Both the Russian President and the reform-orientated Government continue to show a keen interest in attracting foreign investment to the Russian market, the need for which is indisputable. The average age of equipment in Russian enterprises is 50 years, capital investment has declined by 70 per cent since 1990 and EIU estimates a total of US$2,000 billion, which needs to be invested during the next ten years. However, implementation of irrevocable, wide-ranging incentives to convince potential investors that Russia now offers a stable investment environment remains elusive. The result is that the potential investor receives a mixed message from limited incentives, questionable legal and accounting frameworks and practices, and certain protectionist legislation. For Russia to re-build its economy and achieve much needed rapid growth, considerable foreign direct investment (FDI) is needed, in volumes which are yet to be seen. Furthermore, much more investment needs to be focused outside the Moscow region. It is here where it is currently concentrated, to the detriment of much of the rest of Russia.

Following the turmoil caused by the election of 1996 and the subsequent deep uncertainty aroused by President Yeltsin's protracted illness, 1997 was by and large a year of consolidation for the Russian President. He recovered his health and took back the reins of power with a renewed vigour, endorsing his reformist policies with the Government appointment of Anatoly Chubais and the popular former Governor Boris Nemtsov as First Deputy Prime Minister. Both Deputy Prime Ministers have spent much of 1997 making their mark both within Russia and abroad, as major exponents of the Russian reform process. Meanwhile privatisation has continued apace, albeit not without some controversy. Russia now has a track record of three successful sovereign Eurobond issues, plus 1997 also saw the successful closing of the re-structuring of both the London Club Vnesheconombank debt and the Paris Club official credits. Russia has obtained ratings from Moody's and Standard & Poors of Ba2 and BB-, respectively.

The State Duma (the Lower House of the Russian Parliament) has proved to be a constant counterweight to the reform process, given that it is controlled by Communists who have ensured the 1998 budget a somewhat stormy passage on its route to final approval. On-going poor tax collection rates have also had their effect on Russia's drive forward. This was the reason cited by the International Monetary Fund (IMF) for it postponing the drawdown of the next tranche of the current $20 billion Extended Fund Facility loan to Russia until early 1998.

The equilibrium of the Russian economy remains fragile and may easily be upset. As already cited, to date, investment has failed to grow at the required rate and whilst portfolio investment is a positive indicator, it tends to be short-term and volatile. Aside from such key issues as incentives and anti-protectionism already mentioned, a further fundamental to attracting investment is a stable underlying currency. As with all emerging markets, currency stability is based on a responsible monetary policy, together with favourable capital flows. However, perhaps nowhere more so than in Russia can monetary policy be a hostage to political whim, and whilst the tide may now be starting to change, the bulk of capital flow to date has been away from Russia rather than into it. This has largely been due to the reasons cited above, the result being that the much needed increase in productivity within Russian industry has yet to be seen.

On a more positive note, recent data points to an increase in both lending by Russian banks and in the level of personal savings held. This could indicate some degree of optimism for growth in investment. It is a fair assumption that growth in investment will be followed by improved Gross Domestic Product (GDP) which, together with promised tax incentives, should fuel consumption. In turn, this should provide an additional boost to further investment growth. Vital to this process is a minimal increase in inflation and a continued reduction in real interest rates, to encourage adequate savings without acting as a barrier for investment.

As the international investment banking arm of the WestLB Group, one of Germany's largest banks with some DM468 billion of group assets, West Merchant Bank Limited ('WestMerchant') is an established key player in the emerging markets in both Russia and other parts of the Commonwealth Institute of States (CIS), with an excellent track record in both origination and advisory activities. Following an inaugural role as Lead Manager for a $75 million Floating Rate Note (FRN) for Moscow Narodny Bank in October 1994, WestMerchant has gone on to assume a number of roles (Arranger, Joint Arranger, Co-Arranger) in an ever increasing number of new debt issues in Russia - principally for banks but also for Oblasts, and more recently, for corporates. To date, Russian borrowers have raised money through a variety of routes - the Russian Government sources from the IMF and Multilaterals, foreign governments, Government Short-Term Obligations and Ministry of Finance Bonds (ie, GKOs and MinFins), plus the international capital markets; corporates tap into trade and project lending, receivable financing and structured financing; banks are largely restricted to the (unsecured) syndicated lending market.

Initially, syndicated lending to Russian banks was very much vanilla, for straight working capital purposes, short-term and limited to the top 15 banks ie, the former 'specialised' sector banks and the new commercial banks, usually Moscow-based and the dominant players in the Russian banking market. Now, whilst investors are still selective, we are seeing a broadening in the number of banks able to access the syndicated loan market through improving track record, ability to perform and increasing transparency, together with a growing sophistication within the market, with the introduction of new instruments - Bonds, FRNs, Euro-CDs and the future promising a growing market for securities issues. In addition, the investor base is also broadening out, as investor confidence gradually increases in the Russian market. Nevertheless, it remains largely dominated by the leading European commercial banks, plus some US houses. Terms remain short, typically no more than 364 days, although often with an extension option at the lenders' discretion. As is to be expected, spreads are also reducing, especially for the better names - the recent one year $225 million syndicated loan jointly arranged by WestMerchant for the Russian Savings Bank giant 'Sberbank' was launched into general syndication at a margin of two per cent over LIBOR.

There are essentially four key factors driving the syndicated loan market:

• a generally improving economic and political environment;
• the Russian borrowers' appetite for foreign capital, given the comparative cost saving as against raising money in the domestic market;
• foreign lenders' increasing appetite for higher yielding assets;
• the relative flexibility of the syndicated loan as a capital raising tool, the result being that for many Russian borrowers the syndicated loan is their first experience of raising funds internationally.

The bond market in 1997, dominated by the Russian Federation, has provided a greater volume of international funding for Russian borrowers than the syndicated loan market, with a total of $6.9 billion raised by Russian issuers since the Russian Federation's one billion dollar inaugural issue in November 1996. In comparison, whilst the syndicated loan market commenced first, to date it has raised $4.6 billion (in unsecured, stand-alone facilities, excluding multilateral/foreign government sponsored transactions, bilaterals, secured facilities, trade or project related transactions). However, the securities market is much more regulated, usually requires a long-term rating and is generally more expensive than the syndicated loan market.

One of the few regions to have already tapped the bond market is that of Nishni Novgorod, an Oblast situated around 450km east of Moscow. It is of particular interest to the WestLB Group given the presence of a WestLB Representative Office there since October 1995. The region raised $100 million via a Eurobond issue in September 1997, led by ING Barings. The population of the city of Nishni Novgorod (the former 'Gorky') is 1.375 million, which makes it Russia's third largest city after Moscow and St Petersburg. Until March 1997 it was governed by Boris Nemtsov, now First Deputy Prime Minister in the Russian Government. Notwithstanding the fact that Nishni Novgorod is now one of the main industrial, trade and scientific centres of the Russian Federation, with strong emphasis on heavy production industries, including car and truck manufacturing, ship building, chemicals, oil refining and timber processing, undoubtedly the presence of the dynamic Nemtsov as Governor helped the region to receive over $100 million in FDI in 1996, placing it third among the Russian regions. This leading role in the foreign investment stakes is all the more impressive when one considers that until 1991, Nishni Novgorod was a closed city, given the high proliferation of military and nuclear industries in the region.

• political and social stability within the Oblast;
• the availability of 'tax free zones' in the main city, offering potential investors advantageous conditions for their manufacturing and production activities;
• continuing introduction of new legislation reflecting international principles of law and protecting the rights and interest of owners and investors;
• an established policy of privatisation and economic reform (Nishni Novgorod was the cradle of privatisation in Russia under a scheme run jointly by the Regional Administration and the International Finance Corporation - IFC); Nishni Novgorod is one of only nine so-called 'donor regions' which make a net contribution to the federal budget;
• it ranks seventh out of the 89 regions in terms of productivity.

As well as the involvement of the IFC cited above, a number of leading international organizations have assisted the region over the last few years, including the European Bank of Research and Development (EBRD), the British Know How Fund, USAID and the American Business Centre. Major corporate investors in the region include US West, Coca-Cola Inchcape, Pepsi International Bottlers, McDonalds, Ingersoll-Rand, Fiat, Lufthansa, Wella AG, Knauf and M.A.N. International hotelier, Sir Rocco Forte, is currently involved in a project for the construction of a business class hotel in the heart of the city. Scheduled to open its doors in 1999, it will be designed to accommodate the growing number of international business travellers visiting the region.

Nishni Novgorod is home to some of Russia's leading companies, including the country's second largest and most successful automobile producer Gorky Avtomobile Zavod (GAZ). GAZ may well be one of the next Russian corporates to tap the bond market, given their earnest to acquire an international rating from Moody's and Standard & Poors, and their subsequent intention to issue a Eurobond, and Norsi, one of Russia's largest oil refineries. The region of Nishni Novgorod is a good example of how a region can successfully organise its financing by accessing the international markets.

In the immediate future the syndicated loan market is likely to remain attractive to Russian borrowers, particularly first timers; the bond market is certain to continue growing, with more non-government issuers participating as they acquire the requisite rating. We will undoubtedly see more complex transactions, securitisations, longer terms and finer pricing as the Russian market continues to develop, with more and more western banks eager to acquire mandates. So far, no defaults have been seen and no re-scheduling experienced, and whilst a few Russian banks have gone to the wall, none had accessed the international capital markets for finance. Hence their demise had little effect outside of the domestic market. However, recent turmoil in the world's finance markets should serve as a timely reminder that the recent positive trend may not continue uninterrupted, and that many of the risks in the Russian market remain - even if they are a little less prominent than before.

Russia has enormous potential to become one of the world's major financial markets, and doubtless the developments we have witnessed to date are just the first tentative steps along this road.

For more information:
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West Merchant Bank Limited (West Merchant) is regulated by the Securities and Futures Authority for the conduct of investment business in the United Kingdom, and is a member of the International Securities Market Association. This material is intended only for market counterparties, ordinary business investors and expert investors (as defined in the rules of the Securities and Futures Authority). Any advice or recommendations contained herein and any investments to which they relate are not directed at, may not be suitable for, and should not be relied on by private investors. This document is not an offer or a solicitation of an offer to buy or sell securities. Neither West Merchant nor any of its directors, employees, associates or agents shall have any liability for any errors or incompleteness of fact or opinion in it.