Committee for Russian Economic Freedom

St. Petersburg

As the St. Petersburg Economic Forum gets underway, Prime Minister Putin is telling investors to trust him and put away their wariness of heightened risk because of corruption and weak rule of law in Russia. Russian authorities are pulling out all the stops to encourage much needed foreign investment. Deputy Economy Minister Stanislav Voskresensky, Putin’s director of foreign investors had this advice:

Do not scratch your head and wait: Russia is open for business and the potential profits are huge.”

Russia needs to offer high rewards for investing there as its attractiveness has faded despite recent strong commodity prices. Recently Chevron ended its partnership with Rosneft in the Shatsky Ridge deal in the Black Sea. Russian authorities loathe to cede any profits to multinationals, but the Shatsky deal was a concession to the fact that Russia cannot conduct offshore exploration without outside assistance.

Capital outflows have reached record heights from foreign and domestic capital. Over $55 billion has left Russia over the past eight months according to the International Monetary Fund.

Mikhail Khodorkovsky, former CEO of YUKOS estimates that due to graft in the economy, oil would have to be $200 a barrel before Russia can match the growth of the BRIC powerhouses China and India.

Economic reforms require 100 percent guarantees for private property and an effective, lawful state,” Khodorkovsky, 47, said in written answers to questions relayed through his lawyers. “Under the current political and economic model, to get a 10 percent growth rate for the Russian economy the oil price would have to remain solidly above $200 per barrel.

The World Justice Project released their 2011 Rule of Law Index and had this to say about Russia’s situation:

Russia shows serious deficiencies in checks and balances among the different branches of government (ranking 55th), leading to an institutional environment characterized by corruption, impunity, and political interference. Regulations are not always enforced (ranking 52nd), and civil courts, although accessible, are corrupt and inefficient. Crime rates in Russia are not as high as those in other middle- income countries (ranking 8th out of 19), and the criminal justice system is relatively effective (23rd). Violations against some fundamental rights, such as freedom of opinion, freedom of association, and arbitrary interference with privacy are areas of concern. [Read the full report here.]

With all these warning signs investors are right to be cautious about Russia. The market efficiency hypothesis in economics states that financial markets are “informationally efficient”. This hypothesis explains why Russia lags China and India in foreign investment and why until Russia makes comprehensive and visible changes to its legal and judicial systems, even the promise of excess market returns by the Prime Minister will not convince investors.

News of corruption-related crimes involving top government officials and large bribes increasing 100% in 2010 year-on-year in Russia comes as studies in geopolitical risk and economic opportunities reiterate Russia’s decline. Two notable studies on business risk came out this week, Heritage Foundation’s Index of Economic Freedom and Maplecroft’s Political Risk Atlas.

In the Heritage Foundation report, Russia remains in the bottom quintile and is only 0.6 points away from being in the “repressed” category of the index.

Russia scores very low in the categories Freedom from Corruption, Investment Freedom and Property Rights. From the summary report

Economic freedom is severely challenged in Russia. While strong returns from hydrocarbons have buoyed its economy, prospects for sustained, long-term diversification and growth remain dim…Pervasive corruption and limited respect for property rights hinder the development of economic activity that is free from government control or influence. Macroeconomic instability is a drag on economic growth.

In the Maplecroft report, the focus is widened to include political risks as well as emergins risk areas, notably structural risk affecting long-term infrastructure stability. Widening the scope of the survey seems to dampen Russia’s prospects further as Russia moved into the “extreme risk” category of their study for the first time. Russia is ranked 10th most risky country, sandwiched between Pakistan at number 9 and the Central African Republic at 11.

Political Risk Index 2011 (Dynamic) © Maplecroft, 2011

Russia’s extreme risk rating is exacerbated by the increased activity of militant Islamist separatists in the North Caucasus region. In 2010, terrorist attacks in this area doubled. Additionally, the business and investment environment in Russia is under a lot of pressure from the government. The Maplecroft study summarizes Russia’s business climate this way,

The country’s poor performance is compounded by its “extreme risk” ratings for its business environment, corporate governance and the endemic nature of corruption, which is prevalent throughout all tiers of government.

Challenges for companies operating in Russia also stem from an ineffective legal and regulatory system, which includes a lack of judicial independence from the government. This was most recently in the politicised case agained jailedYukos oil tycoon Mikhail Khodorkovsky, which most commentators dubbed a show trial.

Maplecroft also sees worsening stuctural issues for the BRIC countries and particulary Russia. In Ariel Cohen’s analysis of the Khodorkovsky verdict, he sees a “telephone” law at work where “a system in which punishments are triggered by phone calls from higher ups”

Given all this evidence, why risk Russia?

Out of all the recent articles, Eurasia Daily Monitor summed up the current Russian situation best: Medvedev’s Euro-Modernization Hits the Corruption Wall. The European Union is keen on establishing a more normalized business relationship with Russia and proposed a “Partnership for Modernization.” This partnership empasizes the rule of law and corporate governance as European businesses are wary of the Russian commerical climate. The crucial issue in the EU-Russia business relationship is corruption.

The US State Department issued their annual human rights report last week and described corruption in Russia as

widespread throughout the executive, legislative, and judicial branches at all levels, and officials often engaged in corrupt policies with impunity.

Additionally, TRACE International’s Alexandra Wrage mentioned in a Reuters interview that corruption extracts a high tax on development in emerging market economies. And in comparison to other BRIC countries, the corruption in Russia is especially pervasive,

Corruption in China is an inverted pyramid with most bribery at the top while India is the opposite with corruption rampant at lower levels but tapering off higher up. Russia is a solid block. There is bribery at all levels. There appears to be sense of near-complete impunity, a sense of entitlement.

To underscore the endemic corruption, Russian bloggers have found plans by the Interior Ministry to buy a $800,000 golden bed. With only government-sponsored news available to Russians, bloggers have taken on the role of whistleblowers in a country with few outlets for political discourse. But with only 30% of Russian households with access to the internet, the impact of the bloggers remain muted.

Moscow Times reports today that even though Russia is one of the top five places for foreign direct investment (FDI) it is not expected to return to pre-crisis levels until 2013. Russia’s economy shrink by 7.9 percent in 2009 and is expected to grow to 3.1 percent in 2010, according to analysts reports.

According to Capital Economics analysts:

[Russia] may not return to its pre-crisis levels until 2012. By contrast, the Chinese and Indian economies are expected to grow by more than 25 percent over the same period. So for now at least, Russia seems destined to remain the fourth BRIC.