The Emergence of the Private Sector in Russia:

A Financial Market Perspective

 

 

 

 

D. Roderick Kiewiet

California Institute of Technology

and

Mikhail G. Myagkov

University of Oregon

 

 

 

August 1997

 

 

 

 

 

 

A preliminary version of this paper was delivered at the Annual Meeting of the Midwest Political Science Association, Chicago, Illinois, April 10-12, 1997. We would like to thank Peter Boessarts, Oleg Bondarenko, Lance Davis, Mikhail Filippov, Tracy Guyer, Mike Herron, Tom Palfrey, and Phil Roeder for their comments and criticism. We would also like to thank Susan Powell and Carolyn Gray for their work on the graphics. The findings and conclusions reported in this paper are not to be taken as investment advice. Past performance is not a guarantee of future results.

"Nothing is impossible in Russia except reform"

---Oscar Wilde

 

Introduction

By most accounts, economic reforms that have paid off handsomely in other formerly communist countries seem not to be working in Russia. Goskomstat reports that gross domestic product fell in 1996 for the fifth year in a row, leaving Russia with an economy approximately half as large as it was in 1990. The distributional consequences of this slide, according to many observers from Russia as well as the West, are appalling. The collapse of communism is seen to have impoverished most Russians, ripping away the social safety net from tens of millions of workers and pensioners (Varoli 1996). At the same time, the privatization process, combined with the virtual collapse of the state’s authority, has allowed the country’s vast resources to be absconded by a small clique of former Soviet ministry officials, factory managers, corrupt financiers, ruthless entrepreneurs, local and regional political bosses, and gangsters (Holmes 1997). Customers fail to pay their bills, employers fail to pay their employees, and citizens fail to pay their taxes, creating a vast payment-arrears problem that threatens to bring business to a grinding halt (Morvant and Rutland 1996, 1997). In a country where "the only lawyer...is the Kalashnikov" (Remnick, 1997, p. 36), business disputes are resolved through violence and intimidation rather than in courts of law. Perhaps most telling of all, falling birth rates and declining life expectancy, usually attributed to the hardship and stress created by market-oriented reforms, combine to produce an actual decline in the size of the country’s population. Indeed, there are few countries in the world where news reports paint a bleaker picture.

Of theories as to why the course of economic reform in Russia has imposed such great costs and achieved so little in return, there is no shortage. Many blame rampant fraud and corruption, and the stifling influence of powerful and pervasive criminal organizations. This criminality is bad in and of itself, but it is also seen as symptomatic of an even deeper problem -- a dearth of social capital. According to Fukuyama (1995), "There are indeed truly individualistic societies with little capacity for association. In such a society, both families and voluntary associations are weak; it often happens that the strongest organizations are criminal gangs. Russia and certain other former communist countries come to mind, as well as inner-city neighborhoods in the United States" (p. 28).

Other explanations for the alleged failure of Russian economic reform point to self-defeating government policies, i.e., arbitrary, capricious, and ever-changing tax laws, regulations ranging from arcane to outrageous, continued ambiguity of property rights, and a poorly functioning judicial system. Others cite the past and continuing cost of imperial ambitions (Kontorovich 1996), or similarly, the unrealistically grandiose visions of New Russian businessmen (Flint and Klebnikov 1996). Russian workers, especially those in the agricultural sector, are said to have no stomach for the demands of the market, such as punctuality, hard work, and sobriety. A more humane but nonetheless reform-defeating factor is the persistence of Soviet-style paternalism; though now in charge of an ostensibly profit-making enterprise, factory managers feel responsible for the welfare of their employees. They thus keep millions of redundant workers on the payroll, retain inefficient production lines, and eschew the physical and organizational restructuring required to create a profit-making enterprise (Morvant and Rutland 1996).

The apparent failure of economic reform in Russia reinforces the image that Russia is somehow a special case, and a basket case at that. Former Soviet bloc countries, concluding that the return of economic statism and political authoritarianism is only a matter of time, seek the insurance policy that is NATO membership. Russia, in the words of Financial News columnist Yevgenii Vasilchuk, "is moving rapidly toward complete intellectual and industrial degradation, financial disorder, the formation of a criminal elite, and regional disintegration from the federal center" (quoted in Rutland 1997, p. 81.)

A small but persistent band of contrarians proffers a very different prognosis concerning the impact of economic reform and the future of the Russian economy. Åslund (1994, 1995, 1996) writes that market-oriented reforms have in fact been effective in reviving an economy that had virtually collapsed under Soviet communism. The orgy of rent-seeking that characterized the early phases of privatization (wherein it was possible to buy goods at fixed state prices and sell them at much higher market prices, and to convert biznelichnie into real money) has passed, and the transition to a market economy is well on its way. Based upon his continuing interviews with ordinary Russian citizens and businessmen, Shama (1996) concludes that the picture of economic desolation painted by Goskomstat simply wrong. Russian gross domestic product and average income levels are actually about twice as large as official statistics indicate, and the economy has been growing rapidly since 1994. Even Goskomstat reports that real wages are rising (along with automobile sales and residential construction) and that the number of Russians living below the poverty line is falling. Layard and Parker (1996), similarly, argue that the far-reaching reforms instituted by the Yeltsin government have generally accomplished their goals, and that Russia’s highly educated work force and vast natural resources provide the groundwork for a sustained economic boom.

So who is right? In this paper we seek to shed some light on this question by examining data from what is generally accepted to be the most efficient and unbiased aggregator of information available--the financial marketplace (Malkiel 1966; Fama, 1970). In recent years, political scientists have increasingly used changes in the prices of financial securities to gauge the impact of innovations in government policy. The assurance that market reactions to political phenomena accurately reflect the fundamental, underlying reality of the situation comes primarily from investors’ financial incentives. As Roberts (1990) notes, "The market imposes tremendous sanctions upon those failing to judge accurately the implications of political events. To this end, investors .. engage substantial resources in the acquisition of costly political information" (p. 295). We are confident, then, that movements in the relative prices of various Russian securities provide an efficient, unbiased assessment of the degree to which reform in Russia has succeeded or failed.

First, if reforms have been a failure, we would expect investors to remain interested primarily in securities that minimize risk and require only short-term commitments of their capital. The success of reform, on the other hand, should make more attractive investments that are more speculative, less liquid, and longer term, but that on balance can be expected to yield a higher rate of return. To investigate this hypothesis we examine trends in the market for Russian Treasury bills (GKO’s), and then compare yields on GKO’s with the returns associated with stocks of major Russian companies. The period covered by this and subsequent analyses runs from July 1995, by which time most of the fundamental elements of the Yeltsin reforms had been put in place through June 1997.

Secondly, we hypothesize that if the fate of Russian economic reforms is precarious, the stock prices of major Russian companies should be extremely sensitive to major political developments. We thus examine the reaction of Russian securities markets to the Duma Election of 1995, the Russian Presidential Election of 1996, and Yeltsin’s prolonged struggle with life-threatening coronary and respiratory ailments. In a similar vein, we compare the performance of firms situated in different regions of the country and thus subject to the influence of very different local authorities.

Finally, a charge trumpeted by the communists and other critics is that Russian economic reforms have simply allowed the country’s vast natural resources to be exploited by Westerners working in cahoots with small cliques of New Russians. Others do not invoke conspiracy theories, but nonetheless assert that reforms have failed to invigorate most sectors of the Russian economy, which thus remain quite backward and unable to compete. In the case of raw materials, on the other hand, there is very little value to be added, and thus Russian companies with large reserves of natural resources are quite attractive to investors. As a result, shares of these companies should out-perform those of companies situated in other sectors of the Russian economy.

In testing these inter-related hypotheses we thus seek to gauge the riskiness of investment in the emerging Russian private sector, and to thereby better assess the prospects for sustained economic growth. The reader is cautioned to keep in mind the dictum that stock prices tend to fluctuate, and that our conclusions are tentative. It is our contention, however, that the financial markets provide a clearer picture of what is currently happening in Russia today than alternative sources of information, such as Western news reporters or official government statistics.

Russian Treasury Bills (GKO’s) and Russian Stocks

Russian zero-coupon Treasury bills, known as GKO’s (or, in the parlance of the trade, as geckos) are available in three-month, six-month, and twelve-month maturities, and are issued in denominations of one million rubles.1 GKO’s thus represent a very short-term investment. GKO investors can also avail themselves of a very liquid secondary market, and the risk of default by the government is negligible; the communists would likely take several measures to roll back free-market reforms were they to return to power, but in all likelihood they would not repudiate state debt. Until recently, though, holders of GKO’s faced enormous risks from inflation.2 According to official figures, the Russian CPI rose by 844 percent in 1993, 202 percent in 1994, 131 percent in 1995. For accepting this risk investors were able to earn extraordinary real rates of return, at times exceeding 100 percent in dollar terms.

As these figures indicate, however, the pace of inflation slowed markedly during this period, and it has continued to do so. As shown in Figure 1, by late 1996 inflation in Russia had fallen to an annualized rate of about 12 percent. The second trend line plotted in Figure 1 is the (monthly) average secondary market yield for GKO’s of all maturities. As one would expect, as the rate of inflation has dropped over the past couple of years, nominal interest rates have correspondingly fallen to under 20 percent. Moreover, the real rate of return on GKO’s (i.e., the nominal yield minus the rate of inflation) has dropped to a mere five percent or so. This is high compared to US T-bills, but a far cry from the rates of that were available fifteen months ago.

Figure 1 about here

An intriguing feature of the data series portrayed in Figure 1 is the jump in GKO yields in April and May of 1996. As is readily seen, this run-up is not associated with either a contemporaneous increase in inflation or in a subsequent increase, which the GKO market may have been (incorrectly) anticipating. Because most reasons given for this spike in GKO yields are based upon its temporal proximity to the 1996 presidential election, we will have more to say about it later when we discuss the reaction of Russian financial and equity markets to political events. Suffice it to say for now that it is important to keep in mind that by June and July GKO yields had resumed their rapid rate of decline, and that despite the long-run correlation one expects (and does) see here between the rate of inflation and interest rates, in the short run this relationship can be quite erratic.

One of the first and most important goals sought by Russian reformers and their international backers was monetary stability, and these data on inflation and interest rates clearly show that this has largely been achieved. Additional evidence of the ruble’s return to respectability comes from Peresetsky and de Roon (1997), who show that by the end of 1995 the risk premia in the ruble/dollar futures market had come to approximate that of other major currencies such as the British pound and German mark. We think it actually makes more sense to think of monetary stability as a precondition for real economic reform, but this of course detracts nothing from the achievement. As we will see shortly, however, the key thing for purposes of our analysis is that we can accept GKO’s as a very low-risk investment. They may not be the "risk-free" asset that US T-bills are characterized to be, but they are probably the least risky investments that can be made in Russia today.

A basic principle of finance is that higher expected returns on investment come at the price of bearing greater risk. In this country, for example, returns from investing in the stock market have, in the long run, been much higher than yields associated with T-bills, but those who hold stocks necessarily expose themselves to the risk of sudden and potentially calamitous declines in share prices. Similarly, the tradeoff between risk and return implies that when the "risk-free" rate of return increases, the prices of riskier assets fall. Although the correlation is far from precise, the stock market thus tends to perform poorly when T-bills are paying out at high rates (generally during periods of relatively high inflation), as investors become less inclined to bear the risk of holding stocks (Malkiel 1996). Conversely, when T-bill rates fall to low levels, the risk-to-return ratio again favors stocks, and share prices rise accordingly.

Investors holding the stock of Russian companies face the same risk of inflation as do holders of GKO’s. Like investors in any other country in the world, they also bear the risk that the companies they invest in will not be as profitable as expected and that share prices will fall. And, like investors anywhere else in the world, those holding Russian stocks must constantly entertain the possibility of the government (or some future government) pursuing tax and regulatory policies that could seriously impinge on the profitability of certain companies.

But there are other risks as well. There is liquidity risk, as shares of all but a few Russian firms are thinly traded. The Russian Trading System has no central exchange, and there are can be long, inexplicable delays in settlement. There is also the risk of fraud. There are horror stories of shares being stolen, or the entries in share registries, the only proof of ownership of non-bearer bonds, simply disappearing (van de Waal-Palms 1996).3 Even when investors can be assured that the firm will not simply abscond with their money, it appears that obtaining information about Russian firms can be costly and difficult. When Russian companies actually began bothering to issue financial statements, they were typically based upon Soviet-era accounting systems that bear little resemblance to generally accepted accounting principles. This is particularly disconcerting when the average firm’s prospects of profitability are not very good. Based upon their 1995-96 survey of Russian businesses, Blasi et al. (1997) report that "Three quarters of Russian corporations are in need of radical and far-reaching restructuring. At least a quarter of these firms should be bankrupt" (p. 178). Finally, there is the possibility that in the future Russia could again be ruled by a government hostile to private enterprise. Such a government would likely make good on public debt, but could simply re-nationalize privatized companies and provide shareholders with little or no compensation.

To determine how large these additional risks loom in the minds of investors, we compare trends over the past two years in the GKO market, which we hypothesize to be affected primarily by inflation risk, with trends in the Russian stock market, which we hypothesize to be affected by concerns over inflation but also by the many other forms of risk we have just catalogued. If investors deem such risks to be manageable, we would expect to see the same inverse movement between T-bill rates and share prices that we see in this country. Indeed, this is precisely the prediction made by a leading analyst of the Russian economy in early 1996: "Once the GKO market becomes less attractive, Russian equities will become relatively more attractive to investors" (Bean 1996).

If, on the other hand, investors continue to view the risks of investing in Russian firms to be excessive and unmanageable, than we would expect them to stay out of the Russian stock market regardless of how low GKO rates might go. There are certainly any number of alternatives that investors, either Russian or non-Russian, might pursue, most notably those denominated in dollars. According to one estimate, in January 1997 Russian citizens purchased over $5.2 billion in foreign currencies, which is roughly equivalent to one-fourth of their monthly income (Zander 1997a). In addition, capital flight from Russia in 1996 was estimated to be around $12 billion, with Russians controlling some 60,000 off-shore companies (Zander 1997b). Alternatively, those investing in Russia might prefer real estate or other hard assets to the stock market. In any event, excessive risk associated with the Russian stock market implies that share prices would not necessarily move up as interest rates declined. If so, such risk, due to lack of liquidity, fraud, uncertainty over profitability, or the threat of re-nationalization, can be attributed to economic reforms that have either stalled or simply failed.

Another reason why GKO yields and Russian stock market returns may be largely uncorrelated, at least until recently, is because of government attempts to keep these two markets segmented. Until August 1996, foreigners were forbidden to purchase more than ten percent of any GKO issue, and, according to government statistics, officially accounted for only about one percent of the market. Conversely, according to many press accounts, purchases by foreigners dominate the Russian stock market. It is of course little wonder that Russian investors would eschew buying stocks when they could earn spectacularly high yields on relatively risk-free GKO’s.

Bean (1996), however, cites estimates that during this period as much as 70 percent of trading in the secondary market for GKO’s was done by or for foreign interests. And, beginning in August 1996, foreigners have been allowed much freer access to the GKO market.4 The subsequent flow of funds from abroad may have been at least partially responsible for the marked decline in GKO yields. Conversely, a large amount of stock purchases is probably accounted for by "off-shore" money that Russians invest through foreign banks and brokerage houses. We thus believe that the efforts of Russian authorities to keep non-Russians out of the GKO market, whatever the rationale for doing so, were largely unsuccessful, and that there is no practical way of determining whether funds entering the Russian equities market come from Russia or from abroad.

For this comparison of stocks and GKO’s we use data reported by Rinaco, a major Moscow brokerage house. The first is the simple yield to maturity associated with 90-day

GKO’s. This is a slightly different measure than that plotted in Figure 1, which was based upon GKO’s of all maturities, but as we shall see the two series track each other very closely. The stock market series is the Rinaco Plus Equal Weighted Equity Index (hereafter the Rinaco EWEI). It is comprised of about fifty of the largest Russian companies, which together account for most of the capitalization in the Russian stock market. GKO yields and share prices are both expressed in dollar terms, and thus net out the effects of both ruble inflation and ongoing slippage in the value of the ruble against the dollar.

Values for the two series from August, 1995 through June, 1997 are plotted in Figure 2. GKO’s clearly yielded impressive returns in the first part of the series, but, as noted previously, they have declined considerably as disinflation has occurred. As in Figure 1, we also see sharp spike in GKO yields in April and May of 1996, which occurred even though inflation was continuing on its downward path. Most importantly, though, the marked decline in GKO yields over the past couple of years has been accompanied by an equally impressive upward movement in the Rinaco EWEI.5 These data thus exhibit the hypothesized inverse relationship between GKO yields—the relatively low-risk asset—and the price of the riskier assets that are Russian stocks. With GKO yields at historically low levels, it appears that investors have increasingly concluded that the risks associated with the Russian stock market are not enough to outweigh the potentially large returns to be had there.

Figure 2 about here

One reason why the potential returns from investing in Russian companies are so great is because their share prices have been so low—reflecting, no doubt, the perception of substantial risk associated with the Russian equities market. This can be seen in the figures reported in Table 1, which compare the capitalization of Russian, Western European, and North American firms as a function of their physical assets. Based upon these various criteria of proven oil reserves, megawatts of generation capacity, or tons of production, shares of Russian firms have been trading at a few pennies on the dollar compared to American or Western European firms. In a similar calculation. Rinaco estimates that at the end of 1996 the capitalization per access line of Russian telecommunications companies was about six percent of that of comparable Brazilian companies. While it is true that there is no hard and fast relationship between a firm’s share price and the "book value" of its physical assets, it is instructive, and sobering, to consider that in early 1996 the total capitalization of all firms listed in the Russian Trading System was approximately $20 billion, which is about the value of Sears. The recent run-up in the Russian stock market has taken off from a very low bottom.

Table 1 about here

Be that as it may, it is by no means inevitable that low share prices must eventually rise. We think the takeoff in the Russian stock market results not only from the substantial decline in the rate of return associated with relatively risk-free assets (i.e., the GKO), but also from a substantial decline in the perceived degree of risk associated with Russian stocks. As many financial analysts have noted, over the past few years several major Russian companies have aggressively pursued a number of measures designed to reduce the risks associated with holding their shares. In many cases these investor-friendly innovations are required to comply with new regulations issued by the Federal Securities Commission, but, as Willer (1997) observes, it is also the case that Russian companies have chosen to adopt shareholder-friendly practices out of self-interest.

First, a growing number of Russian companies have registered their shares with independent, licensed registrars, a practice that presumably provides investors much greater confidence that their purchases of shares will be duly recorded and recognized.6 Russian companies have similarly undertaken a number of measures to make it more convenient and less costly for traders to transfer stock ownership. Most notably, the Russian Trading System, which currently utilizes the PORTAL software technology upon which the NASDAQ is based, has evolved into a far more investor-friendly system. Under the auspices of the Professional Association of Securities Market Participants (PAUFOR), market-maker firms must now provide firm bid and ask quotes with spreads not to exceed ten percent (Feller 1996).

Over the past few years several major Russian companies have also begun issuing financial reports in accordance with internationally accepted principles of accounting. The adoption of Western-style accounting standards is a prerequisite for the issuance of higher-level American Depository Receipts (ADR’s) and thus, for all practical purposes, a necessary condition for access to international capital markets.7 The Russian government has also encouraged this trend, granting a tax break in September 1996 to companies that adopted internationally accepted systems of accounting (Willer 1997). Not to detract from the far-sightedness of this policy, but it should be noted that the Russian government retains a large percentage of the stock of many of the firms it has privatized, and intends to continue auctioning off these shares over time. This provides them with significant incentive to encourage business practices, which, by reducing perceived risk, lead to higher share prices.

Turning back to Figure 2, we see that the upward movement in the Rinaco EWEI has taken the form of a series of spurts rather than a steady linear progression. There is of course nothing unusual in this, but it does raise the question of why the Russian market has taken off at certain times but stalled at others. In the next section of this paper we investigate the extent to which major movements in share prices, both up and down, are associated with some of the tumultuous events that have transpired on the Russian political scene over the past few years.

Political Events and the Russian Stock Market

Before turning to an examination of the sensitivity of the Russian stock market to political developments, it is useful to briefly review some of the major contributions to an area of financial analysis that is perhaps best described as "political event studies." Dating back to Mitchell’s (1903) classic analysis of how the changing fortunes of the combatants in the American Civil War affected the value of Greenbacks, studies of the response of securities markets to political events comprise one of the oldest fields of study in quantitative social science.

The hypothesis that has probably attracted the most attention is that equity prices rise in response to or in anticipation of the election of conservative, pro-business parties, or, conversely, that they fall in response to or in anticipation of the election of left-wing, pro-labor parties. Such price movements are presumably due to expectations concerning the impact of different party policies on taxes, interest rates, wages, corporate profits, and other factors that make owning stocks more or less attractive. Indeed, in a novel analysis Herron (1996) uses the reaction of stock prices and derivative securities to the changing pre-election odds of Conservative vs. Labor victory to gauge just how different the two parties’ policy priorities actually were!

Analyzing movements in the Dow Jones Industrial Average in the periods surrounding US presidential elections between 1900 and 1976, Riley and Luksetich (1980) conclude that the market does prefer Republicans---or at least it used to; their evidence of a pro-Republican bias is stronger in the prewar era than in the postwar era (p 553).8 Peel and Pope’s (1983) analysis of the ten British General Elections between 1950 and 1979 indicates that stock prices in that country tend to rise with Conservative victories and fall when Labor wins. Gemmill (1987), similarly, reports that the level of the FTSE 100 Index rose steadily during the month preceding the 1987 British General Election, as the passage of each day made the expected Conservative victory an increasingly sure thing.9 In a related study, Bachman (1992) finds that the election of right-wing parties in the US, France, Canada, and Great Britain is associated with a decrease in forward exchange rate bias, presumably in reaction to the prospect of relatively tighter monetary policy.

As for the Russian stock market, we would expect that it too incorporates the sum total of investors’ hopes and fears concerning the direction of public policy. One of the major ongoing threats to economic reform, of course, is the thoroughgoing opposition to them by the Communists and their allies. Although observers disagree as to what a Zyuganov regime would actually do if elected, in all likelihood a replacement of the current Russian incumbents by the Communists (or by a communist-backed coalition) would presage a much greater change in the direction of policy than the replacement of an American Republican president with a Democrat or a Conservative majority in the British Parliament with a Labor majority.

Our hypothesis, then, is that if major Russian companies are subject to a high degree of political risk, this should be reflected in extremely large movements in Russian stock prices as a function of political news. Specifically, we would expect prices to move sharply downward in response to information indicating that Yeltsin and his government are likely to fall from power, but sharply upward in reaction to news that his stay in the Kremlin is likely to continue. Share prices of Russian firms should thus have reacted negatively to the strong Communist and Agrarian showing in the December 1995 Duma Election, surged during Yeltsin’s successful campaign for reelection, and fallen once again as Yeltsin’s health failed, beginning with the heart attack he suffered near the end of the campaign.

Turning our attention once again to Figure 2, we see that in the four months or so preceding and following the December 1995 Duma Election the Rinaco EWEI drifted slowly but steadily lower, losing over 30 percent of its value between August 1, 1995 and March 30, 1996. This is consistent with a scenario that investors were becoming increasingly anxious about the pace and future viability of reform. On the other hand, the strong electoral showing of the Communists and Agrarians, which, as far as we can tell, most political observers had not fully anticipated, does not appear to have engendered a sharp market reaction per se. Instead, the market had been drifting lower and simply continued to do so. In short, the dismal showing of pro-reform parties in 1995 was not associated with any sudden, marked revisions of investors’ beliefs.

As has been widely heralded by most observers of the Russian business scene, Yeltsin’s come-from-way-behind victory in the July 1996 Presidential Election was accompanied by a rapid, sharp run-up in stock prices: between April 1 and July 9, the level of the Rinaco EWEI more than doubled. As is always the case in financial event studies, any simple, one-factor interpretation of these data is compromised by the fact that there were a lot of other things going on in Russia at this time that undoubtedly heartened investors. In April of 1996 the International Monetary Fund approved a three-year, $10.8 billion loan to the Russian government, and indicated that the loan would be withdrawn if the communists won and failed to adhere to the terms of the agreement (Zander 1996a). Soon thereafter the Paris Club rescheduled $40 billion of Russia’s debt to a 25-year term of repayment. During the pre-election period investors were also cheered by reports from LUKoil and several other large corporations that their profits in 1995 were sharply higher than in the previous year, and that the Central Bank of Russia was well on the way to making the ruble fully convertible (Zander 1996b).Even the grain harvest was larger than in the previous year. The spin on all these developments was decidedly pro-Yeltsin, but we doubt that it is realistic to attribute them all to a vast international conspiracy designed to assure his reelection.

As noted previously, however, during the few months preceding the 1996 presidential election GKO yields also rose dramatically, which is not consistent with investor euphoria over the prospect of a Yeltsin victory. While short-run changes in interest rates are consistent with any number of scenarios, it is worthwhile to consider some factors that may have contributed to this phenomenon. First, according to some observers, in early 1996 many companies became concerned that Zyuganov would win and therefore withheld their tax payments—why pay taxes to the government if they are just going to re-nationalize your company anyway? The result is that the government’s deficit ballooned, necessitating large new issues of GKO’s into a market that was already saturated with them, thus producing a tremendous rise in GKO yields.

Unfortunately, we see no evidence to support this account. The Russian government has chronically fallen well short of its revenue targets over the past few years, but there was nothing unusual about the second quarter of 1996. Federal budget revenues as a percentage of GDP were actually higher in the second quarter of 1996 than in the first or third quarters. On the other hand, expenditures were also up in the second quarter and the resulting deficit was somewhat higher than in the other quarters, but the volume of new GKO issues was entirely in line with long-run trends (Working Centre for Economic Reform 1996).

Another explanation for the pre-election jump in GKO yields is that in this period there was widespread perception a) that Yeltsin was going to win b) that keeping his campaign promises, which included the elimination of wage arrears and reimbursement for savings lost to inflation, would require somewhere between a doubling and tripling of the money supply, and c) that there was a real possibility that he might actually try to keep his campaign promises (see Treisman 1996). Soon thereafter, however, GKO yields move sharply downward in the (largely correct) expectation that the third part of the scenario was not developing.

The problem with this scenario is that we see no indication in press coverage of the 1996 election campaign that anyone attached much credence to Yeltsin’s campaign promises (or Zyuganov’s, for that matter). In our view, another factor to be considered is the consistently tight-money policy of the Russian Central Bank. Throughout the pre-election period the CBR showed no sign of wavering from its long-run commitment to lowering inflation. It maintained the ruble-dollar exchange rate in the tight trading "corridor" to which it had committed itself after the severe run on the ruble in October 1994. It continued its policy of allowing problem banks to go under, and, perhaps most importantly, did not allow the government deficit to be monetized through inflation. These policies could easily have provoked a sharp temporary increase in interest rates while simultaneously holding down inflation. In the US in the early 1980s, for example, the sharp upward move in interest rates engineered by the Federal Reserve is usually credited for breaking the back of inflation and the restoration of price stability.

With news that Yeltsin had won the election but wrecked his health in the process, in the ensuing month the Rinaco Index gave back much of its spectacular pre-election gains. As in the pre-election run-up, the subsequent fall in stock prices was considerably larger than what one would expect to see in this country in response to political events. At this point we would probably accept the hypothesis that Russia’s economic prospects remain highly uncertain, and that investment remains risky because of the possibility of adverse future political developments.

Remarkably, however, the market did not react negatively to the severe health problems that Yeltsin experienced over the next several months. After quadruple bypass surgery in November, a high-risk procedure given his underlying poor health, Yeltsin seldom appeared in public during a long period of recuperation. When he did reemerge he was beset almost immediately by pneumonia--a condition from which he again took several weeks to recover and which also suggests the persistence of serious underlying problems. Instead of declining during this period, however, the Russian market moved upward to the highest levels it had heretofore achieved in its brief history.

This could mean, of course, that the market anticipated that Yeltsin would eventually overcome his medical difficulties, which now seems to be the case.10 We believe it is more likely, however, that investors in the Russian stock market were becoming increasingly confident that the eventual departure of Yeltsin from the political arena would not result in the reversal of reform and the return of economic statism. As one financial observer summarized the winter of 1996-97, "Russian stocks were not affected by the gloomy economic news or the uncertainty surrounding the president, and the stock market reached record highs. Analysts expected this trend to continue" (Russian Business News, February 1997). As can be seen in Figure 2, this trend has indeed continued, with a vengeance. In the first six months of 1997 the Rinaco EWEI more than doubled, rising from 134.9 to 278.1. The Moscow Times Index showed even greater strength, rising by 133% during the same period.

Sectoral Differences

Besides examining cross-the-board movements in overall market indices, political event analyses have also investigated the impact that the election of different parties’ candidates have upon the share prices of particular industries, or even of individual companies. According to Roberts (1990), share prices of defense sector firms clearly benefited from the election of Ronald Reagan in 1980, as well as from the unanticipated election of a Republican majority in the Senate.11 Homaifer et al.(1988) report similar findings. In an analysis of the 1987 British General Election, Manning (1989), demonstrates that shares of British Telecom, which Labor had threatened to re-nationalize at its original (and much lower) issue price, responded even more favorably than the overall market to pre-election Gallup polls showing a Conservative victory to be increasingly likely. Herron et al. (1995) also finds important sectoral differences in the 1992 pre-election period in the US; as Clinton’s stock rose on the Iowa Electronic Political Stock Market,12 so too did share prices of firms in the pollution control industry and, somewhat anomalously, in the aerospace sector. Pharmaceuticals and cosmetics, presumably in anticipation of more aggressive consumer-oriented regulation, reacted negatively.

Is it the case that some sectors of the Russian economy were especially sensitive to Yeltsin’s election prospects, and that the share prices of firms in these sectors did particularly well in the three months prior to the July 1996 election? To answer this question we looked at movements in the share prices of the 49 companies reported on by Rinaco between April 1 and July 9. What we find striking about these data is the absence of large sectoral differences of firms in different sectors of the economy, including oil and gas, electrical utilities, steel, aluminum, vehicle manufacturing, and telecommunications. Fully 44 of the 49 companies in the Rinaco EWEI posted gains in the pre-election period. The only big loser was AvtoVAZ, the giant but essentially bankrupt auto-maker, whose share prices declined by 42 percent during this period. Apparently in the view of investors this company was likely to fare better if the communists returned to power than if Yeltsin remained in charge.

But what about in the "long run," which in the case of our data is the period running from July, 1995 through June 1997? As indicated earlier, a recurrent charge made by critics of reform from all across the ideological spectrum is that Russia is becoming a mere source of raw materials for the more advanced economies of the West. Holmes (1997), similarly, asserts that the failure of reforms to produce a nurturing business climate favors a sort of "smash-and-grab" investment strategy; as he puts it, "Long-gestation investment in productive facilities…is unlikely when fixed assets are difficult to defend against lethally armed extortionists. In such circumstances, capital tends to flow into the removal of natural resources that can be guarded at the site of extraction and during trans-shipment and that fetch a handsome price on world markets" (p. 36).

Other investment analysts put a more neutral spin on this situation, but nonetheless agree that the many impediments to stable economic growth that exist in Russia imply that the most attractive investment opportunities are in oil, gas, and mineral extraction, especially gold, diamonds, and the platinum-group metals. We call this the "banana republic" hypothesis. Again, the basic argument here is that most sectors of the Russian economy remain quite backward, and that economic reforms have yet to produce a favorable climate for business and investment. Consequently, investors find most attractive those firms that hold reserves of raw materials, as minimal amounts of value added are required for their products to be competitive in the world economy.

Counter to the banana republic hypothesis is what we call the "human capital" hypothesis. Russia has a large labor force, and the percentage of workers with college degrees and advanced technical skills is higher than in many Western European countries (Overland and Spagat 1966). Because education levels (human capital) and long-run rates of economic growth are highly correlated (Barro and Sala-i-Martin 1995) a crucial prerequisite for sustained economic growth in Russia is already in place. As for what this might imply for investment opportunities, we would expect, as the economic reforms of the past few years were put in place, that investors would bid up the share prices of firms in sectors of the economy that can most readily exploit Russia’s combination of high-quality, low-wage labor, such as electronics, aerospace, weapons systems, business services, computer software, and telecommunications. As it turns out, the only Russian companies of this type for which Rinaco has published price data are telecommunications companies.

In order to pose these hypotheses against each other we compare the changes in share prices experienced by firms in the resource extraction sector, i.e., oil and gas, versus the share prices of telecommunications companies between July 3, 1995 (the date at which Rinaco began providing share price data for most of the firms in its index), and June 24, 1997. It should be noted that the oil and gas companies in the Rinaco EWEI actually consists of thirteen oil companies and Gazprom, the giant natural gas monopoly. The telecommunications firms include the city telephone companies of Moscow and St. Petersburg, several region-based networks, and Rostelecom, the monopoly supplier of long-distance and international telephone services.

If share prices of the oil and gas group have out-performed the rest of the market, this would constitute support for the banana republic hypothesis. Support for the human capital hypothesis, on the other hand, would take the form of superior returns associated with telecommunications companies. By way of comparison we also examine the performance of firms in other sectors of the economy, including electrical utilities, vehicle manufacturing, aluminum, and metallurgy (primarily steel production).

Figure 3 plots share price time series for the 49 companies in the Rinaco EWEI, arranged by sector. We also summarize these data in Table 2, which reports average change in share prices by sector. As these data clearly show, prices of companies in the oil and gas sector have moved upward over the past two years, generating a return of 158%.13 The oil and gas sector has also greatly out-performed the core industrial sectors of aluminum and steel, and has kept pace with the vehicle manufacturing sector. Several of the telecommunications companies, however, rank among the top-performing stocks in the Russian market. Averaging across all firms in each sector, we find that over the time period of our study share prices have risen by over twice as much in the telecommunications sector than in the oil and gas sector, i.e., by 993% compared to 158 percent. To be sure, in July and August of 1997 (after the end of the data series plotted in Figure 2) a number of the oil companies posted spectacular gains in share prices; shares of Condpetroleum, Nizhevartovskneftegaz, and Varyeganneftegaz more than tripled in price. Even though share prices of most telecommunications companies have also continued to rise steadily during this period, updating returns to this later date does make the relative performance of the oil and gas sector look considerably better. Nevertheless, the conclusion to be drawn here is that the data are far more supportive of the human capital hypothesis than of the banana republic hypothesis.

Figure 3 and Table 2 about here

One possible reason for the relatively poor market performance of the major oil and gas firms is that they continue to face high levels of government interference in their operations. Yukos, for example, was "persuaded" by the government to freeze prices of the fuel it delivered to farmers during the spring 1996 planting season. (Zander 1996a). Another problem facing Russian oil and gas producers, most notably Gazprom, is that the government forbids them from shutting off supplies to delinquent customers (most notably the government). In the case of Gazprom, of course, it is hard to know where the government starts and the company ends; the government retains most of the outstanding shares, and tax revenue from Gazprom accounts for about a quarter of all federal government revenues (over 40% in June of 1997, when the company completely paid off its debt to the government).

The problem with this explanation is that the high-flying telecommunications firms, which are generally local monopoly providers of telephone services, are also subject to pervasive government regulation. They too must gain official approval (from regional public utility commissions) for tariff increases and other profit-enhancing measures, such as being allowed to cut off customers who fail to pay their bills.

Willer’s (1997) analysis points to another reason for the superior performance of the telecommunications companies and electrical utilities. According to his analysis of a survey of Russian brokers and other data, companies in these sectors of the economy have tended to be particularly scrupulous in their observance of shareholder rights. He attributes this to their greater need for investment capital, as suggested by relatively high fixed asset ratios, their relatively large size, and that they tend to have large amounts of their stock held by the government. Whatever the case, shareholder-friendly policies imply less risk and therefore, ceteris paribus, higher stock prices. We doubt, however, that this factor can account for most of the sectoral differences in stock market performance, because several oil companies including Lukoil, Chernogorneft, Surgutneftegaz, and Gazprom have undertaken (or are well on their way to doing so) the stock registry and accounting reforms required to issue ADR’s.

We think a much more important reason for the strong performance of telecommunications companies is that demand for their products and services has, as Willer notes, exploded under the transition to a market-oriented economy---exactly what one would expect to see as a highly educated labor force is increasingly employed by profit-seeking companies. According to a recent study of the Russian telecommunications industry, there is enormous pent-up demand for telephone service; in many regions of the country there are more orders for new telephones than there are telephones (Rinaco 1996). Shares of Russian telecommunications companies have thus been bid up for an entirely prosaic but nonetheless fundamental reason, and that is that they have an excellent outlook for long-term growth and profitability. All in all, then, data from the Russian stock market suggest that the exploitation of natural resources is not the main engine that will power future growth in the Russian economy. Investors appear to be counting instead upon firms that are playing a central role in mobilizing Russia’s impressive stock of human capital.

 

 

Regional Differences

Many observers of the Russian political and economic note that one of the main problems that the country now faces is that positive changes in the economy have occurred only in major cities such as Moscow, St. Petersburg, and Ekaterinburg. In contrast, people in the rest of the country, especially in rural areas, have lost all the benefits provided by the former regime and received none of the benefits of capitalism in return. More specifically, outside of the main metropolitan areas, economic reforms have resulted primarily in the bankruptcy of most factories and enterprises, leaving people unpaid and unemployed.

The political implication of such growing inequality is that people living in many regions of the country, particularly in the so-called "Red Belt," vote for old-style communist governors and representatives. In office, communist local authorities can do much to damage or to at least frustrate economic reform. They can impede the firm’s divestiture of its responsibilities for providing housing, education, transportation, medical care, and other social services (Bahl and Wallich 1996). They can block the acquisition of land and other property. Some oblast governments continue to impose retail price controls, to insist on inefficient joint ventures, and to subsidize large, ailing firms.14 The policies and actions of local and oblast governments can thus dramatically affect a firm’s profitability.

We would consequently expect private businesses to avoid operating in areas where the local authorities are disinclined to promote a favorable business climate. A number of hypothesis concerning financial markets follow. First, we would expect publicly traded firms to be concentrated in a few major regions and cities, particularly Moscow and St. Petersburg, but to be largely absent from other regions of the country where reform faces tougher sledding. Secondly, if a firm based outside of one of the major reform-friendly cities is traded, it would most likely be in the oil, gas, or mineral extraction industries, where, as argued previously, it does not require much human capital or marked-oriented consumers. Finally, we would not expect investors to be optimistic about investing their money into the infrastructure of regions where local governments are not supportive of reform.

Turning to the data, we find that the degree of geographical concentration in firm location is not very great. The 49 firms in our data set represent 23 different regions distributed all across Russia from the West to the Far East. Five of them (Volgograd, Astrahan, Orenburg, Lipetsk and Belgorod) are located in the "Red Belt" of allegedly anti-reform, anti-business oblasts, and fewer than one fourth of the companies in the Rinaco EWEI Index are based in Moscow, St. Petersburg, or Ekaterinburg. We thus reject our hypothesis about the over-representation of companies in pro-reform regions and their under-representation in anti-reform regions.

We have seen previously, of course, that contrary to conventional wisdom, companies in the oil and gas and sector have not been the big winners in the Russian stock market, but rather infrastructure-related firms such as local telecommunications and local electrical utilities. What we see here is that many of the latter companies are located in regions that one would consider to be reform-oriented and business-friendly. One example is Volgograd, a region that Yeltsin lost during the last election, and where a communist was recently elected governor. Two firms representing Volgograd Oblast are included in the Rinaco EWEI: ElektroSvyaz-Volgograd, the local telephone company, and VolgogradEnergo, the electrical utility. Have investors been willing to put their money into infrastructure in this supposedly business-hostile region? The answer is yes. ElektroSvyaz-Vogograd’s stock has gained more than 800% since August 1995, and VolgogradEnergo is up by 650% since the presidential election. The bottom line, then, is that it is not only business-friendly locations such as Moscow and St. Petersburg that are believed to have positive future economic prospects, but the more remote cities and regions as well.

Conclusion

The picture that emerges from our look at the "early returns" reported in by Russian financial markets suggests that investment risks related to political uncertainty have diminished considerably. GKO yields have fallen to single-digit levels and the share prices of major Russian firms have risen dramatically. The Russian stock market, which moved sharply upward during the period of Yeltsin’s extended illnesses, indicates that investors are confident that the movement of Russia to a market-oriented economy is no longer contingent upon Yeltsin remaining in the Kremlin. Investors have similarly bid up the share prices of Russian companies operating in cities and regions whose governments are ostensibly unenthusiastic about continuing reform. It is not Russia’s vast natural resources, however, that are sparking most investor interest, as what we call the banana republic hypothesis would predict. Investors in the Russian stock market appear to be wagering instead that it is the presence of quality human capital and developing infrastructure that make Russia’s economic prospects brighter than they appear to most Western observers.

Left to their own devices, major Russian companies have taken and will continue to take steps necessary to overcome investor wariness, primarily because it is in their self-interest to do so (Willer 1997). Many now produce financial statements based upon generally accepted accounting principles, and several have satisfied the requirements for issuing stock in the form of American and Global Depository Receipts. The Russian securities industry has also secured legislation and taken several independent actions to bolster investor confidence (Frye 1997).

There are, however, several important things the Russian government can do to reduce risk and uncertainty and to thereby encourage the ongoing process of capital formation in their country. Above all, they must continue fighting the good fight against inflation. Monetary stability bolsters investor confidence. Because it need not pay the extremely high real interest rates that obtain in high-inflation environments, by holding down inflation the government also lowers its borrowing costs and resultant deficits. And this, in a self-reinforcing way, makes investors even more confident that a return to high inflation is not in the offing.

Many observers of the Russian political scene express considerable concern over the government’s chronic inability to meet its revenue targets, fearing that this presages a new round of inflation. Although there is some basis for such worries, we think the shortfalls in tax collection are due as much to the unrealistic levels at which the revenue targets are set as to the shortcomings in the revenue collection system. Whatever the case, the government has so far responded appropriately to these shortfalls by reducing spending below the budget’s targeted levels, thus leaving deficits that even as a percentage of the official economy appear to be manageable. What would be a real cause for concern is if government did spend all the money that had been budgeted instead of sequestering it in response to revenue shortfalls.

The government has also taken a number of measures to increase revenues. First, under the new Tax Code most revenue will come from the VAT, which can be collected in a relatively low-cost and efficient manner. To the extent the new code stabilizes revenue collections, so much the better. Secondly, the government maintains a steady pace of privatization auctions, which, given the substantial increases in equity prices that have occurred, should yield more revenue than one would have expected a year or so ago. One innovation that we feel could do more harm than good is the creation of the special tax commission, the VChK. The danger is that such an agency might focus its attention not on the most egregious tax evaders, but rather upon the biggest firms with the deepest pockets. If it turns out that the VChK operates in this manner, the Russian government would have added risk and unpredictability to the Russian business environment rather than reduced it.

 

Data Sources

For Figure 1: Monthly inflation data for August 1995 through October 1996 are taken from Russian Economic Trends, 1996 (vol.5-3), Table A14, for November 1996 through April 1997 from Russian Economic Trends, 1997 (vol.2), Table A8 (available at http://cep.lse.ac.uk/datalib/ret/statappendix/vol97no2/a8.htm), and for May and June 1997 from R+ Yield, published by the Rinaco brokerage firm, (available at http://www.fe.msk.ru/infomarket/rinacoplus/yield/welcome.html). Monthly data on GKO yields for August 1995 through October 1996 are taken from Russian Economic Trends, 1996 (vol.5-3), Table 29, for November 1996 through May 1997 from Russian Economic Trends Monthly Update-June 1997 (available at http://cep.lse.ac.uk/datalib/ret/update/

jun97/financial.htm), and for June 1997 from R+ Yield.

 

 

 

Endnotes

  1. Until the beginning of 1997 returns on GKO’s were tax-free, but companies are now subject to a 15 percent tax on profits made from trading GKO’s.
  2. More precisely, the real risk facing holders of fixed-rate instruments is the increased variance in inflation that is associated with high rates of inflation. For example, if it could be known for sure that inflation would be 25 percent, such investors would face no greater risk than if it were known for sure that prices would remain perfectly stable. In reality, however, the variance in inflation tends to increase with the rate of inflation.
  3. One need not look too deeply for a motive for thievery, but many observers argue that such actions are taken by current owner/managers to retain control of the firm in response to hostile takeover attempts. More frequently the manager and directors have simply issued themselves large quantities of new stock. This preserves their control, but dilutes the value of existing shares. For an excellent report on the emergence and evolution of the Russian stock market see Frye (1997).
  4. Foreigners may now invest in GKO’s and convert their earnings back into foreign currency by opening special "S ruble accounts" in authorized banks, but are subject to a maximum annualized rate of return. The rate was originally set at 16% in dollar terms and was recently cut by the Central Bank to 9%, but these rates are only slightly lower than the market rate of return.
  5. A more commonly cited index of Russian share prices is the Moscow Times Index, reported regularly in The Economist among other places. There is a large degree of overlap in the two indices, and so movements in the RINACO EWEI and Moscow Times track each other very closely. However, the secular growth in share prices registered by the MT Index has been considerably larger than that registered by the Rinaco EWEI. If anything, then, the Rinaco index has understated the rapid rise in the share prices of Russian companies.
  6. Actually, the Russian government has required joint-stock companies with more than 1,000 employees to list their shares with independent registrars since 1995. It turned out, however, that in most cases the "independent" registry firm was a wholly owned subsidiary of the company. To be more precise, then, the real confidence-building innovation has been the registry of stocks with firms licensed by the Federal Securities Commission.
  7. There are actually three levels of ADR’s with different financial disclosure requirements. Companies issuing Level I ADR’s need only comply with the requirements of the local market. To issue Level II ADR’s the company must satisfy the requirements of the foreign exchange. Level III ADR’s require full compliance with Generally Accepted Accounting Principles (GAAP) and with the regulations of the US Securities and Exchange Commission.
  8. Riley and Lusketich’s major findings are summarized in the following trading rule: "If a Republican victory is correctly anticipated, buy 26 trading days before and sell 18 trading days after the election. This strategy would have yielded a positive return in nine of ten elections; the average percent return being 8.96 percent since 1900 (3.80 percent since 1944). We trust the reader is able to correctly evaluate the usefulness of trading rules derived a posteriori from market data.
  9. The FTSE Index options price, in contrast, became increasingly volatile in the week or so prior to the election, and had not completely discounted the possibility of a Labor victory. Gemmill argues that the market inefficiency was substantial enough to have created a riskless arbitrage possibility.
  10. Most news reports surrounding Yeltsin’s health in early 1997, of course, were very pessimistic about his chances for recovery. Protestations from his staff that Yeltsin was actually recovering were dismissed as feeble attempts at old, Soviet-style news management concerning the well-being of the nation’s leader. Still, it is not surprising that the financial markets would have made accurate predictions about Yeltsin’s eventual health status. Roll (1984), for example, demonstrates that the frozen concentrated orange juice futures market is a better predictor of weather in the Florida Citrus Belt than is the US Weather Bureau.
  11. On the basis of quotes offered by Ladbrokes, the famous London oddsmaker, Roberts argues that Reagan’s probability of being elected was rising dramatically in the week prior to the 1980 election, and that by election day the markets had fully discounted this information. He asserts that a Republican majority in the Senate, on the other hand, was completely unanticipated and could have been capitalized by the market only in the first trading day following the election.
  12. Bondarenko and Boessarts (1996) infer from their analysis of data from the Iowa Electronic Markets "winner-take-all" contests, such as the one connected with the 1996 Russian presidential election, that traders act in accordance with Bayes’ law. In violation of the rational expectations hypothesis, however, their prior beliefs do not appear to reflect in an unbiased way the distribution of actual outcomes.
  13. Please note that our calculations of stock returns are based only upon changes in share prices, and do not include dividends. Most large Russian companies have been paying dividends, but in a market when share prices move up by several hundred percent dividends do not contribute a great deal to total return.
  14. Even the City of Moscow, which is generally seen to be at the vanguard of reform, is a major shareholder in Zil, and is attempting to prop up this troubled company by purchasing large numbers of the low-quality trucks and automobiles it manufactures.

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Seventy percent of Russian firms opted for the worker-buyout model which enabled the companies workers to receive 51 percent of the shares. "Managers often encouraged their workers to select the worker buyout option to block new outside owners from taking over, restructuring the firm, and perhaps firing them. Weakening problem in the long run, as managers and other groups buy the workers’ shares, bottom line considerations emerge

(Morvant and Rutland 1996. p. 9).

An example of weird incentives that otherwise suggest weird Russian cultural paternalism is the keeping of workers with nothing to do on the payroll. Companies faced a 38 percent excess-wage tax if the average wage of its employees was more than six times the minimum wage. "Canny managers kept low-wage workers on the books to hold the average wage below the penalty level. The tax was abolished on 1 January 1996."

(Morvant and Rutland 1996, p. 9)

Note that several of the energos were added to the sample 9-12-95 Nizhny Perm 7-24-95

Samara Sverdlovsk and Volgograd 6-7-96 somewhat after July 3, 1995. In calculating change in prices we simply start them from the date at which they were added to the sample. In principle this could affect our results but there really wasn’t much systematic movement in the market or in the energo sector until about April 1996.

"Russia," in the view of one leading business analyst, "is a living laboratory of extreme risk-reward ratios" (Bean 1996).