FDI in Russia – rewards justify the risks

Depending on which set of statistics you believe, foreign direct investment in Russia in 2005 amounted to some $14.6 billion and in 2006 more than doubled to about $30 billion.

These figures are much higher than the average of just over $2 billion per annum for most of the 1990s, but they remain far behind that of many other developing countries in per capita terms. And they are far too low given Russia’s desperate need for capital.

In the 1990s, the then prime minister Viktor Chernomyrdin said that Russia needed trillions of dollars to modernise its economy. Take the railway system. This week, at a meeting chaired by President Putin, Vladimir Yakunin, CEO of the state-owned monopoly Russian Railways, claimed that implementing the “Development Strategy for Rail Transport to 2030” would cost nearly 10 trillion roubles, of which Russian Railways could only raise nearly 5.3 trillion roubles. According to Yakunin, these funds were needed not just to support the operations of the rail network, but also to build new infrastructure. Upgrading the Trans-Siberian alone would cost an estimated USD140 billion. Yakunin added that if appropriate measures were not taken by 2011, the railway system – on which much of Russia’s commodity-based economy and exports depend – could start to brake, rather than promote Russia’s growth.

President Putin declared in 2003 that he wanted to see Russia double its GDP within ten years – a goal that requires annual growth of around 7.2%. But growth has only averaged 6.7% annually since the financial crisis of 1998 and has slowed since the spectacular increase of over 9% achieved in 2000 on the back of the 1998 rouble devaluation and rising energy prices. This 9% increase also has to be put into the perspective of a very low base in the late 1990s after GDP had already started falling during the 1980s and then collapsed after the Soviet Union imploded. Russia ended 2006 with its eighth straight year of growth, but GDP rose by “only” 6.6%.

Even so, these figures are spectacular by Russian standards. As Mikhail Kasyanov, then Russian prime minister, said in early 2001, Russia had not seen growth of anything even remotely approaching 9% for decades. And despite the need for at least 7.2% per annum to double GDP in ten years, President Putin has expressed his satisfaction at last year’s growth in televised remarks.

This is not surprising when seen against the poor performance of the country historically. The Soviet economy was already in deep trouble in the 1950s, but repeated reform attempts, for instance in 1957 and 1965, and again from 1985 under Mikhail Gorbachev, failed to break the mould and shift the economy from extensive growth based on increasing labour input to intensive growth based on technology and higher productivity. In fact, despite the huge popularity and respect with which Gorbachev is generally held in the West, his reforms did huge damage to an economy already characterised by major structural weaknesses.

Russia is therefore doing spectacularly well by the standards of the Soviet Union and the 1990s, but it remains far below both its economic and investment potential – and its needs.

Things started improving in the early 2000s, when impressive market-oriented legal and financial reforms attracted both foreign investors and expatriate Russian money from tax havens such as Cyprus – which sent the right signals to foreign investors impressed by Russians who were now willing to invest flight capital in their own country! Money began flowing into Russia to take advantage of investment opportunities, for instance in the oil and gas sector and industrial-scale agriculture, and in the first six months of 2003, for instance, FDI was USD 23 billion, up from USD 8 billion in the first six months of 2002.

The arrest of Mikhail Khodorkovsky and the huge tax claims against YUKOS in 2003 and 2004, hit foreign direct investment hard, however, a problem that was exacerbated by the widespread impression among investors that the pace of reform has slowed under the Mikhail Fradkov, who replaced Kasyanov as prime minister just before the presidential elections in early 2004. After implementing the “easy” reforms in the 2000s, it seems that the government has got rather bogged down. Increasing Kremlin control over the energy sector, although in line with similar trends in the Middle East and Latin America, has also made foreign investors wary.

In other words, even in 2006, FDI remains far below Russia’s potential and needs. Russia has made undoubted progress, but it is often a question of two steps forward, one step back. So while it is now easier than ever to set up a company, bureaucracy has increased. And all too often, it is the step backwards that gets all the publicity.

Not all the blame can laid at Russia’s door, however. Foreign companies often make huge strategic blunders of the type that the well-known economist Jeffrey Sachs committed in the early 1990s. Having successfully advised the governments of Chile and Poland, he thought that the same advice would work in Russia. Even now, companies which have started successful operations in countries such as Poland and Hungary naively think the same approach will work in Russia – only to find they have made an expensive mistake.

Russia still has to learn how to attract foreign investment. Much criticism of Russia is based on western standards of the rule of law and corporate governance and so on – criteria Russia unquestionably fails to meet. Investors expecting western standards therefore get disappointed.

But there is an upside to all of this. The many international companies which are now actually based in Russia and have made successful direct investments understand far better than potential newcomers worried about the negative press that the risk-reward relationship allows them to make superior returns. The YUKOS affair and increasing state control over energy have clarified the situation. Good profits are to be made in Russia, and many foreign companies are doing just that. But they have to play by the rules.

Ian Pryde is CEO, Eurasia Strategy & Communications, Moscow.

The opinions expressed in this article are those of the author and do not necessarily represent those of RIA Novosti.

Originally written for Ian Pryde’s weekly column for the Opinion & Analysis section of RIA-Novosti’s English-language website.

Now available at https://sputniknews.com/analysis/2007041363611472/, the site of the Sputnik news agency, the successor to Russian state-owned RIA Novosti’s international branch, which became defunct in 2013.

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