Attracting foreign investment has been deemed crucial to the development of Russia’s economy. But whether the country can compete with other emerging markets for the available dollars, yen, euros and francs remains to be seen.

Experts say that much needs to be done, starting with government policy, to restore and maintain the confidence of foreigners looking for places to invest, especially after the checkered history recorded here in the past decade and a half.

Investments from abroad first arrived in Russia in the early 1990s, after the collapse of communism. However, the 1998 financial crisis took the shine off the Russian economy and dealt a near-fatal blow to the inflow of capital. Most foreigners, especially those with speculative investment portfolios, fled the country for greener pastures.

The numbers tell a startling story: Gross total foreign investments in Russia in the first half of 1998 — prior to the crisis that started Aug. 17, was $7.7 billion. The gross sum of foreign investments for the whole of 1999 was a paltry $2.86 billion, according to Finance Ministry data.

But all was not lost, and the changes brought about by the crisis — specifically, making foreign goods too expensive locally —spurred Russian industrial output and led to an economic transformation — with an average annual GDP growth rate of 6 percent for five years. That, in turn, has started to make the domestic economy attractive once again to foreign investors.

Experts cite foreign direct investment as the most-desired type of investment into a country – as opposed to portfolio investments, for instance — as FDI helps activate the private-business sector, aids local businesses to expand to foreign markets and simplifies access to new technologies and business-management methods. This increases the possibility of companies retaining profits from operations within countries of origin, instead of exporting them overseas.

An improved, but worrying investment climate

Despite recent gains, a myriad of factors are still in place in Russia against a higher inflow of capital. Constant amendments to business legislation that regulates foreign-economic activity and a myriad of contradictory and ambiguously drafted legislative acts are among the biggest stumbling blocks for foreign investment.

Russia also lags behind most other countries in regard to political and social stability, dynamism of economic growth, degree of liberalization of foreign economic activities, availability of banking services as well as availability of a cheap, educated labor force.

Russia needs to do a lot to be on par with world’s largest economies, experts said at a Corporate Governance forum earlier this year. As an example, they cited Russia’s GDP which currently stands at $500 billion, a figure that pales significantly compared with China’s $1.5 trillion, Europe’s $10 trillion and the U.S.’s $12 trillion. Also, the gross volume of foreign investments in Russia stood at $20 billion in 2003 with foreign direct investment (FDI) accounting for just $5 billion – compared with China’s FDI figures of over $53 billion in the same period, World Bank Chairman James Wolfenshon told the forum.

Wolfensohn called on Russian political and corporate leadership to reduce the country’s dependence on the energy industry and encourage growth from other sectors by building an investor-friendly economy, implementation of corporate governance principles and protection of investors’ rights in the country — steps that would highly boost the country’s attractiveness for more foreign investments. "The issue at stake is whether Russian companies are ready to grow, face international competition and protect investors’ rights. One does not need to be a genius to understand that people lend to companies where they know what is going on, where there is transparency and where they are sure they will get back their money."

Other problems include poorly developed infrastructure, including telecoms, transportation and hospitality facilities, such as quality hotels.

Uneven distribution of foreign investment has helped condemn many regions to become financial backwaters. Russia’s FDI picture shows that the lion’s share of foreign investments is concentrated in select large cities — mainly Moscow and St. Petersburg — and some other regions with large deposits and reserves of raw commodities.

Nevertheless, foreign investment is coming into the country at an increasing level. Experts noted that negative effects of the Yukos case and the summer crisis in the banking sector have been largely offset by sky-high prices on oil and the Russian political leadership’s declared intent to join the World Trade Organization.

Cyprus remains the largest investor in Russia

Russian officials are quick to point out the positive changes at local and international forums. "We expect about $12 billion in FDI in Russia by end-2004," said Yuri Isaev, deputy trade and economic development minister, told a news conference on the sidelines of a New York business forum on "Investments in Russia and the CIS Countries." "According to our prognosis, the lion’s share of these investments is expected to go into telecoms, oil, gas, trade and commercial real estate."

With $1.35 billion in the first half of 2004, Cyprus heads the list of nations investing in Russia. It is followed by the Netherlands with $815 million and Germany with $790 million, according to Federal Statistics Service. The high position of Cyprus on the list is not surprising, experts said, adding that the inflow from Cyprus actually reflects a repatriation of cash and other assets spirited out of the country during the rowdy privatization era that ushered in free-market economy in the 1990s. The Cyprus phenomenon is on its own a positive development for the Russian economy.

Cabinet rolls out investment-boosting programs

Prime Minister Mikhail Fradkov recently said his government would create more favorable conditions for foreign investors. "These include continuing and accelerating the current course of economic reforms, especially in the taxation, administrative spheres, and of course, working out more potent mechanisms for protecting intellectual properties and copyrights in the country."

He also said that much effort will be directed at improving existing legislation to boost securities markets’ infrastructure as well as speeding up the adoption of law governing central depository and clearing. "We also need to close legal loopholes on issues of formation of partnerships with foreign investors," he said.

Fradkov also said the Russian government plans to build a modern banking system that is acceptable to foreign investors. "Today, there is an increasing number of banks that are working in joint ventures with foreign contractors, while some of largest global banks have opened subsidiaries in Russia" he added. Jean Lemiere, president of European Bank for Reconstruction and Development, agreed that the number of contracts with foreign investors is on the ed is for Russia to increase its investment attractiveness in the future," he said.

Russia to learn from China and Brazil’s FDI programs

Major questions remain on whether Russia really has the ability to compete with other emerging-market titans — China, Brazil and India — for foreign capital.

China is currently the most attractive destination for foreign investments. Apart from other competitive advantages, China offers government support to investors in its market. Unlike Russia, investors are heavily betting on both Chinese government and private projects using joint-venture vehicles or direct financing from foreign sources.

This joint-venture approach gives foreign investors confidence that their capital will not be lost in China and that it will attract huge profits in the long run. In the past 15 years, China has increased its volume of trade turnover with the outside world by over three times. And, according to Chun Tsuan, head of chancellery at the Chinese Commerce Ministry, the sum of agreements on foreign investments so far in 2004 is about $82.65 billion, an increase of 39.69 percent over the previous year. Over $38.4 billion has been effectively invested in the country, up by 15.14 percent on the previous year, he added. About 25,217 new companies with foreign participation were set up in the country in 2003, about 15 percent more than in 2002. On the whole, over $501.5 billion of foreign investments has poured into the Chinese economy since 1993, making it the runaway leader in FDI among emerging countries.

Experts attribute China’s FDI competitive advantages to its relatively low political risk and the availability of low interest rates on capital borrowed to fund new joint-venture companies.

Experts also cite Brazil as a favorable destination for foreign capital and a direct competitor with Russia. Brazil and Russia have almost similar socio-political platforms — both were politically and economically unstable throughout 1990s, and to a large extent, are still far from Chinese stability today. The economic reforms adopted in Brazil were also copied in Russia with only one major difference — they were more successful in Brazil than Russia, a factor that also saved it from the worst effects of economic crises that swept across emerging markets in the 1990s.

Prior to 1998, most of foreign capital in Russia was invested in stock markets, while the sum of FDI was very small, and therefore, when the economy came crashing, and foreigners started exiting, Russian officials lost total control over the situation.

In Brazil, however, the situation was the opposite. Thanks to a more prudent fiscal policy, well-thought-out privatization programs where government assets were sold through open tenders and higher level of FDIs, the economic crisis in Brazil was very mild with little or no serious consequences for the economy. Consequently, beginning from 1995, inflow of foreign investments rose from $6 billion per year to $30 billion in 1999, most of which was in the form of FDI.

Experts say Russia has a lot to learn from Chinese and Brazilian policies of attracting, and more importantly, protecting foreign investments in the respective countries.

Putin’s fiscal policies yielding fruits

The good news, however, is that President Vladimir Putin has announced plans to tackle Russia’s perennial problems more actively than his predecessor. Tax reform and clear plans for adopting more business-friendly legislation are on the agenda. Consequently, investors’ attitude to Russia has changed — Moody’s upgraded Russia’s ratings to investment grade, while other investment monitoring agencies are equally positive on Russia. According to Federal Statistics Service data for 2001-2004, foreign investors are gradually coming back to Russia.

One of the first foreign companies to come to post-crisis Russia was Baring Vostok Capital Partners (BVCP), which has invested about $205 million in FDI between 2000-02, according to Vremya Novostei. Another huge capital influx came from BP and TNK merger deal, reportedly worth $6.75 billion in 2003, while ConocoPhillips paid $1.99 billion in September for a 7.59 percent stake in LUKoil — the latest indication of investors’ restoration of confidence in the Russian economy.

Still, most foreign investors’ concerns have yet to be addressed — taxation and administrative reforms have not been completed, corruption still reigns supreme in all sectors of the economy. Consequently, FDI remains scant in Russia, despite relative political, social and economic stability in the past five years of Putin’s presidency.

More needs to be done to remedy the situation. These will require a faster accession to WTO, new and more ambitious government strategies that will avoid the obvious mistakes in official policies on reforms, borrow from successful case studies in other countries..