The last few years have been propitious for emerging economies. As the U.S. and Europe struggled to recover from the deep, self-inflicted wounds of the financial crisis, emerging economies around the world boomed and took on bigger and more important roles in the global economy. During the first quarter, for example, China attracted $95.9 billion in foreign investment, despite the imposition of capital controls that were designed to slow the flood of money.
And then, there’s Russia.
Even as the price of commodities soared during the first quarter, oil and resource-rich Russia was hit by a wave of capital flight. An estimated $25 billion in capital left Russia during the first quarter, according to Alexander Perjéssy, senior economist with asset manager AllianceBernstein. “Capital flight is still a problem in Russia, even though the country has benefited from higher commodities prices. The rates of return are just too low,” he said.
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As other emerging economies have pulled ahead, Russia remains stuck with relatively slow growth and overexposure to the volatile commodities sector. Perjéssy expects the Russian economy to grow 5.2 percent this year. That is up from a disappointing 4 percent in 2010, thanks to the boom in the price of oil and other resources. But it is well below the pace of growth in China, which is forecasted by China’s CICC investment bank to grow 9 percent this year.
Meanwhile, inflation in Russia is 9.7 percent, according to Perjéssy. That is much higher than inflation in China, which CICC estimates at 5.4 percent.
As global growth slows and the boom in commodity prices ebbs with it, there is little reason to expect Russian growth to pick up. Having failed to take full advantage of the growth of the last two years, it is now vulnerable to a deceleration of the global economy.
One reason that China continues to attract capital: a high rate of return in the fixed income area. The country’s central bank is aggressively raising rates. The opposite is true in Russia, where the overnight borrowing rate is 3.5 percent. Considering the nation’s high rate of inflation, real interest rates in Russia are negative. The spread on a basket of Russian debt is 215 basis points above the JP Morgan Emerging Market Bond Index-Global. The spread on Brazil’s debt is 179 and China’s is just 166.
Russian debt appears to be fairly priced at that level, according to Perjéssy. Returns in the equities markets lag other markets, too. Companies tied to the infrastructure market might do okay, given that Russia has set investment targets and is preparing to host the Olympics. “But there is no emerging Russian version of Silicon Valley or of the biotech industry, despite talk about creating one. That is a long-term goal,” Perjéssy says.
Russia’s manufacturing center lacks the competitive punch of other emerging economies such as that of China. Due to upward pressure on the nominal exchange rate (and inflation) from the commodities-centered export sector, Russia’s real effective exchange rate has virtually doubled since 2000 whereas that of the Chinese Yuan appreciated by only about 15 percent, according to Perjéssy. “This clearly says something about the relative competitiveness of the manufacturing sectors in these countries,” he says.
Even as China and Brazil evolve, Russia remains narrowly focused on its resources. “From where I am looking at Russia, I don’t think the Russian economy is very diversified at all. It has missed opportunities during the global credit crunch to sprint into action to do more to wean itself from a heavy reliance on hydrocarbons. That will contain the economy and asset prices going forward,” Perjéssy says.
What is holding back Russia’s growth? “Corporate governance has been the key issue,” Perjéssy says. The government has talked about selling off stakes in state-owned enterprises and in removing government officials from the boards of those corporations. And while that discussion is a move in the right direction, those goals have yet to be sufficiently realized.
The fate of market reform is tied to the country’s political future. President Dmitry Medvedev has appealed to the relatively well-to-do by promoting plans to develop the economy. But he is expected to be succeeded in March 2012 by Vladimir Putin, the former president and current prime minister. Perjéssy says Putin has appealed to the broader lower-income population, which prefers stability to change. Putin is not expected to be a champion of market reform.
Medvedev was picked by Putin, who needed to time-out before he could qualify for another two terms as president. While Medvedev has shown signs of independence, it is unlikely that he would be allowed to face Putin in an election campaign, “which would be the mark of true independence,” Perjéssy says.
Given the likely outcome of the March 2012 presidential election and of the elections for Duma representatives, it is unlikely that market reforms will move forward fast enough to reverse the flow of capital. In particular, investors are put off by high taxes on the extraction of coal, oil, gas and other resources. Those taxes might hinder the development of the private market, but they provide a steady stream of cash for the government. For now, that is the Russian investor that might be satisfied before all others.
