Going From Absolute Bust to Boom in 10 Years
- By Alexander Pertsovsky
- Aug. 20 2008 00:00
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For anybody who lived through it, Aug. 17, 1998, will remain seared in his memory. I remember arriving at work and watching the headlines in growing disbelief as Russia's financial system imploded. First, the announcement that the government of Boris Yeltsin would default on $40 billion worth of GKOs. Second, that the ruble would no longer be supported, signaling a 50 percent devaluation before the end of the month. Third, the declaration of a moratorium on banks repaying their foreign debt, effectively forcing the majority of the banking sector into receivership.
It was, by some measures, the single biggest financial write-off in history. The shock reverberated throughout global financial markets. By the end of the year, the fallout from Russia's crisis had caused one of the world's most respected funds, Long-Term Capital Management, to cease operating. The global cost ran into the hundreds of billions of dollars.
Who would have thought then that 10 years later some of the best investment opportunities in the world would be in Russia? That Russia would have one of the biggest financial sectors in Europe? And that the biggest danger to global markets was the wild exuberance of the U.S. and European financial systems? The irony of the 10-year anniversary of the August 1998 crash is that the biggest danger to Russia's credit markets and asset prices is the fallout from a crisis in the developed world.
This may seem a bold statement given the 25 percent decline in Russia's equity market in the last two months. Many have blamed the decline on events in Russia, and certainly the volatility of the equity market has caused skittish global investors to re-evaluate their perception of risk. But as the last 10 years have proved, the only thing more volatile than the markets is the sentiment of investors toward Russia. In 1998, when the market was at its cheapest, Russian equity was commonly described as "toxic waste." Four years and a gain of 300 percent later, Russia's equity markets were hailed as the "best performing in the world." At the beginning of this year, many called the country a "safe haven" for global capital. Now it is considered "high risk." Meanwhile, earnings and the economy have performed largely in line with the market's expectations. I confidently predict that at some point in the next 12 months, Russian equity will once again be the darling of the investment world. It will probably be time to sell.
I believe that the recent decline is a painful dip caused mainly by a sharp fall in the oil price. After all, Brazilian equity has fallen by 27 percent from peak to trough this year, and Saudi Arabia is down 29 percent. The recent sell-off in Russia is really part of a worldwide rotation out of commodity-producing countries and into commodity consumers. It has been a painful two months. But the main lesson from the experience is not that Russia has something uniquely wrong with it, but rather it is now inextricably linked with global markets.
The resurrection of Russia's financial system from a bankrupt pariah to an integral part of world finance has been perhaps the most extraordinary recovery story in global finance of the last 10 years. Tremendous value has been created. In the aftermath of August 1998, it became theoretically possible to buy the entire Russian equity market -- including all the natural resources of Gazprom, the oil sector and Norilsk Nickel -- for $50 billion. Today, there are four individual companies that are worth more than that. The equity market as a whole is now worth more than $1 trillion at market value, and probably closer to $2 trillion if developed markets were not so gloomy.
As remarkable as the growth in value has been the spontaneous development of the country's financial markets. As the economy has expanded, demand has grown for increasingly sophisticated and liquid financial markets. With very little prompting from government, a combination of good local financial houses and the more farsighted international banks have met those demands. Russia's equity market turnover frequently reaches $7 billion a day, making it one of the most liquid in Europe. With the Finance Ministry careful to avoid the need to borrow, private corporations have been able to raise ruble financing to fund their businesses. More recently, an increasingly sophisticated futures and options market has developed. Turnover on the RTS Futures market is now in excess of $2 billion a day, which is more than that of the CAC or DAX futures turnover in France and Germany.
The brave decision to open up Russia's capital markets in July 2006 turbo-charged the development of Russia's financial markets to allow them to play a role concomitant with the country's growing clout in the global economy. All this from a financial system that by daily turnover was at one point in 1998 less than 10 percent the size of Turkey's.
So what about the next 10 years? The recent weakness has been ugly and is a reminder that financial markets never move in a straight line. At the same time, during a period of weakness, it is always important to keep an eye on the bigger picture. Russian asset markets remains locked into what is fundamentally a long-term, secular bull market. The shift in economic power from the West to the East is something that will define the next 10 years as much as it has the last decade. The growing economic muscle of China and India is virtually unstoppable. Globalization is driving the flows of capital and technology to power the catch-up of these economies with Europe and the United States. The demand for what Russia has to offer, from natural resources to technology, will therefore only grow, placing Russia in a fantastic position to play its historic and geographic role as the link between West and East.
This long-term optimism is something that is demonstrably shared by the business community. While portfolio investment may have been cautious about Russia in recent months, longer-term investment is higher this year than ever before. Moreover, the International Monetary Fund forecasts that Russia will have a $3.5 trillion economy by 2013, or roughly twice the estimated size it is today. To meet the demand for capital that these numbers imply, Russia's financial markets are going to have to expand in both size and sophistication at rates not dissimilar from that we have seen since 1998.
It may seem faintly ridiculous to predict that, in 10 years, Moscow could be spoken of as a financial center capable of competing with London or New York. But it would sound a lot less ridiculous than if we had predicted 10 years ago on Aug. 19, 1998, the success that Russia has attained today.
Alexander Pertsovsky is CEO of Renaissance Capital.