FROM SAVINGS TO INVESTING

Expert, #26, 30.06.2008, p.42
Economics and Finance

Vladimir Dmitriev – Chairman of State Corporation ‘Bank for Development and Foreign Economic Affairs (Vnesheconombank)’, doctor of economics

Using savings of the state and citizens to finance long-term investment inside the country is a main way of the Russian financial system’s development.  In order to fight inflation we have to establish control over budgetary expenses and raise their efficiency.

The foreign financial markets crisis demonstrated how vulnerable the modern financial system was. The risks that emerged are a sort of pay for a potential gain in economic efficiency achieved through creating more complex financial products, upgrading business models of market participants and further development of financial system as a whole.

Russia was relatively isolated from the financial crisis, which affected it only indirectly by limiting foreign financing channels. High-risk mortgage, which caused losses in the banking sector of the US and other foreign countries, is not common in Russia. The total amount of mortgage credits extended in our country is less than 30 billion dollars. The largest foreign banks’ direct credit losses were close to the said figure but write-offs of their losses were far beyond that amount (about 380 billion dollars). The mortgage amount in the Russian Federation is 1.9% of GDP in the US – more than 75%, in the EU – up to 50%. There are few examples of mortgage credit securitizaton on the Russian market and the use of complex financial instruments is quite limited.

But the past financial markets crisis is a warning for the future. Regulators and market participants should be aware that if problems similar to the said crisis would emerge the Russian market might be a lot less protected This would happened because of expected growth in lending, which is forecast to grow from 36% of GDP to 70-75% of GDP in 2015 as well as because of using more complex financial instruments and new borrowings from abroad.

Potential growth in foreign risks makes it necessary to improve the quality of the Russian financial system and compels us to search for new mechanisms for raising domestic savings as a source of long-term financing. In order to achieve required economic growth we’ll have to reduce the gap between the level of savings in the economy (about 30% of GDP) and fixed assets accumulation (about 20% of GDP) and encourage the growth in private savings. Without it, the financial system might be linked to foreign capital in the amounts exceeding reasonable requirements of international integration.

Volatility of financing sources became quite evident once the world’s liquidity crisis emerged. The crisis reduced lending volumes and increased lending rates. Any financial institutions using or intending to use foreign financing might face increased capital raising costs and this inevitably increases lending rates for borrowers.

If domestic financial resources are to be mobilized we should maintain favorable evolutionary background growth in savings above all through reducing inflation and taking structural measures to promote long-term financing through increased assets and long-term liabilities.

Inflation and efficiency of government expenditures

High inflation and its low predictability is a key reason for the lack of private savings. In all social strata, irrespective of their income levels, consumer behavior, financial literacy, financial investments and in the end, their perception of inflation, price growth discourages savings and confidence in financial institutions’ stability. Increased uncertainty makes Russian companies curtail their investment plans; it hampers their plans’ implementation and shortens their business planning horizons.

One of the reasons for inflation in Russia is the outrunning growth in government expenditures and their low efficiency. In the last three years, the federal budget increased almost by 1.5 times in real terms and in nominal terms it almost doubled. This growth outran that of GDP: the federal budget share of GDP increased from 15.8% of GDP in 2004 to 18.8-19.1 in 2008. Only in the first quarter of this year federal budgetary expenditures increased by one percentage point of GDP. The 2007 budget surplus of 5.4% of GDP is projected to all but vanish in the coming three years.

It was traditionally believed that we could control inflation not only through limiting budgetary expenditures but also through strengthening the ruble, which increases imports. Since 2003, when the ruble’s nominal appreciation started imports rose threefold. But now this gives minimal effect: the ruble’s excessive appreciation has a negative impact on domestic producers and mi-term reduction in Russia’s trade balance surplus would stabilize and might weaken the ruble by as early as 2010-2011.

The surge in food prices in world markets caused by the rapid growth in demand in developing countries results in the import of foreign inflation. In the past year, world food prices increased by more than1.5 times and grain prices almost doubled. Nevertheless, increased food production is not expected to return prices to their previous levels. The situation in regulated tariffs is another component of inflation. Nevertheless, growing government expenditures are now the main factor behind inflation.

We can’t limit our fight against inflation to cutting down budgetary expenditures alone we should analyze budgetary expenses efficiency and their final performance per each ruble spent. Budgetary expenses are noninflationary if they are used to reduce high production costs and help accelerate economic growth.

At present, financial authorities give top priority to using relevant mechanisms for administering expenditure rather than to expenditures efficiency and their practical performance. Essential steps have been taken to make budgetary procedures more transparent, to better report and substantiate them but they do not determine efficiency of government expenditures. An attempt to link government authorities’ performance with their financing does not yield tangible results. And we won’t improve the situation without changing the system of financial administration.  Basically, these changes should change the system of personal responsibility inside government agencies. Thus, hard work lies ahead in reforming the budget system, recipient sectors and this work aims to reduce excessive expenses and inflation.

Long financing: role of funded pension system

Control over budgetary expenditures and their performance would allow to make budget surplus more stable and carry on replenishing the National Welfare Fund (NWF), which now amounts to 2.3% of GDP. The establishment of the National Welfare Fund designed to stabilize the pension system is in line with world trends. Already today, the volume of national finds in the world economy established to support pension system exceeds that of sovereign funds accumulating budget surpluses including revenue from raw materials exports and in part international reserves. By an estimate for the year 2007 the amounts of these funds were put at 4,4 and2.5 trillion dollars respectively.

The Budget Code provides for the potential use NWF funds to cover deficit of the Russian Pension Fund and co-finance voluntary pension funds of citizens. These two different options of using NWF funds are designed to secure pension guarantees and raise the level of pension security – two priorities of economic policy.

The decision to use the National Welfare Fund’s financial resources to finance deficit of the Pension Fund is short-term and if we do so we NWF’s resources might be spent very quickly especially under unfavorable foreign oil price conditions. If we finance the insurance pension system’s current deficit we can’t achieve a sustainable solution we can only partially smooth out problems caused by changes in population age structure and imbalance between the Pension Fund’s receipts and liabilities.

The use of NWF’s funds for co-financing individual voluntary savings of citizens sets in motion a principally different mechanism because in this case we do not finance current pension payments but use these funds for building up individual pension savings until a person retires. In this case, pension savings benefit not only citizens but also are a source of long money, which is in short supply in our economy and is needed to finance major investment projects with a long payback period. Thus, NWF’s money will be used to increase lending volumes and credit periods and this would make it possible to finance infrastructure investments.

Hence, we have every reason to use the National Welfare Fund’s financial resources to capitalize pension savings funded portion to promote long –term lending of the economy and improve the pension system. Nowadays, invested pension reserves in Russia are so far as small as about 1.5% of GDP, at the same time in a number of countries this figure exceeds 70% of GDP for example in the US and Great Britain. If we are to achieve percentage levels of such European countries as Germany or Italy (3-4%) we’ll have to increase pension savings by several times.

Increased financial capacity of the funded pension system would yield substantial gains both for the economy and citizens. A part of national savings invested now in the international reserves would secure long-term investment in Russia through the national financial market’s mechanisms. As opposed to using these funds through the budget or for covering deficit of the Pension Fund, their efficiency is much higher if they are invested through the funded pension system including private trust management companies. The funds will be placed to citizens’ individual accounts increasing their own pension savings. In fact, this is the only adequately functioning personicified and transparent way of distributing funds. And principles of calculating accruals bring gains to elderly people.

The decisions taken this year on co-financing citizens’ additional pension savings create an important precedent for using NWF’s funds. The extent of citizens’ participation allows us to reveal their interest in increasing their pension savings and see to what extent they trust the funded pension system. This is a valuable practical experience. Nevertheless, the proposed co-financing volumes would be rather limited and, given citizens limited participation, are comparable with the National Welfare Fund’s interest income.

We must allow for further expansion of financing for pension savings by using NWF’s resources. The flow of these funds into the Russian financial market should be gradual lest an emerging appraisal of Russian assets and interest rates be distorted. If these funds are used in the right way, the proposed reform will improve pension provision to citizens, boost the appeal of the Russia stock and debt market and help establish Russia as the world’s financial center.

A new class of long-term financial instruments

In order to expand long-term investments we’ll have to develop new mechanisms and investment instruments of long duration comparable with the duration of pension liabilities.

This class of debt instruments includes, for example, infrastructure bonds, which are actively used in the US. It’s quite evident now that demand for this type of investments, given increased pension savings, will grow and we should make arrangements for issuing such infrastructure bonds in advance.

There are several options for issuing infrastructure bonds. Under the first option they may be issued in the form of debt instruments of individual or syndicated investment projects with a guarantee granted by the state Russia’s region or a large financial institution. These bonds may also be the state’s target liabilities increasing investment resources of federal or regional budgets. The second option is designed for investments in infrastructure intended for free use, for example, in the education sector. The first option is applicable to paid facilities. This large part of infrastructure includes power engineering, transport, housing and communal services, telecommunications.

Private investors’ interest in infrastructure bonds would depend on the quality of investment projects preparation and implementation because funds are raised for such investment projects. This means that a project’s business model and its organizational and legal framework should be easy to understand, investors should be confident that the project will be paid back, established tariff terms are stable and their investments will be paid back and yield a return.

There is no doubt that by launching a number of new unique projects in various infrastructure segments we are just starting a process of large-scale investing. It is the Bank for Development that is directly responsible for organizing such investments including raising financing and the experience the Bank is gaining in this sector will form the basis for developing and spreading reliable financial instruments including infrastructure bonds. This experience would be highly instrumental in raising long-term financial resources for infrastructure projects on the emerging financial market.