Investing in Russia Euromoney Conference [EBRD

Speech by Hanna Gronkiewicz-Waltz, Vice President for Human Resources and Administration: Russia and the CIS 2003
Moscow, September 9-10 2003

Before talking about the future, I want to remind the audience about the past. It’s important because how the EBRD behaved then qualifies what I am about to say on how we now view Russia’s future.

In the aftermath of the 1998 Russian crisis, the EBRD -- bucking the trend -- remained closely engaged with Russia.

Not only because of the Bank's special mandate but also because we believed in Russia's prospects and continued to invest at a time when Russia was virtually shunned by the entire international banking community.

We are very glad to see that Russia’s rapid turnaround justified our commitment to remain engaged and even gladder to see international banks showing such strong interest in doing business here again.

And it is no mystery why the interest in Russia has increased of late.

Russia is booming with an average GDP growth of well above 6 percent for the 5th consecutive year. And this achievement comes despite the continued gloom in the global economy and despite the uncertainties created by a pre-election period.

The Russian economy has changed almost beyond recognition since the 1998 crisis. The extreme political uncertainties of the late Yeltsin years are a thing of the past. On the policy-making front, the need for constant crisis-management in the 1990s has been replaced by an increasingly sound and predictable macroeconomic policy framework.

The process of market reforms has taken firm roots. Russia has for the first time since the beginning of the transition towards a market economy taken ownership of its own reform process. Although the pace of reform slowed last year, a broad consensus has been established on what remains to be done.

The impressive macroeconomic performance, the broad stability and the reforms of the post-crisis period have gradually translated into an improving investment climate and increasing actual investments. This year has seen new turnarounds here:

Domestic investment has sharply accelerated, increasing by close to 12 percent in the first half of this year, compared with a growth of 2.5 percent during the same period last year.
Foreign investment grew by 51.3 percent in the first half of 2003. Borrowing by Russian corporates is surging (by about 80 percent), while a 35.3 percent increase in FDI is also a welcome change compared with the stagnation/declines of the previous years.

It’s easy to rattle off a list of Russia’s impressive economic achievements, but does that mean the country has turned the corner? Does all this mean the country is already on a sustainable growth path that could end up doubling its GDP in 10 years as President Putin has urged?

Not yet.

First of all, the current macroeconomic achievements are still driven primarily by external factors, which to a large extent mask serious continued structural and institutional problems in the economy.

Russia’s recent macroeconomic performance has been strongly supported by a range of favourable external circumstances. Key among them is the oil price, which averaged close to $24 per barrel in the post-crisis period against an average of $16 per barrel in 1992-1998.

The sharp devaluation of the Rouble helped to boost competitiveness of Russian-made products. In addition, Russia benefited from recent developments in the global economy such as low interest rates and strengthening of the Euro against the dollar.

On the macro level, despite the current benign environment and impressive growth rates, the key longer-term determinants of growth -- technology and the quality of public institutions -- remain very weak.

On the micro-level, despite the undeniable progress towards market economics by some large companies and sectors, much remains to be done in improving the general business climate.

What all this indicates is that Russia’s recovery is largely driven by temporary factors.

The process of diversifying the economy is proceeding haltingly.

The micro-foundations of growth and the quality of the growth process itself are both still fragile.

Russia’s main challenges in the foreseeable future are:

modernisation and restructuring of vast segments of the country’s economy
accelerating new business development
creating efficient, market-oriented public institutions

These fundamental challenges involve both major opportunities and risks for investors in the corporate and financial sectors, two top priorities for EBRD in Russia.

The corporate sector

The modernisation and restructuring process calls for massive technology, know-how and skills transfer into the Russian economy that would guarantee continued and consistent efficiency improvements of the Russian corporate sector.

Foreign investors, especially foreign strategic investors, could and should play a critical role in this.

Of course we are happy to see reputable foreign strategic investors showing increasingly strong interest in doing business here, especially in areas other than the traditional foreign investment targets such as energy, metallurgy, telecoms and food.

This trend is important because it is necessary to diversify the Russian economy and lessen its dependence on commodity exports.

But while the trend is clear, it needs to gain pace.

Despite recent increases, foreign direct investment levels in Russia remain well below those in more developed transition economies.

What this shows that is that despite significant progress in pushing through reforms, significant obstacles and risks persist in the current investment environment.

Bureaucratic interventions, especially at the regional and local level, along with continued weaknesses in corporate governance and unpredictable and uneven enforcement of the existing rules of the game are the most important sources of risk at the current stage of Russia’s development.

In this context, the most recent case of legal investigations into top executives in the Yukos group is a reminder of how much remains to be done to strengthen rule of law in Russia.

The case is still before the court and it is therefore not appropriate for me to comment on its specifics.

It is, however, impossible to ignore the impact of a case that by its magnitude obviously influences the investment climate.

Financial Sector

We do believe that the financial sector holds the key to Russia’s future growth and have therefore invested – and are continuing to invest – accordingly.

The Russian financial sector poses key challenges, opportunities and risks.

It is true that the liquidity of the Russian financial sector has greatly increased. On the other hand, the investment needs in the corporate sector and infrastructure are enormous while financial intermediation remains very shallow.

There have been some recent improvements in the sector and the role of banks in the country’s economy is growing.

Banks have started to focus more on lending to the real economy. The quality of banking services has improved. The banking system is more stable and investor confidence is gradually returning.

However, the banking system is not yet ready to intermediate savings and investments on a large scale.

The sector remains small and continues to be dominated by the state-owned banks and the pocket banks of major groups. Serious governance and regulatory problems remain.

This is still a volatile emerging market. The system remains vulnerable to macroeconomic shocks. Significant changes in oil prices, exchange rates or interest rates could have a strong impact.

Although a systemic crisis is unlikely, the risk of bank and corporate failures remains. These are part and parcel of any maturing process. However, the important point is that Russia today is better able to manage such problems than it was a few years ago.

But banking reforms needs to go faster. The authorities’ determination to strengthen bank supervision and regulation is to be welcomed because this is the only way to make the rules of the game credible. Creating a competitive, de-politicised and transparent banking sector is more important than at any time since Russia’s transition to a market economy began.

To sum up, Russia is coming closer to unlocking its vast potential, but high oil prices and electoral distractions must not be allowed to slow down the momentum of reform. A huge amount still needs to be done and this is not the moment for Russia to rest on its laurels.