Scared of the Stock Market

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In light of the Russian stock market's troubles, it is imperative that the country attracts long-term individual and institutional investors to prevent future market collapses.

  Aside from the defaults on subprime mortgages and the crash in the roughly $500 billion in mortgage derivatives, one of the main problems that led to a full-scale financial crisis in the United States was the country's extremely high rate of internal debt. That problem is far more critical in the United States and Europe than in Russia, where people have not grown accustomed to living with debt. Rather than running up the national debt by printing hundreds of billions of dollars to solve the financial crisis, U.S. leaders could have demanded tougher credit and monetary standards across the board, but such measures are unlikely during election campaigns.

But unlike in the United States, Russia is not going through a financial or economic crisis. We had a liquidity crisis that only an unprecedented infusion of $60 billion in government funds was able to stem.

The sharp drops in the stock market over the past four weeks were followed by the some $40 billion in capital outflow from speculative investors. At the same time, if you look at the country's economy as a whole and the stock market in particular, there are no objective reasons why the markets plummeted as much as it did -- 47 percent in four months.

The absence of long-term individual and institutional investors, which would normally provide a safety cushion against this level of capital flight, is Russia's fundamental investment obstacle. By providing emergency funding, however, the government helped avert an even greater drop. Its response was decisive and successful, although some observers feel that it came too late.

From now until the end of the year, a 20 percent rise in the stock market from current levels is realistic, but of course this will depend on the volatility of world markets and particularly on further developments in the U.S. and European financial sectors. The primary factors influencing Russia's stock market will be tax liberalization, commodities prices and the global financial crisis. It is safe to say, however, that if the world economy worsens, Russia's market will not grow.

Today, Russia's stock market is still highly dependent on the movement of foreign capital. The huge capital flight from foreign investors exposed the vulnerability of the country's stock market. Moreover, much remains to be done to turn the ruble into a global, or at least regional, reserve currency and to turn Moscow into a global financial center.

To increase investment, it is critical that the government tackle the country's high inflation. According to Finance Minister Alexei Kudrin, the rate of inflation will actually increase this year to 13 or 14 percent. The next step is to institute tax incentives that would make it attractive for Russians to put their money into long-term investments. Lawmakers have recently introduced new pro-investment legislation, and this has been a cause for optimism in the business community.

In addition, Russia must increase the number of its private and institutional investors in the stock market. Even though institutional investment is growing by 50 percent annually, it still constitutes a mere fraction of the overall market.

The options available for Russia's pension savings, which totals $20 billion, is another area in need of improvement. These funds are not earning adequate investment returns because the number of companies that they can invest in is limited. The investment options should be gradually expanded to increase the rate of return.

One of the largest hurdles to attracting long-term investment is that Russians are very leery of investing in the stock market. This is compounded by fly-by-night financial investment companies that continue to "guarantee" big returns on investment. These activities require much closer government regulation.

The government and asset management companies also need to increase people's understanding of the financial markets. The problem is that when people lack even a basic understanding of proper investment practices, there is a danger they will fall victim to pyramid schemes. The 60 percent annual returns that were common a few years ago are now a thing of the past. The rule of thumb is: The higher the return, the greater the risk. Investors need to understand and take responsibility for the investment strategies they choose.

About 500,000 Russians -- or roughly 0.5 percent of the labor force -- own stocks through the country's mutual funds. That figure is many times higher in more economically developed countries.

Another reason for the low investment rate is that Russians are not accustomed to planning for the long term, and there is one very good reason. for this: Their life savings have been devalued more than once during the past two decades. Moreover, it is difficult to convey to Russians the basic principles of long-term investing -- do not try to catch the market at a low point, do not change your long-term strategy in reaction to the short-term volatility of specific securities, and do not let daily market fluctuations influence your long-term investment strategy.

Nevertheless, I remain optimistic about the mid- and long-term outlook for the Russian stock market. I suspect that the worst of the crisis is over, and in 2009, as the weakest players will be absorbed by stronger ones, we will see a major consolidation -- and strengthening -- of the country's financial institutions. And with this, we should see an improvement in the investment climate and an increase in the number of Russians and foreigners investing in the stock market.

Andrei Podoinitsyn is CEO of UFG Invest in Moscow.