Economic indicators over the past year were mixed, although a consensus view appears to be forming that they were a net negative and, notably, underscored the long-run structural deficiencies in Russia’s economic development model rather than short-term risks. The cementing of this view gained traction in January, when Fitch cut Russia’s outlook from positive to stable. In April, Fitch’s analysis was apparently vindicated by the announcement that Russia was cutting its 2012 GDP growth forecast to 3.4% (compared to 4.3% in 2011).
In March, Financial Times published an in-depth analysis of Russia’s economic situation, finding that the country will likely begin running twin deficits (i.e., budget and current account deficits) within the next few years. The prospect of becoming a twin deficit country would be particularly threatening to Russia, as such deficits are typically financed by attracting capital from abroad (something at which Russia does not excel).
Also in March, the World Bank released its Russian Economic Report, which noted that, despite recovering GDP growth to near-pre-crisis levels, most of Russia’s recent economic strength was due to the recent surge in oil prices. Moreover, Russia’s post-crisis recovery has been weak compared to other economies. The 2011 OECD Economic Survey of the Russian Federation concluded that a primary source of Russia’s weakness remains the wide gap in the business climate in Russia vs. OECD countries. And rather than facing its dependence on fossil fuels and unattractive business climate, observers argue that the Russian leadership is fixated on short-term solutions, such as retooling the tax system to target gas producers rather than oil producers.
The 2012-14 Forecast for Russia by the Bank of Finland Institute for Economies in Transition similarly anticipates weak GDP growth over the next several years (regardless of unusually high oil prices). BOFIT highlighted that, despite the oil price growth from early 2009 -11, Russia still experienced net capital outflows in 2011. In addition, fixed capital investment growth remains tepid even now that capacity utilization is back to pre-crisis levels.
Investment – Russian, Foreign, or None of the Above?
The surge in domestic capital outflows – i.e., Russians moving money out of Russia – suggests that local investors and business owners are not up to the task of making the investments needed to modernize the Russian economy. The locals’ equivocal stance on keeping their money in-country and the “twin-deficit” specter noted above mean that Russia’s only viable modernization strategy relies heavily on “benevolent” foreign investment. Indeed, while Russian businesses are free to take all “low-hanging fruits” afforded by the Russian economy and then ship profits abroad, the Russian government wants foreign investment only if it promotes its modernization agenda (see, Skolkovo). PM Putin admitted as much the other day when discussing the development of the oil industry on the arctic shelf, saying:
We hope that major global corporations will be our partners in implementing shelf projects. I’d like to say that I have already asked government members to think of ways of making invitations to these projects more effective, and making use of the opportunities of strictly Russian companies. Of course, our domestic companies will have to work on certain terms – they will have to attract the necessary funds and technology rather than simply trading their right to take part in these projects.
What Putin is referring to are schemes in which a Russian company wins the exploration or drilling rights to a given deposit or field during a competitive bidding process, and then turns around and sells the rights at a mark-up to a foreign company that actually intends to develop the field. It was Putin’s Strategic Sectors Law that severely limited the ability of foreign companies from participating in Russia’s extractive sectors, short of playing a minority role in a joint venture with Gazprom or Rosneft. Ironically, BP – which has the most substantial presence in Russia via its TNK-BP – was unsuccessful in forming such a venture with Rosneft precisely because of its ties to Russia (i.e., TNK owners opposed it).
It’s unclear whether Putin’s change of heart will reassure foreign investors. And unfortunately, similar “business climate” risks in other Russian sectors – which are far less profitable than oil/gas – have an even greater cautionary effect on foreign companies. Statistics on FDI seem to evidence the hesitancy of foreign investors to “commit” to Russia. Although all forms of foreign investment inflows fell dramatically in 2008-09 due to the crisis, FDI inflows peaked in 2007 (at $27 bln), with no growth between 2007-08, and then plummeted 44% between 2008-09.
The good news is that growth of FDI inflows was positive in 2011 for the first time since 2007. The bad news is that the aggregate total is still only around 2/3 of the 2007 number, and this slow recovery in FDI stands in contrast to a rapid – almost bubble-like – increase in “other foreign investment.” To the extent the “other” category consists of genuine foreign investment (vs. repatriated capital), it is typically in the form of short-term debt issued to large enterprises with the lender poised to withdraw its money at the first sign of trouble. It was the foreign “portfolio” and “other” investors who led the charge out of Russia following the war with Georgia, culminating in panic sales after the Lehman collapse. In other words, this type of foreign investment will almost certainly not stimulate the modernization of the Russian economy, and may in fact have a net negative effect. Most important, Russia’s FDI inflows as a % of GDP are much too low to sustain the sort of extreme makeover that the Kremlin anticipates (see graph below).
Russia – the Ideal Investment Destination?
One counterintuitive yet compelling conclusion is that the problems facing Russia described above would make it the most attractive investment destination among its fellow BRICs. For example, in addition to the weakening growth in China, 2010-11 was the year that everyone figured out that (i) China doesn’t want/plan to make clothes, toys, and other low-cost consumer goods forever, and (ii) Chinese enterprises have been engaging in massive theft of their Western “partners'” trade secrets and intellectual property, with the goal of replicating entire developed industries, but without the political or social shocks that would likely accompany the organic development of such industries (see this excellent BusinessWeek feature on one companies travails). As for India, it is clear that its impressive growth is largely a function of starting from such a low base, and it’s strange to put a country with 42% poverty rate and 75% literacy in the same group as Russia, China, and Brazil.
Most important, the global anticorruption fervor shined a light on corruption in Brazil, China, and India. As people from or having lived/worked in these countries can attest, the officials have always been just as corrupt. The perceptions of what corruption is, however, have grown less tolerant and more strict as incomes have risen. In this regard, the Russian population’s inherent distrust of officials and penchant for conspiracy theories means they are uniquely attuned to any hints of corrupt behavior. As a result, indicators like Transparency International’s Corruption Perceptions Index are flawed and even misleading in cases where a lower “perception” of corruption actually suggests a greater acceptance of corruption (or at least a definition less broad than TI’s). Despite the methodological problems inherent in trying to measure a real phenomenon like corruption based on the subjective perceptions and judgments of local observers, the CPI is relied on very heavily by anticorruption practitioners and businesses when evaluating which country offers the appropriate risk-reward balance to a foreign investor.
The CPI‘s weakness as an indicator of “real existing corruption” does not mean that the corruption risk in Russia is exaggerated, only that it is not helpful as a tool for comparing corruption risks in Russia vs. the other BRICs. Thus, if Russia’s corruption and weak rule of law are roughly on par with the other BRICs, you could see how Russia would be more appealing. Specifically, Russia’s low FDI/GDP ratio and ambitious modernization plans mean that the Russian government will finally have to start following through on its promises to improve the business climate.
Part II will address the unique non-economic risks that Russia must tackle and mitigate in order to attract the domestic and foreign capital investment it needs in order to transform the economy.