October 19th, 2010

And it all adds up to…

President Dmitri A. Medvedev, in a Soviet-built luxury car, with Gov. Arnold Schwarzenegger.

As a counterpoint to President Dmitry Medvedev’s visit to Silicon Valley back in June, California Governor Arnold Schwartzenegger was invited to visit the Skolkovo, the new business school started by Medvedev to encourage high tech innovation with ambitious Silicon Valley aspirations. Despite intense support by the Russian political and business elite, incubating entrepreneurs in Russia face bureaucratic hurdles to success.

As part of Medvedev’s push to diversify the economy, he has launched an anti-corruption campaign but the results have demonstrated the systemic nature of corruption in Russian society. Recently, Yury Chaika the Prosecutor General has announced that the average bribe increased 30% from last year from 30,500 rubles ($1,015) to 23,100 rubles. At a meeting of the heads of the law enforcement agencies, Chaika exhorted his colleagues, “In 2008 and 2009, we saw a significant revival of work in this area, but the results of the activities of law enforcement agencies in the first half of this year confirm complacency and a decrease of effectiveness and quality of work.”

At the capital markets level, a disappointing IPO market this year reflects the lack of progress in strengthening the rule of law, scaling back government intervention in business and allowing greater political expression. So far, the Russian IPO market has totaled only $3 billion this year, of which $2.2 billion is made up of the Rusal IPO on the Hong Kong Stock Exchange in March. This is only a tenth of the $20 billion IPO market predicted earlier this year by sell-side analysts.

Although markets have been volatile, the Russian stock market has posted a 5% gain this month along with gains by other emerging markets powerhouses China and India. However valuations on the RTS Index are trading at an average multiple of 7 times 2010 earnings where other emerging markets are seeing an average of 13 times earnings. This is the inherent risk premium for businesses doing business in Russia as investors seek safer harbors for their assets.

Transparency International’s 2011 Corruption Perception Index is to be released next Monday, October 25 and it will be telling whether Russia improves or inches ever closer to the likes of Sierra Leone and Zimbabwe.

Jailed Russian businessman Mikhail Khodorkovsky and Hermitage Capital’s Bill Browder know all about doing business in Russia and how successful businesses can be run aground by the capricious whims of government officials. Khodorkovsky’s second trial is approaching its end and despite the trappings of a functioning judicial system, the ultimate decision maker of his fate rests within the Kremlin.

Investors should also heed the fate of Sergey Magnitsky, Hermitage Capital’s attorney who refused to give in to corrupt tax officials only to pay with his life. Recently, both US houses of Congress introduced the “Justice for Sergei Magnitsky Act of 2010”, which is not only symbolic but hits his perpetrators in their pocketbooks. The bill prevents Russian officials implicated in Sergey’s murder from entering the United States and freezes their assets here.

When introducing the bill, US Senator Benjamin Cardin said,

“Nearly a year after Sergei’s death, the leading figures in this scheme remain in power in Russia. It has become clear that if we expect any measure of justice in this case, we must act in the United States…At the least we can and should block these corrupt individuals from traveling and investing their ill-gotten money in our country.”

Although Russia is a tempting place to invest in new business with their highly educated population and large reserves, you should take caution to the promises offered by President Medvedev. He has promised much but delivered little during his term and with the 2012 presidential elections coming up, the winds are blowing against his direction and even his meager declarations of modernization, transparency and accountability may come to an end.

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