Russian intern's blog exposes 'lazy' MPs

Moscow's Capitalist Manifesto

Russia's capital is still a long way from being a global financial center. Economic and legal reform would help.

By ROBERT MACIEJKO

The adviser's comments capture just one piece of the larger challenge in Moscow's quest to become a financial center. There are a number of significant obstacles to overcome.

Corruption is a corrosive force in the country. Russia comes in at 154th out of 178 countries on Transparency International's 2010 Corruption Perceptions Index. The country also has a well-deserved reputation for stifling bureaucracy. In a World Bank survey of the process required, in 182 countries, to obtain construction permits, Russia's was found to be the second most difficult in the world. Other obstacles include inadequate infrastructure, which contributes to massive traffic tie-ups, and occasional forced shutdowns of the stock market, a practice that began during the financial crisis.

For these and other reasons, the latest Z/Yen survey of 75 financial centers throughout the world ranks Moscow 68th, behind Manila, Jakarta and Malta.

Moscow's lowly status is also reflected in the local investor base, which is small in terms of both retail and institutional investors. Large Russian companies, even global leaders in their industries, frequently choose to raise capital in London or Hong Kong. Price-earnings ratios in other BRIC countries are, on average, 50% higher than those in Russia. The country's ratio of market capitalization to GDP is two to three times lower than in the most developed G20 countries, and lower also than in Latin America and in Eastern European countries like Poland. The upside potential for Russia, therefore, is large.

A recent Oliver Wyman survey of leading participants in Russian financial markets underlined the gap between Moscow and leading financial centers like New York or London. Survey respondents cited the rule of law as a key area in need of regulatory improvement, emphasizing deficiencies in combating corruption and prosecuting economic crimes.

Respondents were also asked to identify the most important areas to focus on. The first was to increase market liquidity and expand availability of long-term funding. Second was creation of a centralized depository system. And third was improved transparency.

To attract investment, the survey respondents recommended strengthening regulatory requirements and oversight, improving disclosure, offering more robust protections for minority shareholders and modernizing corporate governance standards.

Implementation of these reforms could significantly increase investor confidence and help reduce the "Russia discount" relative to other emerging markets. These reforms would also help to expand the investor base among both retail and institutional investors.

Russia has taken some steps in the right direction. A new regulator is being created that combines oversight of financial markets and the insurance sector. Steps have been taken to introduce Basel II and III standards in banking, which should improve bank transparency. The upcoming merger of the Micex and RTS exchanges is expected to result in a consolidation of the market infrastructure, which could address the absence of a central depositary. A combined exchange could also help Russia clarify its role in the global markets infrastructure amid ongoing international merger activity.

The government's $50 billion privatization program, bringing the sale of mainly minority stakes in leading oil, banking and logistics companies, will reinforce Russia's commitment to market-driven development, while helping to attract investment. But without legal and judicial reforms, international investors may well remain wary of whether their rights will be protected as minority owners in state-owned companies.

Moscow does possess a number of advantages. Its geography naturally lends itself to serving as a bridge between Europe and Asia. And it has bonds of language and culture that tie it to the former Soviet countries that now make up the Commonwealth of Independent States. The population is also well educated, with a strong base of mathematical and technical skills. Perhaps most important of all, the country's economy is, adjusted for purchasing power parity, the sixth largest in the world, and it possesses a huge reservoir of natural resources—providing a firm foundation for future growth.

While it remains to be seen whether these advantages will enable Russia to overcome the obstacles, the country's leaders should look at the experience of Poland. To develop its financial sector, Poland created strong individual and local institutional investor bases as it privatized industries beginning in the 1990s, while also improving conditions for foreign direct investment. It listed companies through Warsaw, not through foreign exchanges, and at prices that allowed local investors to profit quickly. The IPO of the Warsaw Stock Exchange last November attracted 323,000 individual investors, more than the number of active investors in all of Russia.

Such action has reinforced development of the financial sector in Poland. In the last few years, local capitalization and liquidity have increased, investors and issuers have renewed their focus on Warsaw, and the Warsaw exchange has reinvested in infrastructure and products, leading to an increase in the number of listings.

That experience holds lessons for Moscow's goal of becoming a financial center, and it's been analyzed by the working group President Medvedev created last year. Alexander Voloshin, who served as chief of staff to President Putin, is leading the effort.

But in Russia, some insiders are still skeptical that real positive change will come and are waiting for more concrete steps. Based on past experience, that skepticism is justified. But the potential payoff from reform is significant for Moscow—helping to attract investment, diversify the country's economy and create wealth.

—Mr. Maciejko is a partner in the financial services unit of Oliver Wyman, a global management consultancy, and is the managing director in Central and Eastern Europe for the unit. He has worked in Russia and the region for 24 years.