Serious Money:Russia is set to take its seat at the world's top table. It assumed presidency of the G8 this year and, more than a decade after its initial application for membership, will almost certainly join the World Trade Organisation (WTO) in 2007.
The turnaround in the country's fortunes since it defaulted on public and private debt in 1998 has been exceptional and early last year Russian debt was assigned investment-grade status by all of the major credit rating agencies. Stock prices have advanced almost threefold since the start of 2005, while the yield on long-term government bonds is little more than one percentage point higher than that available on comparable US treasuries. Accession to the WTO will complete Russia's rise from the ashes.
Following the collapse of the Soviet Union in 1989, Russia endured an economic collapse far greater than America's Great Depression of the 1930s. Indeed, 10 years after communism's demise, national output had dropped by more than 40 per cent. It inevitably defaulted in 1998 and stock prices declined by more than 90 per cent. However, the country's fortunes have turned since Vladimir Putin succeeded Boris Yeltsin as president.
Russia has enjoyed positive economic growth in each of the past seven years. Inflation has more than halved over the past five years and is currently running at 7 per cent. There has been a 12 percentage point reversal in the state's budgetary position from a deficit of more than 4 per cent of GDP in 1999 to a surplus of nearly 8 per cent last year. The country is running a large current account surplus and the central bank's foreign exchange reserves exceed sovereign external debt by a substantial margin.
Not surprisingly, Russia has become an increasingly attractive destination for foreign businesses and investors. KFC and Pizza Hut have returned to Moscow, Ford and Renault have begun car production, while Coca-Cola, Heineken and Ikea have all invested in the consumer goods sector. Investment in the energy sector has been substantial, most notably with BP's purchase of a 50 per cent stake in Tyumen Oil in 2003, as well as its purchase of a stake in the recent initial public offering of Rosneft.
The Russian stock market has benefited from increasing foreign inflows following the country's re-rating to investment-grade status as well as the easing of foreign ownership restrictions in Gazprom, the country's largest company. The increased foreign interest has enabled the market to absorb an unprecedented number of new issues, including the successful flotation of oil giant Rosneft in July. There is no doubt that Russia's ascent to the world's top table has been impressive, but it is important to note that this has taken place against a background of surging commodity prices. The country's economy and its stock market are heavily dependent on the energy sector.
Indeed, record energy prices have accounted for as much as one-half of economic growth in recent years, while the oil and gas sectors account for more than two-thirds of the stock market's total capitalisation. The recent drop in prices will be a stern test of the economy's resilience.
Russia's growth rates have been laudable in recent years, but its investment rate is not sufficient to sustain the recent pace. The country's investment rate is less than 20 per cent, far less than the 30 per cent rate apparent in the emerging economies of Asia. Furthermore, its infrastructure is crumbling. The average age of plant and equipment in the manufacturing industry is more than 20 years old, three times the OECD average. Roughly half of its fuel pipelines are more than 25 years old and the resulting loss of oil each year is substantial. Its roads, railways, power lines and water supply also require extensive upgrading. The lack of new investment means that Russia is internationally competitive in few industries apart from military hardware or nuclear power stations, for which overseas demand is limited.
Russia also faces a serious demographic challenge, which alongside its low investment rate hampers its future growth potential. The country's fertility rate is half the replacement level and consequently the working population is expected to decline for at least the next two decades. Roughly one-eighth of the population is aged 65 years or older and the dependency ratio continues to rise. Immigration rates are far too low to ease the problem. The implications for future growth are obvious.
Despite Russia's return to the world's stage, it remains an unattractive proposition for foreign investment. The World Economic Forum ranked the country 62nd of 125 in its 2006 Global Competitiveness Report. Transparency International ranked it 126th of 159 countries in its Corruption Perceptions Index. Indeed, estimates suggest that the monies paid by Russian businesses in exchange for protection or in bribes and kick-backs have soared from $33 billion (€25.7 billion) five years ago to $316 billion last year - an amount equivalent to almost one-half of GDP. Russia ranked behind Uganda and Zambia in the World Bank's 2006 corporate governance ratings.
The risks inherent in Russian capital markets are high. Political risk is never far away as evidenced by the recent spats with Georgia, the murder of journalist Anna Politkovskaya, and the recent poisoning of Alexander Litvinenko in London.
Unfortunately, these risks are not reflected in current prices. Stocks no longer look cheap relative to international markets following their strong performance in recent times, while the additional yield available on government bonds is close to record lows. Intelligent investors should steer clear of Russia.
Charlie Fell is an independent consultant and lectures in finance and investment at UCD and the Institute of Bankers in Ireland
