From Russia With Love: Exploring the Economic Future of One of the World's Largest Emerging Market Nations (Part 1 / 2)

With a substantial collection of untapped energy resources, abundant liquidity, sustainably low interest rates, and strengthening currency, Russia continues to be a force among the world's emerging markets nations. The World Bank expect Russia's economy to grow by 4.5% this year, and sees Russian economic growth as one of the main drivers of economy recovery in Europe and Central Asia. Yet despite positive projections for the future, it is hard to ignore the contraction that the Russian economy experienced during the worldwide recession. While other emerging market nations such as India and China grew throughout the global slowdown, Russia's economy suffered as oil prices fell and demand decreased. This drop resulted in a massive outflow in capital, destroyed investor confidence, and jeopardized future foreign investment. After a decade of strong growth, Russia's GDP sank 7.9% in 2009, its worst decline on record. Without question, part of this decline can be attributed to the country's highly energy-focused economy which leaves the Russian economy vulnerable to credit and commodity market fluctuations. Additionally, many of the Russian oligarchs, who had borrowed heavily from foreign banks, were forced to sell as stock prices fell. Their withdrawal further devastated the Russian equity market. For many investors, Russia's inability to cope with instability in global financial markets, as well as the severity of the decline, was alarming. Recent deals, such as Gazprom's proposed union with French utility EDF regarding the South Stream gas pipeline project, have helped increased investor confidence. Unfortunately, many questions remain regarding the short term and long term opportunities available to Russian investors, both domestic and foreign. In this two part report, I will attempt to address & demystify conceptions regarding Russian investment. Is Russia truly read to stand with China, Brazil, and India, as one of the four great emerging market nations? Has the Russian government diversified enough to attract foreign investment? What are the social, economic, and geographical issues impacting Russian trade and development? Does short or long-term investment in the Russian market make economic sense? Finally, for both corporate and individual investors, what are the best ways to invest within the Russian market while minimizing financial risk?

As a nation, Russia is blessed geologically and geographically. Currently, Russia holds the world's largest proven natural gas reserves, second-largest proven coal reserves, third-largest known and recoverable uranium reserves and eighth-largest proven oil reserves. Because of this, Russia stands at the center of a group of smaller economies including Ukraine, Belarus, Armenia, Bulgaria, Latvia and Lithuania, who rely on access to Russian resources for their own GDP growth. During the global recession, as oil prices fell and exploration slowed, many of these smaller partners suffered. As the global economy begins to recover, leaders in the surrounding states continue to look toward Russia to lead the resurgence. Yet, despite having one of the most attractive resource basis in the world, one of the greatest challenges Russia currently faces can be directly attributed to its own geography. With vast territory, a fragmented population, and poorly developed internal transportation networks, critical infrastructure is needed to ensure that businesses have access to key resources while having the capacity to quickly move extracted resources to foreign markets. Unfortunately, must of the critical infrastructure needed to support domestic and foreign trade is lacking. While Russia is moving to address a number of these issues with solutions such as the proposed natural gas pipeline to Greece, these deficiencies continue to be major deterrents for foreign businesses. Furthermore, self imposed limitations on foreign investment as well as rigorous governmental authorization continue to create capacity bottlenecks while deterring foreign investment. Unfortunately, many of these stresses are further amplified by the harsh climate and inefficient wealth distribution mechanisms that increase social friction in certain areas. While Russia seems focused on becoming a global leader, unless the Russian government can find ways to address these deficiencies while decreasing the reliance on state driven economic development, the pace of growth within this critical emerging market will continue to remain constrained.

Still, despite geographical and infrastructure related issues, there are many signs that Russia's economy is turning. Russia's sovereign credit quality is high, with a 7% debt-to-GDP ratio projected for 2010. In comparison, the sovereign debt-to-GDP in other emerging markets as well as developed nations ranges from 15% for Australia to 227% for Japan. Additionally, like other emerging markets, Russia continues to maintain large foreign reserves and is expected to have a current account surplus. This surplus gives the government monetary and fiscal flexibility to address opportunities as well as create opportunities for foreign investors. This spring, Russian inflation reached a historically low level. Inflation has continued to drop year over year, and Prime Minister Vladimir Putin recently pronounced that inflation could be as low as 6.5% this year. Under these financial conditions, the ruble, which lost considerable strength during the 2008-2009 oil price declines, can be expected to appreciate while sovereign yields remain low and balance sheets for Russian households and corporations strengthen.

While inflationary pressures ease, questions surrounding foreign direct investment and government intervention still remain. As the start of the 2008 global recession, emerging markets were the first places that foreign investors withdrew capital from. Prior to 2008, investor frustration had risen significant due to the Kremlin's repeated meddling in foreign affairs, as well as Russia's August 2008 intervention in Georgia. In response to government intervention, as well as the worsening global economic climate, net capital outflows reached a record $130 billion in 2008, followed by $39 billion in the first quarter of 2009. Investors scrambled to sell Russian assets, using the returns to buy dollars, francs, yen or gold. To counteract the effects of capital outflows, the Central Bank of Russia (CBR) intervened. The Kremlin used its massive reserves of dollars and Euros to purchase rubles on the open market, opted to proactively manage the inevitable decline of its currency as well as the entire economy. This intervention appears to have bought the Ruble enough time to allow natural market forces to create enough real demand to support it. Moreover, this intervention, while not unusual, has alarmed some investors who look to the Kremlin's actions as benchmarks of future activity.

Be sure to check back tomorrow for the conclusion of this discuss on the Russian. Part 2 will include a review of the Russian banking system, diversification threats, market risks, social & labor issues, as well as short and long-term investment recommendations.