Russia: Falling for Business as Usual
Jim Rogers, a former George Soros’s partner and a prominent Russian “bear” (no pun intended), has recently taken a job at a Russian investment fund after several months of enthusing about the country’s long-term perspectives in his interviews1. He is not alone in his enthusiasm as Russian equity prices saw a decent run-up after ECB’s statements in August and Blackrock’s Sam Vecht was quoted saying that Russian dividend-paying stocks are poised for a 40% gain. Moreover, after a decade of delays and intense negotiations and despite Russia’s median voter’s fondness for protectionist rhetoric, the Land of tsars finally entered the WTO, which is expected2 to boost its economic growth and competitiveness. Rich in natural resources, underleveraged and showing promising growth of domestic consumption, the country has great untapped potential for economic development and thus could be seen as an opportunity to allocate one’s capital at a premium. Should we look forward for a boom in Russia’s capital market then?
With its fully subscribed $5bn share offering in London on September 19, Sberbank, the largest government–owned lender, has shown that Russian assets are marketable. Indeed, since the moment Ben Bernanke finished his speech two weeks ago, the exchange traded funds (ETFs) investing in Russian equities attracted $ 200m – significantly more than India or Brazil and lagging only China among BRICs3.
This is hardly surprising – the market has been showing signs of undercapitalization for a long time and is considered one of the cheapest in the world. Russian average price to earnings ratio is just 5 (meaning that you buy a stock at just 5 times its annual profit per share) compared to 8-10 that is common for emerging markets. In addition, this recent success does very little to ensure that rallies translate into real economic benefits: both blue chip shares and ETF are very liquid and this capital will pull out as quickly as it arrived.
What policymakers seek are direct investments, long-term oriented, large in scale and “accountable”. However, similar to the stock market, this segment has been shunned by foreign investors. From 2009 to 2011 Russia received a total of $ 1.5 bn. in foreign direct investments (FDI) compared to $ 5 bn. for Brazil, its economic proxy, and just about 4% of the total European FDI flows4.
The country’s “ugly” factor most commonly quoted5 by key global investors is risk. The value of security factors into every investment decision - both on the level of a financial model as a required return rate premium and on the level of investment committees’ meetings as a bullet point on the pro- or con- list. Investment professionals often point to the Russia’s oil dependence being the main factor comprising the risk premium. Indeed, Russian composite indices are closely correlated with the oil price and oil price expectations. The oil risk, however, is not the entire problem, as it wouldn’t explain why Russian oil companies are underpriced compared to their foreign peers. Far more important is the risk to shareholders as a result of the corruption of Russian officials, and unpredictable business and political environment
The corruption risks relate mostly to the practices of the local authority officials where they would render local businesses dysfunctional until those refuse to “contribute” or if they compete with another business under patronage. The tools can vary from random “checks” where, say, General Electric employees would have their work laptops seized “for examination”, to IKEA being rejected construction permits6 without a proper reason. This however can quickly deteriorate into extremely violent cases, such as the one of Hermitage Capital, which saw its assets seized and its legal professional die in prison awaiting trial after a conflict with local tax authority.
What turns local companies into easy targets is often the way they structure their operations. Even some of the smallest companies are controlled through legal entities based in Cyprus or on the Isle of Man. In turn, annual reports of larger companies can contain fine print mentioning opaque working capital arrangements with offshore counterparties, which does not make it easier for a potential acquirer to trust the sellers. Russia also scores quite poorly on corporate governance, to which TPG could testify when it acquired a retail chain for $ 1.1 bn in St Petersburg. The acquisition was followed by reports of shareholders and management getting into fights and rumors of top executives being locked out of the offices7. Though this situation has been ultimately resolved, legal professionals, like Brian Zimbler from Dewy&Lebouef, noted8 that such practices are another problem that spooks foreign investors. This is especially true for minority investors, who have to rely on the goodwill of their partners.
When making a significant majority investment, a thoughtful foreign player would want to ready himself by securing protection from the higher-ups in the Russian government. BP, a thoughtful investor, did just that before signing contract for joint development of an oilfield with the Rosneft state corporation. However, during BP’s litigation with its partners at TNK-BP it turned out that there is always a shifting line in the sand, over which Russian patrons would or would not go. Such blurry shifting political lines ultimately translate into cash flow variance, higher risk premium and more bullet points on the cons list.
Recognizing these “imperfections”, the “tandem” of Russian President and Prime Minister frequently spoke out about the necessity to attract foreign capital. To promote FDI growth, it was decided to establish the Russian Direct Investment fund, intended for the state to invest jointly with foreign entities in various local companies.
Nothing testifies to the problems of the Russian government’s business practices better than creating a $ 10bn fund whose CEO recently suggested injecting state pension system funds into infrastructure bonds and index funds to “boost stock market liquidity”. But RDIF is not merely an example of the conflict of interest in large scale public-private partnerships. Although, the fund itself has closed several important deals, the whole idea behind it shows just how unwilling the government is to make meaningful changes in the society. What is telling about story of RDIF is the concept it markets to private partners: “RDIF co-investors gain increased access to … growth opportunities with the security of investing alongside a government-backed fund.”9 It is remarkable that instead of trying to change the business environment with legal reforms and correcting the corrupt judicial system, state decides to take ad-hoc measures to provide security for a pool of chosen investors. Against the background of political trials, tightening of legal system and populist rhetoric actions such as these help cement the economic system similar in some respect to feudalism, where any enterprise has to be informally sanctioned by the authorities. RDIF appears to fit the series of previous government-led projects very well: its predecessors are United Aircraft Corporation, ROSNANO and Skolkovo (projects intended to spur hi-tech sector growth). Thus, Russian state exhibits a similar pattern of thought in all its economic undertakings.
Recent months saw a series of new laws promoted by pro-government advocates to control the dissent after the reelection of Mr. Putin, including the treason law, the blasphemy law, the “foreign agents” law and tightening amendments to the law on “mass gatherings”. Evidently, these do not intend to encourage local businesses and citizens to take their own initiative to stem corruption. Instead, such legal changes grant protection to those currently in power. This in turn guarantees that the aforementioned security does not expire prematurely, but undermines the healthy bottom-up development of the society and social institutions that could eventually remedy the ills of Russian investment environment.
However promising Russia may appear to some foreign investors, a belief that it will deliver outstanding performance within the political framework that is in place is naïve. The adherents of this framework avoid liberal reform and pursue inefficient and corrupting tools of direct intervention, which undermines country’s long-term competitiveness and suppresses the freedom of enterprise. Without the freedom of enterprise protected by reasonable modern laws and functioning judicial system the growth of domestic market will not reach its full potential warranted by the resource-rich land. We may indeed see an equities boom, but as long as it is “business as usual” for Russian policymakers, the country will continue lagging behind BRICs in economic development and the size of capital market.
- Vedomosti Newspaper, Jim Rogers video interview to Vedomosti during “Meeting with Jim Rogers Event” by KMPG, May 2012, available at http://www.vedomosti.ru/politics/video/62_1162
- Thomas Rutherford, David Tarr, " Russia’s WTO Accession: What are the macroeconomic, sector, labor market and household effects? ", The World Bank Group, 2005
- OECD FDI statistics, available at http://stats.oecd.org/
- Vedomosti Newspaper, “Приток в российские фонды не прекращается”, September 28, 2012 issue
- Maria Shao “Don’t Invest in Russia Today, Warns Bill Browder”, Stanford Graduate School of Business News, October 1, 2009
- Alexander Osipovich “Bed, Bath & Bribes”, Foreign Policy, September/October 2010
- Tamika Cody, "To Russia, with Love", Mergers & Acquisitions: The Dealmaker’s Journal, March 2012
- RDIF official site, available at http://rdif.ru/Eng_Index/