#20 - JRL 7139 Analytical department of RIA RosBusinessConsulting April 9, 2003 Capital to flow into Russia An unprecedented inflow of capital to Russia is expected this year: foreigners and large exporters started buying Russian assets actively Speaking at a meeting of the “Open Russia” club of regional journalists earlier this week, Senior Deputy Chairman of the Central Bank Oleg Vyugin said that the inflow of capital to the Russian economy in 2003 would be record high. In the first quarter of 2003 alone, Russian companies borrowed $3.3bn on foreign markets, and about $1bn was invested in the Russian economy by foreigners. An unstable situation on the international market, on the one hand, and high profit margins of Russia’s raw materials sector, on the other hand, attract foreign investments to the country. In addition, “raw material” earnings of Russian exporters, earlier taken out of the country, are returning to Russia. Amid unstable markets and a lack of choice for investors, Russia becomes a “magnet for capital”. Last year, capital flight from Russia’s private sector reached a record low level over the past seven years. According to the Central Bank, $10bn was taken out of the country in 2002, $6bn less than in 2001 and $14bn less than in 2000. At the same time, the inflow of capital to Russia increased. According to the Central Bank, foreign obligations of non-financial organizations in January-March 2003 reached $4.3bn. Economists say there are several reasons for that. Firstly, it is high oil prices, which were around $30 per barrel in the first quarter of 2003. “Profits of exporters were rising, and, accordingly, export proceeds were rising, too,” Olga Belenkaya, an analyst at the Olma investment company, told RBC Daily. “Clearly, with profit margins of raw material exporters being high, investors give them loans readily. On the other hand, low interest rates on international financial markets fuel the demand for corporate borrowings from non-financial Russian companies,” she noted. Raw material earnings of domestic exporters, earlier taken out of the country and now being repatriated, account for a substantial portion of capital inflow to Russia. For example, Cyprus, one of the most popular offshore centers for Russian businessmen, remains one of the main investors in the Russian economy. “Because of a continuing recession in the West, and, as a result, falling stock indices, investors are turning to the developing markets,” Alexander Kuzmichev of the BKG company told RBC Daily. “Russia, which has been growing steadily over this entire period, becomes attractive for investments,” he added. In 2001-2002, export-oriented companies showed a great interest in acquiring processing companies in the Commonwealth of Independent States and Eastern Europe, but this tendency is weakening. “Market leaders became convinced that, to strengthen their positions, they have to take care that processing companies be built in Russia,” Alexei Kazakov of the NIKoil company told RBC. Perhaps, the current increase in the capital inflow is due to the coming re-division of the land market. Although the land reform “slowed down” ahead of the presidential elections, nobody doubts that this issue will be solved within the next few years. “Large Russian companies are preparing for the re-division of the land market, which will require huge investments from them. To solve this important issue, they will both repatriate their capital and borrow on foreign markets,” Mr. Kazakov said. Portfolio investments make up 80 percent of investments pouring into Russia. According to analysts, most of direct investments in Russia are made in the consumer sector. They say the growing consumer demand and high profitability of the consumer market will be attracting investments to this sector over the next five years or even longer. “Apart from a deal with the British Petroleum, the largest part of direct investments is being made in trade, the beer sector, the production of consumer goods and food products,” an analyst with Troika Dialog brokerage told RBC Daily. “This is a highly profitable sector, and, I think, the tendency for increasing direct investments in this sector will remain in place,” he added. Meanwhile, the largest part of portfolio investments is still received by export-oriented companies in the oil, gas and metal industries, and, to the lesser extent - in the fishing and wood-processing industries. “Many large financial and industrial groups in Russia are now striving to complete the restructuring of their portfolios. This is confirmed by the fact that the volume of mergers increased in 2002. In order to complete the process of consolidation and creation of horizontally and vertically integrated holding companies, financial groups will need additional resources,” Mr. Kuzmichev said. He noted that there was a tendency for growing portfolio investments in the processing industry in ferrous and non-ferrous metallurgy. “For example, the Russian Aluminum group does not want to produce ‘prime aluminum’ any more. Instead, it is investing in the development of the processing industry,” the analyst said. According to analysts, the tendency towards growing foreign investments will remain in place in Russia over the next few years. “Russian companies still have a low debt/equity ratio, that is why they need loans. On the other hand, with a steady 4 percent growth in Russia, foreigners are interested in investing in the Russian economy,” Mr. Ivanov believes. For his part, Mr. Kazakov expects that Russia’s investment rating will be upgraded soon, which will make Russia more attractive for foreign investors. “The Central Bank will be able to ensure the stability of the ruble’s exchange rate, because it has been accumulating its gold and currency reserves over the past few years. They are expected to reach $60bn by the end of the year. In addition, the political situation is also stable in Russia. Indeed, there is no real alternative to the incumbent president in the coming presidential elections. That is why investors can expect that there will be no major economic and political changes in Russia over the next four years,” Mr. Kuzmichev said. On the other hand, experts say that an increase in the capital inflow could also have negative consequences for the Russian economy. A massive inflow of dollars into the country will force the Central Bank to print more rubles, at the same time buying dollars and euros from exporters. But this printing would not be secured by a corresponding increase in the productivity of domestic demand industries. The budget will also be unable to remove the excess ruble liquidity, because it is forecast to have a lower surplus. And an inflow of unsecured rubles might fuel inflation. To prevent that, the Central Bank will have to “let the ruble free”, which will lead to the strengthening of the national currency, a decrease in the profits of exporters and a boost to the competitiveness of imported goods. “The Central Bank is facing a dilemma: whether to continue accumulating its gold and currency reserves, preventing the ruble from strengthening in real terms, or to let the ruble ‘float freely’ and decrease the profits of exporters,” analyst Sergei Pukhov said. However, according to experts, the situation might become critical only if oil prices remain at $30 per barrel. In addition, the government has another option to get rid of the excess liquidity. “It can be used on making early debt payments,” Mr. Pukhov believes.