Investment mirages

Despite all problems associated with doing business in Russia, between 2002 and 2007 the country demonstrated steady investment growth. In 2007 alone the net inflow of foreign capital into Russia amounted to $75 billion. Neither corruption, the arrests of prominent businessmen, weak infrastructure, nor the dysfunctional justice system were enough to scare off foreign investors during that period. Foreign businessmen smiled and praised the Russian government for having instituted macroeconomic and political stability. Investors strived to overcome all the barriers created by the same government angling to take advantage of the rare opportunities on the rapidly expanding Russian market.

The massive capital inflow wasn’t a product of the Russian economy alone, but was made possible by the availability of cheap credit on the global market, as well as high oil prices. Only a small proportion of the investments made in that period ultimately turned into new infrastructure, jobs, and enterprises. Most of the investments from the boom had been structured as short-term loans to leading Russian companies; as soon as Western banks saw they were in trouble, they wanted their money back. The investors who had made fortunes in Russia now fled the country as quickly as they had come. These included major strategic investors such as ConocoPhilips, which sold its 20% share in Lukoil, the largest privately-owned Russian oil company, and BP, which recently put its once-treasured stake in TNK-BP, a joint venture with a group of oligarchs, up for sale. Russians entrepreneurs followed suit. Instead of investing in Russia, they began buying up foreign assets: sports teams, mansions, and Facebook share packages.

As a result, between 1990 and 2008, the amount of man-made capital per capita has shrunk by an astonishing 37%. According to the UN 2012 Inclusive Wealth Report, the total wealth of the nation decreased 3%. At the same time, it wasn’t until 2006 that the investment capital per capita stabilized.  Considering Russia’s great investment needs, investment volume should be much greater, with a more effective infrastructure.

Russia’s natural resources should mean staggering returns for the country. However, one shouldn’t bet on miracles. Foreign investments won’t be the major engine of the Russian economy any time soon. For now, Russia will have to make do with what it already has. There are a number of reasons for this dearth of opportunity, but also room for growth.

Investment desert

On the whole, investors worldwide have lost their taste for volatile emerging economies. Western money is badly needed in order recapitalize the broken down financial systems of Europe and the U.S. and to finance growing domestic budget deficits. In a perfect world, investment in Russian assets could have created more value than investments in American or German treasuries; however, in the current world economic climate, investors tend to avoid unknown risks.

The second reason for shrinking foreign investments is that the Russian resources sector doesn’t seem as rich as it did six years ago. Shale and liquid gas technologies have led to decreases in natural gas and coal prices, making returns on potential Siberian projects hardly worth the risk. The development of energy-saving and renewable technologies has also contributed to this trend. On top of that, the slowdown of the Chinese economy has led to stagnation in the global raw materials markets, which makes investment in Siberian mineral resources even less appealing.

When it comes to labor-intensive, export-oriented industries, Russia also can’t compete. Many Eastern European and South Asian countries can offer a qualified work force for cheaper, along with a better investment climate, established industry specialization, and easy access to European and American markets.

Increasing political instability in Russian similarly contributes to the economic uncertainty for investors.  The instability affecting investment isn’t simply on the level of federal officials. For instance, utilities investors need to be certain that their investments wouldn't be expropriated in ten years' time.  In the absence of a stable justice system, these investors may not be protected from, say, a new mayor ousting parties contracted by his predecessor.

Finally, the heavy inflow of government investment could drown domestic industry. In attempts to compensate for anemic foreign investments, the government has eagerly contributed funds to a number of projects directly or through state-owned corporations. These projects include: construction of another 'bridge to nowhere'—the world’s largest cable bridge, to transverse the Eastern Bosphorus Strait to Russky Island (population of about 5000); the world’s most expensive ever 2014 Sochi Winter Olympics, with a total budget of $30 billion USD; the construction of stadiums and transportation infrastructure for the 2018 World Cup; a new Silicon Valley-style entrepreneurial zone; a new city for federal government officials near Moscow; new capitals for North Caucasian states; the revival of the aerospace and shipbuilding industries; a state-owned nanotechnologies corporation; and, of course, the construction of gargantuan gas and oil pipelines. Russian citizens find some of these projects completely unnecessary, many are not worth their cost. Increasing state employee salaries and the cost of providing pensions to the rapidly aging Russian population will prohibit the government from supporting this many projects for much longer.

Investment Oases

It seems that Russia’s future holds a dearth of both foreign and domestic investments opportunities. However, there are oases in this desert.  First and foremost, these are Russia’s mineral resources industries. Oil and mining companies are, for the most part, in good financial health. For example, Surgutneftegas, the fourth largest Russian oil company, holds over $25 billion USD in cash and, according to a recent statement from its CEO, is willing to increase its investments in extraction if the government cuts taxes on the oil industry.

There is still room on the global raw materials market for profitable investments. However, the balance of power has shifted from resource-rich autocracies in favor of Western corporations, which are largely capable of providing for state-of-the art technologies and capital resources. Funds only go to the best projects on the market and only on investors’ terms.

The second oasis for the Russian economy is its underdeveloped internal consumer market. Many consumer industries are naturally protected from international competition because the goods and services provided by them need to be produced and consumed locally.

Additionally, many consumer markets have high entry barriers including unfavorable consumer patterns, the costs and logistics of transporting goods over long distances, and strong domestic brands. Global consumer goods corporations are generally in good financial health and some invest billions in Russia’s candy, soft drink, solvent, and other industries. Consumer goods are not considered ‘strategic’ like natural resources and infrastructure, the Russian government regulates these industries more loosely, which makes greater foreign investment possible. Russian telecommunications, retail, automotive, insurance, and Internet companies will continue to attract sizeable investments. Private healthcare could become the next big thing.

Finally, healthy returns could also be generated from investments in the operational restructuring of Russian businesses. In terms of labor productivity, Russia lags behind most of Eastern Europe. Adopting modern management practices and IT solutions doesn’t require huge investments but has enormous potential for boosting the profitability of Russian companies.

Shifting the Paradigm

Thanks to its numerous consultants, the Russian government is perfectly aware of what needs to be done in order to improve the investment climate. The state must curb corruption, minimize its participation in the economy (i.e. privatize and deregulate key industries), break up monopolies, and restore the independence of the justice system.

However, institutional transformation is not the Russian government’s top priority. This kind of change requires the support of a broad coalition of elite and public groups. The current political regime is unlikely to be able to foster this kind of coalition, especially as it loses popular support. Furthermore, efficient rules would impose restrictions on leading political figures: reforms will hurt many people in the present and only bear fruit in the distant future. Thus, from the perspective of the ruling elite, institutional changes are not only unnecessary, but potentially dangerous.

Government rhetoric usually propagates the idea that a good investment climate is essential for attracting major international corporations. However, considering the state of the global economy, it makes much more sense to appeal to the Russian citizens, who could act both as consumers and investors. A savings rate of 25% and the urgent need for improved urban infrastructure could serve as solid foundations for domestic investment growth.

The degradation of existing urban infrastructure is a major problem affecting all Russian citizens. According to a recent report from the Center for Strategic Research, this issue is much more important to most Russians than corruption and bad roads. Improving housing, utilities, schools, and hospitals could potentially attract efficient government and private investments. To unlock this investment potential, Russian cities need to exploit new socially-oriented solutions, be allowed greater financial independence, and create vibrant city brands.

 

Dilapidated houses in Samara, Russian Federation

 

In order for Russian cities to develop, officials must implement socially-oriented solutions that enable collaboration between citizens, local businesses, and local government. Self-taxation experiments in the Kirov Region, which is among the most economically-depressed areas in the Russian Federation, have demonstrated that even an impoverished population is eager to contribute their own money to urban renewal projects if they are selected by the people themselves. By publicizing these kinds of positive examples of cooperation among citizens, the private sector and municipal administrations could significantly boost morale and promote innovation. If the citizens of Krymsk, a small city in the south of Russia that was recently devastated by flooding, had had their say in establishing investment priorities, they would have allocated investments into emergency communications systems and a dam to protect their city. Instead, the federal government concentrated all resources on building high-profile Olympics-related structures in the vicinity of the decimated city.

Russian cities need more control over their budgets. Currently, cities have great expenditure responsibilities but limited sources of income. As a result, mayors must beg for regional and federal funding, which depletes their political power, restricting it to the authority to take out loans or sign contracts legislating financial obligations beyond the annual budget cycle. In order to attract capital investments for long-term infrastructure projects, they have to comply with non-transparent, semi-legal schemes and pay out various premiums. Such schemes can work for a city’s good as long as a mayor has the  support of the regional and federal government; once he falls out of favor, he could be easily be convicted of corruption and forced to bear all the consequences. Transparency and accountability must take the place of the rigid control of the regional and federal governments. Greater financial independence will additionally improve cities’ abilities to attract private investments into housing. All of these measures will increase investments into city infrastructure and make the latter more efficient.

Finally, a vibrant city brand is crucial for boosting investments. City branding is not about spending, it is about ideas and the creative individuals who can promote them. A city short on either history or a vision for the future will always be an uncomfortable place to live. When calculating risks, investors will often add subjective premiums for places that seem strange and unknown. For instance, the last year's New York Times article about the modern-art festival in Perm made this city more tangible and thus attractive to potential investors. The controversy surrounding the art itself was also important because it served as the basis for many crucial conversations among the citizens of Perm themselves, thus uniting them.

A successful regional development strategy will improve urban demographics, ameliorating the gravest problem for most Russian provinces. The newly economically active population wouldn’t leave in search of better lives elsewhere. Remaining in their native cities, citizens will start new businesses, invest in real estate, and thus fuel further development.

Instead of concentrating on cities, the government has renewed its efforts to promote “large-scale privatization.”  In the absence of the demand for Russian assets, the government is considering selling its shares to Russian sovereign funds. An elegant scheme will allow it to claim that it doesn’t control the largest Russian companies, and effectively, in the end, nothing will change.