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Investing In Russia: Is The Risk Still Too High?

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Russia’s recent military forays into Crimea and Eastern Ukraine — combined with reports of President Vladimir Putin’s complicity in the murders of Russian dissidents and the hacking of Democratic National Committee computers last year — have reinforced Russia’s reputation for instability, and Putin’s image as a power-hungry dictator. However, because U.S. President Donald Trump has spoken so admiringly about Putin, many observers expect the Trump administration to remove sanctions on Russia soon and to forge a closer relationship with the country. Could these rapidly evolving dynamics provide a significant new investment opportunity for U.S. companies in specific sectors? Or is Russia under Putin too risky a proposition for all but a handful of U.S. and foreign investors?

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Although Russia is rich in oil and gas resources, and provides investors with a consumer market of 143 million people, its role as a supplier of goods for the U.S. and a market for U.S.-made goods has steadily weakened despite Russia’s ascension to membership in the World Trade Organization in 2012. Moreover, while America’s economic relationship with Russia has stagnated, U.S. economic ties with China — which has nearly 10 times the population of Russia (1.38 billion) — have expanded rapidly. Since the dawn of the 21st century, bilateral U.S.-China trade has grown nearly five-fold, from $116 billion in 2000 to $577 billion in 2016, while bilateral U.S.-Russia trade has barely doubled, from a mere $9.75 billion in 2000 to $20.3 billion in 2016.

Equally troubling for future prospects, the influx of Foreign Direct Investment (FDI) into Russia fell by 92% in 2015, year-on-year, to $9.8 billion, according to the United Nations Conference on Trade and Development (UNCTAD), and the share of FDI in Russia’s GDP has remained low — only 1.5%. That same year, the influx of FDI into China grew to $135 billion, and FDI stock as a percentage of China’s GDP was 11.1%, or more than seven times higher than its share in Russia. According to the Santander Trade Portal, Russia’s “FDI is not expected to recover due to the absence of real improvement in Ukraine and the enduring issues of governance,” such as “corruption and uncertainties about the rule of law and regional stability.”

The Biggest Disincentive: A Weakened Economy

Philip Nichols, Wharton professor of legal studies and business ethics, cites three major disincentives for foreign investment in Russia. “The biggest disincentive in the last few years has been the economic contraction; the economy has shrunk.” The Russian economy shrank 0.2% in 2016, following a downwardly revised 2.8% contraction in 2015, according to estimates by the country’s statistical office.

Explains Nichols: “Three factors are responsible for that contraction.” The first is the steep decline in the price of oil following the global financial crisis of 2008-2009. “That factor is huge, but it is not determinative.”

The second factor is the impact of the sanctions against Russia for its actions in Crimea and Ukraine. Unlike U.S. sanctions against Iran and Cuba, which were meant to damage those economies, the Russian sanctions “were meant to be targeted at individuals or individual firms that may have played a role in decisions about Ukraine.” However, because of the sanctions, “it was really difficult to move money, and that led to a psychological scare on the part of a lot of Russian investors to get money out of Russia as quickly as possible.”

A third factor in the contraction is that “the Russian government has increased its presence in and control over the economy. We’ve seen this creeping nationalism. Seventy percent of the Russian economy is state-owned. That’s a huge number when you compare it with Eastern Europe. It is not necessarily encouraging for innovation and entrepreneurship, and certainly not for foreign investment.”

The growing role of the government in Russia’s economy “is not necessarily encouraging … for foreign investment.”–Philip Nichols

Although Russia has significant natural resources, a qualified workforce and huge potential, its weak points include an “unstable investment climate, complicated and sometimes contradictory accounting regulations and legislation,” endemic infringement of intellectual property, and the fact that many sectors considered to be strategic are closed to foreign investment, the Santander Trade Portal notes.

What kinds of products are attracting foreign investment? “A measurable amount of light manufacturing is moving from Western Europe to Russia,” Nichols notes. “As for North American products, Russians are interested in consumer products, mostly food. Finance is interesting to some people. But the big ticket is oil and gas — [and it] is a tough one. The ruble has collapsed — fallen by half — so while consumerism in Russia has not abated, it is not growing really fast. And retail has had a tough go in the last four years,” after a period of “huge growth, when there were Western shops opening up. That has stagnated or reversed. They are predicting that there will be actual growth in 2017 — you might see retail coming back — but I have a feeling they are going to wait at least a year.”

Improvements in the Investment Environment

And yet there is reason for long-term optimism, say some Russia specialists. Randi B. Levinas, executive vice president and chief operating officer of the U.S.-Russia Business Council (USRBC), notes that Russia “continues to make improvements in its investment environment, as shown in its steady increase in the World Bank’s Doing Business survey. In 2015, for the first time, Russia received the overall best ranking among the BRIC countries (Brazil, Russia, India, China). Russia jumped 24 spots in the ‘Getting Electricity’ category, owing in large part to a significant decline in the cost of obtaining permits. It rose 19 spots in the ‘Getting Credit’ category, as the World Bank judged that the country’s legal protections for borrowers and creditors are now on par with those of high-income OECD countries.”

Only 12 out of 189 countries in that survey have carried out at least four key reforms to improve their business climate, but Russia implemented five such reforms. Levinas adds that “USRBC … believes that our companies’ active presence in Russia and their sharing of best practices are positive influences in the market.”

Patricia Dowden, president and CEO of the Center for Business Ethics and Corporate Governance, noted that while there is a widespread foreign perception that corruption and violent crime are commonplace in Russia, EY’s Global Fraud Survey (2016) showed that “Russia has continued to develop and extend the scope of its anticorruption legislation with an increased number of government officials now required to disclose their personal income and potential conflicts of interest. Russia has also maintained a focus on fighting corruption at a regional level, with several governors and officials under criminal investigation, and also at a multinational level, repatriating several well-known businessmen whose fortunes are alleged to have been accumulated through fraudulent schemes.”

In a survey question about whether “Bribery/corrupt practices happen widely in business in this country,” Russia ranked 31 of 57, just ahead of the U.S., which ranked number 32, Dowden points out. Moreover, Russian anticorruption laws provide regulations very similar to the U.S Foreign Corrupt Practices Act and the U.K Bribery Act, and these are being aggressively enforced, she notes. Putin has signed an executive order on the National Anti-corruption Plan for 2016–2017.

“Multinationals have had a big influence on developing an impressive contingent of Russian compliance professionals.”–Patricia Dowden

“Government initiatives have focused on fairness and transparency in procurement procedures, both by major state enterprises and large private companies,” Dowden adds. “And state-owned organizations have developed sophisticated systems for handling tenders transparently.” Dowden cites the The Public Procurement Institute, founded in 1998. Certified by the Russian Government, it provides a procurement educational center for state and municipal procurement, corporate and other government regulated purchases, and has been part of public anti-corruption activity. “Anti-competitive activities are vigorously pursued by the Federal Antimonopoly Service, which aggressively enforces level playing field practices for procurement. Transparency in procurement requirements is a major issue.”

When it comes to curtailing corruption among government officials, Dowden points out that in Russia, deputies at various levels, state officials and members of their families are required to report annually about their incomes and their assets. “Small and midsize enterprises are protected by an official government ombudsman whose organization reviews complaints of improper treatment by government officials.” And the four major Russian business organizations, representing companies of various sizes, have joined together to create the Anti-corruption Charter of Russian Businesses, which is heavily promoted by the Russian government, particularly through various chambers of commerce and industry throughout Russia’s regions.

Overall, Dowden says, “In my experience, the progress [in Russia] has been remarkable. Multinationals have had a big influence on developing an impressive contingent of Russian compliance professionals, and Russian-owned businesses, including state-owned companies, have also shown great interest in addressing corruption. The Russian government has also officially supported aggressive prosecution of corruption.”

Roots of Suspicion

So why are so many outside of Russia suspicious of the country’s standards of corporate governance? Argues Dowden, “Some of these misperceptions and exaggerations come from a general American negativity towards Russia, residual stereotypes from Cold War days, fed by relentless and often inaccurate media stories. [Henry] Kissinger describes it as ‘demonizing Putin,’ and it does seem to those of us with strong Russia interests that it is unique. As one friend says, ‘Americans need somebody to hate.’ Another theory is that because Russians look like us, we expect them to act like us — and are more critical when they don’t.”

Dowden adds, “Some of the exaggeration of corruption in Russia comes from Russians themselves. They are getting used to a market economy, but in the beginning they were convinced that anyone who was successful was by definition corrupt — in fact, a Russian newspaper ran a contest asking for positive stories about businessmen, in order to start changing this self-destructive pattern. Russians are also [living in] one of the most distrustful nations in the world, and this tends to support their exaggerated sense of the unethical behavior of others. And they freely express this opinion to others.”

For Nichols, the problem is rooted in the fact that “Russia is just enough like Western Europe or North America to make people think that it is like North America and Europe. But there are differences — that will fool you.” When it comes to politics, most Americans “understand that the political realm affects the business realm, and the business realm affects the political realm. That’s natural. They look at Russia and they think that everyone [there] must be entirely consumed by Ukraine. Or they think business is trying to do things apart from the government, and the government is holding them back.”

Another common misperception is “that Russia is a bunch of inward-looking people,” notes Nichols. “But Russians are as cosmopolitan as anybody; they are very aware of what is going on in Europe and Asia and North America. They are not isolated, but they are Russian, and they think of Russia first. We think of them as different in ways that they are not; and we don’t think of them as similar [to us] in ways that they are.”

“Even if sanctions are lifted, the impact on Russia’s GDP will likely be minimal.”–Randi Levinas

Removing Economic Sanctions

How much difference would it make if the U.S. removed its sanctions against Russia? Dowden notes that because the sanctions have been focused on specific state-owned companies and individuals, “they have not had nearly as much impact on the economy in general as the dramatic drop in oil prices, which led to a dramatic reduction in the value of the ruble….

“The bigger impact has probably been psychological, contributing to a pre-existing American distrust of Russia in general and apprehension that Americans are not welcome there,” she continues. “In my experience, nothing could be further from the truth. Russians, unlike Americans, separate perceptions of citizens from their governments. My impression has been that people have been more welcoming, more eager to establish relationships than before the Crimea-sanctions situation began.”

Notes Levinas, “Energy sanctions have been painful for companies, but the drop in the oil price put a damper on many energy projects in Russia anyway. The financial sanctions have been more constraining. All that said, Russian officials have pointed to the importance of structural reform as key to getting Russia’s economy back on a path to growth. They have noted that even if sanctions are lifted, the impact on Russia’s GDP will likely be minimal.”

What advice does Levinas have for foreign investors? Russia “has proven a profitable market for many companies over time, and that has been based on strategies that approach Russia as a long-term play, where a company works hard at building relationships of trust in the market; where senior levels of the firm give Russia their attention and time, and where the firm has an appetite to manage uncertainty. Some firms are more comfortable and prepared to do this than others.”

Article by Knowledge@Wharton

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