As the turmoil has dropped its U.S. share price to less than 9 percent of its former peak, VimpelCom has tacked a new line onto its "Be Happy" slogan: "Don't Worry." (By David Hoffman – The Washington Post)

By Steven Mufson and David Hoffman
Washington Post Staff Writers
Sunday, November 8, 1998; Page A1

Dana F. McGinnis was not a Russia expert when he went to Moscow on a trip organized by Morgan Stanley & Co. in fall 1994. He did not speak the language and he had made his first visit to Russia only six months earlier. But the San Antonio-based fund manager had something Morgan Stanley and Russia were interested in: a couple of hundred million dollars from rich and adventuresome individuals and institutions in search of new investment frontiers.

McGinnis and two dozen other managers of big U.S. pension, mutual and private investment funds were given a grand tour: a glitzy dinner at the Kremlin, an enchanting night at the Bolshoi Opera, a stroll through the famous Novodevichy convent gardens, receptions at the elegant Metropol Hotel, and meetings with leading lights in Russian politics and economic policy. Meanwhile, in private meetings with Russian executives, McGinnis plotted major investments in Russian cement, telecommunications and electric power companies.

"There was great optimism that there would be an end to the arms race and that some 250 million people would be brought into the capitalist fold," McGinnis recalled. "There was a buzz in the air. The country was evolving by the hour. You could feel it." It seemed like a historic moment and a historic business opportunity.

McGinnis and many other people bought into that vision. Over three years, tens of billions of dollars of foreign money flooded Russia's tiny new bond and stock markets.

Then just as quickly, the money poured back out in a financial panic this spring and summer, leaving Russia and many banks and investors high and dry. Russia's new market economy collapsed, throwing emerging markets into turmoil worldwide, sharply reducing earnings at several major Western banks, and forcing McGinnis to put his three investment funds into bankruptcy, wiping out about $200 million of his investors' equity.

Those sorry results now stand as a cautionary tale about the new global economy and its treatment of developing nations. Russia, like many developing and formerly communist countries, acquired the trappings of a market economy in the early 1990s – bonds, stock markets, people in business suits and a boom psychology. But like a number of emerging markets around the world, Russia's new capitalist veneer hid deep unresolved problems from the old era. Its underlying economy was still rooted in cronyism, lacking rule of law, and hostile to the long-term direct investment it needed most.

Western investors, in their haste to seize a new market, overlooked or willfully ignored these realities. And while the wave of capital they supplied temporarily buoyed stock prices, enriched the politically well connected and papered over the government budget deficit, little of it went into new plants or equipment that might have helped Russia grow. When the investment managers suddenly lost confidence this year, their money flowed out of stocks and bonds with bewildering speed, leaving the Russian economic terrain scorched.

Now, after defaulting on its $40 billion worth of domestic bonds and devaluing its currency on Aug. 17, Russia's government has virtually no hope of obtaining the foreign loans that have been its lifeline for three years. Leading Russian banks are insolvent, and the ailing Russian economy contracted by 9.9 percent in September. Above all, the whole notion of free markets has been discredited in Russia for the time being.

The story of how Russia's meltdown happened shows how the removal of barriers to global capital flows has led to extremes of speculation by investors who barely understand what they are buying in new foreign markets. It demonstrates how ill-equipped international financial organizations such as the International Monetary Fund are to help new capitalist nations manage their foreign accounts or survive speculative attacks.

Most of all, it shows that countries that embrace free markets do not necessarily benefit from the money that pours into those countries. Instead, their failure to fully and quickly implement reforms – or other mistakes in policy – invite a virulent new form of financial punishment. "It doesn't help to have a tidal wave of money go in and out of your country," said Ian S. Campbell, an analyst for emerging markets at BancBoston Robertson Stephens Inc. "One day you're swimming in money and the next day you're beached."

The Investors

Because they usually employ huge amounts of borrowed money, hedge funds tend to move quickly in and out of markets in an effort to make fast returns and avoid potentially fatal downturns. After several years of economic growth and booming stock markets, managers of such funds began to look abroad in the mid-1990s for even greater rates of return than they could get at home. According to the Institute of International Finance, private net flows of capital to 29 emerging markets peaked at close to $310 billion in 1996.

McGinnis, a 1973 Princeton graduate, had coached football at his alma mater for a year, then worked in his father's construction business. Later he was a stock broker and dealer for the San Antonio branch of a national brokerage firm before striking out on his own 10 years ago.

"I thought there was opportunity in the international market," McGinnis said. He credits his French wife with broadening his perspective.

McGinnis had persuaded more than a hundred individuals and institutions to make minimum investments of $1 million in his hedge fund, which was designed to focus mostly on emerging markets.

One was Robert Freedman, a Michigan venture capitalist who felt that U.S. markets were "awash in money" and who was looking for better opportunities abroad. Freedman had read about McGinnis's track record, and for a while he enjoyed the ride. "I look at people who give results, and he rated high over a number of years," said Freedman. From 1990 through 1993, the McGinnis Partners Focus Fund averaged 72 percent annual returns.

After making rich returns in Latin America and Asia, McGinnis was looking for new opportunities, and Russia was the next frontier.

The thirst for new investment frontiers dovetailed with economic and political reforms in Russia.

In the political arena, President Boris Yeltsin appeared to have brought some political stability to Russia by the mid-1990s, despite a disastrous war in the breakaway republic of Chechnya and a violent confrontation with hard-liners in parliament. In 1996, Yeltsin won reelection as president over the Communist Party leader, bolstering political confidence.

In the economic sphere, tight monetary policy was choking hyperinflation. Russia's oil and raw material exports gave it a steady supply of foreign exchange earnings and a trade surplus, and its debt levels were relatively low.

The Russian stock market was opening up too. After the Soviet collapse, Russia privatized 15,000 companies with individual coupons, or vouchers, which were distributed to 144 million people. The voucher phase ended in mid-1994, and the government started to auction off portions of key firms, even in the energy sector, for cash.

In April 1995, the Templeton Russia Fund Inc. became the first U.S. mutual fund allowed to invest in Russian securities. In 1996, a nationwide stock trading system took shape. Instead of trekking to remote regions to accumulate privatization vouchers, investors could trade in an over-the-counter electronic network that U.S. officials and academics helped design.

Major investment banks began to issue upbeat reports about Russian markets, even though the economy was still shrinking and factories were shuttered. In a September 1995 report called "A Bullish View of the Bear," Salomon Brothers Inc. analysts wrote that "tabloid headlines about starving Russians notwithstanding, Russia is not a poor country. It is a major, middle-class industrialized nation undergoing dynamic transformation, whose equity market is only just beginning to emerge."

A Morgan Stanley report a few months later said "the potential of the Russian equity market is too great for emerging market investors to ignore. Rewards could be high."

Targets were high. McGinnis said his objective was a 10 to 1 return on his investment. "It was a number you picked out of the air," he said. "It wasn't very scientific."

Many investors were lured by the cheap asset values. Some analysts said that the cheapest place to drill for oil and natural gas was on the Russian stock exchange, where you could buy oil for pennies a barrel. Russia's entire stock market had a capitalization of less than $20 billion, Salomon Brothers said.

"All Russia's newly privatized companies, which represent some 5 percent of world oil reserves plus the world's second-largest forestry reserves, massive mineral assets and its huge network of utilities, telecommunications and industrial capacity could be bought for ... little more than twice the market capitalization of Peru," the report said.

What Salomon didn't point out, analysts said in retrospect, is whether Russian companies could operate efficiently enough to make any profits on those assets, or whether any profits would be passed on to shareholders. But most investors paid little heed to that.