Russian Roulette for Investors

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When Russian troops moved into Georgia, foreign investors moved out and the Russian market plummeted. When U.S. troops moved into Iraq, foreign investors hesitated but the U.S. market barely blipped. Is this a double standard?

Not really. The difference lies in the way investor perceptions are challenged or fulfilled by the political decisions of a country's leadership. Investors create models about their investments -- how much they are promised at the point of sale and how much they are likely to get back in a variety of circumstances. These models can be simple, ranging from a conceptual understanding about a company and the environment it operates in, to a complex econometric simulation with all the macro indicators included. Investor models implicitly include uncertain factors, such as interest or exchange rate movements. Geopolitical decisions must also be included because investors need to know in advance the possible trajectories of government action.

What investors do not like is a factor that is not included in the model. When an unknown factor suddenly appears, investors react immediately and in the same direction -- they dump anything that may be affected by that factor. The global liquidity crisis is an example. The ratings of securitized subprime instruments did not match the realized risk; all securitizations became suspect, and swaths of the market lost value globally with domino effects on the financial system.

Russia's actions in Georgia were also unpredictable and unexpected. Its aims and goals -- starting with official pronouncements and ending with its actions on the ground --were difficult to disentangle.

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Many international investors who were active in Russia have been increasingly drawn to Georgia. Under Georgian President Mikheil Saakashvili, the country has seen a rapid reduction of corruption, changes in the laws to increase market flexibility and positive developments toward building democratic institutions. These factors have all increased the attractiveness of the country to foreign investment. Georgians have begun investing in their own country as well.

Whatever the reasons or motivations for Russia's invasion into the sovereign territory of another country, investors were not prepared for this unpleasant surprise. Their investment models did not include this factor. When U.S. troops go anywhere, they are accompanied by journalists, news conferences and public warnings. Investors may not like a military conflict and they may be severely damaged by it, but they are prepared.

Investors of some sort will return to the Russian market -- as long as there is profit to be made in relation to the risk. But first they will want to understand how to predict Russia's reactions. What matters is the model they build, the economic and political risks that they attach to Russia, and the profit they will need to compensate for these risks.

Investors are also communal -- they exchange understandings, models and perceptions. High-risk countries attract investors with appetites for high-risk. The model defines the investor type.

The fundamental problem is that Russia's reactions to a variety of events -- whether it be in the Caucasus or in business -- have traditionally been difficult to predict. After a lengthy, almost unnoticed buildup of tension in Georgia, Russia reacted to Georgia's irresponsible and indefensible aggression by moving in overwhelming force and continuing to act without any regard to international concerns or consequences.

We saw a similar situation with former Yukos CEO Mikhail Khodorkovsky. He was warned of the impending danger to himself personally and to Yukos, but he ignored both of them. The foreign investor community also did not take the risk seriously. The government reaction was swift, severe and selective with no regard to what anyone else might think. Is this a pattern?

In Russian roulette, when the trigger is pulled and nothing happens, everyone relaxes and it seems that the game is not so bad after all. But when the trigger hits a loaded chamber, the result is lethal. There is a long-term danger that Russian investment will be considered as a proxy for Russian roulette. A model like this will influence the sort of investors who will come to Russia. Sane and sober investors will stay away, but risk-taking and foolhardy rogues will flood in. The returns on investments will be massive because of the perceived risks, and the profits enormous because in most cases there will be no loss. But once in a while, the trigger will land on a loaded chamber and the loss will be catastrophic.

As for the prospects for Russia's investment climate, risk weights will rise, the potential for returns will be enormous, and investors will come back. But because of the impact of the Caucasus crisis, which will probably linger for quite a while, and the likelihood of a prolonged downturn in the global economy, investors' return to Russia will take some time -- perhaps until the end of 2009.

Richard Hainsworth is CEO of RusRating, a Moscow-based credit rating agency.