Russia represents an under-valued and over-looked investment opportunity and those who can look past the present sanctions will be best-placed to take advantage when those opportunities become more widely appreciated, as Luis Saenz, co-head of equities at BCS Global Markets explains.
Exploring the potential of Russia requires some understanding of this vast country, the largest on earth with 143 million people across 11 time zones and a land mass almost twice that of the United States.
How to categorise the Russian economy is the first hurdle we face. It has some of the features of an emerging market, such as relative under-development and a traditional reliance on commodity exports. But its demographic profile, with an ageing population and relatively low birth rate, has more in common with a developed market.
It is not unique in this regard – the central and east European region displays these characteristics, bringing into existence regional investment funds tailored to such economies. We would argue that Russia is best defined as, quite simply, a large emerging market.
To look beyond the present sanctions, it is first necessary to have some grasp of the effect that sanctions have had on the Russian economy. In one sense, they could hardly have come at a worse time, coinciding as they did with tumbling oil prices, albeit crude prices have since recovered somewhat.
However, the combined impact has, we believe, frequently been overstated, and independent estimates rarely put the cumulative loss at more than two to three per cent of gross domestic product (GDP).
Lifting of sanctions will tell us how the shape of the Russian economy has changed as a result of the international embargo against individuals, companies and certain goods and services. Experience suggests sanctioned countries can be ingenious in terms of import substitution – South Africa, for example, responded so successfully to an oil embargo that, by 1990, petrol was cheaper in Durban than in London.
In Russia’s case, the sanctions included controls on the export of equipment for the oil industry and restrictions on issuing and trading certain bonds and shares relating to Russian entities. All these cases provide clear scope for import substitution.
As, indeed, does the embargo on arms and related products, which takes us to a clear development of the Russian economy during the sanctions period, the growth of the industrial-military complex under official patronage. Post-sanctions, the economy ought, all things being equal, to receive a boost from the lower risk of investment, hence a lower cost of capital, coupled with the greater ease of conducting global trade once the country no longer faces an embargo. Exports should be helped by the devaluation of the ruble.
This is unlikely, however, to outweigh the incremental damage caused by the sanctions. (1/2)
Furthermore, investors ought not to assume that the classic emerging-market investment opportunity – backing companies that are set to cater to the needs of a growing middle class – will apply in Russia’s case. Middle classes do not appear from nowhere, they are a product of economic growth, and Russian growth has been fairly stagnant recently – the International Monetary Fund (IMF) puts it at 1.7 per cent this year, slowing to 1.5 per cent next year, “weighed down by structural headwinds and the effect of sanctions on investment”, according to the IMF’s World Economic Outlook, published in April.
The over-riding need to get Russia “match fit” for the post-sanctions era is for pro-growth reforms of the type urged on Moscow by the IMF last year, including better guarantees of property rights, better corporate governance, infrastructure investment and an extension of free-trade deals beyond the neighbouring countries that are currently covered.
Diversification of the export base beyond oil, gas and minerals has been high on the to-do list for years, but not a great deal has actually been done. Real action in this area will need strong financial and other incentives from the government to attract global companies.
All these issues are linked, of course. The diversification away from commodities and towards the export of consumer goods will need foreign investment to bring such goods up to the standards expected in developed markets. The Russian workforce is key to making a success of the companies whose products will help diversify the country’s exports.
Such export diversification should give a lift to GDP growth which, in turn, would assist the process of expanding Russia’s middle class, which should create further investment opportunities.
A virtuous circle can come into being for the benefit of Russians and outside investors alike. But first, the issue that overshadows all the others – sanctions – must be resolved.
Taking advantage of a post-sanctions world will need the sort of vigorous international promotional campaign to generate investor interest that is second nature in many jurisdictions but which has been sadly lacking until now from the Russian authorities. Such a campaign would highlight the bug attractions for investors of a country with a well-educated labour force and very competitive pay rates.
There is a good story to be told. It is time to tell it. (2/2)