Economic growth through foreign direct investment

Global Finance, May 1998

or the first time since market reforms were launched in 1992, Russia posted modest GDP growth of 0.4% in 1997. Encouraged by the result, Russian officials predicted growth of 2% for 1998, despite the world market turmoil that ripped through the country last October. However, political uncertainties triggered by the last Cabinet shake-up in March, coupled with a global oil price slump, are threatening Russia's trade balance, while budget finances remain precarious.

Immediately after sacking long-standing prime minister Viktor Chernomyrdin and the entire Cabinet on March 23, President Boris Yeltsin appeared on Russian television saying his decision was an attempt to breathe new life into Russia's beleaguered economic reforms, not to reverse their course. Russia's financial markets initially plunged on news of the political shake-up, but were quick to rebound after Yeltsin said the Cabinet reshuffle was aimed at speeding up reforms.

Yeltsin's surprise choice to replace Chernomyrdin with 35year-old Sergei Kirienko attracted optimistic reviews. Kirienko, a little-known oil executive, came to Moscow from Nizhny Novgorod with his mentor, reformer Boris Nemtsov, in March 1997 to join the government. Seen as a rather independent reformer and a skillful manager, he did a stint as deputy, then became the fullfledged fuel and energy minister.

In Moscow, the investment community initially expressed cautious optimism. Viktor Sakharov, president of the Moscow Stock Exchange (MSE), said he was "deeply surprised" that the Cabinet reshuffle had not dramatically influenced the securities market. "Investors now are more sophisticated than in the past. They did not interpret the reshuffle as signifying any change in the macroeconomic situation or in the reform program. Expectations did not change objectively." The market, it appears, is concerned mainly with one factor: Yeltsin's health. "Power in Russia depends on the president. For investors, the main thing is predictability," Sakharov notes. "As long as Yeltsin appears to be in charge and sending the right signals, the markets will be all right."

"A growth forecast of 2% is rather ambitious," says Dirk Damrau, head of research at MFKRenaissance investment bank. "The next six months will be crucial for the government. It must use that time to accelerate investment, particularly from non-resident investors." He adds, "When noticeable investment increases take place in the corporate market and through private equity funds, then we'll be able to say the economy is picking up."

FINANCIAL MARKETS

The market's reaction to the Cabinet's dismissal encouraged the government to proceed with 1998's first eurobond issue. The day after Yeltsin's reshuffling, Russia received a vote of confidence from foreign investors, raising $685 million from international markets with a seven-year bond priced to yield 4.75 percentage points over German government bonds. The government is planning to raise nearly $4 billion in eurobond offerings this year, and the March issue was the first since last year's Asian crisis. The Moscow city government announced further eurobond issues of $275 million.

Russia has issued three previous eurobond tranches since November 1996. Some analysts had expected the eurobond issue to be delayed until a new Cabinet was formed. Others said the move was meant to indicate that no political crisis was under way and that a delay could have upset foreign investors more than the govemment reshuffle.

The cities of Moscow, St Petersburg, Nizhny Novgorod, the Sverdlovsk region, the republic of Tatarstan and other Russian municipalities successfully placed eurobonds last year or announced plans to do so this year. Moscow became the first Russian region to obtain an international credit rating in 1997. Standard & Poor's and Moody's Investors Services rated the City of Moscow BB- and Ba2, respectively, the same speculative grades as Russian government bonds received on the eve of Russia's first eurobond issue.

Earlier in March, Moody's lowered Russia's foreign currency borrowing rating a notch to Ba3, downgrading a string of public sector and corporate bonds. Analysts played down the move, however, saying it had largely been predicted and was a reflection of past economic difficulties and the impact of the Asian financial crisis rather than of current fundamentals. Investor reaction to the downgrading was mitigated by the concurrent IBCA rating of Russia's foreign currency borrowing, two notches above that of Moody's.

The Russian stock market as a whole plummeted 8% at the beginning of April. On April 3, markets were particularly volatile, recording a 3% drop when the State Duma failed to vote on Kirienko's appointment. On the same day, Boris Brevnov, the reformist CEO of United Energy Systems (UES) stepped down, on the eve of a pivotal shareholders' meeting, sending the share price down more than 4%. The Russian Trading System (RTS), the NASDAQ-modeled electronic trading vehicle carrying most of the market, reported a trading volume of $84 million on April 3, with more than half of it coming from UES shares alone. UES closed at $0.3006, down 4.6% from the previous day, 8.6% from the previous week. Oil blue chip LUKoil dropped 2% on the same day, closing at $17, down 5.7% by the end of the week.