Taking the ‘R’ out of BRIC: How the Economic Downturn Exposed Russia’s Weaknesses

Last June, when Russia’s president, Dmitry Medvedev, gathered fellow BRIC heads of state — Brazil’s President Luiz Inácio Lula da Silva, India’s Prime Minister Manmohan Singh and China’s President Hu Jintao — in the central Russian city of Yekaterinburg for the group’s first-ever leaders summit, he called for those present to “create the conditions for a fairer world order … a multi-polar world order.”

Medvedev’s rhetoric is a giveaway to how, at least in some quarters, the BRIC concept, first put forward in 2003 by analysts at investment bank Goldman Sachs, has evolved from one of economic shorthand to one of political posturing, primarily against American superpower dominance. In a similar gesture, Medvedev dedicated significant air time at the summit to calling for a diversification of world reserve currencies away from the dollar — a point about which China, which holds some $2 trillion in dollar-denominated reserves, remained silent.

Ever since BRIC was first postulated as a way to group those large, fast-growing emerging markets that, at the time anyway, were expected to be the main engines of world economic growth in coming years, observers have wondered which other countries might have BRIC characteristics. Certainly, there is an ever-growing list of countries being promoted for their BRIC-like qualities to attract international business and investment interest. Goldman Sachs, in a 2005 follow-up to its first BRIC report, put forward its so-called “N11″ — or Next 11 — group of BRIC aspirants, including Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey and Vietnam.

But now many experts question whether the once promising BRIC label has begun to lose its luster — especially in the case of Russia. Last year, Russia’s economic performance was the worst among the BRIC economies by a large measure: For the whole of 2009, its real GDP is expected to have declined by at least 8% and some quarters by more than 10%. That compares to Brazil’s smaller real GDP decline of 5.5%, while China’s and India’s GDPs grew by 8.3% and 6.5%, respectively. Russia’s performance is even worse when compared to 2008, which takes into account the bursting of the oil-price bubble in the middle of that year.

Oil and Other Risks

Russia is the world’s largest producer of oil and gas, which is the primary source of its power but also a significant source of economic risk. According to Witold Henisz, a management professor at Wharton, oil and gas are “both a blessing and a curse” for the country. Unlike other major emerging economies, such as Korea, Russia hasn’t had to aggressively seek its revenue. And because it has never made a clean break from its feudal past, economic — and political — power lies in the hands of a few. This has reverberated throughout the country, Henisz says, bringing with it a “tendency toward centralization, control and coercion.”

Although the severity of Russia’s economic decline has been due to several factors, Ira Kalish, director of global economics at Deloitte Research, says that the obvious beginning was the bursting of the oil-price bubble in mid-2008. This sharply curtailed export revenues and made the country’s foreign debt obligation loom much larger than it had when oil prices where heading toward $150 a barrel. Then the worldwide credit crunch squeezed the government’s debt position even further and, in turn, percolated into Russia’s domestic financial sector, leaving several large institutions in need of bail-outs. Rising interest rates to support a collapsing ruble completed the vicious cycle, leading to even tighter credit and further declines in foreign currency reserves.

Still, while oil prices fell by more than 70% from their 2008 peak, they recovered during 2009 to an average price for the year that was above that of 2007 and well above the average of most of the last decade, when Russia’s economy was still growing at a healthy clip. Furthermore, although about 65% of Russia’s export earnings come from oil and gas, the sector accounts for only about 20% of overall GDP. Other more oil-dependent economies, such as Kazakhstan or Saudi Arabia, suffered much smaller GDP declines over the same period.

So why has Russia done so poorly compared with its BRIC counterparts, as well as other oil-rich emerging economies?

The reason is “a combination of corruption, poor governance, government interference in the private sector, and insufficient investment in the oil and gas sector,” says Kalish. These problems and others — such as erosion of civil liberties — will continue to stymie growth unless they are tackled aggressively, according to experts.

Even if there were the will to change, solutions are not obvious, says Wharton professor of legal studies and business ethics Philip Nichols. Consider corruption. “In most countries, the mistrust generated by corruption leads to disengagement from government institutions and the creation of relationship-based networks,” he says. “In Russia, you do find these networks and they are quite strong, but they are not as pervasive as in the other BRIC countries. In fact, [in Russia,] in the absence of trust it seems that people often turn to the government for direction. And so it seems that corruption … has the odd, and indirect, effect of further concentrating power in the government.”

Nonetheless, Nichols also sees some change in the right direction, including among the country’s small and mid-sized enterprises (SMEs), which he has been studying over time. “In the early 1990s, [SMEs] mostly talked about the deal they were working on and maybe the next deal, but rarely looked ahead,” he notes. “Now, they talk about their businesses in terms of years. They understand that this requires a sustainable, trustworthy business environment, and that they themselves need to act in trustworthy ways.”

More Red Flags

As for the future business environment, Russia’s Ministry of Economic Development put forward some fairly optimistic economic growth forecasts at the end of 2009 for the 2010-2012 period. Growth in GDP would be as high as 3.1% in 2010 and 3.4% in 2011, assuming oil prices continue to climb, and GDP growth would rise back to pre-crisis levels by 2012 as foreign investment returns and the domestic economy rebuilds stocks.

The forecasts were quickly dismissed by others, including leading Russian economists. The immediate prognosis for the economy is highly dependent on external factors, argues Sergey Aleksashenko, director for macroeconomic studies at the State University-Higher School of Economics in Moscow. Furthermore, too rapid a recovery — which might occur if there is another oil price surge — would be bad for the Russian economy, he says. That would lead to a strengthening of the ruble and foreign currency reserves, an influx of speculative capital, inflation and the strong likelihood of another collapse and an even more severe recession than the one that took place in 2009.

Another red flag that Aleksashenko raises is that Russia’s government could be disinclined to follow the healthiest path for recovery — that is, a long steady one — ahead of presidential elections in 2012, when former President Vladimir Putin (currently prime minister) is hopeful of a return to the top job.

This highlights the most persistent problem for Russia: its institutional weakness, something that was evident in the dithering over last year’s stimulus package, which at 4% of GDP was large by international standards but which was not implemented until late spring because of worries about stoking inflation further. Thus, in the first half of 2009, according to a report by the Economist Intelligence Unit (EIU), Russia had the humiliating distinction of joining the Ukraine and Zimbabwe as the only countries suffering from both a double-digit output decline and double-digit inflation.

Since the fall of communism two decades ago, the Russian business landscape has gone through a turbulent transition that is still nowhere near complete. Corruption, bureaucratic morass and the often arbitrary enforcement of rules have taken their toll. Yet its oil and gas riches are so vast that very large companies still are willing to pump in billions in foreign capital for huge projects — including BP, Exxon Mobil and Royal Dutch Shell — despite having been burned on several occasions. “Just by virtue of its size, it deserves continued attention from the investment community,” says Henisz.

Inflows, Outflows

But Western companies, on the whole, are wary and have been more inclined to seek less volatile environments for their investments, as was especially evident during the downturn. A case in point: Carrefour. In October, the French retailer — the second largest in the world after Wal-Mart — pulled up stakes in Russia, citing bleak short- and medium-term prospects for growth. The move was a surprise given that just months before in June, it had cut the ribbon on its first hypermarket in the country.

That episode underscores not only the fragile investor confidence in the country, but also the difficulty that Russia faces in developing other industries that can reduce its heavy reliance on oil and gas. Outside that sector, the opportunities are “very limited,” Henisz notes. “Russia does have the capacity [to develop other sectors] — there are a lot of engineers and the education level is high. But we’re not seeing many entrepreneurs who can develop large service or manufacturing companies. There’s a massive gap between the small entrepreneurs — who want to stay off the tax and political radar screens — and the oligarchs.”

With oil and gas clearly continuing to be a dominant force, Medvedev’s new world order for BRICs is perhaps best illustrated in early 2009 by the “oil-for-loans” deal between Russia and China, when the latter arranged for its China Development Bank to lend $25 billion to Russia’s Rosneft and Transneft oil companies to build pipelines and secure oil deliveries for the next couple of decades. Russia has been looking to diversify its markets away from the West, while China has aggressively sought to secure energy resources from as many sources as it can.

The oil-for-loans deal also underlines the potential for friction between these two BRIC members. While the BRIC summit was getting under way in Yekaterinburg in June, there was a simultaneous gathering in the same city of the Shanghai Cooperation Organization, made up of Kazakhstan, Uzbekistan, Tajikistan and Kyrgyzstan, as well as China and Russia. While the meeting may have been billed as a further display of independence from the West, Russia and China have competing interests in how these energy-rich countries bring their oil and gas to market. China — which pledged $10 billion in economic stabilization loans for the Central Asian countries at that meeting — has the upper hand.

Another destabilizing factor is the effect of concentrated ownership in the hands of a few billionaires, and the risk of capital flight from this small group, which has happened on more than one occasion and leaves the economy open to sharp and volatile outflows of capital during hard times. In the final quarter of 2008, as the financial crisis deepened after the collapse of Lehman Brothers, $164 billion flowed out of Russia’s capital account.

The shortcomings of Russia’s ruling political and business elite are by now well known. What’s more, the warning signs of more economic trouble ahead are growing — for example, the increasing rate of non-performing loans on Russian banks’ balance sheets. Experts say that strong leadership would be required now to stabilize the financial situation and, more than anything, to encourage foreign investment and management expertise to help steady Russia’s economy. But the prospects of that happening soon are slim. For the time being, according to Henisz, “the path forward is looking a little darker” for Russia.

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