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The uncertainty in these areas remains animportant factor behind persisting high risks of corporate governance andinvestment in Russia. Accordingly, the court reform (ideally resulting inindependent and transparent courts, where the prosecution arguing with thedefense must prove the necessity of procedural actions, which only the courtmay authorize), period of limitation for privatization transactions, clearlegislation on nationalization are at present the objective indicators of true aims of the authorities.

4.3 Sources of Financing inthe Corporate Sector

This important aspect of the problem isdirectly related to the more active operations of the largest companies in thesphere of improvement of corporate governance. According to a survey of largestRussia’senterprises conducted in 2000 through 2001, 80 per cent of the surveyedenterprises indicated their demand for shared investments, although only 14 percent of companies practice them, mainly via ADR – GDR programs, 66 per cent haveno possibilities to attract them, and 20 per cent are not interested in suchinvestments. Debt financing (borrowings) are used by 59 per cent ofenterprises. However, internal funds remain the major source of investment (91per cent of enterprises)18.

The highest demand for external sharedinvestment is demonstrated by Уinvestment depressiveФ industries with obsoletefixed assets and high capital intensity (telecommunications, power engineering,mechanical engineering). At the same time, these industries demonstrate leastactual results. The most active in attraction of external shared investment areУinvestment growingФ sectors with short production cycles, which are close toend consumers (consumer goods, retail trade). Lower demand for sharedinvestment was registered in Уinvestment staticФ industries disposing ofconsiderable amounts of internal funds (raw material industries, petrochemistry,metallurgy).

It is interesting to note that accordingto the data provided by the Bureau of Economic Analysis (BEA) the consolidationof joint stock capital is most characteristic of mechanical engineering andleast characteristic of light industry. In oil industry and metallurgy, the process of consolidationis practically completed. It is also registered that consolidation of propertyhas no positive effect on investment activity.

As concerns sources of financing, the dataprovided by the BEA sample is less optimistic. The following trends wereregistered for 289 investment active enterprises (in 1997 through 1999): anapparent growth in the use of internal funds (275 enterprises in 1999 ascompared with 257 enterprises in 1997), rehabilitation of pre-crisis level ofattraction of bank credits (37 and 38 enterprises respectively), decrease inshared investment at the expense of issues of corporate securities (1 and 8enterprises respectively), increase in external financing from Russian privateinvestors (14 and 5 enterprises respectively), and decrease in financing from foreign privateinvestors (0 and 2 enterprises respectively). The increase in the share of Russian privateinvestors is characteristic of enterprises where a significant share of control isexercised by other industrial enterprises (shares in the capital, members ofthe Board of Directors).

May significant shifts be expected in ashort time period The problem has several aspects.

The mentality of Уwild directorФ as apsychological problem of investment attraction was important in the 1990s.Practically every researcher of psychologicalspecifics of Russian directors registered their attitude towards externalinvestors based on theprinciple Уgive me your money and do not interfere in my work,Ф at the sametime, all of them welcomed the inflow of investment to their enterprises. As itwas mentioned above, the rotation of УoldФ general managers in Russia occurredat a rather high rate. At many enterprises there changed owners and the veryconcept of the investment process. In other words, УwildФ (and, therefore,hopeless cases) are mostly past history. A modern director, who became an owner or is closely relatedto the controlling group fully understand that in the situation of uncertaintyinvestments may be only exchanged for property, what is psychologicallydifficult after ten years of struggle and dangerous because it is possible to loosecontrol.

The problem of objectively limitedpossible sources of sources of financing is much more important. It is apparent that the overwhelmingmajority of enterprisesin processing industries, if only in theory, are interested in external jointstock financing. The latter is only one of the many types of corporatefinancing available intransitional economies; however, Russia has no luxury of choice19. The opportunity to usethe banking system as the engine of corporate governance and financing wasemployed in the mid-1990s and brought negative results. At present, banks arestill unable to finance the real sector for a long time due to insufficientinternal funds and short liabilities.

Some economies in transition were able touse direct foreign investment to stimulate corporate investment andrestructuring. At the same time, the corporate governance model based on the massive presence ofstrategic foreign investors in key sectors of the economy requires a stable andthoroughly cultivatedpolitical climate (exactly stability is the key element, as confirmed by theChinese experience).Although the attraction of direct foreign investment shall remain the priorityin certain sectors, there is low probability of a massive inflow in the short term outlook.

At the same time, under the presentconditions in Russia real external financing(both joint stock and borrowed) sharply increases the threat of hostiletakeovers (via purchase of shares, creditor indebtedness, promissory notes and/ or bankruptcy). In 1998 through 2001, such takeovers became a usualphenomenon.

The schemes of buying up of shares,financial bills, and creditor indebtedness, appointments of УloyalФ irremovable arbitration managers(in the framework ofcurrent legislation) and bankruptcies – i.e. actions aimed to takeover enterprises are well known. In 2001, there was used a new method– merchandise bills, which were issued inaccordance with the Presidential Decree УOn Merchandise and Finance BillsФ in1995 through 199720. Originally,merchandize bills wereviewed as order papers transferable by endorsement and denominated in goods. In1999, after several conflicts the Supreme Arbitration Court ruled that merchandise bills were Уdebtwritten liabilitiesФ transferable under cession agreements and registered inaccounting (creditor and debtor indebtedness). At the same time, debts overduemore than 3 months should be included in the profit tax base. Since it was notdone, all participants of bill payments automatically could be accused ofconcealment of indebtedness and tax evasion. In 2001, this opportunity was usedby УAlfa EcoФ to take control over Orsko Khalilovski integrated iron and steel works (NOSTA).Taking into account the fact that in 1997 the amount of merchandise bills incirculation was 2.5 to 3 times over M2 aggregate, the potential of thistakeover method becomesquite clear. The only natural limitation of this method is that potentialaggressor has to involve regional authorities, FSFO, and tax agencies, i.e. to mobilizeУadministrative resourceФ in order to detect debts to the budgetoriginated over theperiod of bill payments and to initiate bankruptcy procedures.

In this connection, the self-purchase ofshares and intentional accumulation of creditor indebtedness (resulting in the concentration ofshares or all liabilities in an affiliated company) becomes a wide-used methodto prevent hostile takeovers. Obviously, it results both in undermining ofself-financing capacity, and in lower attractiveness of enterprises forexternal investors. Yet another constraint on external joint stock financing isthe market undervaluationof many companies(regardless of reasons).

In this connection, it is of interest torefer to the results of an IET survey on the dynamics ofenterprises’indebtedness conducted in1999 and 2000. Thus, 82 out of 109 surveyed enterprises responded that theyeither had no debts to suppliers and the budget in year 2000, or could decrease the debt incomparison to 1999 figures. Although this trend may be initiated by manyfactors, it may be anindirect evidence of growing anticipation of debts as an instrument of corporate takeovers.

In this situation, corporate bonds becomethe only safe way to attract external financing. Among advantages of this method of financing,what caused the surge of interest to it in 2000 and 2001, there may beindicated the following:

- relative safety in terms of retainingcorporate control;

- deficit on the market of corporateinstruments with fixed yields in the favorable business situation (budgetsurplus, low inflation rates, decreasing rates on the market of public debt);

- interest of Russian investment agents(broker and dealer companies and banks) to promote new instruments of the stockmarket;

- lesser dependence of borrowers on onecreditor;

- more flexible system of management ofliabilities, longer terms of credit, and lower cost of borrowed resources;

- tax-related advantages over bank creditsand bills;

- formation of (via УtrialФ and,most importantly, repaid relatively small loans) credit history and image of afirst-class borrower;

- absence of defaults, which would resultin higher yields on the market, in the post-crisis history of the marketsegment (although thevery amounts of issues of 2001 are a growth-generating factor).

The FCS register lists 370 issues. In thepost-crisis period, the first issue of Ruble-denominated corporate bonds wascarried out by NK УLukoilФ (May of 1999). УGazpromФ and TNK followed the suitin hope to attract funds of non-residents to УCФ accounts. By mid-2001, morethan 40 companies issued bond in the aggregate amount above Rb. 110 billion. Inthe first half-year of 2001, the FCS registered 66 issues (Rb. 11.5 billion).In the second half-year of 2001, the rate of issue was maintained at the samelevel (not less than 20 issuers, some of them issuing several tranches).

In 2001, there were registered changes onthe secondary market. Prior to the autumn of 2001, the overwhelming majority ofissues was placed with previously chosen investors, who were not inclined to sell bondsbefore the repaymenttime, i.e. was of the closed nature and placed over a very short period oftime. These issues were often used as an alternative (to crediting) way of financingof various projects in the real sector related to takeovers carried out viasubsidiaries and affiliated structures, or to optimize tax payments. Not morethan 10 issuers (about Rb. 6 billion worth of issues) were present on thesecondary market. MICEX became the main trading ground (80 per cent of themarket), since 1998 there have been placed bonds worth about Rb. 60 billion. Byend-2001, more issuers offered their bonds on the open market (publicissues), while the amountof the market increased threefold (secondary turnover at about Rb. 20 billion).The bond boom resulted in revaluation of the liquidity of this market segment:the share of liquid bond in rankings increased from 1/5 to 1/3. According toestimates, by the end ofsummer of 2001 50 per cent of bond issues were publicly placed21.

As a result, over 2 years the amount ofexternal funds attracted by enterprises and banks has reached US $ 2 billion, or about 3 per centof gross investment inthe Russia’s fixedassets. At the same time, in G 7 countries 30 to 60 per cent of investmentprojects are financed at the expense of bond issues. A number of problemshinders the development of this market: the tax on operations involving corporate bonds (0.8 per cent offace value of the issue prior to its registration); the lengthy registrationprocess in the FCS; general standards of additional issues of stocks, ordinary and convertiblebonds; the problem ofdifference between theauthorized capital and assets of the company (the amount of issue can notexceed the registered charter capital); in some cases the feasibility toguarantee bond issues; the danger of saturation of investment demand and relatednecessity to intensivelydevelop the secondary market in order to secure the inflow of new investment,etc.22

Besides, in the short term outlook, thelargest Russian companies will retain their dominating position in this segment of the market(although the number oflargest and medium-sized companies-issuers present on the market is almostequal). In terms of demand, the market is dominated by commercial banks (up to75 per cent of issues placed on the market) and various institutional investors. The participationof private investors is minimal. It seems that incentives for attraction of individuals to the marketmay be, first, effective guarantees with regard to bonds, second, theintroduction of the institution of collective (group) claims. The fact that the civilprocedural law still lacks this institution even after the collapse offinancial pyramids in mid-1990s is not only an evidence of inability to learn from experience, butalso about a serious opposition to this obvious and simple idea.

Therefore, there are two most typicaloptions for a medium term outlook: 1) self-financing, including the return ofinternal funds as creditsand shared joint stock participation as the УbaseФ source for УindependentФenterprises outside any technological chains or conglomerates united by formal or informalproperty control (i.e.УgroupsФ); 2) quasi-external investment in various forms for the enterprisesincluded in the УgroupsФand receive part of centralized financial resources regardless of their place in the grouphierarchy. In the latter case the possibility of direct self-financing is oftenlimited due to the specifics of organization of financial flows within thegroup, therefore, it is possible only as a УmeasuredФ return of previouslywithdrawn financial resources (assets), i.e. a substitute of self-financing23.

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