Russian President Dmitry Medvedev claimed that he wants to make an International Financial Centre out of Moscow. And this became a key driver of all his plans regarding modernization of the Russian economy. Nevertheless, during the Q1 of this year, capital outflow was estimated at USD 21 billion. Besides, chief economic advisor to Mr. Medvedev recently admitted that the President is certain that “we didn’t have any real progress in investment climate improvement. We need this progress right now, as soon as possible. The level of investment is very low, but the capital outflow is quite substantial”.

The comments of the President’s advisor relate to just one part of a larger global problem, a Moscow’s self-imposed greater challenge to become a Financial Centre. There is a number of serious obstacles to overcome.

Corruption is corrosion in our country. Russia occupies the 154th place out of 178 in the 2010 Corruption Index by Transparency International. Russia also has a well-deserved reputation of a deeply bureaucratized country. In the World Bank report covering the process of obtaining a construction permit in 182 countries, Russia takes the 2nd place in the world in terms of complexity of the procedures. Among other obstacles is inadequate infrastructure affected by mass transport delays, as well as unexpected forced shutdowns of the stock market, a practice brought about by the financial crisis.

Due to this or other causes, the latest Z/Yen rating of 75 international financial centres places Moscow at number 68, behind Manila, Jakarta and Malta.

The low profile of Moscow is reflected by a low investor base, which is quite small both among retail investors, and among institutional investors. Large Russian companies, even global leaders in particular spheres, frequently choose London and Hong Kong for IPOs.

The prices vs salaries ratio in other BRIC countries is 50% higher than in Russia on average.

The market capitalization vs GDP ratio is twice or three times as low as in the majority of in developed G20 countries, and even lower than that in Latin America or the CIS, for instance, in Poland. Despite all this, Russia has very strong potential.

Oliver Wyman’s recent report on leading Russian financial market players highlighted the gap between Moscow and the top financial centres such as New York and London. Respondents stated the rule of law as the key problem area in need of regulatory improvement, pointing out a lack of counter-corruption measures and fighting economic crime.

Respondents were also asked to name priority areas. Improving market liquidity and boosting long-term financing was named as the most pressing task is. Next is the creation of a Centralized Depositary system. The third is improving transparency.

To attract investments, respondents recommend tightening regulation and oversight, improve disclosure, offer better protection of minority shareholders and modern corporate governance standards.

These reforms may considerably boost investors’ trust and help eliminate the ‘Russia discount’ versus other emerging markets. Also, the reforms will widen the retail and institutional investor pool.

Russia has made certain steps in the right direction. A new regulator is being created to perform both financial and insurance market oversight. Steps have been taken to implement Basel II and Basel III accounting in the banking sector, which is bound to improve transparency. The MICEX - RTS merger is expected to consolidate the market infrastructure, compensating the lack of a central depositary. The consolidated exchange could also be instrumental in defining a clear role for Russia in the global market infrastructure, while global M&A activity continues to grow.

The state USD 50bn privatization programme primarily focused on selling minority stakes in leading oil, banking and logistics companies, will add to Russia’s drive towards free market development, bringing in more investments. However, without legal and court reform, international investors will still worry about minority rights protection in state companies.

Moscow indeed has a series of advantages. The city is naturally poised through its location to bridge Europe and Asia. Besides, there are language and cultural ties with the former Soviet republics, today’s Commonwealth of Independent States (CIS). The overall education level is high, there are many high-profile math and tech specialists in the area. Possibly the most crucial factor is the country’s economy, with the world’s 6th strongest buying power and massive natural resources providing solid base for future growth.

While it still remains to be seen whether these advantages will help Russia overcome the hard times, the country leaders should consider Poland’s experience. In order to develop the financial sector, Poland built a strong base of private and local institutional investors, when privatization started in various industries in the early 1990’s. In the meantime, conditions for direct foreign investment were being improved. Companies were listed through Warsaw, not through foreign exchanges, at a cost that could offer fast profit for local investors. The Warsaw Stock Exchange IPO last November drew 323 thousand private investors, more than there are active investors in all of Russia.

This strategy boosted the development of Poland’s financial sector. In recent years, local capitalization and liquidity rose, with investors and IPOs focusing on Warsaw, and the Warsaw Stock Exchange reinvested the funds in infrastructure and production, inciting more placements.

This experience has value for Moscow becoming a financial centre, and it is being analyzed by the Taskforce assembled by President Medvedev last year. Alexander Voloshin, the ex-Head of President Putin’s Executive Office, directs this effort.

Still, certain Russian insiders are skeptical, doubting the possibility of actual positive change and expecting concrete steps. Based on past experience, this skepticism is justified. However, the potential outcome of the reform is valuable for Moscow – it will help attract investments, diversify the country’s economy and improve well-being.

Mr. Maciejko is Partner at Oliver Wyman, a global management consultancy. He has 24 years’ experience in Russia and the region.

Robert Machejko

Trading infrastructure, Project Group №1, Project Group №2, Robert Maciejko, Alexander Voloshin