Russia Growth Diagnostics (3): Finance

< Part 2: Introduction to Russia

I test for financial constraints in Russia in two steps. First, measuring the amount of resources potentially available to Russian companies. Second, checking whether the financial sector mediates these resources efficiently.

HRV do these test to separate two groups of symptoms: those caused by financial constraints and the symptoms of low social returns to investments. In other words, an economy may have big growth opportunities that get no funding because of some problems in the financial industry.

Savings and Capital Markets

In some narratives, banks create money out of nothing and lend them to firms. In others, the central bank purposefully keeps the rates high and, thus, deprives business of credit. Such monetary issues aside, the economy can invest only what it hasn’t consumed yet. International borrowing may smooth this choice between consumption and investment, though only temporarily. Let’s see the internal resources first.

Savings are defined as GDP minus consumption: S = Y - ( C + G ) in the GDP definition Y = C + G + I + X - M). Savings already include investments I. The remaining term in S is net export X - M. It’s basically the part of output that has not been invested or consumed, and therefore, is potentially available for business investment:


The gap between these two lines is Russia’s trade balance. It’s positive, while the average savings rate at 30% stands above the world median:


So Russia doesn’t seem constrained in domestic resources.

How about the access to international capital markets? The government has (at least, had before 2014) a very favorable macro and could borrow abroad. Large companies also had access to external credit. They even accumulated some debt. This debt isn’t entirely “external” since capital moves mostly between Russia and a few offshores, where Russian business owns proxy parent companies. When a Cyprus proxy lends to its Russian subsidiary, this can’t be called an “access to international debt markets” (until each word is taken in separate quotes).

For this and the recent sanctions, Russia has problems with reaching international capital markets. But given the trade surplus, financial resources don’t bind on average.

The Financial Sector

Maybe the resources are abundant and the financial sector mediates them poorly? Consider key players.

The Central Bank

Does the Central Bank of Russia (CBR) set rates too high? Adjusted for inflation, it does not seem so. In fact, if you take the GDP deflator, instead of the CPI, the rates turn negative. The CBR key rate (sort of a Federal Funds Rate for Russia) remained below the deflator for years.

Russian business complains about high lending rates, but reducing the key rate won’t help much under full employment. Worth recalling: the market rates depend on the key rate, macro risks, and firm-specific risks. Even taken together, they still don’t beat the deflator, meaning that the real lending rate is already low:


This plot is based on a somewhat arbitrary average market lending rate, so we’ll look at this market closer.


A monopolistic banking sector may induce credit rationing and high market rates. Is it monopolistic in Russia?

Russian financial assets are managed by commercial banks and large industrial holdings. A non-banking asset management industry (mutual funds, private equity, hedge funds) is virtually absent. Banks manage household savings and industrial groups manage their own corporate investments.

In banking, assets are concentrated in three banks, with Sberbank alone having as much assets as the other nine banks in the top ten. The government owns major stakes at these largest banks. State-owned banks are managed independently from each other, so they compete to some extend.

This structure does not generate excessive profits for banks. The net interest spread declines:


Many discussions in Russia concern long-term funding. A popular suggestion is to get the funds from people. A recent innovation is the tax-deductible retirement account (similar to the US IRA) at brokers and asset managers.

Though undoubtedly useful for citizens, such supply-side solutions do not add much to long-term investments, because matching maturities isn’t the only way to get things done. Short-term debt also can fund long-term investments. Alternatively, banks can smooth fluctuations in short-term deposits and supply long-term debt to businesses.

Why neither happens? Because long-term investments themselves must be sufficiently attractive.

Why not Finance?

Russia has freely available financial resources and a competitive financial industry. Maybe not as much and as competitive as somewhere else, but it’s not the main problem. The lending rates appears to be high to businesses because business returns nearly equal these rates. It’s expected after finding no signs of wedges in the financial industry.


Since the funds don’t bind, it’s time to find out what contains returns to investments. The factor of human capital follows.


Data sources: PWT7 and World Bank.

Notes: More on variable definitions and computations will be available in the Stata file later. For more detailed checks of the financial industry, I recommend the IMF data.

It’s a Wonderful Loan: Economics of P2P Lending

The Financial Times wonders why big banks are going after P2P lending. Why do banks need companies like Aztec Money and Lending Club, which have negligible credit portfolios and messy business model? Well, banks themselves might say about their motivation in this case (so far they didn’t), but I can think of a good economic reason why they should pay attention to P2P lending.

This reason is older than the Internet, computers, and banks themselves. It’s information about the borrower. In between conspiracies against the public, banks do a very useful thing: they take off the lender’s headache about the borrower’s payback. Banks have to know their borrower well. And typically, they do and keep the net interest spread low. Here’s the rates for banks and credit unions:


Credit unions have been in the industry like forever. They would fit what the FT names “democratizing finance” and have much in common with the ideology behind P2P technologies. Credit unions have higher deposit rates and lower interest in the table because they know more about borrowers. Unions lend only to trusted folks and the number of individual defaults decreases, so you see better rates. Better rates also mean an even lower probability of default, so it’s reinforcing.

The Grameen Bank (and Nobel laureate Yunus) played this idea brilliantly. They radically reduced the market interest rates in poor countries, where high rates coupled with high default rates had been strangling the economy. The Grameen Bank entered very much like a credit union. Borrowers had to provide references from local peers to get access to money. The interest rates have been reduced from 50–100% annually to a single-digit number.

The Grameen-type firms and credit unions are limited in geography and expertise. You could back only your neighbor and only in a very simple business. If he tells you he’ll buy a cow to sell milk, you’re okay. But if a guy on the other coast needs a credit line to build “radar detectors that have both huge military and civilian applications,” you want to know the risks better. That’s why in a complex economy, Grameen is no longer relevant. Each loan application requires more information about the borrower, his credit history, and, most importantly, the purpose of the loan.

The purpose is vital for business loans. Banks learned to dig information about the borrower and to come up with the individual probability of default (you can try to predict yourself). But they’re getting worse in knowing the client’s business. First, businesses are getting more complex. Second, banks reduce their human workforce and local branches, while local branches provided a lot of soft information on borrowers and their performance. Jimmy Stewart’s banking was about observing his little town’s economy and deciding what would be creditworthy there. Without this source, banks pool risks and set higher interest rates, deterring borrowers.

Here comes online P2P lending. When a nuclear physicist from CERN lends money to a nuclear physicist from NASA via P2P system, it tells something about the borrower’s project. The guy from CERN is the right guy to judge. He also throws his own money into this. And that solves both the complexity (you can always find a lender-investor with the right expertise) and neighborhood problems (an expert comes from anywhere). Plus it’s technically free. The CERN physicist has already done the job banks couldn’t do: he found the borrower’s project, evaluated, and approved it. It looks like an investor’s job, and it is. P2P lending platforms like Kiva do mix investing and lending. Users do informal research before lending money.

This info allows banks do P2P loan matching (like some VC and foundations do), buy individually-backed loans, securitize them, and so on. This is a rare example when new technologies are not eating someone else’s pie (like YouTube does to mass media) but create their own. Without this easy expert-loan matching, businesses face higher interest rates, often above their breakeven point, which means no business at all.

Still, P2P platforms themselves seem distracted from this advantage. Most reasoning behind them mentions phantom problems like “predatory interest,” much paperwork, and refused applications in traditional banking. These are not the problems. The financial industry is highly competitive even after the series of post-80s M&A. It evaluates the risks with huge volumes of data, hires good quants, and saves a great deal on scale. In fact, the low market capitalization of major banks indicates that they have no means to “exploit” customers (Google and Amazon do, though in a delicate manner, as here and here). So net interest margin declines:


The bank’s paperwork and rejections are just the costs of low interest rates. It makes no sense for startups to “fix” banking in this direction because it’ll increase the rates—sort of getting the industry back into prehistoric times. The information flows between lenders and borrowers is the real thing to focus on.