Russo-Georgian War Aftermath Impact on Financial Markets

By: STRATFOR

A redefinition of Russia has taken place — rather jarringly — following its war with Georgia, and the entire world is reassessing its position and relations with the resurgent power. This reassessment includes financial factors — a much more tender area for today's Russia than for the Soviet Union, because Russia's large economy is tied into the global economy.

During the Russo-Georgian war , Russia's stock index declined to its lowest level in two years, the ruble registered its largest monthly decline against the U.S. dollar in more than nine years, and foreign investment flight amounted to $25 billion in just three weeks, according to French investment bank BNP Paribas.

But the flight of foreign direct investment that has resulted from deteriorating ties between Russia and the West will not hurt Russia as much as is believed. Rather, Russia will be dealt a massive blow when the West ceases giving Russian companies the financial access they need to continue expanding or even operating. The main reason Russian companies have done so well in the past few years (and made Russia a much stronger country) is that foreign entities have been the ones financing their expansion. This is all about to change.

The Russian Model

There are three main types of financial models in the world: Western, Asian and Russian. The Western financial model is economically based, with gaining money and profit as the end goal; such a model tends to crush inefficiency and protect the system as a whole. The Asian model is socially based. This model's goal is maximum employment and social stability, where money is used as a political resource for nonfinancial ends despite all inefficiencies. The Russian model is politically based. In Russia, finance is a political tool to control the country and operates much like money for loan sharks or organized crime. The system is highly inefficient, but it allows a very small few to hold all the power in an enormous country.

It is the Russian model that has made it nearly impossible for Russian companies to gain access to cash outside their own earnings and has led them to look outside the country. To put it simply, a company needs money in order to grow; in its search for that money, it has three options. It can use its own money, but this limits a company in its ability to make major purchases, take on large projects, or greatly or quickly expand. This option has been seen not only in companies' purchases, but in most financial transactions in Russia. A good example of this in Russia is mortgages, which the country had never seen until the past few years. Previously, Russians had to use their own money to buy homes without any financing options.

The other two options involve borrowing money, either by taking out loans or by issuing bonds. A loan would have to come from a bank, and any sizable loan would have to come from a large (most likely Western) one. Issuing bonds is like dividing up pieces of a loan to a number of purchasers.

Most Russian companies cannot turn to Russian banks for loans, because the banks are either too small to finance major projects or are state- or oligarch-owned. Of Russia's 10 largest banks, the top five are all state-owned, which means that if a company wants to finance a major project it has to develop an understanding with the Kremlin. Traditionally, the major state banks have stayed out of financing large projects, mainly because they have no expertise in these fields. When the government does actually step into the role of financier, it is usually because of political or control issues and not because the Kremlin sees a good investment.

The other large banks in Russia are typically oligarch-run. The oligarchs are billionaires who lead most of Russia's vital sectors, both private and state-controlled. Most of these individuals rose to power during the Yeltsin-era “shock therapy” transition from socialist structures to capitalist ones (which more resembled a free-for-all), but the oligarchs who have remained in power are either owned by the Kremlin or have the Kremlin's blessing to continue holding strategic sectors. During their rise, the oligarchs basically created their banks in order to fund projects or manage their own companies. For example, Rosbank was created by the owners of Interros — oligarchs Mikhail Prokorov and Vladimir Potanin — in order to finance projects by Interros' Norilsk Nickel, the world's largest nickel company. These banks typically are not able to take on any other company's major projects and often cannot handle major financing for their own related firms; moreover, these oligarchs have no interest in funding any rival oligarch's expansion plans. The oligarchs also created these banks in order to keep the Kremlin from having a say in their companies and projects (though the Kremlin has since either worked its way into partial ownership of most “private” banks or placed lackeys as bank chiefs).

Russian companies cannot issue bonds to the domestic market simply because there are not enough interested people in the country with the money to buy them. Those who have money to spend are, once again, the government or the oligarchs, and all the same rules apply to their investment in bonds as to the banking sector.

The only option left has been for Russian companies to turn to foreign money and banks. This is an option Russian companies have turned to only very recently (in the last five years) after the fall of the Soviet Union and a decade of economic turmoil. The Russian market has been so starved for capital — particularly for investment, and for nearly a century — that foreigners are seeing a lot of bang for their buck in financing Russian companies, and they have been lending cash and snapping up bonds left and right. The potential for growth in Russia is so great that foreign cash is estimated to fund 70 percent of Russian debt. It is foreign loans and bonds that are actually making a difference in Russian companies and economic expansion.

Sudden Changes

But the Georgian-Russian war has changed all of this. It is not that the war was the proximate trigger for the massive fall in Western confidence in Russia; rather, it was a clear sign of a downfall already in progress. General perception of and confidence in Russia has now changed — especially in the West. Russian companies (and then the Russian economy) will have to shift when the reality hits that the West simply no longer has confidence in Russia or its companies. Russia was already a risky market, given the Kremlin, oligarchs and organized crime, but when global credit conditions are poor — as they are now — investors tend to shun riskier ventures.

According to BNP Paribas, the amount of debt raised by Russian companies in August was 87 percent less than July's levels, and the issuance of new equity nearly halted — from $933 million in July to $3 million in August. This dramatic slowdown will not lead to a Russian collapse (the country does have its own money), but Russian companies will find it very hard to raise capital and fund expansions, leading to stagnating operations.

Russian President Dmitri Medvedev is already hearing the cries of Russian companies and oligarchs over the tightened situation and restrictions from world financial markets. Medvedev will be meeting with the country's biggest firms and businessmen at the annual Russian Union of Industrialists and Entrepreneurs summit on Sept. 19-20. Medvedev has vowed to unveil a new program for easy credit soon after the summit, once he has input from the country's business leaders.

The Kremlin's Options

There are three options for Moscow. First, Russia could just take the blow, no matter how many ticked-off oligarchs it creates. This would mean that some of Russia's most powerful companies would have to revamp their plans entirely. Such a move would definitely affect the expansion plans of nonstate firms, but it will also hit many state companies — like energy giants Rosneft and Gazprom — which have been gorging on the bonds markets. It also means that the Russian government, which uses many of the companies as champions and tools for domestic or foreign control, would have to overhaul its future strategy as well.

Second, the government could learn how to spend money. Moscow does not have a problem with cash and holds the world's third-largest foreign currency reserve (currently just under $600 billion). The problem is that the government does not like to spend any of its reserves unless it is desperately needed. The only time in the past decade the Kremlin has dipped into the reserves was to finance its war with Georgia. But some Russian oligarchs, like Potanin, are already calling on the Kremlin to tap its reserves to ease the crisis.

The third option is the most difficult: Russia could actually set up a real large bank for real large loans. But this would change the country's entire financial model and cut the Kremlin's and local politicos' abilities to control and manipulate who can borrow money and for what. The social and economic implications of this option are something that the Kremlin has never shown it is willing to risk. Setting up a real banking structure would offer people in Russia a resource outside the government's control, which would in turn give them the ability to have an opinion and hold economic power, and potentially rival the government in making decisions — something that Russia has never seen or allowed before.

By George Friedman

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