The structure of Russian capital flows has been transformed over the past decade and a half. When Russia emerged as an independent sovereign entity, inward capital flows were heavily risk mitigated and largely speculative, while outflows primarily took the form of capital flight. As the economy enters its 10th consecutive year of real growth, and with substantial surpluses being sustained on external and fiscal balances, investment demands have altered accordingly. While bond issues and structured lending remain considerable, equity portfolio investment and real direct investment have become more significant.

Given that economic growth has been accompanied by real improvements in the standard of living across the population, with increasing numbers taken out of poverty, the demand structure within the economy has become much more broad-based. As a result, commercially viable investment opportunities have proliferated. On the external side, outward capital flows are now essentially comprised of strategic positioning actions as Russian corporates seek to consolidate international market share and global presence.

Turbulent times

Notwithstanding genuine concerns over the fairness of December’s Duma elections, coupled with the increasingly restrictive nature of the current campaign for March’s presidential campaign, political stability and consistency in macroeconomic management seem assured over the medium term. However, for a country experiencing only its second constitutional change of the head of state, and continued narrowing of the scope of civil society, the process will not be without sudden turbulence.

With massive expectations, real need for infrastructure investment, capital re-equipment and plant modernisation, demand for foreign direct investment will not diminish under the (presumably) forthcoming administration of Dmitri Medvedev. However much the administration may wish to dictate the terms and conditionality of inward investment, and while the parameters may become more discernible and the available sectors more intelligible, FDI will be a key component supporting future economic development.

Fortuitously, Russia’s capacity to generate inward capital investment flows continues unabated. This is despite deteriorating conditions in global capital markets and in the face of the tightening legislative and regulatory environment within Russia itself. Notably, it is with regard to sensitive, but in many cases largely ill-defined, strategic national sectors, particularly extractive industries. Nevertheless, according to preliminary United Nations Conference on Trade and Development estimates, Russia’s FDI flows increased more than 70% to the equivalent of $48.9bn, up from $28.9bn in 2006. Not only was the Federation the recipient of just over half of FDI flows into transitional economies, it was the second largest destination, after China (including Hong Kong), of FDI flows toward emerging markets, and even exceeded Italy in terms of receipts.

Market impact

With its accumulated reserves and comparatively prudent husbanding of oil-derived revenues, the immediate impact of the global tightening of market liquidity on Russian economic performance is likely to be constrained. Not that Russia is expected to emerge unscathed. In the third quarter of 2007, Russian capital outflows increased to the equivalent of $9bn, contributing to the sharp drop in Russian asset prices experienced during that period, with the reserve position easing the equivalent of $7bn. In the final quarter of last year, however, there was a limited recovery of capital inflows, which contributed to renewed reserves accumulation.

Official estimates for the period from January to September 2007 indicate net inflows of foreign private capital amounted to $131bn, more than 50% of that recorded for the whole of 2006. This mainly comprised external financings, raised by both corporates and banks. Corporate bond issuance increased to $16bn in net terms; and bond issues by corporations doubled to $16bn.

Given the apparent scale of the global credit crunch and its potential longevity, the banking sector’s recourse to international capital markets during 2007 could prove problematic, although not insoluble. During 2007, foreign borrowing exceeded the amount incurred in 2006, with roughly $60bn committed over the year. In a sector already dominated by state-owned institutions, further extension of state participation in the banking sector could prove an immediate consequence of the reshaping of global capital markets during 2008. With borrowing and bond issuance sharply scaled back in the final quarter of 2007, this year could prove to be an interesting period for corporate and bank refinancing.

A particular feature of Russian capital flows is the proportion of returning Russian funds, reflected by the fact that offshore financial centres provide a significant core of Russian FDI. Nevertheless, adjusting for returning Russian funds, foreign direct equity investment was the equivalent of $7bn in 2007, and primarily the result of initial public offerings by two state owned financial entities, VTB and Sberbank. In the first three quarters of 2007, inward FDI is estimated at $21bn, or 2.5% of GDP. Net outflows of resident capital jumped to $75bn between January and September, equal to almost 10% of GDP. Although equity investment abroad accounted for one third of capital outflows during the first nine months of 2007, and a further third was attributed to foreign lending by Russian domiciled institutions, capital flight increased significantly during 2007. Monthly capital flight flows are now more than $4bn, double that sustained in 2006.

Economic expansion

Given the difficult global market conditions, 2008 could mark a new stage in the structure of FDI for Russia. While Russia itself can mobilise considerable capital investment resources, the scale of demand, both actual and potential, will ensure that FDI will continue to play a key role in the expansion of the economy.

Indeed with the anticipated narrowing of surpluses in 2008 and 2009, FDI is set to play a more significant role. How this will be achieved will depend on the stance that the Russian authorities take. While there have obviously been problems in the so-called strategic sectors across the wider economy a more favourable attitude prevails.

This can perhaps best exemplified by the development proposals associated with the Sochi 2014 Winter Olympics. The federal government itself has implemented a $12bn federal investment programme to develop the Black Sea resort into a global winter sports capital. Associated investment into the city’s infrastructure and resources are likely to be double if not triple the cost of the federal investment programme. Both the regional government, Krasnodar Krai, and the Sochi City authorities have adopted a proactive approach to secure the financing to start realising these projects. With a range of options available, including public-private partnerships, foreign investment is being actively courted. The degree to which FDI can be attracted to Sochi will be indicative of the likely scale of FDI flows into Russia generally, and will probably provide a model for future projects.

Paul Forrest is director of Forrest Research Ltd, providing global country risk analysis for Europe, the Middle East and Africa.

IN FOCUS:

RUSSIAN ECONOMY

As in preceding years, the dynamism of the Russian economy’s performance has been primarily underpinned by high global oil prices, with real GDP expected to record growth in the region of 7.7% last year. With the sensitivity of the overall economy to oil prices and further erosion of international competitiveness forecasts, some easing in 2008 and 2009 can be anticipated, although it is likely to remain in excess of 6% in real terms annually.

Indeed, over the medium-term, essentially the period encompassing Dmitry Medvedev’s putative first term, the strong foreign exchange reserve position (equivalent to $475bn as of end 2007) and the resources held in the restructured stabilisation funds (about $150bn as of end 2007), the economy and the fiscal position will be largely insulated from any downturn in global oil prices.

Even at the comparatively low levels of $35 to $40 per barrel, the Oil Reserve Fund and the Welfare Fund (successors to the Stabilisation Fund) are structured to continue to accumulate resources. This is despite greatly increased fiscal expenditure and rising import demand, which is unlikely to be reined in during the first few years of a new administration.