in the early 1990’s. They continue to evolve as their respective economies transition further away from the centrally planned legacy. Already, though, they have begun to serve important roles in their domestic economies. By linking capital-starved sectors of the economy to foreign and pent-up domestic funds , these markets are serving the critical function of capital allocation to growing businesses that equity markets do so well.

The Russian equity universe comprises around 750 issues of all types of share classes. Total capitalization has surged with higher valuation and a larger number of issues coming to market. In general, though, issues are separated into as many as 3 “tiers”. Definitions are not standard among market players, with some focusing on company market cap while some others make distinctions based on trading volumes as a percentage of float, or liquidity.

The equity market is dominated by two exchanges, the Moscow Interbank Currency Exchange (MICEX) and the Russian Trading System (RTS), which together account for more than 95% of total trading volumes. Some regional exchanges have maintained relevance in the consolidated national market by developing specialized trading in certain issues. In particular, the St Petersburg exchange focuses on trading shares of Gazprom.

The MICEX is two years younger than the RTS exchange, but handles much more volume thanks to its advanced technology platform that allows a higher proportion of remote trades. The exchange focuses on trading the top 150 most liquid issues in the economy. It allows trading on a cash settlement market denominated in rubles as well as on a delivery-versus-payment market. Given the relatively high counter-party risks of trading in an emerging market with only limited securities law, the “security present” safety of the delivery-versus-payment market is much more popular.

While MICEX handles more than 80% of the total trading volume in Russian equities, the story is more subtle. The top ten companies on the exchange, for example, account for as much as 95% of the volume of the market. Indeed, Gazprom accounted for as much as 43% of total volume after its first month of trading on the exchange (February, 2006). Midcap stocks, conversely, only represented about 0.5% of total volume.

The other main exchange in Russia historically focused on a different end of the spectrum. The RTS long centered only on the RTS “Classic” segment of dollar-denominated cash trading with settlement as long as 30 days after the trade. This section of the market lists 396 stocks issued by 279 companies of all market capitalization and liquidity levels. The limited liquidity of many issues also means that the “Classic” section of the exchange is quote-driven in order to address potentially wide spreads. In addition, the market is not anonymous and has high levels of counter party risk.

In order to address those deficiencies, the RTS introduced a delivery-versus-payment (or “T+0”) exchange for the top 8 most liquid issues. Other issues outside the top 8 have begun to trade in this segment, too. Much like the MICEX, not surprisingly, the RTS “T+0” volume is dominated by the most liquid shares in the country, like UES and Gazprom. In fact, the exchange reports “T+0” trade volumes net of Gazprom data.

A recent disclosure, however, has significantly changed both the market share picture between MICEX and RTS and the overall impression of liquidity in the Russian market. A regulation effective January, 2007 requires all brokers and market participants to report any OTC trade if the security is quoted on at least one exchange in Russia. The OTC market was rumored to be quite large, but the first daily data release in February highlighted that the market is, in fact, much larger than even the most bullish commentators imagined. While the RTS Classic exchange volume totaled 4,718 trades for $1.1 billion in December 2006, the OTC market totaled 14,066 trades for $4.6 billion volume in the first 5 trading days of February 2007 alone .

Equity markets in Kazakhstan, while in decent structural shape, are not nearly as important a part of the national economy as in neighboring Russia. The equity universe in Kazakhstan is much smaller, with 94 companies issuing 68 securities. The market capitalization of the entire market stands at around $65 billion. More important, though, total equity capitalization represented only 19% of GDP in 2005, while that tally was as high as 72% in Russia.

Diversity of economic activity in each country varies and may account for some of the difference. Kazakhstan, after all, is slightly more dependent on natural resources and agriculture compared to Russia. But that difference is much smaller than the wide gulf between equity capitalizations as a percentage of GDP. Instead, the difference is likely a result of at least two important structural discrepancies.

First, Kazakhstan has a relatively well-developed banking sector that has been more efficient at providing funding to domestic businesses. Of the 19% year-over-year growth in fixed capital in 2006, at least 50% of it was internally financed . Indeed, Kazakh banks are even aggressively financing businesses in Russia. Given the more efficient flow of capital from natural resources to the private sector, there may be less impetus for private companies to list their shares publicly.

Second, the difference may arise from the varying levels of privatization that the respective governments pursued in the 1990’s. Russia’s headlong privatization left much of the country in private hands after the 1990’s while Kazakhstan’s path was much slower. Indeed, the Kazakh government founded a holding company to manage the 5 leading strategic infrastructure firms in the country (electricity, rail, telecommunications, post, and oil & gas). Holding portions of such large industries outside of equity markets may significantly affect overall capitalization levels in the country.

Russia and Kazakhstan are Emerging Markets to Watch
Russia and Kazakhstan can be best understood through the lens of an emerging economy. As such, the economy is relatively uni-dimensional, capital markets need outside financing, and trading on exchanges is heavily concentrated in top “champions” that may have a heavy amount of government control.

Still, even a cursory look at data shows that economies and equity markets in both countries are moving toward more diversity. In the case of Russia, equity markets have been shown to be much more liquid and diverse than thought only two weeks ago. Both countries have attracted a flood of foreign capital at first interested only in oil profits. That will probably remain a significant part of the investment case for some time to come. In the meantime, however, both countries look to be emerging as more balanced growth markets.

Bibliography

DePoy, Erik. “OTC Market Emerges from the Shadows.” Alfa Bank Equity Strategy (Feb 7, 2007): 1-3.

External Relations Department, "Information Notice." Central Bank of the Russian Federation. 2 Feb 2007. Central Bank of the Russian Federation. 4 Feb 2007 .

“Raising Capital in Russia and Abroad: Trends and Developments.” MICEX/LSE Joint Conference. Moscow, 1-2 March 2006

"RESULTS OF TRADES IN CORPORATE SECURITIES." Kazakhstan Stock Exchage. 9 Feb 2007. KASE. 10 Feb 2007 .

"RTS Classic Market: December 2006 Market Data." Russian Trading System Stock Exchange. 11 Jan 2007. RTS. 2 Feb 2007 .

"Russia." World Bank Country Economic Report. 2006.

“Russia Country Profile.” Economist Intelligence Unit. 2006.

"Russian Economic Review." World Bank. December 2006.

Sachs, J. and A. Warner. “Natural Resources and Economic Development: The Curse of Natural Resources.” European Economic Review 45, 2001.

Spilimbergo, Antonio. “Measuring the Performance of Fiscal Policy in Russia”, IMF Working Paper December 2005.

"Stabilization Fund of the Russian Federation - Statistics." Ministry of Finance. Ministry of Finance of the Russian Federation. 2 Feb 2007 .

Tabakh, Anton. "Infrastructure Overhaul, Consolidation, Globalization." UralSib Russia Equity Research (2006): 11-17.

"Top World Oil Net Exporters, 2005." Offical Energy Statistics from the US Government. Energy Information Agency (EIA). 10 Feb 2007 .

Weafer, Chris. “Monitoring Investory Activity in Russia.” Alfa Bank Equity Strategy (Feb 8, 2007): 1-5.