The relatively undeveloped state of Russia's capital market highlights the acute problems of raising capital or increasing liquidity on the local market, according to sector experts.

Inadequate legislation, numerous restrictive measures, an archaic banking system in need of urgent reform and several other negative factors have all combined to make the local financial market unattractive to most strategic investors, thus limiting the inflow of foreign capital into the economy.

Setting off a chain reaction, the unattractive nature of the market often amplifies such problems as capital flight or the unwillingness to bring capital to Russia from abroad for investment purposes.

Local business moguls often whisk their hard-earned (or illegally acquired) capital out of the country as soon as their multi-million-dollar deals are concluded, while key strategic investors such as George Soros and others are still smarting from losses incurred during the 1998 financial crisis, when they watched their billion-dollar investment portfolios turn into white elephant projects overnight or were outsmarted by local businessmen during Russia's "wild capitalism" period of privatization.

"Most of the foreign investors are sentimental people and, having lost billions of dollars here once, they have yet to be convinced that the current local market's risk/reward capability is ripe enough to warrant making another financial commitment," said Patricia Cloherty, board chairwoman of the U.S.-Russia Investment Fund, which manages $440 million disbursed by the U.S. government to support business and mortgage issues in Russia.

Capital generally moves freely to markets with lower risks and higher reward levels, and the local capital market does not meet this definition at the moment, she noted.

Attracting foreign capital into the country for real-estate projects has been virtually impossible, partly due to the high risk level perceived by the foreign investment community, said Gerald Gaige, head of real-estate consulting at Arthur Andersen's Moscow office.

Peter Westin, a senior economist with ATON Brokerage, shares the view. "The local financial market is currently dominated by small and very often illiquid stocks with the oil majors as the key players, thus prompting most investors to view Russia as an oil play at the moment," he said.

However, most experts agree that the financial crisis did have some positive effects on the market.

While Cloherty conceded that the crisis weaned the market of financial speculators – thus paving way for the traditional investors interested in making long-term strategic investments – Westin contended that the crisis gave key players time to regroup and reassess the relationship between risks and rewards.

Another factor limiting development of the local capital market is that most of the financial instruments used on international capital markets to raise funds are either nonexistent or are only in the nascent stage, with the legacy of speculation-driven activities still prevalent on the local market, experts added.

Consequently, more than 80 percent of local companies are experiencing extreme difficulties in raising or accumulating operating capital on the financial market.

For example, as far as real estate is concerned, the capital market is either limited or nonexistent, key real-estate market experts said.

The Moscow-based International Financial Corp. Bank said that it has been contracted by the Federal Mortgage Agency to act as the financial consultant as well as the organizer of the first agency in the country to emit mortgage-backed securities.

"The plan to lay this foundation for such a vital financial instrument, which is used on developed capital markets to attract strategic investors through stock markets, is a positive step in the right direction," said Olga Sovrelia, managing director of Paritet, a leading local agency on mortgage issues.

"The traditional sources of capital for major investment projects such as pension funds, insurance company reserves, bank funds from long-term savings and investment funds with long-term secured debt objectives have not been sufficiently developed in Russia, either because the capital situation in the country has been so constrained with huge government borrowing, unstable currency or because of restrictive legislation in the past decade," Gaige added.

Real estate requires large bites of capital for relatively long periods – 10 years or more – and currently this market lacks capital pools with these characteristics. What is available is limited to relatively small amounts from local banks or private entities, and only for short terms – three years or less – he added.

The archaic banking sector – which continues to remain mostly a vestige of the communist financial system, with the hegemony of Sberbank remaining largely unchallenged – is another major hindrance to the development of the local capital market, as all efforts at reforming the sector have been blocked by interested parties, including the Central Bank, insiders said.

Sberbank controls up to 80 percent of the retail credit market segment, compared with about 4 percent controlled by Alfa Bank, the second biggest operator in the sector. This trend highlights the monopolist stature of the former in the sector, said Andrei Ivanov, a banking analyst at Troika Dialog.

"Most of the numerous local banks are not yet operating as bona fide financial intermediaries between savers and investors," Westin noted, adding that "some of them are not really banks per se, but financial departments of the local financial and industrial groups and their companies."

Consequently, the level of intermediation of the local banking system as measured by loans as a percentage of the GDP at 12 percent pales in comparison with that of other emerging countries, which is two to five times higher, according to Kim Iskyan, a banking analyst at Renaissance Capital.

The absence of the notion of moral hazard in Russia's banking system, the high level of collusion between the government and banks, systemic opaqueness and perennially fudged numbers have coalesced over the past few years to lay the foundation for stagnation in the sector, he added.

Arthur Andersen's Gaige called for sweeping reforms not only in the financial system, but also in the legislative sphere.

"Attempts to revive the market will require the development of appropriate legislation such as securities laws, tax laws and other regulations necessary to stimulate pooling of capital, and comprehensive reform of the banking system to restore the depositors' and savers' confidence in the system," he said.

The removal of bank shares from the books of the Central Bank is paramount to the success of any proposed banking reform, as it is inappropriate for a regulator to have shares in the entities that it is supposed to regulate, he added.

All the experts, however, concede that the situation on the local capital market is not yet beyond repair, as recent government actions in the sector and the economy in general lend credence to palpable optimism.

"The process to overcome these inadequacies on the market is already under way with a demonstrated movement toward rational economic reform, encouragement of free markets and reduction of risk through provisions for protection of investors' rights," Gaige said.

However, to improve market conditions, the government still needs to curb bureaucracy, reduce corruption and demonstrate a record of transparency and predictability for investment results. And much can be accomplished through legal reforms, and more importantly, their enforcement, experts said.

Secondly, all efforts should be made to maximally diversify the economy in order to create an environment for the emergence of new securities outside the oil/energy sector, insiders urged.

This is strategically important to avoid the local equity market being continuously dominated by the oil stocks and, subsequently, held hostage to world market oil prices as is evident today by the fluctuating oil prices, experts added.

Also, they said, further liberalization of capital movement and removal of the exchange-rate restrictions will help to boost activities on the local market.

"A conducive economic environment coupled with business-friendly legislation, and not the proposed amnesty for return of flight capital, should be seen as the panacea to the general issue of capital flight in the country," Westin added.

"These conditions are now improving and we are beginning to see the development of some capital pools that will provide a source for investment in Russia in the future, Gaige said, adding that "the necessary enabling legislation in the form of securities laws, tax laws and banking reform will be forthcoming to further support the development of the capital market."

(The author is a Moscow-based freelance writer.)