Liam Halligan of Prosperity Capital Management
May 2, 2012
Over the last year, and increasingly in recent months, a great deal of comment has been made on the "torrent of capital outflows" that are leaving Russia.
Mainstream opinion continues to have it that "capital is quitting Russia by the bucket-load". The result is that most investment professionals are unwilling even to consider entering the market. The reality is, though, that there are many ways to interpret these numbers and, on balance, the outflow data overwhelmingly point to financial and commercial phenomena, which reflect Russia's growing economic strength.
The Central Bank of Russia (CBR) reported $80.5bn of private sector "outflows" in 2011, up from $33.6bn the year before. Outflows have lately accelerated to $35.1bn during the first three months of 2012. While such data are routinely portrayed by overseas analysts as "proof of political risk in Russia", these "outflows" are happening largely for technical reasons which have almost nothing to do with politics. What's more, the CBR is keen to encourage perceptions of such "outflows" for its own policy-making purposes – which is why it has lately encouraged Western Moscow-based journalists to focus on the outflow story each month on the publication of its monthly bulletin.
Russia's recent "capital outflows" can be largely explained by the following factors:
1) Re-financing by Russian corporates
With the Western banking sector looking shaky, many Russian companies have been swapping their expensive dollar-, sterling- and euro-denominated overseas loans for ruble-based credit with stronger local banks. This often provides Russian firms with cheaper finance and a less erratic and more reliable creditor. Prosperity Capital Management estimates that Gazprom repaid at least $5bn of foreign debt in 2011, while Bashneft redeemed $1bn. The wider availability of domestic credit also means most of the large food retailers we know have also now paid-off their foreign debts. Redeeming an overseas loan obviously involves sending money abroad, scoring on the CBR balance sheet as a "capital outflow".
2) Subsidiary borrowing by foreign banks
Cash-strapped foreign banks are routinely borrowing from their Russian subsidiaries. Given that Russia has an open capital account, the only large EM that does so, the Ministry of Finance has committed itself not to oppose this practice. The numbers show, though, that in several months over the last year, such operations – western banks accessing liquidity from their better-regulated Russian subsidiaries – accounted for half of Russia's capital outflows.
3) Outbound M&A by Russian firms
As the strongest Russian companies grow and prosper, many are expanding overseas - which often involves sending money abroad to buy foreign firms. Far from being a weakness, such "outflows" are a sign of strength. Last year, TNK-BP spent $772m on a Brazilian oil and gas stake. Sberbank bought part of Austria's Volksbank for $585m. Russia-based Digital Sky Technologies sent $563m to the US in return for 10% of Twitter. Mechel spent $412m on Ukraine's Donetsk Electro-Metallurgical Plant (DEMZ). Such transactions, all of which took place in 2011, are registered as "capital outflows". Yet all of them are the result of companies generating profits in Russia and then expanding their interests abroad.
4) Overseas retention of Russian earnings
When Russian companies earn money abroad, and such earnings are retained overseas and then reinvested, they also appear on the CBR's balance-sheet as "capital outflows" Given that domestic real interest rates remain low and many Russian firms (especially in the energy sector) are investing heavily overseas, retained earnings also account for a significant share of the outflow data. Again, those, such flows reflect the legitimate commercial activities of successful Russian multi-nationals.
The reasons above go a long way towards explaining Russia's "capital outflows" – and they are largely describing activity which reflects the country's growing economic strength. The detailed breakdown of the CBR's outflow data, such as it is, suggests that, of the $35.1bn of outflows in the first quarter of 2012, the corporate sector – flows linked to company loan re-financing and overseas M&A – accounted for $19bn, with the banking sector taking $16bn. While the latter category may capture some personal "capital flight", it also includes the far more significant practice of Western banks tapping their Russian subsidiaries for cash.
"Capital outflows" also need to be seen in the context of Russia's huge current account surplus, which was 5.5% of GDP in 2011, up form 4.8% the year before. During the first quarter, the surplus reached $42.3bn, 37% up on the same period in 2011. Capital outflows are natural for a surplus country – not least at a time when many of Russia's energy exporters are retaining, and then re-investing, foreign exchange revenues earned overseas.
During 2005-2007, Russia saw significant capital inflows, as oil prices rose and in the wake of capital account liberalization. Such inflows stoked inflation and fuelled the ruble "carry-trade", which pumped-up Russia's currency to a dangerous high, causing a serious downside overshoot when Western banks lurched, and global panic spread, in the aftermath of the Bear Stearns and Lehman collapses.
While remaining committed to an open capital account, and aiming eventually for a ruble free-float, the CBR is determined that the Russian economy won't once again be over-heated by "hot money" from elsewhere. As such, recent "outflows" help the CBR control the growth of Russia's money supply, while bearing down on inflation. By reining-in the ruble - which might otherwise over-appreciate like the similarly petro-backed AUD, NOK and ZAR - such "outflows" also boost Russia's export earnings and, therefore, tax revenues. As such, the CBR likes occasionally to fan the flames of the 'outflow' story, working with the grain of the Western media's view of Russia and using it for its own purposes.'Just like the central bank of any other major economy, the CBR plays the media in order to achieve the outcome it wants.
None of this is to say there aren't problems with Russia's investment climate. Improvements are clearly needed. Also, in the run-up to the election, some Russian firms did put domestic investments on hold until the future was clearer, which perhaps increased the retention of overseas earnings. But it seems extremely far-fetched, almost willfully misinformed in fact, to attribute every dollar of 'capital outflow' to 'fears about Putin's Russia?.
If Russia is such a terrible investment destination, those who equate 'capital outflows' with 'basket case' need to ask themselves why foreign direct investment (FDI) into Russia was $49bn in 2011, up 28% on the year before, despite the serious deterioration in the global investment climate.
Western executives who make decisions about FDI into Russia are generally much better informed about the relative merits of doing business here than portfolio investors, the latter tending rarely even to visit the country, making them far more susceptible to 'fads' and alarmist newspaper headlines. It is interesting, then, that FDI into Russia is rather higher than is commonly supposed. Figures from the UN show that while China attracted $465bn of FDI between 2006 and 2010, Russia placed second among the BRICs with $240bn, well ahead of Brazil's $173bn and the $145bn that was channeled to India.
In terms of FDI per head, Russia attracted twice as much money as Brazil, five-times more than China and 13-times more than India during this period. This reality, with Russia more than holding its own as an FDI destination among the BRICs, isn't reflected in the relative portrayal of these markets by the Western media.
It's also not true to say that all Russia's FDI is related to oil and gas. Of the FDI Russia attracted in 2006-2010, around 40% was directed at 'primary activities', including oil, gas and agriculture, while 35% was for manufacturing sub-sectors such as food processing, machine-making, construction, transport and electricity generation. The other 25% was in Russia's service sector - which, having barely existed in Soviet times, is now half as big again as oil and gas, accounting for a third of Russia's total GDP.
While we have highlighted the impact of out-bound M&A on the 'outflow' numbers, it is also instructive, in any assessment of Russia as an investment destination, to look at in-bound M&A. 'Deal Drivers - Russia 2012', recently published by mergermarket.com, in conjunction with the Moscow-based law firm CMS, is an authoritative study of M&A connected with Russia.
The latest edition of this annual study suggests that the Russian M&A market as a whole came under pressure last year. Combined in-bound and out-bound activity declined to 214 transactions worth '54bn in 2011, down from 223 deals worth '57bn the year before. This marked a 4% drop in volume and a 6% fall in aggregate value.
Yet inbound M&A - foreign companies buying Russian assets and therefore bringing money into Russia - remained strong. In 2010, overseas firms conducted 55 major purchases of Russian companies, or stakes in Russian companies, with a combined deal total of '9.8bn. Last year, though, there were 70 major in-bound deals, worth $21.2bn in all. That represented a 21% rise in deal volume and a 116% increase in deal value, despite the drop in M&A volume overall much worse 2011 global investment climate.