On Russia, Part I: investment climate

As readers of IPE Journal will know, I am fascinated by Russia (see here). The geopolitical and economic implications of Russia’s rise are immense, and its actions are both bold and confusing. This is the first in a series of pieces on the implications of Russia’s resurgence. Part I: Russia’s investment climate.

The Russian investment climate has been shaped by a number of startling developments over the past five years. The Yukos affair, re-nationalization of strategic industries such as energy, questionable legal proceedings against foreign energy companies operating Russian oil and gas fields, and most recently the deterioration of the TNK-BP joint-venture have all increased uncertainty over the integrity of Russian contracts and vulnerability of assets to expropriation. The 2005 “gas war” between Russia and Ukraine signalled to many the political levers behind the commercial actions of state-run companies like Gazprom. Prime Minister Vladimir Putin’s verbal assault on Mechel Co. (the Russian steel maker) last month knocked $6bn off of its market cap in mere hours of trading. And just last Monday, Russian authorities formally sanctioned the British Chief Executive of the TNK-BP joint-venture.

However, Russia has been a top destination of foreign direct and portfolio investment. FDI has grown over 800% since 2002. By 2006 it accounted for over 3% of GDP (comparable to China). From 2005-2006, net capital inflows rose sharply from $300m to $40bn.

There are a number of explanations for the increase in capital inflows in spite of rapidly rising political risk. Russia’s economic fundamentals are sound, growth large, external debt low, and foreign exchange reserves the third largest in the world ($58bn). Additionally, its capital markets (particularly corporate bond markets) are underdeveloped, and thus foreign investors provide the bulk of corporate finance to Russian companies. Finally, low real interest rates in the U.S. and Japan have driven capital into emerging markets in search of higher returns, and Russia has been among the best performing markets in recent years.

But Russian military action in Georgia appears to have finally reversed investor sentiment. Chris Palmer, head of emerging markets at UK fund manager Gartmore, says, “Absolutely the worst thing that can happen to a political economy is that it is involved in any kind of military activity”. Since the beginning of August, the RTS index (Russian benchmark equity index) has fallen 18.2%, including a 6.6% drop on the day President Medvedev recognized the breakaway provinces. Russia’s central bank reports that the country lost $16bn in foreign capital following the incursion into Georgia, the largest and most rapid withdrawal since the 1998 crisis. August also brought the largest monthly decline in the ruble in almost a decade. Perhaps most important to the real economy, Fitch said last week that rising tensions between Russia and the West could significantly undermine corporate borrowing conditions.

This dramatic reversal signals that foreign investor perceptions have finally converged with the actual level of political risk in the Russian economy. According to Keynes, investor confidence is largely based on the assumption that present circumstances will continue unchanged into the future. In other words, perception (not probability) drives the risk tolerance of foreign investors. For years investors have been willing to swallow a higher risk premium because Russian performance was high. But Russia’s military actions have altered this risk calculation, and the potential for political isolation has injected even greater uncertainty into capital allocation.

The negative impact of declining investor sentiment on Russian growth is likely significant. Deteriorating corporate borrowing conditions will hit Russian companies hard. As Patrick at Zeitgeist noted yesterday, the financial interests of the Russian elite are not served by poor corporate performance. However, the Kremiln has yet to demonstrate a willingness to adjust policy in reponse to declining investor sentiment. Even in the energy sector, where foreign capital and expertise is critical to upstream production, the Kremlin has pushed ahead with its aggressive expropriation and nationalization agenda.

Therefore, with the stand-off between Russia and the West unlikely to diminish any time soon (more on this to come), the Russian investment climate will be among the more immediate casualties of the escalating tensions. It will be interesting to see if Russia turns East for long-term corporate finance (to SWF’s and Chinese banks), and whether the economic policy divisions between the liberals around Medvedev and the Silvoki under Putin will burst into the public. Russia’s vast foreign exchange reserves will undoubtedly cushion it from any short-term risks. But the lack of a developed corporate finance market and banking sector will heighten the long-term impact of capital outflows. While the West has struggled to respond to Russia’s resurgence, foreign investors have cast their judgment.