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The economy has now regrouped and, although it's recovery is not as fast and furious as many predicted it would be, Russia is re-emerging from its ashes. The question is: has Russia's financial frontier finally become the new land of opportunity, or is it still a land of pipe dreams?
The Wild East analyzes the Russian economy from the unique angle of leading international business figures who have made incredible profits, as well as those who were brutally burnt. Between them, they unearth the real, underlying causes for the country's economic problems, and provide an insight into future issues and how the transition to economic recovery is taking place.
The Wild East will show investors in and observers of Russia how they can hope to negotiate, and profit from, the turmoil of this uncharted financial frontier.
The business and investment pioneers who have contributed to The Wild East are:
l. EXPLORING THE WILDERNESS.1. Banking Regulation in a Context of Extreme Legal Underdevelopment: Lessons From the Russian Meltdown.
Il. RUSSIA: THE ULTIMATE ADVENTURE.3. Tight Politics and Easy Economics: The New Russian Model and its Parallel to Latin America.
III. MOVING THE FRONTIER.8. Bubble.
IV. OUT OF THE WILDERNESS.11. The Challenge of Economic Policy, Investments and Growth.
Referring to Russia as the 'The Wild East' has become commonplace in the financial world. It is meant to evoke images of the Wild West and the frontier civilization that has captured our imagination for more than two centuries.
The Wild West has two faces. On one hand, the dark image of crime-ridden, male-dominated towns where favourite pastimes were drinking, gambling and visits to the 'whore house'. The rule of law was embryonic at best, with physical strength and prowess with guns, rather than judges and juries, resolving conflicts. But there is also the more positive picture of the pioneers leaving their relatively secure, but desolate lives in Europe or the Eastern United States, to seek their fortunes in the open landscapes of the West. The Land of Opportunity held high risks and high returns. Settlers came to build new communities, and shaped a culture that is still with us today. There was a sense of mission: the Wild West had to be tamed through new institutions erected from scratch.
This book tells the stories of the settlers (some temporary) of the financial frontier in Russia. Our narrators have shared a common experience: as portfolio investors they observed and participated in the events that led up to the financial crisis of 1998. Some of these accounts, like their counterparts in the Wild West, have already made it into legend. Others are new, brought to us first-hand by investors who have had time to reflect on their often tumultuous experience of a few years back. To our knowledge this is the first book that brings them all together.
But hold on, some might say, many of these pioneers misjudged Russia then; why should we hearthem out now? Like many settler accounts of the Wild West, these are likely to be partial and maybe even self-serving. Moreover, why should we listen to portfolio investors at all? They often lack the on-the-ground knowledge of foreign direct investors. Portfolio investors usually come in late and leave early, and have neither the time nor the incentives to learn much about the institutions of the country. They manage large, diversified portfolios and are evaluated on short-term performance. They also tend to move in herds, suggesting that the views of the individual investor are less interesting.
Nevertheless, there are many reasons why we should listen to, even study, these accounts. While portfolio investors are sometimes less familiar with the intricacies of local institutions, they do have well-trained noses for macroeconomic and political vulnerabilities. They have broad international experience, in particular from emerging markets, giving them a rich set of comparisons. Moreover, the portfolio investors are important actors at the heart of the crisis; they are the short-term capital outflow. If we understand what makes portfolio investors act in certain ways, we are also closer to understanding the origin of the crisis.
And the contributors in this volume are not your average portfolio investors, either. The group, with some of the most experienced and highly regarded representatives of the profession, offers impressive combined experience. Dean LeBaron, for instance, even came to Russia during the perestroika. Many played important roles in the dramatic events leading up to the 1998 crisis. To the extent there was herd behaviour, these investors were among the leaders of the pack. Furthermore, not only do the stories of portfolio investors help us identify the problems; their experience can also help lead us to solutions. Several of the contributors here have participated actively in the economic decision-making process in Russia, as advisors and commentators, and occasionally as policymakers. Some have also taken part in privatisations and other important financial transactions. Many are still involved in negotiating the financial frontier in Russia and building the institutions necessary to establish the rule of law.
So why did many of the authors here seem to have seriously misjudged Russia? Their own answers in this volume suggest that it was the lack of understanding of the weaknesses of local institutions, in particular the poor protection of minority investors, that hurt them in Russia. Economic research has borne out this lesson: work by Simon Johnson and three co-authors suggests that it was precisely the differences in the rule of law and minority protection, not the macro-imbalances and indebtedness, that explained why some countries were hit by the Asian Crisis and others not. But more recent findings also imply that many observers did not fully appreciate the implicit contingent liabilities of the governments in these countries. In Russia these liabilities originated in a bloated market for government bonds and a fundamentally defunct banking system saddled with large amounts of bad debts and huge exposures in markets for foreign exchange and bonds.
There is also much to suggest that the crises we see today are different from those of the past, a factor that helps to explain why the portfolio investors may not have anticipated the Russian crisis. Financial and economic crises are more contagious than they were during earlier periods of high capital mobility. The new crisis pathologies provide yet another reason for why we should listen carefully to the voices in this volume.
Another related issue is that some portfolio investors, like Letitia Rydjeski, did have serious concerns but did not heed these. This leads to the deeper issue of why portfolio investors, and investors in general, move in herds. As Al Breach confides, 'it is hard to remove yourself from the crowd'. Obviously, in the financial industry incentives matter. It is more costly to be wrong alone than in a crowd. But there are also more subtle psychological factors that cause us to doubt our own judgement. This is the exciting new area of behavioural finance, which is rapidly changing our understanding of financial markets and institutions.
But did these portfolio investors really misjudge Russia? To quote Al Breach, they seemed to have been 'fooled' not once but twice. Many with money in the market held their positions too long, and sold too early, before the upturn. But was this serious misjudgement, or just simple calculation? Those investors that did not manage to sell before August 1998 lost money relative to the peak of the boom. But to know whether they lost money we need to know when they entered and at what prices. Those who bought equity did so in a heavily discounted market, in some stocks by a factor of a hundred. These prices reflected fundamental concerns about the lack of institutions and macroeconomic imbalances in Russia. Others loaded up on government securities at unbelieveable interest rates, several hundred per cent on a yearly basis right before the crisis reaching 135 per cent on average in August 1998. Obviously, these rates incorporated the possibility of default. Experienced investors that bought in these markets knew what they were getting into. The risks were huge but so were the potential rewards.
In investment, timing is, if not everything, at least very important. While the collapse in August 1998 could not have been a surprise to most of these investors, the upturn in 1999 and 2000 seems to have been. Most observers had anticipated that the impact of a financial crisis on the real sector would be limited, after all very few firms relied on credits from the financial sector. It was also obvious to most that a depreciation of the rouble would give an impetus to many industries. But very few observers expected such broad and rapid growth. Manufacturing has grown by a third in three years; industries previously pronounced dead were revived, and parts of the country that had contracted for decades suddenly showed signs of life. The world oil price has helped substantially, but it only explains part of the development. After the crisis, Russia has experienced a period of renewed political vigour and ambitious reform plans; the federal state has reasserted itself. Limited progress has already been made in tax reform and administrative simplification. Critical judicial reform is now on the agenda.
Yet the vulnerabilities remain. The frontier of the Wild East, like its counterpart in the American West, is not always well-defined and does not always move forward. Negotiating the financial frontier in Russia is a long and arduous process where no gains of terrain are ever secure. The Phoenix rising out of the ashes of the Russian financial sector may have shorter wings and less vigour. This may prevent it from flying as high as it did in 1998, thus making a plunge less dramatic, but another crisis in the near future cannot be ruled out. The banking sector has not been restructured, and the rules of the game in the financial sector are far from clear. The supervisory bodies lack bite and the Central Bank and its governor, previously branded for not believing in the relationship between money and inflation, are now ignoring all international experience on bank restructuring. If nothing serious is done about the Russian banks, we may well see an eerie rerun of the 1998 crisis with an overvalued rouble and an extremely fragile and bloated banking sector.
This is one reason to be cautious about the prospects for Russian economic reforms, and there are others. The government has an ambitious reform programme, and President Putin has increasingly put his weight behind it. It is by far the most comprehensive programme to date in Russia and local ownership is stronger than it has ever been. But the programme lacks clear priorities. Together with Club 2015, a group of young Russian business leaders and policymakers, SITE and our Russian-born offspring CEFIR are trying to assist the government in setting these priorities. Transparency and broad public debate are critical to this process. In a project with the Ministry of Economic Development and Trade, and with support from the World Bank, we are developing a programme for monitoring implementation of the programme at the level of the individual enterprise. It is only when the reality facing the individual entrepreneur improves that we can hope for sustained economic growth in Russia.
Like the old frontier towns of the West, Russia has yet to establish the very foundation upon which 'rule of law' must be built: a strong, competent and fiscally sound state with clear demarcations towards special interests, and contained corruption. The problem of Russia is not an absence of laws on the book; it is enforcement of these laws. A combination of institutional reform and stronger norms helped to build the foundations for a stronger state and an unprecedented period of sustainable economic growth in the Wild West. For Russia this is the ultimate challenge.
Learning from foreign experience, and the experience of foreign investors, is important, but genuine progress will only come once the analysis and its conclusions have been internalized. Building domestic analytical capacity through a reversal of the brain drain and stronger domestic training is critical to a sustainable reform process. To this construction SITE is committed.
Stockholm, 17 July 2001