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18.06.07
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Russia And China: Growing, Globalizing, Gambling With The Stock Market
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By Irina Aervitz
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Editors Note:
In 2003, economists at the Goldman Sachs Research Institute introduced the idea of the BRIC – an acronym that refers collectively to Brazil, Russia, India and China. The economists at Goldman Sachs believed that these emerging markets, if properly managed, could dominate the world economy. Over the next few months, Russia Profile will run a series of articles comparing Russia with its BRIC counterparts, focusing particularly on issues of population growth, education and adherence to Western business practice and guidelines.
The market-oriented reforms in China started a decade earlier than those in Russia and China’s reforms have been characterized by a slower pace than Russia’s prompt transformation. Despite China’s flashy credentials as an economic “whiz kid,” both countries continue to face challenges in their economic development.
Russia has maintained stable economic growth, averaging 6.7 percent a year since the financial crisis of 1998. The economy has been on the rise due primarily to oil and gas exports and, to a lesser extent, to growing consumer demand and investment. The federal budget has run surpluses since 2001 and ended last year with a surplus of 9 percent of GDP. Foreign debt decreased to 39 percent of GDP, including commercial debt to foreign investors. Foreign direct investment (FDI) rose from $14.6 billion in 2005 to about $30 billion in 2006. In 2006, Russia's GDP grew 6.6 percent, while inflation was below 10 percent for the first time in the past decade.
Despite Russia's recent accomplishments, serious problems remain. Oil, gas, the metallurgical industry and timber account for more than 80 percent of the country’s exports and 32 percent of government revenues, exposing Russia to global instabilities of commodity prices. The banking sector is still in an embryonic stage of development, even though loans and mortgage plans have become an everyday reality for many Russians. Russia suffers from political instability, the authoritarian tendencies of the current regime, and corruption at all levels of government. Russia’s international reputation as a destination for investment has suffered from political backlashes and scandals like the state appropriation of the Yukos oil company. The rule of law is loosely interpreted by politicians, which undermines investors’ confidence.
In the 1990s, Deng Xiaoping announced that China should not be constrained by ideological and political arguments over which name economic reforms should carry – socialism or capitalism – implying that the economic transition was not about the name, but the process. Today, China is the world's fourth-largest economy. The economic reforms were made up of a variety of measures, including: fiscal decentralization, the amplified autonomy of state enterprises, a diversified banking system, the creation of stock markets, amplified growth of the private sector and opening up to foreign investment. China has allowed foreign investors to create joint ventures with Chinese partners to manufacture and sell a wide range of goods on the domestic market. In some industries, the state even authorized the establishment of wholly foreign-owned enterprises. China is now one of the leading recipients of FDI in the world, receiving $60 billion in 2005, and a cumulative total of $623.8 billion since the beginning of the economic transition in 1978. In 2006, China's holdings of foreign-currency reserves, the gains of fast-growing exports, reached $1 trillion. Also as of 2006, exports constituted $974 billion and imports, $777.9 billion. China has experienced more than two decades of solid economic growth, averaging 10 percent annually, the highest growth rate in the world. In Africa, China has surpassed the UK to become the continent's third-most important trading partner after the United States and France. According to Citigroup, 25 years from now, China will be the world's largest economy.
Despite the impressive economic development record, China has to pay a high ecological price for rapid industrialization, with millions of deaths every year attributed to air and water pollution. The enforcement of environmental laws leaves much to be desired. Many power plants and factories depend on coal and don't invest in clean technologies. A continual increase in car consumption has led to high levels of air pollution in cities. If China’s number of motor vehicles per capita was comparable to the world average, its fleet would total 160 million, with 10 million new and replacement vehicles bought each year. If the Chinese government does not act quickly, the long-term costs of health problems linked to environmental hazards will aggrandize. There is also a social downside of economic acceleration – the growing gap between the rich and the poor. Economic growth has been more successful in China’s coastal provinces than its interior, and there are large discrepancies in development across regions. China’s economic miracle is a combination of successes and challenges and requires a balanced analysis.
Improving the Investment Climate
Increasing FDI is on the priority list for the Chinese government. Major ingredients for successful attraction of investment include, among other things, developing infrastructure, creating tax exemptions and an overall improvement of the legal system. One of the most important goals of the Chinese state is to increase the effectiveness of state-owned enterprises, which are encouraged to form partnerships with foreign investors in search of technology and financial flows. Another means of financial assistance to state-owned enterprises is the Chinese stock market, which is closely supervised and administered by the government.
Russia has also succeeded in attracting investment, since a number of improvements have been made in Russia’s legal system and overall adherence to corporate governance principles. Like in China, the Russian government is heavily involved in the business sector, particularly in extraction and other strategic industries. The lack of consistency in investment policies due to conflicting vested interests and minimal inflows into infrastructure development has thus far prevented Russia from attracting more FDI.
In China, the investment policies are decentralized. The special economic zones (SEZs) are financially independent from the central government. Officials in the SEZs invest into infrastructure, and frequently the zones compete with each other to lure investors. The major infrastructural hubs are in the coastal areas, while the regions to the west are lacking in development.
The Chinese government is building infrastructure networks, particularly in the telecommunications sphere, at a rapid clip across the country. In December 2006, three Chinese telecommunications operators that belong to a large international consortium signed an agreement with Verizon Business to build the first next-generation optical cable system directly linking the United States and China. The usage of mobile phones in China is widespread – 437.48 million in 2006. The total number of Internet users in 2006 was 123 million.
Russia’s infrastructure is improving in quality and quantity, especially in large urban areas. The telecommunications market is still monopolized by government-backed Rostelecom, which remains the largest long-distance telecommunications operator in Russia. However, multiple companies have acquired licenses to offer communication services; 1,000 firms were reported to have purchased licenses in 2005. Access to digital lines has improved. The estimated number of mobile users increased from fewer than 1 million in 1998 to 120 million in 2005. Additionally, in 2005, 23.7 million Internet subscribers were recorded.
China and Russia use railways to a similar degree of efficiency. China has 74,408 km (46,000 miles) of railroads, Russia - 87,157 km (54,000 miles). China is currently investing into the construction of highways, trying to increase the number from the current 1,870,661 km (1,162,374 miles) of roads. In comparison, Russia has only 871,000 km (541,000 miles) of highways.
In order to create a favorable investment environment and to encourage foreigners to invest in China, at the end of the 1970s, the Chinese government began to build a relatively complete legal system for investment. This system includes industrial policies, regional policies and financial policies. At the regional level, SEZs control the most successful mechanisms for attracting investment, including tax incentives. Furthermore, local administrations in SEZs provide additional benefits for investors in the form of import tax exemptions and advanced infrastructure including roads, communication networks, R&D institutes and even housing and recreational facilities.
Russia’s investment policies are more centralized. Most tax revenues in Russia are allocated from the federal budget, which does not give regional authorities the right to grant special tax privileges to investors. Furthermore, there is not enough money in local budgets to spend on infrastructure, which, according to the Chinese SEZ model, is crucial for creating a favorable investment climate.
The Russian government has acted, however, to increase the inflow of FDI by adopting the Organization for Economic Cooperation and Development’s (OECD) Principles of Corporate Governance, reforming its land law, its customs code and foreign exchange regulations. Furthermore, following the Chinese experience of SEZs, Putin signed the Federal Law on SEZs in July 2005. The ten prospective economic zones will offer customs and tax privileges. By the end of 2007, two kinds of zones will be created: Technical development zones and manufacturing zones. The companies in these zones will be exempt from local property taxes for five years, and freed from import and export duties to stimulate exports and overall industrial development. The government plans to invest $280 million from the federal budget into infrastructure projects in these zones.
Corporate Governance
The Shanghai Stock Exchange began operations in late 1990, and in 1991 China’s second stock exchange was opened in Shenzhen. The China Securities Regulatory Commission (CRSC) was founded in 1992. Since then, the Chinese stock market has become one of the largest and most active in the world. By 2005, China had about 1,400 publicly listed companies. Currently, the capitalization of the two stock exchanges exceeds 16 trillion yuan ($2 trillion), or 80 percent of the country's GDP. At the end of 2005, the government made it possible to turn non-tradable state holdings in listed companies into tradable shares. The stock market inflated like a balloon with the Shanghai Composite Index accounting for 130 percent of its 2004 figure. The stock market hit a record with more than 90 million investment accounts. With so many people involved, a market crash might lead to a political backlash. Every 14th Chinese person is now an investor. In fact, the public enthusiasm in stock specialization is unprecedented; in some ways, it is like a gold rush. Taking into account the scale of public interest and volume of investment, establishing an effective corporate governance system that protects the rights of shareholders and assures transparency is one of the critical elements for the future success of China’s stock market.
The decision at the end of 2005 to lift restrictions on the purchase of state-owned non-tradable shares was dictated by an attempt to improve the overall corporate governance practice. When the stock market was founded, most of the listed firms were converted from state-owned enterprises with the government majority ownership. This system presupposed a high level of control exercised by the state in these companies, which was frequently accompanied by a lack of transparency and financial disclosure. The creation of the stock market was always seen by the government as an additional financial source for state-owned enterprises and therefore, the state has made a constant effort to maintain the balance between control and growth. Almost 50 percent of the company’s boards were reported to be appointed by the state, and another 30 percent were affiliated with the state.
Several traits shaped the emergence and development of China's stock market: State control over the listed firms, the high concentration of ownership in a few hands, the close relationship between the management and the board of directors – which is dominated by a few large shareholders. The state’s desire to maintain control over the stock market was motivated by its social and political obligations to enhance the effectiveness of and allow for financial inflow into its own enterprises, to preserve jobs and exercise control over strategically important industries. Currently, state efforts at control are being overruled by the desire to create a more market-oriented corporate governance regime and a more wholesome investment environment as part of the ongoing reform of the stock market.
A series of post-Soviet laws from 1994 through 2001 created a corporate governance system in Russia. Russia's Federal Commission for the Securities Market (FCSM) was established in 1996. In 2004, it was replaced by the Federal Financial Markets Service (FFMS), which inherited all of FCSM's controlling and supervisory powers. Moscow Interbank Currency Exchange (MICEX), the largest stock exchange in Russia, opened in 1992. Today, about 600 domestic companies are listed on MICEX, including such “giants” as Gazprom, RAO UES, LUKoil, Norilsk Nickel, Sberbank, Rostelecom, Surgutneftegaz, Mobile Telesystems, Tatneft, Uralsvyazinform – the total capitalization of which is almost $900 billion. Like the Chinese, Russians actively buy stock. In 2006, the total value of transactions on the MICEX reached 20.4 trillion rubles ($755 billion) with stock trades accounting for 14.9 trillion rubles ($550 billion), which constitutes 90 percent of the total exchange-based turnover on the Russian market.
Like in China, high ownership concentration and close state involvement are problems for Russia. In the 1990s, the so-called red directors – former Soviet managers –concentrated stock in their hands and thus combined both ownership and control, which is why many Russian companies suffer from low liquidity. However, according to federal commercial law, a company’s CEO cannot be chairman of the board of directors. Russian law also allows the federal government to exercise power over changes to company charters. The presence of government representatives on boards of directors is widespread – particularly in strategically important sectors. Russian companies in general have issues with financial transparency, disclosure of major shareholders and accounting standards.
Russia’s experience with privatization was very different from China’s. In China, the stock market was established to support Chinese state-owned enterprise. In Russia, however, privatization was launched for the sake of privatizing itself in light of Russia’s rapid attempt to become a full-fledged market economy. Russia’s privatization led to the allocation of property in the hands of the former Soviet managers and other interested parties, which later resulted in a wave of corruption, rent-seeking, internal dealings and political and actual racketeering.
Both Russian and Chinese companies and regulators are making an effort to transform the current corporate governance practices since as the economies grow, so does the competition for investment. The reforms focus on increasing financial transparency, improving voting procedures and creating better mechanisms to protect shareholder rights. The imposition of the U.S. Sarbanes-Oxley Act or the UK Combined Code on accountability and financial transparency principles is a distant target for most companies in Russia and China, however, the process is under way as more and more firms become listed on the stock exchanges in London and New York. Both outside and domestic inventors are also pressuring for better corporate governance practices. Furthermore, the legislation process in both countries is influenced by international organizations like the International Monetary Fund (IMF), the World Bank, the OECD, and the World Trade Organization (WTO).
Irina Aervitz recently received her Ph.D. in political science from Miami University. This is the third in a series of three articles comparing Russia with China in the context of the BRIC framework. |
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