FDI in Russia

Here's part of an essay on FDI in Russia I worked on for an assgnment. I'm learning heaps, and I thought I'd share it since it's a pretty interesting topic.

Conditions for major foreign investment in Russia have changed in the past few years. According to a report to US Congress, “investors complain [investment in Russia] is inhospitable with respect to factors such as poor property rights protection, burdensome tax laws, inefficient government bureaucracy, and a tendency to limit foreign investor participation.”[i] Others, like HSBC Anisa Redman, argue that taxes are the single biggest factor limiting FDI in Russian oil projects – the Russian government takes as much as 92% of profits when export duties, corporate, production, and payroll taxes are factored in.[ii] This type of challenge is increasingly common since the Russian government has moved away from PSAs like those mentioned in the case.

Political instability has increased in the years since the case was published. An interesting example is the case of Mikhail Khodorkovskii, the former Chairman and CEO of Yukos mentioned earlier. Khodorkovskii was arrested for tax evasion in 2003, and has been in prison since. An embezzlement charge followed. His legal council argues these charges contradict one another, and that they are politically motivated as Khodorkovskii was thought to have interfered with Vladimir Putin. According to Lyudmila Alekseeva, as quoted in The Economist, “Mr Khodorkovsky [sic] was not a prisoner of conscience and was not tried for his beliefs – but he is a victim of political repression.” [iii] One interpretation of these events to foreign investors could be that if even former communist oligarchs are not immune from political interference in Russia, the climate may not be suitable for FDI. The political climate is further worsened by Russia’s military resurgence.

In August 2008, Georgia was invaded by the Russian army, and the rouble suffered its worst decline in more than 9 years. In September 2008, the MICEX benchmark of Russian equities fell by 30%. The FDI implications were enormous, as investors were already concerned by a badly-handled dispute between BP and its partner TNK.[iv] A less dramatic turn of events also shattered investor confidence in late 2006 and early 2007.

According to a report to US Congress, “Russia cut off and/or threatened to cut off gas or oil supplies going to and/or through Ukraine, Moldova, Georgia, and Belarus in the context of price and/or transit negotiations — actions that damaged its reputation as a reliable energy supplier.“[v] This action sent a signal to foreign companies that FDI should be approached with caution since it was implied that Russia would continue to leverage energy to exert political pressure on former Soviet states.

A weak judicial system has led to unfavourable conditions for FDI. This was illustrated in the context of the petroleum industry when Exxon Chief Executive Rex Tillerson said that “there was no trust in Russia's judicial system and that should be changed if the country wants to attract major foreign investment.”[vi] Corruption also plays a role in the poor investment climate. According to The Economist, “the decision by Ikea, a well-known Swedish furniture supplier once bullish about Russia, to suspend investment because of graft is an indictment of the dire commercial climate.”[vii]

Although high oil prices helped Russia’s economy in 2008, one additional factor affected Russia’s economy. The global credit crunch hit Russia particularly hard, eroding cash reserves, contributing to inflation, and causing a GDP freefall.[viii] (See exhibit 1)
In evaluating Russia as a target for FDI, it is interesting to compare Russia to its modern day peers, the other BRIC countries, and consider the elements that enhance FDI prospects. Many different considerations and factors influence FDI attractiveness.[ix]
For instance, GDP size and market potential influence FDI. Russia has the third largest GDP compared to its BRIC counterparts, making it a poorer economic performer with lower value of goods and service. Russia also has a low, sparse population with a weak consumer market and a heritage of socialist market tendencies. Russia’s neglected infrastructure also limits investment potential.

Labour skill also plays a role in attracting FDI. Even with a PSA favouring domestic Russian resources, it was difficult to match requirements with domestic skill and understanding. Russia has a lower unemployment rate than China and India. Low employment rates can signal long lasting depression and underdevelopment. Unlike China and India, which have state and provincially set minimum wages, Russia has a national minimum wage. This may make FDI more attractive as labour costs can be more easily estimated across regions.

Despite the very high aggregated taxes on oil profits mentioned earlier, Russia has the lowest corporate tax rate of all BRIC members, and more cuts are projected. Although Russia has a high VAT at 20%, this is also forecasted to decline as well.[x]
Russia is not a member of the WTO, which makes it a less attractive target for FDI. FDI without WTO governance will result in less security surrounding transactions, since there is no official recognized and enforceable recourse for disputes.

Although Russia is now moving away from PSAs for petroleum projects, such agreements historically increased FDI attractiveness because they superseded local laws and limit tariffs. Under a PSA with Shell and Russia, the Sakhalin project was considered a “win-win” based on the mutual benefit to both the foreign investors and the local economy. The challenge in Russia with these agreements is to achieve governmental support throughout all layers of government.
As seen with other BRIC members, these multiple levels of approval can impede full FDI potential. Where Russia is unique compared to other BRIC members is in its unwillingness to subsidize local capital and infrastructures required for FDI.[xi] This reluctance instigated recent legislative roadblocks such as the March 2008 Duma bill, which restricted the ability for foreign investment to exceed a 50% controlling interest of a company.[xii] The TNK-BP case clearly depicts why investors may be gun-shy about investing in Russia. Other political deterrents facing foreign investors include the level of corruption.

Similar to India, Russia’s political system is conducive to long-term planning through a dual leadership structure. This system provides policy continuity, making foreign investment more desirable.

Russia is resource rich and the top energy exporter among all other BRIC members; they are also the highest producer of oil next to Saudi Arabia. However, availability and accessibility to natural resources is a significant challenge based on limited infrastructure.

[i] Robert Pirog, ‘Russian Oil and Gas Challenges”, CRS Report for Congress, Order Code RL33212 (June 20, 2007)
[ii] Russia’s Oil Industry, “Trouble in the pipeline” The Economist (May 8th 2008).
[iii] Europe Section, “A New Moscow Show Trial” The Economist(April 2nd 2009).
[iv] Finance and Economics Section, “Russian Bears” The Economist(September 4th 2009).
[v] Robert Pirog, ‘Russian Oil and Gas Challenges”, CRS Report for Congress, Order Code RL33212 (June 20, 2007)
[vi] Reuters, “UPDATE 1-Russia clears Exxon's Sakhalin investment plan”
http://www.reuters.com/article/companyNewsAndPR/idUSL845409720090408 (April 8, 2009)
[vii] Leader Section, “Welcome to Moscow” The Economist(July 2nd 2009).
[viii] Briefing Section, “A new sick man” The Economist(June 4th 2009).
[ix] Economics Web Institute, “Foreign Direct Investment” http://www.economicswebinstitute.org/glossary/fdi.htm (2005)
[x] Allianz RCM BRIC Stars Fund, September 2008, Allianz Global Investors (http://www.bricstars.co.uk/literature/10_general/61_Country_profiles.pdf)
[xi] EconomyWatch, “Foreign Direct Investment among Countries”, http://www.economywatch.com/foreign-direct-investment/countries/
[xii] Voice of America, “Russia Drafts Law Limiting Foreign Investment” http://www.voanews.com/english/archive/2008-03/2008-03-24-voa14.cfm?CFID=294144625&CFTOKEN=99643327&jsessionid=de30e815fe56d475590b681f6e2b51572736 (March 24th 2008)