Monday, February 16, 2009

Michael Reyen: Are You Bullish on The Bear?

Recently, I heard a commentator on CNBC say that he is bullish about Russia, which he claimed to be one of the few countries poised for positive growth in 2009. As a member of one of the ‘BRIC’ countries, Russia has experienced an economic resurgence within the past decade. But is the specter of positive growth enough? There are several alarming trends that demand attention when considering an investment within Russia.

1.) Falling oil prices pose a serious risk to Russia’s ability to balance its budget, prop up the ruble, and maintain complacency among the people. Russia was able to build up a cushion of cash to guard against falling oil prices, estimated in October of 2008 to be the third largest in the world.[1] However, as the economic crisis intensified, Russia has burned through more than 30% of its currency reserves within the past six months while the ruble has tumbled in value by more than a third.[2] Additionally, inflation stands at 13% a year.[3] Although Russia is better poised to resist a repeat of the 1998 default with $388 billion in cash remaining, a defense of the ruble at the promised 41 ruble to euro/dollar basket of currencies may prove unsustainable, with the ultimate devaluation coming at the expense of confidence in the government and its ability to manage the economy.[4]

2.) Government corruption and general disregard of the rule of law are serious problems within Russia. The ruling party of former members of the KGB and state security services, collectively known as siloviki, or hard men, is strategically placed to accelerate the transfer of wealth and assets from the private sector to their control. The nationalization of successful private companies within Russia is not a new phenomenon, with the most glaring example being the nationalization of the petroleum company Yukos and the imprisonment of its owner Mikhail Khodorkovsky. However, the current economic crisis provides a perfect opportunity for the intensification of this type of nationalization under the guise of government aid to distressed firms. These actions could result in the emergence of a “corporatist state” within Russia, consisting of a “highly monopolistic system, based on a peculiar state-private partnership in which the profits are privatised by Kremlin friends and debts are nationalised.”[5]

Unfortunately, the courts offer little recourse for private investors. The Russian legal system is ineffective and fails to provide adequate protection over property rights, which is a pre-requisite for private investment. Judges serve at the mercy of the President and the ruling siloviki. Corruption also permeates the judicial system and society as a whole. Openly acknowledged as a part of doing business in Russia, the country received a 2.1 out of 10 rating on the corruption index (with 10 being a low rate of corruption) while the corruption market is valued at $300 billion or 20% of GDP.[6] Many large Russian companies seek justice in London and the European Court of Human Rights is flooded with Russian cases.[7] Apart from the ineffectiveness of the legal system and the prevalence of corruption, it is also dangerous to be a high profile legal operator within Russia.

3.) Russia has recently seen a rise in ultra-nationalism that has undercurrents of neo-fascism and xenophobia. The most glaring example of the danger of this ultra-nationalism is the recent murder of prominent human rights lawyer Stanislav Markelov. Mr. Markelov was gunned down in broad daylight in central Moscow along with a freelance journalist working for Novaya Gazeta, a Russian newspaper highly critical of the government. Speculation is that he was gunned down by ultra-nationalists for announcing that he would fight against the release of a Russian tank commander who was imprisoned for murdering an 18 year old Chechen woman. The journalist is the fourth Novaya Gazeta reporter to be murdered or die under mysterious circumstances since 2000.[8]

The rise in ultra-nationalism is due in part to the influx of immigrants during Russia’s decade of prosperity, with the number of migrant workers estimated at over 10 million – making Russia second to only the U.S. in immigrant population.[9] These migrants, primarily Muslim and hailing from the former Soviet Republics of Central Asia, live in squalid conditions and endure both attacks from ultra-nationalists (667 attacks and 86 murders motivated by racism last year) and police harassment.[10] Although the migrants are crucial to Russia’s economy and dwindling native workforce (Russia’s population of 142 million is decreasing by 700,000 a year),[11] the economic crisis is likely to exacerbate their hardship while increasing the frequency of attacks against them as the general populace begins to feel economically desperate and resentful of these low-wage workers. Unfortunately, the Russian government’s recent rhetoric has fanned the flames of ultra-nationalism.

4.) Aside from nationalistic rhetoric, the Russian government also uses the economy to further its political goals, specifically its power within the international energy markets. President Putin is highly involved within the country’s energy industry, and has been active in using politics to prevent Central Asia from building a pipeline to Europe that bypasses Russian territory.[12] These actions, involving Russia’s most attractive industry, are likely to come at the expense of private business. The most recent example is the government’s shutdown of a natural gas pipeline to Ukraine that distributes heating fuel to homes throughout Europe. For three cold weeks much of Southeastern Europe was without heat as Russia renegotiated natural gas contracts with Ukraine. Although it superficially involved natural gas pricing, the undertones of this disagreement are Ukraine’s overtures to the West, contemplation of NATO membership, and weapons sales to Georgia.[13]

The Ukrainian episode along with the war in Georgia is part of a larger pattern of increasingly frosty relations with the West. Other concerns include Russia’s recent arms sales to anti-American governments such as Venezuela and Iran, and the use of the promise of aid and loans to Kyrgyzstan as enticement to force the closure of a U.S. airbase crucial to the mission in Afghanistan.[14] Although the base closure is not an explicit condition of the $2.5 billion in Russian aid to Kyrgyzstan, it is suspicious that the Kyrgyzstan parliament is delaying the vote on whether to expel U.S. troops until after it receives the $450 million down payment from Russia.[15]

It is not a foregone conclusion that any of these trends will hurt GDP growth or hinder returns on investments in Russia (the same cannot be said for the global economic downturn). However, these trends do indicate that any investment in Russia should be carefully considered and an appropriate risk premium factored into any expected return.

Michael Reyen is a former bank auditor and graduate of Colgate University. He is currently pursuing his law degree and Masters in Economics at the University at Buffalo.

[1] The anti-West: An Axis in Need of Oiling, The Economist, Oct. 26, 2008, at 72.

[2] Down in the Dumps: The rouble, a symbol of the Kremlin’s power, is looking sickly, Finance & Economics, Feb. 5th 2009, available at

[3] Id.

[4] Id.

[5] Russia: The Long Arm of the State, The Special Report, Nov. 27, 2008, available at

[6] Russia: Grease My Palm, The Special Report, Nov. 27, 2008, available at

[7] Russia: A Matter of Judgment, The Special Report, Nov. 27, 2008, available at

[8] Michael Schwirtz, Leading Russian Rights Lawyer Shot to Death in Moscow, Along With a Journalist, New York Times, Jan. 19, 2009.

[9] Michael Schwirtz, For Russia’s Migrants, Economic Despair Douses Flickers of Hope, New York Times, Feb. 10, 2009, at A11.

[10] Russia: The Incredible Shrinking People, The Special Report, Nov. 27, 2008, available at

[11] Id.

[12] Andrew E. Kramer, Russia and Ukraine Sign Agreement on Gas, New York Times, Jan. 20, 2009, at A11.

[13] Id.

[14] The anti-West: An Axis in Need of Oiling, The Economist, Oct. 26, 2008, at 71; Associated Press, Krygyzstan: Vote to Close U.S. Base Is Delayed, New York Times, Feb. 10, 2009, at A11.

[15] Id.

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This work by Nicholas E. Radice is licensed under a Creative Commons Attribution-No Derivative Works 3.0 United States License.