One YearAhead Five YearsAhead
Risk Category Year Ago Current04/11 Worst Case Best Case Worst Case Best Case
Political Risk 64.0 62.0 57.5 66.0 56.5 70.0
Financial Risk 44.5 46.0 43.5 46.0 36.5 45.5
Economic Risk 38.0 39.5 37.5 40.0 32.0 41.5
Composite Risk 73.3 73.8 69.3 76.0 62.5 78.5
Risk Band Low Low Mod. Low High Low


Government Stability

Tussling at the Top?
Signs of a power struggle between President Dmitry Medvedev and Prime Minister Vladimir Putin have become more evident in recent weeks. In early March, Medvedev harshly rebuked Putin for publicly criticizing NATO intervention in the civil war in Libya, declaring that Putin’s use of the word “crusade” to describe the military operation was “unacceptable.” Shortly thereafter, the president ordered all government ministers to resign from positions on the boards of state-owned companies by July 1. The move is consistent with Medvedev’s long-stated goals of reducing corruption and depoliticizing business activities, but, if enforced, the order could also decrease the influence of several of Putin’s top political allies in economic affairs.

To all appearances, Medvedev is seeking to establish his independence from Putin, without whose support he would never have become president in the first place. However, his motive for doing so is far from clear.

Putin was constitutionally barred from seeking a third consecutive term in 2008, and hand picked Medvedev to be his successor. Given Medvedev’s thin political resume (he had never before held elected office) and his lack of an independent base of support, most observers assumed that Putin saw Medvedev’s role as that of a placeholder, and that he had every intention of returning to the presidency as soon as he was legally permitted to do so.

Against that backdrop, some have suggested that Medvedev’s actions indicate that he has decided he wants a second term, regardless of Putin’s plans. But that is quite likely not the case. The identity of Russia’s next president will not be determined at the polls, but rather by backroom negotiations among leaders of United Russia, whose dominance is such that its candidate is all but assured of victory in the 2012 election. As such, Medvedev cannot win re-election unless he secures the nomination of United Russia, which will only happen with Putin’s blessing.

Thus, to the extent that Medvedev’s recent actions are guided by career ambitions, they have been taken in consultation with Putin. Indeed, the two leaders have long been suspected of engaging in a “good cop, bad cop” role play aimed at creating the impression of debate within the upper ranks of the government.

That said, it is possible that Medvedev truly disagrees with Putin and his allies about what is best for Russia, and has decided, however late in the game, to use his presidential powers to make a difference where he can. But if that is the case, his actions are not intended to establish a basis for winning a second term, but rather reflect his recognition that he needs to act now because he is not going to get a second term.

The latter of those scenarios has clearer negative implications for investors, as the very fact that there is not a clear line between business and politics means that Russia’s commercial partners are vulnerable to becoming caught in the middle of a fight between Medvedev and Putin. However, the possibility that Putin and Medvedev are actually engaging in political theater is hardly reassuring, as that would suggest that Putin is willing to disguise his true policy preferences for political reasons, a strategy that points to a high potential for government priorities—and policies—to shift with the political winds once Putin returns to the presidency

Investment Profile

Major Oil Deal on the Rocks
Although Medvedev’s prohibition on government ministers holding board positions with state-owned companies is intended to improve the climate for business, the immediate effect has been anything but positive for the British-owned energy giant, BP, which is the single largest foreign investor in Russia. In late March, Deputy Prime Minister Igor Sechin, a close political ally of Prime Minister Putin, announced his resignation as chairman of Rosneft, a state-owned oil and gas company, and his departure marks a significant setback for BP’s hopes of salvaging a massive share swap deal with Rosneft that is being challenged in the courts.

Back in January, BP agreed to a$16 billion share-swap arrangement with Rosneft. If implemented, the deal would provide BP with a big leg up on the competition in the race to develop Arctic oil reserves in the South Kara Sea. For its part, Rosneft would benefit from the technology and expertise that BP brought to the partnership, and the legal cover provided by the transfer of some of the assets it obtained following the controversial dismantling of Yukos, previously Russia’s largest privately owned oil company, to BP.

However, BP’s partners in its other Russian ventures, a group of firms owned by four Russian oligarchs known collectively by the acronym AAR, contend that they have a contractual right to veto any deals between BP and domestic companies with which they compete. An international court of arbitration in London is considering their argument, and has prohibited BP and Rosneft from holding further negotiations pending a ruling on the merits of AAR’s complaint.

The government is very keen to move ahead with the deal, a fact that has fueled speculation that Rosneft might seek to overcome the legal encumbrances created by BP’s partnership with AAR by cutting a deal with another foreign investor. Both Royal Dutch Shell and ExxonMobil have expressed interest in stepping into that role, but they have rejected a share-swap arrangement, no doubt wishing to avoid being targeted in lawsuits filed by former investors in Yukos, who incurred significant losses when the conglomerate was seized by the state and its assets auctioned off at bargain prices. Likewise, BP’s attempts to negotiate a buy-out of AAR’s interest in the TNK-BP consortium have collapsed over a significant disagreement on the purchase price.

In mid-April, BP and Rosneft agreed to a one-month extension of the deadline for concluding the deal, an indication that both parties want to forge ahead. But under current circumstances, it would seem that achieving that objective will require a political solution, namely, the application of state pressure on AAR to withdraw its objections. The recent retrial (and second conviction) of former Yukos owner Mikhail Khodorkovsky on charges of stealing $27 billion in oil from his own company has created a fresh picture for the oligarchs behind AAR of the fate that could await them if they get in the government’s way.

Sechin has been among the most enthusiastic backers of the share swap, which he saw as key to raising Rosneft’s global profile and ensuring state control over the development of Arctic reserves. It is generally assumed that BP proceeded with the deal, despite the high potential for legal complications, on the basis of Sechin’s assurances that he would be able to eliminate any obstacles that emerged, and his departure from the company’s board has sown doubt as to whether there will still be sufficient political will (and clout) to salvage the deal. Of course, eliminating reliance on political clout to get deals done is precisely the purpose of the presidential order that led to Sechin’s resignation.

Thus, barring a quick arbitration ruling in BP’s favor, which seems unlikely, the episode will inevitably reinforce negative impressions of the business climate in Russia. On the one hand, BP’s forced withdrawal from the deal will serve as an example of how an investor can be burned by a shift in the domestic political winds. On the other hand, the implementation of the deal will almost certainly require action by the government that is inconsistent with unequivocal respect for the rule of law.

WTO Entry Will Have Limited Immediate Impact

None of which poses any impediment to what appears to be Russia’s impending accession to the WTO. The government in Moscow reached an agreement with the EU on the terms for Russia’s admission in December 2010, clearing a major hurdle to the country’s membership bid. The only remaining obstacle is the possibility that neighboring Georgia might exercise its veto within the WTO in order to punish Russia for its support of secessionists in the breakaway provinces of South Ossetia and Abkhazia, which led to the brief eruption of armed conflict between the two countries in August 2008.

Representatives from Georgia and Russia met in Geneva in late March for talks aimed at avoiding that scenario, but no obvious progress was made. Georgia’s negotiators have demanded that Georgian customs officers man checkpoints along Russia’s border with the two provinces, a proposal that is unacceptable to the secessionists in South Ossetia and Abkhazia and their Russian sponsors. Russia has accused Georgia of politicizing the WTO accession process, while the government in Tbilisi insists that the issue is quite germane, as the border checkpoints are essential to ensuring that Russia is enforcing cross-border trade regulations.

Ahead of a second round of Swiss-mediate talks scheduled to take place in late April, the US expressed confidence that a “creative solution” would be achieved, making it possible for Russia to enter the WTO by mid-year. Russia has made no secret of its opinion that the US and the EU should lean on Georgia to reach an agreement, which the government in Washington contends it will not do. However, the US government has made clear that Russia’s accession is a high priority, indicating that the “creative solution” might include a US offer of incentives (economic or otherwise) to the government in Georgia.

Assuming WTO membership is achieved in the near term, the practical effect will be minimal, as Russia is already well integrated into global trade networks. As for the more substantial promises to improve the business climate, investors are clearly skeptical, a fact highlighted by the substantial capital outflows recorded in recent months. According to the central bank, net capital outflows totaled $11 billion in the first two months of 2011, bringing the total for the six-month period beginning in September 2010 to $44 billion. While significantly lower than the losses sustained in 2008 and 2009, the figure nevertheless indicates that Russia remains the least attractive of the so-called BRICS, the club of leading developing nations (whose other members include Brazil, India, China, and, as of mid-April, South Africa).


Inflation Set to Rise, Despite Firming of Ruble

The federal statistics agency estimates that the economy expanded by 4% in real terms in 2010, suggesting a marked improvement in the fourth-quarter following a deceleration to just 2.7% in the July-September 2010 period. The annual figure marks an impressive turnaround from the previous year’s contraction of 7.8%, and is largely attributable to a strong rebound in industrial output, which grew by 8.2% in 2010, a more favorable external climate, and the revival of domestic demand.

Industrial output is forecast to slow in 2011, following a period of restocking last year. Higher prices for key exports will help to offset the impact of weaker external demand, and the appreciation of the ruble will have a beneficial impact on prices of imports. Even so, a combination of strong domestic demand and higher global prices for commodities will sustain strong growth of imports, limiting the positive contribution to real GDP growth from external trade. On balance, the pace of economic expansion is forecast to accelerate only slightly, to 4.3%, in 2011.

Inflation came in much higher than projected in 2010, averaging 6.9%, as the consumer price index rose steadily over the second half of the year, reaching 8.8% (year-on-year) in December. The sharp rise in the final months of the year was largely attributable to the negative impact of fire and drought on the domestic wheat harvest. The government has set a target of holding inflation to 6%–7% in 2011, but officials have conceded that price increases are likely to remain above the upper target at least through mid-year.

The consumer price index rose by an average of 9.5% (year-on-year) in the first quarter of 2011, but the central bank has displayed reluctance to raise interest rates, instead relying on increases in reserve requirements, which have been hiked three times since the beginning of the year, to hold inflation in check. Monetary authorities did increase the refinancing rate by 25 basis points (to 8%) in February, but signs of weakening consumer confidence and sluggish business investment have stirred concerns that further rate increases could discourage borrowing and choke off the recovery. Consequently, no further rate increases are expected until late in the third quarter, at the earliest, a prospect that in combination with a generally expansionary fiscal policy will contribute to strong inflationary pressure over the coming months, pushing the annual rate up to 9.1%.

Historically, the Russian stock market has moved in unison with trends in oil and gas prices, and with unrest in the Middle East and North Africa likely to keep global prices elevated, the current rally is likely to be sustained for the next several months. Overall, the market also typically loses some ground in the second quarter of the year, but energy stocks will continue to attract strong interest as long as prices remain sable.

A steep rise in crude prices has contributed to a significant increase in income from energy exports, and healthy dollar inflows have exerted upward pressure on the value of ruble. The local currency is forecast to appreciate by about 5% against the euro and by 2%–3% against the dollar in the coming year, a factor that will discourage an aggressive tightening of monetary policy.

The current account surplus widened to 4.9% of GDP in 2010, as significant growth of energy exports increased the goods surplus by about one-third to $151 billion, more than offsetting the impact of larger deficits in the services, income, and transfers balances on the current account balance. That pattern is forecast to persist in 2011, as growth of energy exports continues to outpace the increase in imports, widening the current account surplus to $89.7 billion, equivalent to about 5.8% of GDP.