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. Last Updated: 07/27/2016

Investor vs. Bureaucrat

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In his government's mission statement for 2000, written on the eve of his becoming acting president, Vladimir Putin wrote: "I freely admit that without foreign investment this country will only recover slowly and with difficulty. We don't have time for a slow renaissance. That means we have to do everything we can to bring foreign investment to our country."

Foreign direct investment is low in Russia compared with other emerging markets, especially since much of it is flight capital returning. Russia has one of the lowest ratios of the stock of FDI to GDP in the emerging markets, of about 10 percent. Only Ukraine is lower, although it is worth noting that Italy has a similar level, as does Japan. The picture looks even worse given that 31 percent of the FDI flow in 2000 was from Cyprus and the Netherlands, and we think most of this is actually Russian. This may be flight capital, or local companies taking advantage of tax breaks on imported equipment for foreign investors.

What are the key factors deterring potential investors? A survey by the Russian and European Center for Economic Policy highlighted the instability of the tax regime and insecure property rights as the main issues. Corruption and organized crime were well down the list.

So the government is mainly to blame for the absence of foreign investors. Taxes are frequently and arbitrarily changed, and some investors complained that whenever the local tax office had a target to meet, they would just turn up at the big foreign company with extra demands, rather than deal with their local nonpayers, who were better connected politically. Insecure property rights stem from the relative ease with which Russians can expropriate foreigners using corrupt local courts, loopholes in the law, and support from local government.

Procter & Gamble point out that to introduce a new cosmetic line in Germany, they just notify two government bodies when they release it. In Lithuania, they need approval from the Center of Public Health, which takes four weeks. In Russia, they need five separate approvals, including three separate ones from the Health Ministry, which can take up to 25 weeks. To be fair, all businesses in Russia suffer from this, not just foreigners. The Russian bureaucracy is an equal-opportunities strangler of entrepreneurs.

The bureaucracy's finest hour comes with natural resource projects. Both the government and the investors would like to use production-sharing agreements to regulate taxation for natural resource projects. The fact is that the PSA law has gone through parliament twice, but is still not workable because the government is dragging its feet on enabling legislation, and has revoked key tax breaks that investors thought had been agreed upon years ago. We think that the PSA saga shows the government's deep ambivalence about having foreigners make money out of Russia's natural resources.

A quote from Alexander Natalenko, deputy natural resources minister, gives a flavor of the opposition. "We are now asking the question: Do companies have the right to maintain three offices in Houston that we pay for with our oil?" In other words, God help foreign oil companies if they have the temerity to make a profit out of their projects in Russia. And this refers to projects in Sakhalin, the only ones in Russia to have successfully used the PSA legislation.

There is a lot of good news, though. Every non-Russian reader of this newspaper either is an employee of a foreign firm that has invested here or knows a number of people who are. Why do investors come to Russia? Most come for the size of the market, as Russia is one of only nine countries in the world that can boast a population of over 100 million. Others are drawn by the skilled labor force, which costs much less than workers with equivalent skills elsewhere. Many of them have built their biggest plants in Europe in this country, recognizing that in time, probably even this will not be big enough to satisfy the demand.

Not all of Russia is a graveyard for foreign investors. The right local government can be a crucial ally in overcoming bureaucracy. Eighty-three percent of FDI in Russia goes to 10 of the 89 regions. The attitude of the local government is the most critical determinant of the success of an FDI project. We have looked at these 10 most successful regions in a report to be released this week. Governors who have supported investors in their regions have been able to bypass obstruction from the federal bureaucracy and ensure that their own bureaucrats are helpful.

They have established a friendly tax regime for investors, especially in the early stages of projects. Tax breaks are useful but not critical for foreign investors. They send a signal to the local bureaucracy that foreign businesses are to be treated fairly. As long as the rules of the game are transparent, and stable and observed, then foreign businesses can make, and follow, business plans.

We are glad that Russia has a president who is committed to attracting foreign investment. We applaud those investors who have invested and reinvested in this country, and also those governors who have helped them do it. However, we will feel a lot happier about recommending investing in Russia when we see a Russian court awarding damages against a ministry for the costs they impose on entrepreneurs, whether foreign or Russian.

Tom Adshead is political analyst for Troika Dialog Investment Company. He contributed this comment to The Moscow Times.