How to Revive Investor Confidence

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Russia's benchmark RTS Index has dropped nearly 50 percent since peaking on May 19 and nearly 30 percent since the outbreak of war with Georgia over South Ossetia. Addressing ongoing declines last week, President Dmitry Medvedev and other officials promised that the government has the power to return the market to previous highs and blamed the drop on the financial crisis under way in the United States.

Certainly, the developed world's credit crisis is affecting Russia's financial sector, as global markets are more interrelated than ever. But the causes of this market rout can be found predominantly within Russia's domestic market.

The stock market imploded for a single and simple reason. Share prices had risen until the potential returns ceased to justify the risks of investment. After seven years of positive performance, Russian equities peaked with consensus upside of just 20 percent. Lower potential returns, coupled with peaking commodities prices, focused investor attention on the risks. Then a series of disappointing events over the summer proved that Russia's risk profile had not declined as quickly as potential returns. In fact, it had increased. Equity prices swiftly corrected to restore the most basic rule of finance: Returns should be commensurate with the risks of investing.

There are currently two remedies under consideration for tackling the market crash: oil tax cuts and investing state reserves. A plan to cut oil taxes is welcome and overdue. Long predicted, such fiscal change would improve the fundamental value of the country's oil and gas sector, its largest index component. Conversely, investing portions of the National Welfare Fund in the stock market would substantially compromise all that Russia has achieved in eight years of commodity-driven growth.

While this summer's equity market collapse has been a disastrous event for all involved, like all problems, it can also be viewed as an opportunity. With more than $500 billion wiped off the nation's market capitalization, the country's stocks can't fall much further. Now is the perfect time to implement the aggressive changes necessary to turn Russia into a global financial center.

The necessary foundations could be set now, while the market is already sold far below fundamental logic. The key steps that need to be achieved include:

• Eliminate the shareholder caste system. At present, wealthy government-friendly individuals and companies occupy a higher caste, foreign businesses and smaller companies are blatantly treated as lower castes. If Russia is to become an international financial center, it must implement equal rights for all types of corporation and investor.

• Institute transparent legal controls. The bureaucracy should stop selectively applying gray laws. This weakens confidence in the clarity and application of the law.

• Recognize that the world is tightly interconnected and design a foreign policy with this in mind. Russia has a rightful place at the top table of global decision makers, but acting unilaterally alienates global investors, who crave predictability and stability above all else.

• Complete economic objectives. Certainly Russia has moved far economically since its default 10 years ago. The stock market, which is a means of observing economic progress, peaked more than 6,000 percent above its 1998 low. But now the same risk-reward imbalance that hit equities threatens the economy itself. As Russia gets richer, growth will naturally slow. Yet, the costs and complications -- the risks, in other words -- of doing business here continue to rise. To achieve sustainable long-term development, Russia must move fast to diversify its economy and reduce corruption. At the same time, lower inflation would maximize real growth.

The market is now oversold and offers an excellent buying opportunity, but this inflection point offers far more. If the government takes these decisive steps, it can build a sustainable foundation for its economy and capital market. Unfortunately, the proposals currently reverberating around the market offer no such long-term solution.

Many participants support the idea of investing the National Welfare Fund into the local equity market. As justification, some cite that the United States cut interest rates or bailed out financial firms whenever its market starts crashing. Yet, these two ideas are starkly different. Washington acts to correct the economic causes of equity market declines.

At stressful junctures, it is crucial to differentiate between cause and effect and act appropriately.

Cutting oil taxes will help at the margin. In addition to boosting company valuations, it will reassure investors that there is a plan to sustain budget revenues by preventing production declines. By contrast, pumping the National Welfare Fund into the equity market will dramatically compromise Russia's greatest modern achievements: economic stability and low sovereign credit risk, achieved through responsible fiscal management. The government can do much with its reserves to benefit the country, but investing them into the domestic equity market will put them at risk of collapsing exactly when they will be most needed.

Sovereign wealth management is a controversial subject. But the International Monetary Fund is about to release a code of conduct, and there are recognized best practices for protecting national wealth for future generations. The global financial centers of the 21st century will define themselves by adopting these best practices. Filling the role of domestic equity investor of last resort is certainly not a recommended strategy.

The equity market has halved, yet commodities prices are resiliently elevated, despite recent deep corrections. With a strong and determined government in control, Russia has a unique opportunity to implement the necessary changes to become a 21st-century global financial center. The right choices at this inflection point can set the country on the path to a bright and prosperous future.

James Beadle is a Moscow-based investment strategist.