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Analysis & Opinion
02.03.09 Russia’s Investment Forecast: Mostly Cloudy
Comment by Irina Aervitz

Critics of the state policy claim that the Russian government does not seem to have a clear understanding of the current economic crisis and its consequences, or worse—it is in a state of denial that there is any serious crisis in Russia, which means that there is no coherent anti-crisis strategy. Russia’s economic survival depends on its ability to exercise a balanced approach to industrial development: using its natural endowments and diversifying at the same time. But both require investments that are not easy to make.

After the collapse of the Soviet Union in 1991, then-President Boris Yeltsin attempted to implement new economic policies to transform Russia into a free market economy. Yegor Gaidar, a liberal economist, became the architect of the first stage of these liberal economic reforms, pursuing a policy of price liberalization, subsidy reduction, and the opening of the domestic economy to the world market. These measures were later aptly named “shock therapy,” as the ensuing inflation soon made domestic savings practically worthless, and obsolete industries were quickly wiped out by foreign imports.

In 1992 the first stage of privatization in Russia began, which included corporatization, insider benefits, voucher privatization and auctions resulting in state property being hijacked by the “Red Directors” – the former Soviet managers of those same enterprises. Voucher auctions promoted corruption and machination, which created the system of “oligarchs.” By early 2001, two-thirds of the formerly state-owned enterprises were privatized, in a process nicknamed by the general public as “piratization” or “prikhvatization.” The connotation of these terms is clear: the economic transition process in Russia was characterized by high levels of corruption. Russia was driven by the vision of a quick transformation into a full-fledged market economy with minimal state involvement in economics.

This trend was reversed by Vladimir Putin when he was “elected” president in 2000. He has consistently and systematically increased state control over the exploration, processing and export of natural resources. He also curtailed the power of regional authorities, strengthened the military, and took control of the legislature – the Duma –with the pro-Putin United Russia winning the majority of parliamentary seats in 2007. He also whipped the business community by introducing a “glass ceiling,” limiting business forays into politics. Two thousand seven marked the end of Putin’s second term as president, but the general direction of the reforms did not seem to change. The new President Dmitry Medvedev was handpicked by Putin, who still remains in power as prime minister. With the current crisis, a new chapter of Russia’s economic development is in the writing.

Financial myths and economic realities

On July 21, 2008, the World Bank, in its latest review of the transformation of the economies and governments of Eastern Europe and the former Soviet Union, acknowledged that investment per capita in Russia - $12,000 in 2007 - was 50 percent higher than in China, and three times higher than in India. Thus, Russia was ranked as one of the most attractive developing markets for investors after China and India. However, Russia has been negotiating accession to the WTO for years, and the major obstacles included protectionist measures and the weak rule of law, including insufficient protection of intellectual property rights. Due to the crisis, it is possible that these symptoms might get worse. Even though a high return on investment (ROI) was possible in the past in Russia (profitable industries included the consumer market, natural resources, real estate, the financial sector and IT), the main risks lay, and still lie, in political factors, including the nearly 100 percent control of the legislative and judicial branches by the executive branch. Little has changed since Yeltsin transformed Russia’s economy from a Soviet to an ersatz liberal economy based on presidential decrees.

In December 2008, Russia’s annual GDP growth fell back to zero. Prior to that, Russia’s growth rate had been stable since 1998, averaging seven percent annually. In February 2009, Russia’s Finance Minister Alexey Kudrin announced that Russia’s budget deficit will reach eight percent of GDP in 2009. As the oil prices dropped globally, Russia’s heavy dependence on extraction industries was revealed once and for all. The myth of the “diversified Russian economy” melted away. Even if the oil prices rise up again one day, the extraction industry still requires large and constant investment to increase exploration and output.

The total amount of foreign direct investment (FDI) in Russia’s economy in 2007 constituted an estimated $55 billion, according to PricewaterhouseCoopers. Other sources report 2007 FDI inflows of only $28 billion (Rosstat). In 2008, the volume of FDI decreased to $27 billion, Rosstat reported. However, Russia’s difficulties in attracting FDI are not unique--there are liquidity constrains all over the world. Thus, as the crisis unfolds, the competition for investment will become fiercer.

There is a lot of discrepancy in the methods used to calculate FDI inflow in Russia. The main issue is how “foreign” the investment really is. According to Rosstat, the three biggest country investors into Russia’s economy were Cyprus, the Netherlands, and Luxembourg. Both Cyprus and Luxemburg have a long history in accepting and hiding Russian capital during the capital flight from Russia in the 1990s, which included not only criminal money, but even the “quick” money made by Russian oligarchs. People kept their capital abroad because of the weak rule of law and compliance with property rights. In 2007 this capital may have been coming back in the guise of FDI due to the high profitability (ROI in Russia could reach 30 percent) and the general familiarity of Russian businessmen with the environment. Now, however, even this money is no longer coming in.

There is a steady trend of the capital outflow. Even during the peak of the economic activity, money was leaving Russia between 2005 and 2007. Russians were actively buying and investing abroad: acquisitions abroad exceeded foreign investment into Russian assets in 2007. Russian investors acquired $23.2 billion worth of assets mostly in Western Europe, while foreign investors into Russia invested into $20.2 billion worth of assets. Fifty four percent of Russian M&A abroad was in mining and metallurgy. For example, Norilsk Nickel, the world's leading producer of nickel and palladium, bought the Stillwater Mining Company in Montana in 2003. Stillwater was the only U.S.
producer of palladium, which raised a lot of protectionist sentiment and cries that “the Russians are coming” in the United States. Another Russian “trophy” was the John Maneely Company, a U.S. steel pipe and tube manufacturer which was purchased by Russia's Novolipetsk Steel.

However, because of the liquidity shortage caused by the global financial recession, the shopping intensity has practically stopped, with one or two exceptions. Furthermore, Norilsk Nickel has recently announced that it would forgo its assets in Africa and Australia, while Basic Element sold off its 9.99 percent stake in Hochtief, a German construction firm, as well as its 25 percent stake in Magna, a Canadian auto parts manufacturer.
The state and the investor: who needs whom?

Russia’s investment policies are highly centralized. Most tax revenues in Russia are allocated by the federal budget, leaving the regions dependent on central redistribution. In 2004, the direct elections of governors were abolished, and by 2007 a massive swapping out of governors took place, wherein “old” governors in multiple regions who fell out of favor were either pushed to resign due to charges of embezzlement or criminal activities, or resigned of their own accord. This trend continued in 2009, most recently in February, when president Medvedev fired four regional leaders because they were allegedly unable to deal with the negative consequences of the crisis, including burgeoning unemployment. The government’s heavy involvement in the regions cannot possibly create a stable environment for investment since all investors, especially those targeting the regions, crave political stability and the ability to build long-term relationships with local authorities.

In July 2005, Putin signed a federal law on special economic zones (SEZs) that introduced customs and tax privileges for investors opening enterprises in the SEZs. Several kinds of zones were created: technical development, manufacturing, tourism and recreational zones. And in 2007, a law was passed to establish a new type of SEZ – port zones. The companies in these zones are exempt from local tax on property and land for five years (or even ten years depending on the zone), and freed from import and export duties in order to stimulate exports and industrial development. The federal government pledged to contribute hundreds of millions of dollars for infrastructure projects in these zones. In 2007, the investment environment was expected to improve.

In April 2008, Putin’s new law on FDI into strategic industries came into force. The spheres of “federal strategic significance” include national defense, mining, oil and gas exploration, atomic energy, fishing, and space. The main goal of this law was to strengthen state control over natural resources and bring subsoil users into compliance with licensing terms, while limiting foreign control in these industries. In some cases, foreigners are allowed to have no more than 25 percent of the shares, as in the aviation industry. The Ministry of Natural Resources (MNR) had been lobbying for this legislation for a long time.

Prior to April 2008, a number of precedents showed the general movement in the direction of decreasing foreign and private stakes in the strategic industries. These actions were viewed as Putin’s “personal” strategy to curtail the involvement of foreigners in the exploitation of Russian natural resources. These perceptions created an atmosphere of mistrust toward the Russian government among foreign investors.

The tax and anti-monopoly agencies, the MNR, and state companies like Rosneft and Gazprom, have been acting quite coherently to implement the grand vision of state control over natural resources and put pressure on foreign investors or Russian privately owned companies. The most famous case is that of Yukos. Another example of the state establishing control over strategic industries is the Sakhalin-II PSA Project. In September 2006, the MNR accused Sakhalin Energy, the operator of the Sakhalin-II PSA Project, of numerous environmental violations, which led to a decrease in its market value. As a result of these power games, Gazprom became the controlling shareholder in the project, which was almost entirely built on foreign investment. Another recent example is Mechel, owned by billionaire Igor Zyuzin. In July 2008, prime minister Putin publicly accused Mechel of manipulating prices in the coal market. As a result, Zyuzin lost $5 billion as the price of Mechel’s stock fell sharply. Putin added insult to injury by promising to send “a doctor” to Zyuzin, who was hospitalized with heart problems. The case against Mechel was initiated by the Federal Antimonopoly Service. Robert Dudley, the CEO of TNK-BP, a BP joint venture in Russia, was denied a work visa allegedly due to labor code violations. Dudley objected and stated that the Russian government was using terror tactics to seize control of TNK-BP. Even though the Russian stock market had started declining (which can be attributed to dropping oil prices and the world economic crisis) before Putin attacked Mechel, it had the effect, along with that of BP and other cases, of increasing the feeling of high political risks for foreign investors in Russia. Another factor was the military crisis in Georgia in August 2008. As a combination of all the above factors, a “perfect storm” of negative confluences, the Russian stock market has dropped by 70 percent since May 2008.

Before the crisis, the Russian government exuded confidence in being able to develop its natural resources without the help of foreign investors. However, that attitude might be changing now. In February 2009, President Medvedev attended the opening of the first natural gas liquefying factory in Russia as part of Sakhalin II project. He thanked the foreign investors, including Shell, Mitsubishi and even Sakhalin Energy for their efforts in completing the project. Some analysts interpret this step as a “Medvedev thaw” after “Putin’s terror” against foreign investors in Russian strategic sectors.

Russia still has high hopes for the 2014 Winter Olympic Games in Sochi. In terms of infrastructure, Sochi could emerge as the third urban and financial center after Moscow and St. Petersburg. The Federal Target Program (FTP) for the infrastructural projects in Sochi is supposed to provide billions of dollars from the federal budget to develop the Krasnodar region and the city of Sochi. The plan is to attract investment from private sources, including FDI. The economic crisis might alter these expectations. However, a number of multinational companies in the food and retail sectors are optimistic about Russia’s consumer market. Carrefour and WalMart, the French and American retail giants, expressed their commitment to the Russian market. McDonalds, which is doing well globally due to the increased demand for cheap food, announced its decision to invest $120 million in expanding in Russia. Coca-Cola plans to invest $1.2 billion in the country.

Since the competition for investment worldwide is becoming tougher, the Russian government will have to work harder to attract investment into the broad spectrum of industries, including possibly lifting the modern “iron curtain” shielding the extraction industries from foreign ownership.

Irina Aervitz, Ph.D. in political science, is the vice president of the Federal News Service in Washington, DC. She is also an adjunct faculty at George Mason University, where she teaches Global Affairs.
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