With Western-imposed sanctions hitting Russia’s economy, Russia could turn to Asia in an effort to attract investors and boost capital inflow to the regions. Will it succeed?

Will China be able to shoulder the burden of capital outflow from Russia. Photo: AP

The Sochi Olympics were expected to boost Russia’s image and investment profile on the world stage, yet the Ukraine crisis and the resulting “Crimea effect” seem to have dispersed these great expectations. To paraphrase some skeptics, a great leap forward in Sochi was overshadowed by a greater leap backward in Crimea.

Indeed, the capital outflow from Russia was approximately $50 billion to $60 billion in the first quarter of 2014, according to different estimates. While Russia’s Central Bank and International Monetary Fund claim that about $50 billion in capital left Russia, the European Central Bank (ECB) gives an even gloomier forecast of nearly $220 billion in capital outflow.

According to an OECD report, the capital outflow from Russia (at $70 billion) outpaces the capital inflow (almost $55 billion) in 2013, creating a negative balance. In comparison with 2012 (when almost $63 billion fled Russia) such figures, if accurate, are a bad sign for the prospect of Russia’s economy at the end of 2014.

Oleg Buklemishev, an associate professor in the department of economics at Moscow State University (MGU), who previously worked as an assistant to Russia’s finance minister and prime minister, warns that in terms of capital outflow from Russia, the major economic danger might be the lack of new investment. No capital inflow poses a greater threat, he says, because it can bring about the closure of current projects. 

“I am familiar with a couple of promising projects in the timber industry and agro-industrial and biotech sectors that busted because there was no funding after Crimea,” Buklemishev said.

He claims that Russian capital primarily is fleeing abroad, particularly to Europe, pointing out that some people invest in property and “buy a flat in Berlin by sharing the cost, not because they need it, but because they want to save money,” while others are selling their assets and equities to invest in Europe. 

The problem is aggravated with lower economic growth and decreasing business activity, especially compared to prior expectations. HSBS Bank has lowered its forecasts on Russia’s economic growth from 2 percent to 0.6 percent in 2014 and from 2 percent to 1.2 percent in 2015. Likewise, the International Monetary Fund predicted in April that Russia’s GDP would not grow and, instead, remain at the 2013 level of 1.3 percent, down from a 2 percent prediction made in January.

Indeed, the latest economic growth figures appear to support these forecasts. The country’s economy contracted by 0.5 percent in the first quarter of 2014 and Economic Development Minister Alexei Ulyukayev has conceded that Russia has now entered a recession.

Will Asia decide to invest in Russia?

All this indicates that Russia may have to tighten its belt in the future. Given the impact of the Ukraine crisis, China’s slowing economic growth and Russia’s reliance on oil, it remains to be seen if Russia will be able to attract foreign investors. The question is where this investment comes from in the long run, in the context of geopolitical risks and economic fluctuations. Will the East be able to counterbalance the loss of Western investment?

China has already demonstrated its interest in investing in transport infrastructure in Crimea. As Russia’s daily Kommersant reported in early May, the China International Fund (CIF) is expected to invest in a Crimean infrastructure project that costs anywhere from $1.3 billion to $3 billion, with the China Railway Construction Corporation (CRCC) involved in the construction of a transportation corridor through the Kerch Strait. It might be a railway bridge or an underground tunnel with a bridge.  

Yet this stance is largely seen by experts as a political move to strengthen Russia-China relations amidst tensions in Russia-West relations. The expectation that the project might be financed with Chinese Yuan is also indicative: Attracting investment in Yuan might be Russia’s response to instability in dollar or euro investments, according to Kommersant.      

Yet Buklemishev questions China’s interest in Crimea. This project is hardly likely to bring investment returns and any capital inflow because it is a contract-based project: It’s not China that invests capital, but Russia that pays China to invite Chinese contractors to build infrastructure projects.

“It will only increase the negative balance of payments, not capital inflow,” Buklemishev explains.  

Likewise, Jack Goldstone, a prominent U.S. sociologist and a professor at George Mason University, is very doubtful of the capability of Asian investors to shoulder the loss of Western investment.

“Russia needs investment in energy production technology; in that area, Chinese gas and petroleum companies are behind Europe and the U.S.,” he told Russia Direct. “Russia also gets investment from companies selling name-brand goods in Russia, but since China has very few such companies, I do not know that they would invest in the place of Western ones. Russia's high wages mean that Chinese companies would not invest here for manufacturing at all.” 

Likewise, India's foreign investments, primarily, focus on internationally successful companies to extend India's brand name presence and experience, but because Russia has few of those, it is not attractive to Indian investors, Goldstone said.

“So if Western investors pull out or are barred from activity in Russia by sanctions, I do not think there will be any inflows from Asia to make up for that,” he warns.

At the same time, James R. Barth, the Lowder Eminent Scholar in Finance at Auburn University and a senior fellow at the Milken Institute, argues that even though Asian countries may make investment decisions "on the basis of economic factors rather than political considerations", nevertheless, they are hardly likely to "fully compensate for the loss of investment from Europe and the United States."

Will Asia invest in Russia’s Siberia and Far East?

Russian Minister of Foreign Affairs Sergei Lavrov, left, and China's Foreign Minister Wang Yi during the signing of joint documents in Beijing. Photo: RIA Novosti

Before the Ukraine crisis, Russian authorities struggled to attract more investment in the regions to step up new infrastructure projects. And Siberia and the Far East were seen as a final destination for Asian investors. This challenge was addressed at the 2014 Krasnoyarsk Economic Forum that brought together Russian investors, economists and their foreign counterparts, both from the West and the East.

During this Forum, Viktor Ishayev, Presidential Plenipotentiary Envoy to the Far Eastern Federal District, made no bones about Russia’s interest in “more active cooperation with Asia-Pacific countries,” while other pundits pointed out that future demand for raw materials would come primarily from the East.

With a new Cold War between Russia and the West catalyzing Moscow’s vigor in stepping up ties with the Asia-Pacific Region, optimists hope that energy collaboration with Moscow will be highly relevant for Asian countries, and particularly, China, given its increasing hunger for energy to maintain economic growth.

Barth argues that although Russia has substantial potential for economic growth and important energy resources demanded by other countries, "there is substantial uncertainty about what Russia will do next with respect to the Ukraine and therefore the reaction of Europe and the United States."

"This, in turn, generates uncertainly about its growth prospects," Barth said. "This tends to do deter some investment and trade with Russia at the present time. Uncertainty is big enemy of well-functioning financial and economic markets."

Can special economic zones help?

At the Krasnoyarsk Economic Forum, Russian and foreign  economists discussed other tools of attracting Asian investment such as establishing special economic zones (SEZ) in the regions. After all, SEZ in Far East and Siberia, they argue, could provide some perks for investors, including tax breaks, facilitation with registration, a better quality of life, free access to necessary infrastructure, natural resources and workforce.

For instance, the Minister for Development of the Far East, Alexander Galushka, proposed some perks including tax breaks, facilitation of the administrative procedures for obtaining licenses and construction permits, customs rules, and technical regulations.

Meanwhile, Professor of the Higher School of Economics Sergei Karaganov argued at the Forum that it was necessary to develop those industries where Russia has a competitive advantage, including agriculture, petrochemicals, timber, energy-saving technologies, water supply, and water treatment.

At the same time, Vladislav Inozemtsev, scientific director of the Center for Post-Industrial Studies, argued that Siberia and the Far East should be “less restrictive” in terms of regulations for foreign investors.

“Investors should be given an opportunity to develop mineral deposits there, and to build and buy up oil and gas pipelines and other parts of the transport infrastructure,” he said. “The economic goals should override the political circumstances.”

Yet again it remains unclear whether all these proposals will work in terms of geopolitical instability, capital outflow and “brain drain” that might be spurred by the Ukraine crisis. Access to a high quality workforce, tax breaks and other perks might be difficult in these conditions.

Taking other macroeconomic and political factors into account, such as a high level of public corruption, recorded by Transparency International, and Russia’s ranking in the 2014 Index of Economic Freedom (140th of the 178 countries), and it will only aggravate the problem.

Russia’s middle class to the rescue

Some experts propose to improve the investment climate by boosting small and medium-sized business and expanding the middle class. Yet only 15-20 percent of jobs in Russia are created by small and medium-sized business. And that is “low by comparison with developed countries, where this figure may reach 60-70 percent,” said Alexander Ivlev, Ernst & Young (EY) Country Managing Partner for Russia in an interview with Russia Direct. 

In this context, he pointed out to growing demand from the middle class that will seek improvements in infrastructure, state services, healthcare and education.

“It’s important not to miss the opportunity to invest in these sectors,” Ivlev told Russia Direct at The Krasnoyarsk Economic Forum. “The middle class is traditionally a source of long-term money and an active consumer of services. In developed countries, the middle class is over 53 percent of the population; in Russia, according to experts, that figure is no more than 10 percent. The development of the Russian middle class is thus of great interest to foreigners.”

Indeed, in 2008 then President Dmitry Medvedev looked very ambitious and overly optimistic about boosting Russia’s middle class, which should have reached 60-70 percent by 2020, as he saw it during his presidential term.

However, some research studies create a far less rosy picture. Although some Russian experts and officials argue that nearly 20 percent of Russians were part of the middle class in 2008, the real figure was about 7 percent, claimed independent Russian experts.   

In 2013, Russia media quoted the Moscow-based Independent Institute for Social Policy, which found out that Russia’s middle class is growing very slowly, with only 19 percent of families now part of the middle class.

It contradicts the findings from EY that claimed that “the middle class in Russia is stronger than other emerging markets and growing vigorously.”

Goldstone assumes that EY is judging "middle class" by a standard that applies across all the emerging market countries. 

“So if the common standard is an income of $5,000 per year, then Russia will have many more people in that category, as a percentage of its population, than Brazil, or China, or India,” he said. “But if the standard of "middle class" is something like a European standard of middle class, which would be more like $10,000 per year in income, then the percentage will be much smaller. So it all depends on what level you set for "middle class." There is no standard international definition.”

Another problem is the composition of professionals in Russia’s middle class. The high-qualified professionals, entrepreneurs, academics and professors are being replaced by those working in the government sector such as officials, bureaucrats, and military personal, who represented about 20 percent of Russia’s middle class, according to Independent Institute for Social Policy. It argues that such a trend doesn’t support entrepreneurship and, hence, is hardly likely to attract investment.   

It remains to be seen how the middle class will adjust to the implications of capital outflow. In this context, Buklemishev argues that, unlike capital, the middle class is not fleeing. As such, it shoulders all burden of the capital outflow, with the number of jobs decreasing and level of compensation for these jobs shrinking. All this spurs domestic migration and drives people to the center, he warns.

UPDATE: This article was updated on May 14, 2014 to include commentary from comments James R. Barth, the Lowder Eminent Scholar in Finance at Auburn University and a senior fellow at the Milken Institute.