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Russia bank reform needed to prevent bubble-W.Bank
By Andrew Hurst

MOSCOW, June 6 (Reuters) - A dangerous speculative bubble may be building as money floods in to Russia but a reform of the country's tiny banks offers the best hope of a cure, the World Bank said on Friday.

Christof Ruehl, World Bank chief economist in Russia, said an undersized banking industry was in no fit state to absorb the rush of funds into the country and put them to productive use.

"Russia's banking sector is not prepared to be hit by an avalanche of liquid funds. It has no capacity to absorb them or to facilitate an efficient allocation of these resources," he said in a report made available to Reuters.

As a result, much of the money coming in is likely to be invested in a handful of giant conglomerates and retailing and real estate ventures in Moscow and St Petersburg.

And prices of these assets look likely to soar. A large and efficient bank system would help fix the problem by spreading money more evenly around the country.

Hopes for banking reform were dealt a blow earlier this week when the state Duma postponed a first reading of a law introducing universal deposit insurance, seen as a cornerstone of a modern banking system, until September at the earliest.

The law also calls for a big increase in the central bank's powers to supervise the banking industry.

Analysts fear that with a presidential election looming in March 2003, up to a year may go by before the Duma passes the bank reform.

"The banking sector in its present shape is the bottleneck which prevents funds from flowing into the areas where they have the highest use," said the report.


Russia badly needs a network of big modern banks to channel savings into productive investment, a process known as "intermediation," which is one of the engines of economic prosperity in advanced capitalist countries.

"While asset prices in Moscow have started to soar, people elsewhere can't get money to fix a shop, or build a road or pay their teachers," it added.

The inflow of money into Russia looked likely to accelerate in the months and years ahead, Ruehl said.

Investment inflows jumped to $20 billion last year from $9.5 billion in 1999, the year after a financial meltdown brought the banking industry to its knees, and have gathered speed in the early months of 2003.

"It is not inconceivable to expect inflows exceeding 10 or even 15 percent of GDP, if political and economic stability prevails and so long as the rest of the world has little to offer by way of investment opportunities," the report said.

With up to $250 billion held by Russians offshore the potential is there for the flow of money back into Russia to turn into a an uncontrollable flood.

"What usually happens in such circumstances is that banks try to cope with the influx of liquidity by building up assets, they increase lending and investment activities," he added.

"Typically this carries the danger of building a bad loan portfolio -- a credit bubble -- and of bidding up asset prices."

Ruehl said he did not believe Russia, whose economy is enjoying a fifth straight year of robust growth after a debt default in 1998, was in danger of getting into trouble any time soon. "There is no crisis imminent in Russia."

But as hopes for an early banking industry shake-up appear to recede, the danger of a financial bubble developing which could lead to another 1998 style crash is slowly rising.

"Short of restricting capital inflows, the only protection against such an unpleasant scenario is to generate a banking and financial sector which is strong, competent and hence fortified against the temptations of "easy money," said Ruehl.

"This is difficult in the best of circumstances. In Russia not much has been done in the good years to accelerate banking reform," he added.

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