Investing In Russia: A Risky Game?

By Ben McClure AAA

Russia has never been the easiest country to understand. Winston Churchill described the country as a "riddle, wrapped in a mystery inside an enigma," and today a lot of investors would share his viewpoint.
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It's still hard for many investors to shake their memories of the Soviet era. Blame it on the heavy-handed government and crony capitalism. Nonetheless, in Russia it is still possible to generate returns. The trick for investors is to understand Russia's opportunities and its risks.

Bust to Boom
For investors, Russia has ample economic and market growth opportunities. Since devaluation of the rouble and Russia's financial crisis in 1998, growth in Russia has increased steadily to keep relatively on par with other dominant emerging markets such as Brazil, India and China. Equity markets in the country have soared. Between 2005 and 2010, the Russian stock exchange has delivered steady double-digit returns to investors, and the country's performance is expected to continue showing sign of improvement.

Russia has one of the largest populations in the world - around 150 million people - many of whom have been getting slowly wealthier for the past decade and are spending an increasing amount of their income on luxury goods, services and holidays. A 2010 per capita GDP of approximately $16,000 puts it in the higher reaches of upper middle-income countries. As Russia makes significant strides to tap into its natural resource pool and implements policies to reduce disparity, per capita growth is likely to show improvement as well. A GDP growth rate averaging 7% between the crises of 1998 and 2008 made it not only a large market, but a large market that was growing rapidly. While Russia has been the laggard of the so-called BRIC economies (Brazil, Russia, India and China), Russia has enjoyed plenty of foreign investment. (Emerging markets provide new investment opportunities, but there are risks - both to residents and foreign investors. Check out What Is An Emerging Market Economy?)

Natural Resources
Plentiful natural resources represent Russia's biggest draw for investors. Oil and gas play a major part in the Russian economy in terms of production for internal purposes and exports. In 2010 the country had nearly 80 billion barrels of proven oil reserves and tops the world's rankings for natural gas. Russia also has exposure to the energy industry through a number of key joint ventures throughout Africa and other energy producing nations. But oil and gas are not the only natural resources that are plentiful in Russia. The mining and production of precious and non-precious metals is an enormous industry in the country, with great promise.

That being said, energy and minerals are part blessing, part curse. Russia's heavy dependence on resources represents a risk. When you invest in Russia, you have to keep in mind the direction of commodity prices.

It is a very resource rich country, not only in hydrocarbons and minerals, but also in terms of human capital, talent and education, Russia's Soviet tradition of education - superb in math and the hard sciences, excellent in languages - still produces plenty of brainy workers. Russia has an astounding 99% literacy rate and approximately half of the country's citizens have some sort of post secondary education.

Politics
Russian politics may represent the biggest investment risk. Take Yukos, arguably one of Russia's biggest and most successful oil companies. In 2003 its CEO, Mikhail Khodorkovsky, ran afoul of then-president Vladimir Putin and Russia's courts convicted him on trumped-up charges that resulted in an eight-year jail sentence. Yukos was forced into bankruptcy, and its pieces were sold off at a discount to Putin's allies for fractions of the actual market value. Yukos shareholders lost their shirts in the affair.

Russia has at times even made it difficult for foreign investors to operate in a environment free from bureaucratic pressures. For example, in an attempt to persuade shareholders to sell their stake in the TNK-BP joint venture, police raided BP's Moscow office in 2008. Various other barriers on international corporations such as Carrefour and DeBeers have forced them to withdraw their operations in Russia. The Russian government has a record of putting pressure on foreign energy companies as part of its effort to consolidate control over the country's largest and most important hydrocarbon deposits.

Corruption and Lack of Governance
Corruption and weak corporate transparency is another major ongoing risk for investors. Many analysts admit say that this is a big problem - particularly among some of the smaller companies, whose accounts are not particularly transparent.

Even well-known and respected companies like Ikea which heavily focus on practicing ethical businesses activities declared a moratorium on subsequent Russian investments due to the ongoing concerns of corruption. Based on the Corruption Perception Index, Russia has a lot of obstacles to fair and efficient business practices. Even Iran, Libya and Pakistan are perceived as having less corruption.

The Bottom Line
As they seek investment opportunities around the world, investors need knowledge of the national risks that may threaten their investment. We all know that the high returns come from high risk investments and emerging markets are the likely area to find returns that outperform those of the developed nations. While Russia offers high returns, it is dominated by energy companies, the state of regulations still under development, and there are political risks that are larger in that country than others. The striking feature of investing in Russia - the risks and rewards are both high. (Get the full story on this asset class before you write it off as too risky. Refer to Re-evaluating Emerging Markets.)

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