China Research

One of today’s puzzles is the low valuation of Russian equities. On average, these cost just 6 times the expected profits of 2012, while Canadian stocks trade at 15 times earnings and Norwegian stocks at 12 times, to mention just the two commodity producing countries which lie in the same climate zone. The message from the price-to-book ratios is similar: if a company is attractive for investors, the ratio should be well above 1. But Russian stocks average only 0.85 whereas Canadian and Norwegian stocks trade at 1.85 and 1.58.

Creating conditions that bring valuations on par with those of other stock markets would do wonders for the country’s spending on capital goods, including foreign direct investment, the growth rate of real GDP and thus for the standard of living.

One way to achieve this is to create an institutional framework similar to that of the democracies of Western Europe. This is just as important as broadening Russia’s production base and reducing its dependency on raw materials. Indeed, a comprehensive and state-of-the-art institutional framework is probably the precondition for that sort of structural change. Economists emphasize more and more the role of institutions in development, such as independent courts, media, regulators and central banks, a fair and efficient tax system, genuine opposition parties which have a reasonable chance to oust the existing government in secret ballots, an incorruptible bureaucracy, good and affordable kindergartens, schools and universities, a well-maintained infrastructure, and so on.

Russia has serious deficiencies in all these areas and pays the price in the form of undervalued equities and real estate. In spite of its enviable endowment with natural resources it is an unnecessarily poor country.

One approach to improve things is to use the European Union’s “Acquis communautaire” as a guide for institutional reform. Norway and Turkey, very successful economies for some years now, have done this – without being members of the EU. The Acquis covers the EU Treaty, the whole body of laws, decrees and guidelines passed by EU institutions as well as the judgments of the European courts. These are binding for all 27 countries, and new members have to fully adopt them. Dauntingly, the complete edition of the text comprises 31 volumes and more than 85,000 pages. Cyprus and Malta have been able to do it, so Russia’s civil service could certainly do it as well.

For years, Russians did not care much about institutional reform. They were able to increase their spending at a higher rate than production, as export prices have outpaced import prices. The general feeling is that the standard of life continues to improve. Since this is not accompanied by political and institutional progress, the rising middle classes are getting restive, demanding a bigger say in the country’s decision making process.

To rely on ever higher commodity prices is not a sustainable growth model in any case – prices will certainly not go up all the time. Every so often they crash and cause havoc in the rest of the economy. The 8 per cent decline of Russian GDP in 2009, the 80 per cent fall of stock prices between mid and end-2008, the 36 per cent depreciation of the rouble against the dollar during that time, and the collapse of the real estate market were direct consequences of the crash of raw material prices, in particular the oil price which imploded from $146 to $35 in just half a year. To this day, markets are not yet back to pre-crisis levels.

If Russia had more robust institutions and took the rule of law seriously, investors would demand lower risk premiums for holding shares of companies and government and corporate bonds – which is another way of saying that asset prices could be much higher, and the cost of capital correspondingly lower. A big increase in capital spending is needed to wean the country from its reliance on commodities. China’s impressive growth model has at its core very high saving and investment ratios. Anything that helps to boost these must have top priority for policy makers. Right now, the value of Russia’s firms that are traded at the stock exchange is about 19 trillion roubles (€465bn).

If the government could credibly show that it will launch an institutional reform process on the basis of EU standards, this number could easily double, cutting the cost of capital expenditures by one half. Perhaps more importantly, Russia would become a more normal country where people like to live, rather than trying to emigrate.

Dieter Wermuth
Chief Economist & Partner, Wermuth Asset Management

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As the March presidential elections approach, Russia is stirred but not shaken.  December demonstrations were the biggest in two decades, but still they gathered only tens of thousands of demonstrators in the capital city, even less elsewhere. There is no atmosphere of fear, but neither are there proper organizations or policy demands. Arab spring has again shown that social media can call many people to the streets, but it takes a split of elites to transform demonstrations into a political movement. The call for honest elections is a fundamental one, but there is not much else to unify the tens of aspiring leaders of the crowd. As a rule they are men in ripe age, scarred by two decades of mutual battles and proven inability to cooperate. The demonstrations will in all probability not evolve into a political movement offering an alternative to the Putin regime.

Therefore Russia is not really shaken. And if it were, we had better beware. At the time of the post-Soviet color revolutions Yegor Gaidar said that he did not wish one in Russia. The color, he feared, would be black and brown like in a cockroach: those of nationalism and reaction. Just before the demonstrations another friend of mine, also somebody with rich experience of high-level positions during the past twenty years, argued that Putin with his attempted power vertical is the only barrier between today’s Russia and a criminal state. This speaker is a ranking member of one of the unregistered opposition movements. His children have vowed not to return to Russia as long as the Putin regime remains.

Vladimir Putin is scarred as well. Twelve years ago he had an evident program though that was not easy to detect in the beginning. Russia had been dependent on outside finance, a nation to which conditions were dictated. Poor Yeltsin, Bill Clinton once noted, we keep tabling demands that he has little possibility of fulfilling. That had to go and it did, not least because soaring oil prices helped Russia to pay back debt, accumulate reserves and start financing the rest of the world. For a few years Russians were high on oil. Still money was cheaper abroad, and the 1998 crisis was repeated ten years later.

Russia also longed for stability, and for years the Putin regime helped deliver it. Inflation and unemployment went down, consumption, foreign travel and life satisfaction up. Putin was repeatedly voted the sexiest Russian man, not so much because of the muscles but because his regime facilitated sexy things. There was also a kind of political stability, maintained by thugs when deemed necessary.  Putin wished Russia and the world to function like a hierarchic bureaucracy. He had after all worked in one for sixteen years, and uses many pages of his dissertation to copy American organization science on how such a hierarchy should handle uncertainty.

But that is not the way the world or Russia actually functions. Not surprisingly Putin has grown frustrated and cynical. That is not a good starting point for a leader who should reinvent himself.

That Putin should do: politically, as there will be a real opposition; policy-wise, as Russia can no longer rely on those drivers of growth that just years ago made it one of the fastest growing major economies in the world.

Needed mental readjustment started in about 2006 when it was understood that Russia cannot rely on energy alone. It needs diversification and modernization. The readjustment continued a year ago when Putin tasked the leading economists to write a policy program for the post-elections. They did write, over 500 pages of program, with more than a thousand specialists contributing. In a little-noted speech just before Christmas Putin seemed to sign the basic message of the program. Russia’s future growth must be based on investment, and a major overhaul of investment climate is needed.

An authoritarian regime faces its biggest challenges when attempting partial democratization. That happened with Gorbachev’s perestroika. Putin is no Brezhnev but he risks becoming a Gorbachev – without Yeltsin as the alternative. The world and Europe in particular must pay great attention. The alternatives are several, and the most positive ones the least probable.

Pekka Sutela
Nonresident Senior Associate Carnegie Endowment, Washington D.C.  &  Visiting Professor at the School of International Affairs, Paris

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