Political Climate in Russia and FDI

November 29, 2010

In evaluating political climate of Russian Federation in regards to Foreign Direct Investment (FDI) there are two tendencies that can be clearly observed in existing risk assessments for foreign investors.

One approach is fairly optimistic, with the assumption of relative political stability, and major emphasis on the tremendous economic opportunities present for FDI constituents in the country.

The other view, while recognizing the above mentioned facts, gives considerably more weight to the negative aspects of the political establishment of today’s Russia, and effectively diverge the aspirations of the potential foreign investors from doing business in Russia.

Given the existence of these essentially polar trends in evaluating the riskiness of FDI in modern Russian economy, we have chosen the path of assessing the known facts from the most recent history and their impact on the investment climate in today’s Russia.

Russia has been exposed to the very possibility of any form of FDI only in the last 20 years. After the collapse of the Soviet Union in the 1990’s the era known as “Wild East” under the rule of Boris Yeltsin descended on the country. This was the time when formerly state-owned property was privatized by a small group of people who shortly became known as oligarchs, and who effectively privatized not only economic, but essentially all spheres of Russian society, including politics, judicial system, mass media, and mass culture.

These years were dubbed as “piratization of Russia” by Marshall Goldman, one of the leading experts on Russia, who also specializes in oil and gas sectors of Russian economy. This was also the time when western companies, lured by Russia’s vast natural resources, as well as its huge and largely untapped market for consumer goods and services, entered the Russian marketplace for the first time after almost 70 years of communist rule.

These companies, who were acting as the first movers, had to undergo through all the perils of the transition period that was characterized by absence of articulated government policy on foreign investments, lack of standardized legal framework, inefficiency of bureaucratic system, weakness of judicial branch, and rampant corruption on every conceivable level.

Those major problems were also exacerbated by the political uncertainty, when the return of the communists to power and successive de-privatization, and even persecution and abolishment of any form of entrepreneurship, was a very plausible outcome of the political struggle.

Fast forward 10-15 years from that period of chaos and unpredictability, we are facing very much the same questions about feasibility and level of risk involved in FDI in today’s Russia.
The years of political and economical anarchy of the 90’s were followed by the “new order” represented by Yeltsin’s successor – Putin, who served as the country’s president in 2000-2008, and is currently holding the Prime Minister post under President Medvedev.

These years of Putin being at the office have been marked by tremendous positive economic changes for the country, which actually started under Yeltsin’s presidency with reforms implemented in the wake of the financial crisis that hit Russia in August 1998.

From poverty-stricken, debt-ridden country often referred to as a “third world country” Russia ascended back to its prominent position as the 9-th largest economy in the world as measured by GDP in 2008 (World Bank). Today’s Russia boasts about 20-25% of population being a “middle class”, with corresponding increased purchasing power, a group virtually non-existent just 10 years ago. With the growing economic prowess of Russia however come significant implications for foreign investors.

The three most remarkable tendencies in the official course of the government in the last 5-6 years have been re-defining Russian national idea (return to “strong” Russia), re-centralization of power to the Kremlin by taking it away from the oligarchs and the regional federal constituents, and strangling down any political opposition and dissent. In-depth analysis and colorful illustration of this new strategy is presented in the book The Russia Balance Sheet, April 2009, by another prominent expert on Russia and the Former Soviet Union – Anders Aslund, co-authored with Andrew Kuchins.

This course correction manifested itself in a number of landmark events that were sending clear and very strong signals to business community both in Russia and abroad.

One of them was arrest and sentencing to jail of Mikhail Khodorkovsky, the owner of one of the most successful oil companies in Russia. This trial was accompanied by expropriation of the company and its auctioning, which de-facto resulted in nationalization of its assets, as they were eventually acquired by the state-controlled oil company Rosneft. This event became known in the world as “Yukos affair” and was largely interpreted as the successful attempt by the Kremlin to settle political accounts with the still remaining oligarchs who had been meddling with the country’s politics and trying to continue the tradition of keeping high political profile they had been enjoying under the Yeltsin’s rule. But apart from the political and human rights aspects of this affair, the disturbing fact remains about the very obvious political undercurrent of the formal charges of “tax evasion” and later “money laundering”, and the highly questionable manner in which the private property was confiscated. The other outcome was an estimated loss of $6-7 billion by the US shareholders due to the enforced bankruptcy of Yukos. (http://iiea.iie.com/publications/papers/paper.cfm?ResearchID=844)

If the Khodorkovsky case could be discarded as an unfortunate fallout of the internal political struggles, there was another warning sign, this time involving a foreign investor. We refer here to the highly publicized contradiction surrounding the handover of half of the shares of Royal Dutch Shell and its Japanese partners in Sakhalin-2 natural gas project to the state-controlled Gazprom. The formal excuse this time was environmental violations during the development of the project. This time there was no jail sentencing for the accused party, just a loss of the controlling packet in the enterprise. And partners cumulatively received about $7.5 billion for a 50% stake in the estimated $20 billion worth enterprise. (http://www.nytimes.com/2006/12/11/business/worldbusiness/11iht-shell.3864505.html)

The latest high profile issue with the government meddling in the business affairs involving foreign investor, even though fiercely denied by the Kremlin (not surprisingly), was a controversy surrounding the business dispute between BP and its four Russian partners in the TNK-BP. Even though the nature of the dispute is widely considered purely of business nature, the outcomes for foreign investors are highly suspicious: ousting the TNK-BP’s American CEO from Russia and banning him to work there for two year. Again, the lurking shadow of Gazprom is seen behind this dispute, as they had indicated their interest in acquiring the share of the enterprise and getting control over the strategic assets of the company. (Entrepreneur.com, August 18, 2008 http://www.entrepreneur.com/tradejournals/article/183314472.html)

Review of just these cases that have received the widest publicity in the western media shows that the Russian government is seeking to consolidate its power by gaining back control over the strategic resources. This intent is quite understandable from the country’s perspective of restoring and enhancing its national security. However the question remains whether the government is using the underhanded ways in dealing with these highly sensitive issues, and whether the property right of investors, including foreign, are adequately protected in accordance with the norms of the civilized free market.

One of the positive signs for foreign investors was passing of the bill on Foreign Investment in Russian Strategic Industries in spring 2008 (http://www.amcham.ru/_images/upload/FL57_2008_OnForeignRestrictions_ENG.pdf). The very least this law does is that it shows very clearly where the foreign investments are essentially not welcome due to the country’s strategic interests.

Recommendation on feasibility of FDI into Russia’s economy.
Russia is still posing a moderate risk for foreign investments in regards to political climate, in spite of all attempts of the government to present the country as free and stable market economy to the outside world. The examples we brought up here of handling the situations involving foreign investments show that the Kremlin is prone to using strong armed techniques and high pressure in the spheres where they see their strategic interests being crossed. In such cases the authorities would resort to the tactics of using formal excuses and selective application of the existing laws in order to achieve their goals behind the scenes, while making every effort to save appearances of the due legal process.

In spite of these warnings we think that FDI to Russia is a feasible option as long as the potential investors adhere to the following guidelines:
• Carefully select the industry
• Keep low political profile
• Prepared to deal with other negative peculiarities of Russian business environment, such as inefficient bureaucracy, week judicial system, corruption, organized crime, undeveloped infrastructure, among the most notable
• Develop comprehensive exit strategy
• Carefully calculate economic rewards, make thorough risk assessment analysis, and accept the possibility of losing it all

The Piratization of Russia: Russian Reform Goes Awry, 2003, by Marshall I. Goldman

The Russia Balance Sheet, April 2009, by Anders Aslund, Andrew Kuchins.

US-Russia Economic Relationship: Implications of the Yukos Affair-Testimony before the Committee on Financial Services, Subcommittee on Domestic and International Monetary Policy, Trade, and Technology, US House of Representatives October 17, 2007 – Anders Aslund

Federal Law on Procedures for Making Foreign Investments into Business Entities Having Strategic Significance for National Defense and State Security – April 29, 2008

Challenges 2020. The View from Russian Business, the study by the New Economic School (NES) for the Ministry of Economic Development of the Russian Federation – Spring 2008