May 30, 2006
Banking on Russia’s Growth
By Paul Abelsky
Russia Profile
But Is the United States Standing in the Way?
For years now, Russia’s accession to the World Trade Organization (WTO) has remained an elusive goal. Recent political volatility has raised new doubts about the possibility of an imminent breakthrough in talks with the United States, Russia’s main sparring partner in terms of accession. Official promises of a swift resolution to a set of lingering disputes have not helped to overcome the stalemate.
On several occasions last year, Russia’s Minister of Economic Development and Trade, German Gref, forecast that Russia’s entry would take place by the end of 2006. In May, however, Maxim Medvedkov, head of the Russian delegation for accession talks, sounded less optimistic, saying that Russia could join next spring if negotiations are wrapped up by the year’s end. But he also referred to another scenario, in which continuing inconclusive talks could prolong the process indefinitely.
Despite years of negotiations, there has been a lack of significant progress on the few outstanding problems. Chief among these are questions concerning the protection of intellectual property rights and the opening up of Russia’s financial services sector, including banking and insurance. A particular point of contention centers on allowing foreign banking institutions to open branches on Russian territory. So, despite a general consensus on the importance of implementing copyright law, the Russian side is split on the question of admitting foreign banks, even as capital inflow from abroad is playing an increasingly large role in Russia’s financial sector.
This impasse poses the principal challenge to Russia’s WTO aspirations. American negotiators have long insisted on unhindered access for foreign banks as an essential prerequisite for membership.
Although Russian legislation requires foreign banks to undertake the more costly option of opening subsidiaries in Russia, as many as 137 financial institutions in 30 different regions today are at least partly foreign-owned. Despite the present restrictions, the share of foreign capital in Russia’s banking sector increased by more than 5 percent in the last year alone, to 11.5 percent.
“There are currently no formal obstacles against foreign banks operating in Russia through resident subsidiaries,” said Richard Munn, a partner at PricewaterhouseCoopers in Moscow who specializes in the financial services sector. “If you look at Raiffeisen, which has recently acquired Impexbank, one of the largest Russian banks in terms of regional network size, or Citibank, with its aggressive sales strategy, you will see that those who would like to do business in Russia are already here, and most of them are quite successful.”
There are several traditional arguments in favor of liberalizing financial services markets in developing economies. Some studies have found a strong correlation between increased economic growth and more efficient capital allocation, the introduction of international banking standards and the growing access to foreign financial markets that foreign participation can bring.
The banking sector can also play a vital role in economic diversification by distributing funds to various sectors. A 2001 analysis by the International Monetary Fund (IMF) illustrated other advantages of open economies by examining the performance of 50 developing countries. The presence of foreign banks accounted for greater annual stock market turnover, while the volume of credit advanced to the private sector exceeded the same figure for closed economies by 7 percent.
A report issued by the Moscow Carnegie Center makes the case that an insufficiently developed banking industry is one of the basic constraints on the development of the Russian economy. Outside the energy sector, which has consistently been able to secure foreign capital and banking services, other segments of Russia’s economy could generate considerable growth if more foreign banks were present as intermediaries.
Advocates of the protectionist stance contend that foreign banks would enjoy a strategic advantage in the form of access to cheaper capital overseas, and would thus imperil the operations of domestic outlets by exposing them to unfair competition. Russia’s Central Bank would also be unable to oversee the sources of capital flow, increasing the likelihood of money laundering and other machinations.
“There’s no need to allow foreign banks to open subsidiaries in Russia,” said Richard Hainsworth, general director at RusRating, an independent bank-rating agency in Moscow. “The leading transnational banks that wanted to work in Russia are already operating here through their local branches. The Central Bank is not imposing any hurdles, and Russian banks enjoy no advantages over foreigners, since conditions are equal for everyone. In general, we believe that direct subsidiaries will create loopholes for terrorists and will enable illicit schemes.”
Among those who oppose opening the country’s banking industry are many powerful government officials, including President Vladimir Putin himself. Last December, during a meeting with bankers in Novosibirsk, the president vowed to resist the changes. In arguing against greater access to foreign institutions, Putin raised concerns over national security, noting the difficulty of tracing capital movement in a globalized world economy. “The activity of branches of foreign banks in the Russian Federation should be limited,” he said. “In essence, it must be banned.”
Other key government officials have spoken out against further concessions, including Medvedkov and Deputy Prime Minister Alexander Zhukov. Garegin Tosunyan, the president of the Russian Banking Association, has similarly opposed outright liberalization, while arguing in favor of other effective strategies to attract foreign banking. Alexander Shokhin, president of the Russian Union of Industrialists and Entrepreneurs, said recently that yielding to the United States on this issue might necessitate additional consultations with countries that have already agreed to Russia’s accession, as they could demand to rework their deals in light of new developments.
The present Russian legislation imposes a number of checks on the participation of foreign players in the country’s banking sector. A foreign branch office that is subject to the laws of the Russian Federation is under the jurisdiction of the country’s Central Bank and all of its directives. In the official Russian view, the banking industry, along with several other strategically important sectors of the economy, is entitled to state protection and oversight.
Finance Minister Alexei Kudrin has stated that setting up direct branches would divert investment away from Russian banks. Considering the relative vulnerability of domestic banks, the fear is that giving greater access to foreign institutions might also deprive the country of financial independence. Unlike Russian-based subsidiaries, direct branches are backed by the mother company’s guarantees, which allow them to raise money in their home jurisdiction according to capital costs there.
According to data compiled by the IMF, foreign control of bank assets rose from 3 to 53 percent in Central Europe and from 8 to 25 percent in Latin America between 1994 and 1999. “Lower costs of financial resources and the lack of control over capital movement could destabilize the banking system,” said Dmitry Lepetikov, director of the Center of Development, an independent economic think tank in Moscow. “Foreign banks are already active through their branches in Russia, which are among the country’s largest financial institutions.”
A number of foreign banks have established a secure foothold in Russia, and are now looking at further development through regional acquisitions. France’s Societe Generale, for example, took over Samara-based Promek-Bank last year. Turkey’s Finansbank, Austria’s Raiffeisen, and Citibank, from the United States, are the main foreign banks with a growing presence throughout the country. “Transnational banks already present strong competition in Russia, having a well developed practice of business operation and corporate style of management,” said Hainsworth of RusRating. “That allows them to be more efficient, reliable and profitable. Russian banks need to adopt their experience and transform themselves in order to endure the competition. Russian banks should, in turn, become transnational, first winning the confidence of their main clients the domestic businesses and then following their clients as they begin to expand beyond Russia.”
Despite the possible destabilization of the Russian banking sector and lingering concerns over national security, easing the terms of foreign entry is likely to benefit consumers. A more competitive environment will compel domestic outlets to restructure and adjust the terms of their operations.
“Russian banks will have to invest a lot of time and resources to increase their investment attractiveness and competitiveness,” said Munn. “They are tracking what foreign banks do both in Russia and abroad, and trying to implement innovative products and technologies. As a result, it is the customer who finally gains from this expansion and increasing competition with foreign banks. With the growth in the number and sophistication of products, the quality of customer service is improving and the costs of banking are falling.”
The experience of the banking system’s breakdown in 1998 still shadows today’s recovery. The 1998 crisis brought the total value of deposits down to $13 billion, almost half of what it was before the collapse. By the third quarter of 2005, however, deposits had risen to $119 billion. The system is still dominated by several state-owned enterprises, such as Sberbank and Vneshtorgbank, which enjoy the competitive advantages of federal guarantees and the consequent lower cost of funds. Reducing the state’s share in the internal financial market is one of the government’s declared priorities.
The limited presence of American banks in Russia stands in contrast with the activity of European institutions. Indeed, both the European Union and Switzerland have settled all issues pertaining to Russia’s regulatory banking mechanisms.
Against the background of growing strains in Russian-American relations, many observers say the stalemate in WTO talks between the two countries is affected by broader political tensions. As the lone remaining holdout on the issue of financial services, Russian negotiators believe the United States is sabotaging Russia’s integration into the global economy. At a time of growing criticism of the Putin administration by American officials, the United States is unlikely to make a conciliatory gesture to Russia and compromise on what it believes to be a consistent, long-standing policy applied to all WTO hopefuls.
This political undercurrent will complicate the bargaining process and undermine the search for a pragmatic settlement to the dispute. “American stipulations do not sound compelling in economic terms, and may increasingly reflect a chill in bilateral relations,” said Lepetikov. “A possible compromise solution could consist of adopting the Chinese approach, which permits a setup of foreign subsidiaries, but monitors the sector with stringent supervision. Russia could agree to a similar tradeoff, but there aren’t any obvious benefits to us in such a swap.”
Hainsworth believes the situation is unpredictable enough to allow for different outcomes, depending on America’s political priorities. “The American side presents the last obstacle in the way of Russia joining the WTO,” he said. “There isn’t a convincing economic case for privileging bank subsidiaries over resident branches. That is why a resolution to this question rests solely on the political will in the United States.”
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