March 12th, 2012

Guest post: Foreign investment should be wary of Putin’s return, by James Kimer

Vladimir Putin’s inevitable return to the throne in Russia shouldn’t have come as a surprise to the business community, but nevertheless markets are showing some early signs of unease in response to the election result. 

Although shares began the week with a slight rise, the violent arrests of hundreds of protesters caused the RTS Index to sag by 4.4%, while U.S.-traded shares slid the most in three months.  Bond market yields on Russia’s 2020 dollar bonds fell to their lowest since they were issued in April 2010, while the ratings agency Fitch announced that it would re-evaluate its outlook for the country.

These developments are in many ways counterintuitive.  Money doesn’t care about democracy, human rights, or freedom of expression; it is instead attracted to stability, predictability, and opportunities for growth.  On the surface, having 16 continuous years of the same leader in Russia would seem like the definition of stability, but upon closer examination, there is actually very little continuity of the 2000-2007 boom that brought Russia into the ranks of the BRIC economies.

First, there have been key changes in the administration’s staff, with the notable departure of Finance Minister Alexei Kudrin, the individual who has been credited with building up Russia’s foreign reserves.  Mr. Kudrin was not removed from his post over performance, but instead tendered his resignation last fall because the Kremlin continually ignored his warnings that the administration was over-exposed.

Alexei Kudrin

“Over several months, despite my numerous objections, public and otherwise, decisions were taken regarding budget policy which undoubtedly increased the risks to budget execution,” Kudrin wrote in his resignation statement last September.   “These risks [would] spread inexorably to the whole national economy.”

Unfortunately, there is little indication that the Russian government has heeded Kudrin’s warnings, and have instead further over-extended fiscal commitments while remaining overwhelmingly dependent on oil prices and subject to future price swings.

Because of the deepening unpopularity of Vladimir Putin prompted by the protest movement, he was compelled to extend extravagant populist spending promises in order to shore up support for the election, including pay raises for all public sector workers.

Although in a recent speech, Putin said that his new spending promises would not exceed 1.5% of annual GDP, independent sources say otherwise.  An independent assessment by Capital Economics calculates the total bill for election-related promises will be even higher, reaching 4.8 trillion roubles ($165 billion) per annum, or 4-5% of GDP.  Meanwhile, Fitch Ratings points out that the new defense, healthcare, public wages spending are unsustainable:  “If delivered, these increases could cost $160 billion, or 8% of projected gross domestic product (GDP), over his six-year term (…) pushing up the fiscal breakeven oil price to around $117 per barrel for 2012.”  These unfunded fiscal commitments will soon put significant pressure on the stabilization fund, which will quickly gnaw away at investor confidence.

If foreign investors believe that another go-around with Vladimir Putin means a reduction in political risk, they should run the numbers.  In January and February of this year, spending rose by 37% compared to a year earlier. That’s more than twice the 14% increase previously budgeted for 2012 – itself more than double expected inflation of 6%, while the implied expectation that oil stay well above $117 a barrel represents a seriously risky bet.

During the presidency of Dmitry Medvedev, who, despite being constrained by the looming veto of the prime minister, there was an emphasis placed on economic modernization, as the government pursued policies to build innovation capacity, higher education, technical training, and special tax incentives to attract research and development investments.  Under Putin, we can expect such efforts to diversify the economy to be halted and reversed, while dependency on oil exports deepens even further.

Justin Burke of EurasiaNet has argued that Putin has had very little success in moving Russia away from oil.  During his tenure, “The performance of knowledge-based economic sectors have experienced declines,” he writes.  “The share of equipment and machinery, for example, fell from 10.9 percent of all exports in 1999 to 4.5 percent in 2011. Meanwhile, exports of chemical products declined from 8.5 percent of overall exports in 1999 to 6 percent in 2011.”

Adding to these basic structural challenges, most analysts believe that Putin’s strident anti-American and anti-Western outlook will contribute to a deterioration of diplomatic relations among trade partners, further reducing its opportunities to reach new markets through its new status as a World Trade Organization member.

Many bankers maintain a rosy outlook on Putin’s ability to competently manage the economy, however, these same analysts concede a direct tie between their confidence in the Russian economy and the strength of the protest movement, which alone should be cause for concern.

In an environment of growing opposition, unpunished corruption, and unsustainable fiscal exposure, the investment community would be wise to revisit the “stability narrative” and realize that today’s Russia is a different world from the last Putin administration.

James Kimer is president of K Social Media Solutions.

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