Money to the Winds: Russia’s Capital Dilemma

Alexander Zemlianichenko The Associated Press

(Revised February 5, 2015) I had just pulled out of the parking spot when a tone called my attention the dashboard display.  It read “Oil pressure low – turn off engine immediately.”  The timing couldn’t have been worse; I was on my way to a job interview and had neither the time nor the wardrobe to deal with car troubles.  I pulled over and checked the oil.  The dipstick was dry.  My oil was critically low and without immediate attention, my engine would seize up.  I went to a nearby store and bought enough oil to keep the car going until I could get it to a mechanic.  There, they initiated a check to find out where my oil was going.  Eventually the mechanic told us the oil was leaking into the cylinder and being burned there.  My oil was literally being burned and blown to the winds.

Just as oil reduces friction inside an engine, capital ensures a market economy works efficiently.  Left to market forces, money generally flows to the most effective sectors, while inefficient ones, deprived of it, die out.  When market forces are allowed to work unhindered, capital supports those areas where a given economy has the greatest potential for growth. 

Since investment normally goes where it can find the greatest expected growth, capital flowing out of a company, industry, or country shows there is a problem.  The cause must be determined and fixed or the economic engine seizes up.  This is currently the case with Russia, which is hemorrhaging financial and human capital.  This threatens her long-term economic and social health. If the causes are not addressed, the economy could seize up.

To understand this situation, we must look at factors that influence capital flows.  We begin almost 240 years ago with Adam Smith’s classic The Wealth of Nations where he described capital flow with a concept called comparative advantage.  This posits that if someone can produce a given good comparatively better or more efficiently than another, the customers (and one can assume, the capital) would flow to them.  This means that each country, in a truly free market should produce what it is more efficient at. 

It is also important to remember that countries’ advantages are not necessarily fixed.  With proper planning, marketing, and management a country can develop higher value added industries and therefore comparative advantages in those new areas.  But capital must be attracted there.  Conditions need to be created that either offset or eliminate perceived risks and limitations inherent in a given market.  Left to itself, capital will go to sources of growth that provide either high returns or safe investments.  Anything that increases or decreases either of these will affect capital flow.

Countries like Ireland, Costa Rica, and Georgia have been able to reinvent themselves and grow their economies by creating attractive conditions for foreign capital.  For example, before the Rose Revolution in 2003, Georgia was ranked 124 on Transparency International’s Corruption Perceptions Index.[1]  By 2014, it had climbed to 50.[2] This spectacular progress required a concerted effort to push through structural and cultural changes.  This required the power and wealth brokers to forgo short-minded illicit acquisition for the long-term advantages of transparency.  This requires them to allow others to prosper and to not extort bribes, kickbacks, protection money, and the like from legitimate businesses and foreign investors.  According to a 2009 OECD report, foreign direct investment flowed in, going from $340 million in 2003[3] to almost $2 billion in 2007 as a result of Georgia’s improved climate.  In 2013, five years after the double shock of the worldwide economic crisis and war with Russia, it still stood at almost $1 billion.[4] 

 Factors that may affect the flow of capital are lack of innovation, lack of diversification, risk, and corruption.  These can have a telling effect on long-term economic development.  Russia is a prime example of how these can negatively impact investment.    

Over the past fifteen years, high oil and natural gas prices brought massive flows of wealth to Russia.  While she wisely used this wealth to pay off the huge foreign debts that had drug her into default in 1998 and to build a sovereign wealth fund, she did not use this wealth to finance the development of a competitive industrial and high technology sector.  Money in a bank does nothing for long-term growth other than defend the currency and bail out firms when the economy goes south. Used effectively, this wealth could have moved Russia up the value chain from commodity dependence to a producer of more profitable finished goods.  Unfortunately, due to lack of progress on this front, Russia has failed to make many inroads into the high value added world markets. 

President Vladimir Putin, in his first annual address to the Federal Assembly in 2000 recognized the need to diversify the Russian economy, attract foreign capital, and control cronyism, graft, and corruption. He said, “We are losing the competition on the world market, which is more and more oriented on the innovative sector, on a new economy – the economy of knowledge and technology.” [5]  This has been a running theme in each address since, including his most recent address in 2014 when Putin said, “Our goal is to acquire as many equal partners as possible…We must create new technologies and competitive products, strengthen the financial system, and develop a modern workforce…[We] must work to create a large group of manufacturing companies capable of competing not only domestically, but on international markets…But they come up against a deficit in capital, technology, personnel, and equipment.  We must make maximum effort to remove these limitations, to give them a real boost through investment.” [6]

Unfortunately many of these noble goals made over the years have not been achieved.  Despite some progress, corruption, cronyism, and waste still prevail.  As a result, both foreign and domestic capital continues to flow out of Russia.  This has only accelerated with western sanctions and the collapse of oil prices.  Losses have risen to $130 billion dollars in 2014 from less than $60 billion in 2013.  The government has spent over $100 billion propping up the ruble, reducing its foreign currency reserves.  What is behind this?

As mentioned above, risk plays into this equation.  One of the main factors is that capital is risk averse.  If risk is higher, the cost of capital will also be higher.  If the risks to an investment are too high and expected returns too low, investors will find more attractive investments elsewhere even if that other market is less efficient at producing that good. 

Risks fall into two basic categories – economic and political.  Economic risk is based on market factors that may jeopardize one’s investment.  This includes costs of inputs, market prices for outputs, labor, and disposable income.  Political risk, on the other hand, is the risk of losing an investment from government action.  While the difference between the two can be nebulous at times, the one affecting the other, these two terms are important to keep in mind. 

The Russian economy is suffering a “perfect storm” of political and economic risk.  Russia’s oil dependent economy is reeling from falling prices and economic sanctions.  This is exacerbated by the actions of an ever more erratic and authoritarian regime.  These factors have combined to spook investors, who are taking their money and leaving. 

Furthermore, Russia’s corruption problem has also worsened.  In contrast to Georgia, Russia moved from 86 in 2003 to 136 today.[7]  Together with the political risk of Russia’s aggressive actions towards its neighbors, this has had a telling effect on its economy.

As a result, the capital that streamed into Russia in the early 1990s and again after the 1998 default crisis has been flowing out.  This flow increased to almost $130 billion for 2014.  While Russia blames Western actions for her economic woes, her problems go beyond any real or perceived coordinated effort to counter Russia’s resurgence on the international stage by sabotaging its economy and political system. 

Putin’s attempts at limiting the flow of Russian money offshore show that he sees capital outflows as a huge problem.  It also points to a serious confidence gap among Russian businessmen. If they must be coerced into keeping their money in their own country because they find it too risky or expensive, why would foreign businessmen invest? 

Furthermore, Russia has been hemorrhaging not just foreign but domestic capital since long before the current crisis.  Even more disconcerting, it is not only losing rubles, dollars, and euros, but also human capital. This mass exodus has increased over the last several years as corruption, cronyism, and the Russian government’s increasingly authoritarian and erratic policies toward the opposition, the independent mass media, and dissent have increased. 

Since the fall of the Soviet Union, many of Russia’s best and brightest have left their homeland drawn by better opportunities abroad.  Russian émigré specialists can now be found in leading laboratories and businesses throughout the world.  This includes Pavel Durov, the founder of VKontakte, Russia’s Facebook.  As quoted on the Ukrainian television channel ICTV, he explained, “The absence of open courts, justices chosen by the people, and the plethora of contradictory laws, which stimulate corruption and retard economic growth has deprived returning to my homeland of any sense.” [8]

Human capital is one of Russia’s most vital long-term assets.  The Soviet Union produced some of the world’s best scientific and technical minds.  While Russia has lost some ground in this area, its educational system continues this great tradition.  Unfortunately, the tightening of civil liberties since Putin’s return to power in 2012 combined with limited economic prospects has led to a growing number of Russia’s highly educated, motivated, and innovative middle class leaving the country.  Russia cannot afford to educate innovators and creators of wealth for other countries, she needs them to stay and build prosperity at home.

According to official data from the Federal Service of State Statistics, 122,751 people left in 2012, 186,382 in 2013 and over 200,000 in 2014 as compared to less than 70,000 in 2010 and 2011 combined.[9] 

While immigration is still ahead of emigration, the loss of the well educated professionals is far from being compensated by the less educated immigrants from Russia’s former Soviet neighbors including the approximately one million refugees from the turmoil in Ukraine.  This unequal demographic churn will reduce the pool of qualified workers and experts foreign investors will need if they are to build profitable ventures in Russia.

While we must acknowledge that the West has not always been cognizant of Russia’s interests, leading to a feeling there that she must stand up for her interests at all costs, the course she has chosen has not improved her lot.  These actions have led not to respect, but to increased concern among her citizens, neighbors, and global partners that Russia is becoming increasingly irrational and aggressive, violating international norms and taking measures against her own long-term interest to make a point. 

This approach is threatening capital inside Russia.  Foreign firms in Russia have long been wary of the government and government backed businessmen.  Companies like Hermitage Capital and BP have suffered at the hands of the Russian government and their own business partners.  The in-country expatriate leads for both companies had their work visas revoked and assets seized because their actions were at odds with power brokers within the Russian government. 

Russian businessmen such as Gusinsky, Berezovsky, Khodorkovsky, and recently Yevtushenkov have also suffered at the hands of the government when their actions ran counter to Putin’s desires.  Although none of the fallen oligarchs were lily white, they were singled out from among their colleagues with equally questionable backgrounds because they challenged the existing power structure, Putin himself, or because they simply had something a Putin ally wanted. 

These events have not gone unnoticed by possible investors.  When the business elite feel that the risks of doing business in Russia have overwhelmed the expected benefits, they take their capital and leave.  This, together with energy export dependence and sanctions imposed in response to Russia’s annexation of Crimea and support of separatists in Eastern Ukraine is what is behind the Russia’s economic woes.  Russia must do more to reassure investors if she is to reverse this trend.   

Politically, Russia has the ability and potential to play an important role in world affairs, but she must play by the accepted rules if she is to gain the respect and prestige she so ardently craves and deserves.  No two countries’ interests will ever coincide at all times, and no one should expect Russia to support another’s interests at her own expense.  Nevertheless, defending those interests should be done in a productive, not obstructive manner.  Annexing territory and fomenting unrest on others’ territory does not build trust.  Conversely, it pushes neighbors into hostile alliances to counter the perceived threat.  This, more than Western action, is behind NATO expansion.  Russia needs to employ more productive approaches that build credibility and productive ties that a more vibrant, prosperous, and diverse economy can be built upon.

This also requires that the West take Russia’s interests into consideration.  It would be unfair to lay the blame for the current state of affairs solely at Russia’s feet.  The West has repeatedly sidelined Russia and ignored her pleas for inclusion and the consideration of her interests.  It has only taken notice of Russia when, after years of seeing her interests encroached upon, she feels the only way to stand up for herself is through aggression. 

A drop in rhetoric on both sides would allow for a dialog that would decrease the political risk in Russia and in many of the problem spots throughout the world.  In fact, Russia’s influence over “pariah states” could be a boon in resolving their issues with the rest of the world community. 

However, the Russian government also needs to get its own house in order.  The drains of corruption, cronyism, and overly complex and restrictive rules for foreign businesses only serve to drive out what capital is in the country and discourage potential capital flows from entering. 

If Russia is to realize Putin’s stated goals of economic diversification and innovation, she must create a better investment climate.  Until she does so, she will continue to see the capital that is so vital to achieve her goals flow to countries where it can find better, more reliable returns with lower political and economic risks. 

Since the fall of the Soviet Union, western investors have dreamt of unlocking the unlimited possibilities of Russia’s natural and human wealth.  Billions have been invested in trying to develop that potential. 

Despite Russia’s claims to the contrary, an economically and politically weak Russia is not in the West’s interest.  A prosperous Russia, where property, investor, and civic rights are respected would be a boon not only for the West and its investors, but for Russian businessmen and citizens themselves.  A Russia where one can do business without having to pay off government officials, utilities providers, or the local mafia; where taxes are used for their proper purpose and not to line the pockets of government officials or their friends; where judges can make decisions independently; and where all have a fair shot at success and equal access to resources is a Russia that can only contribute to the wealth, prosperity, and stability of the world and its economy. 

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[1] Transparency International. "Corruption Perceptions Index 2003." 2003. Transparency International . 31 December 2014 <http://www.transparency.org/research/cpi/cpi_2003/0/#results>.

[2] Transparency International. "Corruption Perceptions Index 2014: Results." 2014. Transparency International. 31 December 2014 <http://www.transparency.org/cpi2014/results>.

[3] Ministry of Economic Development of Georgia. "Georgian Economic Outlook." 2009. OECD.org. 10 January 2015 <http://www.oecd.org/investment/psd/43361054.pdf>.

[4] Economic Policy Research Center. "Georgian Economic Outlook 2014, First Quarter." May 2014. 10 January 2015 <http://eprc.ge/admin/editor/uploads/files/Economic_2014_Report_Eng_WEB.pdf>.

[5] Putin, Vladimir. "Послание Федеральному Собранию Российской Федерации (Report to the Federal Assembly of the Russian Federation)." 8 June 2000. Official Site of the President of the Russian Federation. 23 December 2014 <http://archive.kremlin.ru/appears/2000/07/08/0000_type63372type63374type82634_28782.shtml>. (Author's translation)

[6] Putin, Vladimir. "Послание Федеральному Собранию Российской Федерации (Report to the Federal Assembly of the Russian Federation)." 4 December 2014. Official Site of the President of the Russian Federation.  9 January 2015.  http://www.kremlin.ru/transcripts/47173#sel=56:1,56:47;72:1,72:43. (Author’s translation).

[7] Transparency International. "Corruption Perceptions Index 2014: Results." 2014. Transparency International. 31 December 2014 <http://www.transparency.org/cpi2014/results>.

[8] ICTV . "Побег из «империи зла»: массовая эмиграция россиян. (Fleeing the "Evil Empire:" a Mass Russian Emmigration)." 5 December 2014. «Гражданская оборона». 10 January 2015 <http://oborona.ictv.ua/ru/index/read-news/id/1535871>. (Author’s translation)

[9] de Carbonnel, Alissa. "Disenchanted with Putin, Some Russians Vote with Their Feet." 24 July 2014. Reuters. 8 January 2015 <http://www.reuters.com/article/2014/07/24/russia-putin-emigration-idUSL6N0PI4TH20140724>.