Investing in emerging markets

Table of contents

List of abbreviations

List of figures

Executive summary

1 Background
1.1 Topic introduction
1.1.1 FDI
1.1.2 Political Risk
1.2 Prior research (literature overview)
1.3 Research questions, objectives and relevance
1.4 Research methodology

2 Historical overview of FDI and political risk
2.1 Introduction
2.2 Political risk assessment
2.3 Russia
2.3.1 Before 1992 (Gorbachev)
2.3.2 From 1992 until 1999 (Yeltsin)
2.3.3 From 2000 (Putin)

3 Investment opportunities in Russia
3.1 Introduction
3.2 Selected sectors of the economy
3.2.1 Oil, gas and chemical industries
3.2.2 Metallurgy and mining
3.2.3 Machine building and metal working
3.2.4 Construction and utilities
3.2.5 Agriculture, food and beverages
3.2.6 Retail
3.2.7 Finance and Insurance
3.2.8 Travel, tourism and transportation
3.2.9 Media, ICT and other service sectors

4 Research questions and results
4.1 Introduction
4.2 Different perspectives
4.2.1 Russian government and society
4.2.2 Foreign investors

5 Conclusions and limitations
5.1 Introduction
5.2 Conclusions
5.3 Limitations
5.4 Managerial implications
5.5 Academic implications and future research

Appendices

A. Russia

References

List of abbreviations

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List of figures

Figure 1: GDP per capita in Russia and other countries in 1989-2007, in US$;

Figure 2: FDI in Russia and other countries in 1990-2004, in % of GDP;

Figure 3: FDI inflow in Russia, Poland and Ukraine in 1992-2005, in US$;

Figure 4: FDI inward stock in Russia and other countries in 1992-2005, in % of GDP;

Figure 5: FDI inflows in Europe and the world in 1990-2003, in US$ billion;

Figure 6: Corruption perception index in Russia and other countries in 1996-2006;

Figure 7: Russian capital flight and external borrowing in 2001-2004, in US$ billion;

Figure 8: Russian public versus private debt in 1999-2005, in US$ billion;

Figure 9: Correlation between Russian exports and average yearly oil prices;

Figure 10: Foreign-exchange and gold reserves in the Russian Central Bank at the beginning of the year in 1993-2007, in US$ billion;

Figure 11: Reserves of the Russian Stabilization Fund in 2004-2007, in US$ billion;

Figure 12: The largest exporters of capital in the world in 2005, in % of world total;

Figure 13: Russian Trading System Index in current US$ terms as of 9 March 2007;

Figure 14: Political risk index for Russia and other countries in 1992-2000;

Figure 15: FDI potential vs. performance in Russia, Poland and Ukraine;

Figure 16: Cumulative outward and inward FDI around the world, in US$ bn;

Figure 17: Internal versus external sources for political risk evaluation;

Figure 18: Ranking of information sources for political risk evaluation;

Figure 19: A general framework of political risk assessment;

Figure 20: Major variables for assessing project specific political risk;

Figure 21: Political forecasting models classified by orientation and geog- raphy;

Figure 22: Use of political risk assessment methods;

Figure 23: Example of short- and long-term political risk ratings in 2005;

Figure 24: Country risk sub-components from previous research; p. 29 Figure 25: Country risk sub-components from the relevant rating agencies;

Figure 26: Risk framework;

Figure 27: Last leader of the Soviet Union and the first two presidents of Russia;

Figure 28: Structure of production in Russia by industries in constant 1999 prices, in %;

Figure 29: Distribution of FDI in Russia by economic sectors in current prices, in %;

Figure 30: Russia’s exports and imports of main product groups in 1994- 2004;

Figure 31: World events and import oil prices in the United States, 1973- 1981;

Figure 32: World events and import oil prices in the United States, 1981- 1998;

Figure 33: Distribution of the Soviet export markets in 1981-1991, in %;

Figure 34: Share of individual Soviet republics in total exports in 1989- 1991, in %;

Figure 35: Soviet exports by republics in 1988, in % of net material prod- uct;

Figure 36: Number of farms and enterprises in the nonstate sector and people employed by them in the Soviet Union in 1991;

Figure 37: Average inflation in Russia in 1990-2006, in %;

Figure 38: The official exchange rate of 1 US dollar to Russian roubles, 1992-1997;

Figure 39: GDP growth vs. FDI inflow in % of GDP in Russia, Poland and Ukraine;

Figure 40: Share of the Russian public sector in total GDP, in %;

Figure 41: Stages of Soviet commercialization and Russian privatization;

Figure 42: The official exchange rate of 1 US dollar in Russian roubles*, 1998-2006;

Figure 43: Russia’s arms exports in 1992-2004, in constant 1990 US$;

Figure 44: Percentage of managers not comprehending the economic policies of the government in the last 3-4 months from 1992 until 2001;

Figure 45: Top 25 countries in the FDI Confidence Index*, 1998-2005;

Figure 46: General government budget balance in Russia in 1990-2006, in % of GDP;

Figure 47: Distribution of FDI in the federal subjects of Russia, in % of total;

Figure 48: Map of regional investment potential in Russia, November 2001;

Figure 49: Ranking of industries with the most potential for growth in Rus- sia in the period 2006-2008;

Figure 50: Dynamics of production industries in Russia, 1990 = 100; p. 73 Figure 51: Share of industries in total industrial production*, in %;

Figure 52: Crude oil and condensate production in Russia, ‘000 barrels per day;

Figure 53: Natural gas production in Russia, billion cubic metres per year;

Figure 54: Russia’s existing and planned gas pipelines to Central and Western Europe;

Figure 55: 10 countries with the largest oil and gas reserves at the end of 2005;

Figure 56: Oil and gas imports from Russia in 2003; p. 81 Figure 57: EU25 projected energy import dependency; p. 81 Figure 58: World’s largest exporters of steel;

Figure 59: Russia new car market value forecast in US$ billion, 2004- 2009;

Figure 60: Russia construction and engineering industry value forecast in US$ billion, 2004-2009;

Figure 61: The Moscow’s Federation Tower in comparison to some of the world’s tallest buildings;

Figure 63: Russia alcoholic drinks market segmentation in 2004, in % of the total value of US$ 17.2 billion;

Figure 64: 2006 market attractiveness of retail sectors in emerging mar- kets;

Figure 65: Russia insurance market value forecast in US$ billion, 2004- 2009;

Figure 66: Russian travel and tourism industry in comparison to other countries;

Figure 67: Distribution of international visitors to Russia by citizenship in 1995-2003, in ‘000;

Figure 68: International visitor arrivals to Russia, in ‘000;

Figure 69: Money an average international visitor spends in Russia, in US$;

Figure 70: Russia’s market share of world travel and tourism demand, in % of total;

Figure 71: Russia airlines industry value forecast in US$ billion, 2004- 2009;

Figure 72: Russia road and rail industry value forecast in US$ billion, 2004-2009;

Figure 73: Russia media industry value forecast in US$ billion, 2005-2010;

Figure 74: Russia media industry segmentation by value in 2005, in % of total;

Figure 75: Several of the top 40 countries for the most common remote services as of 2005;

Figure 76: Operating models expected to be used for offshoring in the coming years;

Figure 77: Political risk reduction strategies of 23 surveyed Dutch firms in 1996;

Figure 78: Ranking of cities according to popularity among European ex- patriates;

Figure 79: Ease of Doing Business Index for BRIC and other countries as of 2006;

Figure 80: Map of Russia;

Figure 81: Russian total population in 1985-2005, in million;

Figure 82: Average life expectancy in Russia and other countries, in years;

Figure 83: Population density in Russia in 2002, in number of people per sq. km.;

Figure 84: Distribution of Russia’s major cities in 2002;

Figure 85: The top and bottom 5 federal subjects in terms of GDP per capita;

Figure 86: 10 largest administrative units of Russia in terms of total GDP;

Figure 87: Real unemployment in Russia in 1993-2005, in %;

Figure 88: Social hierarchy around the developed world (ISSP) and in Russia (RF);

Figure 89: Concentration of Pre-tax incomes in Russia, in % of total;

Figure 90: Russia’s 15 major traiding partners, in % of total;

Figure 91: Relative share of Russian trade with CIS countries in 1994- 2005;

Figure 92: Approval ratings of president Putin in 2000-2006, in % of total*;

Figure 93: Public opinion about Putin, Yeltsin and Gorbachev, in 2000- 2005;

Executive summary

Since the break up of the Soviet Union, Russia’s economy has undergone an enormous transition. However, the majority of people around the world see Russia as far less successful in its transformation as for example China or most of the countries from Central and Eastern Europe. There is no doubt that for most developing countries, including Russia, achieving macroeconomic stability and developing market institutions is not an easy task. Factors such as the lack of an adequate legal framework, corruption and/or political uncertainties are frequently used when there is a need to explain why some countries achieved better results than others.

With this research we aim to uncover whether or not political risks have had any direct influence on the inflow of FDI in Russia. Why have we cho- sen to study this particular issue? The fact of the matter is that many ex- perts regard FDI to be one of the most powerful instruments in moving away from a central-planned system and achieving a deeper and faster integration into the modern global economy (Bandelj, 2002). We also share this view and therefore consider it extremely important and exciting to learn more about the subject.

As a person who knows both Russia and the Western world very well through my studies, my previous work, traveling and parentage, it seems almost like a personal duty to use this knowledge and these experiences in order to shed more light onto the question of why in the last two dec- ades Russia has remained very much behind the expectations of many experts in terms of FDI attraction. The lack of previous research on this particular question makes our objective particularly exciting and challeng- ing. We also understand that this subject interests not only many prospec- tive investors or the Russian government but also any manager or aca-demic around the world who deals with the topics of international invest- ment and risk management.

At the same time we understand the enormous complexity of such a re-search. It is also very clear to us that the relatively low FDI levels in Russia can also have been caused by numerous other factors. However, many possible causes are somehow related to uncertainties and risks, derived from government policies as is argued by Martin (1998). The aim of this work will be to examine one very particular element, namely political risks, and their influence on FDI. The following research question states this accordingly:

How do political risks affect the FDI in Russia?

We would like to understand much better the roles of the local government and the local business community in the process of attracting FDI. How- ever, since we will be looking for any connection between FDI and political risks we will first need to investigate how the political risks are defined and assessed. That is why the main research objective will be complemented by the following three sub-questions:

1. How is political risk assessed?
2. Which aspects of political risk are of particular importance for invest- ment decisions of foreign firms?
3. How strong do these aforementioned aspects influence the investments of foreign firms?

For many years most Russian industries have been outdated, structurally underinvested and therefore unable to compete internationally. That ex- plains why numerous politicians and business people both in Russia and other emerging markets constantly try to find new ways of increasing FDI in their respective countries. With this work we also hope to contribute to a successful transition of Russia and other emerging markets into modern developed economies. A deeper knowledge of the interplay between po- litical risks and FDI should help to improve this process in the future. Our investigation is about how FDI is affected by political risks in Russia in general, without narrowing this down to industry-specific elements. How- ever, we also understand that it will be necessary to study, in more in detail at least view sectors of the Russian economy as well as certain periods of the local economic history in order to make any sound conclu- sions.

New findings on the issue of FDI in connection to political risks would be very interesting and useful for governmental organizations which might use the gained insights for future policy making. At least as important, these new findings will also be useful for Western companies that are seriously considering or currently planning to invest in Russia. Our re- search should help everyone to understand and to prepare better for fu- ture challenges and risks both in Russia as well as in any other emerging market.

Even though in one way or another we expect to find a direct connection between political risks and FDI levels, it is, of course, too early to make any estimations. Even if we discovered a link between the political risks and FDI, it is impossible to say now how strong the connection could be.

„You can't force anyone to love you or lend you money.” - An Israeli proverb

1 Background

1.1 Topic introduction

Since the break up of the Soviet Union, Russia’s economy has undergone an enormous transition from a state planned economy to a sort of market economy (Hoskisson, Eden, Lau and Wright, 2000). Today, Russia is one of the four major emerging markets in the world. Since the publishing of a popular Goldman Sachs report in the year 2003, these four contries are now also commonly known as BRIC: Brazil, Russia, India and China. Nowadays the media is full of reports about the possible developments in BRIC countries and their future roles in the world economy.

Generally speaking an emerging market is characterized by rapid eco- nomic development and government policies favoring a free market sys- tem (Hoskisson, Eden, Lau and Wright, 2000). Many of these emerging countries have indeed been very successful in developing their economies the most notable of which is China. The largest state in the world was able to triple its Gross Domestic Product (GDP) per capita in the period from 1989 until 2003 alone (see Figure 1).

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Figure 1: GDP per capita in Russia and other countries in 1989-2007, in US$ 9.000

Source: Worldbank, IMF

Russia, in comparison, was far less successful. After a decade of shrinking GDP figures in real terms, in 1999, the country was finally able to create some growth, reversing the strong negative trend of the previous years, for the first time since the dissolution of the Soviet Union. However, despite the popularity of the BRIC term, Russia, Brazil, China and India in particu- lar are hardly comparable with each other. Each of those four countries has had very different economic structures, histories, political systems, and so on.

For many reasons and purposes it often makes much more sense to com- pare Russia to some other countries, most notably those of the Common- wealth of Independent States (CIS)¹, or more generally, the former East- ern block countries. Poland and Ukraine in particularly provide the best points of reference. Even though each of these three countries has chosen different ways and speeds for reforms, at the beginning of the 1990s they all had relatively comparable economic structures and problems. That is less the case when one compares Russia with China or Brazil. That is why, for the purpose of this master thesis, we are primarily going to use the Eastern European states as a point of reference and to a much smaller degree China and Brazil when comparing the developments in Russia to other countries. India is from every perspective a completely different case and therefore it is not suitable for any meaningful comparison.

1.1.1 FDI

One of the strongest indicators of the attractiveness of a country for the international business community is the inflow of FDI. Despite the fact that Russia is potentially a very big market for many Western companies and it has enormous natural resources (Lynch, 2002), the local economy still remains behind most other developing countries in terms of FDI per capita (Hoskisson, Eden, Lau and Wright, 2000; Lynch, 2002), such as those states of Central and Eastern Europe (CEE² ). Whereas in the most CEE countries, during the period of 1992-2005 the level of FDI as percentage of GDP was on average between three and five per cent, in Russia it has never exceeded two per cent, with the exception of the year 2005 (see Figure 2, Figure 3, Figure 4 and Figure 5). But, even then, a large propor- tion of growth in foreign investments came mainly from the energy sector (see Figure 29).

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Figure 2: FDI in Russia and other countries in 1990-2004, in % of GDP

Source: Worldbank

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Figure 3: FDI inflow in Russia, Poland and Ukraine in 1992-2005, in US$

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Source: UNCTAD

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Figure 4: FDI inward stock in Russia and other countries in 1992-2005, in % of GDP

Source: UNCTAD

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Figure 5: FDI inflows in Europe and the world in 1990-2003, in US$ billion

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Source: UNCTAD

Professor C.R. Harvey from Duke University defines FDI as “the acquisi- tion abroad of physical assets such as plant and equipment, with operating control residing in the parent corporation”. A more detailed defition of FDI comes from the OECD. According to this organization:

“FDI is a category of international investment made by a resident entity in one economy (direct investor) with the objective of establishing a lasting interest in an enterprise resident in an economy other than that of the investor (direct investment enterprise). 'Lasting interest' implies the exis- tence of a long-term relationship between the direct investor and the en- terprise and a significant degree of influence by the direct investor on the management of the direct investment enterprise. Direct investment in- volves both the initial transaction between the two entities and all subse- quent capital transactions between them and among affiliated enterprises, both incorporated and unincorporated. As a matter of principle, foreign direct investment statistics cover all enterprises in which direct investors have, directly or indirectly, a direct investment interest.”

Even though there are different types of FDI, for the purpose of this master thesis it is not necessary to go into details and therefore all foreign invest- ments will be treated equally, as is done by most organizations and re- searchers.

For most developing countries, including Russia, achieving macroeco- nomic stability and developing market institutions has been suggested to be particularly difficult. The resulting economic and political instability, as well as the lack of adequate legal frameworks, must have lead to in- creased uncertainty and risks, which in turn had a deterring effect on FDI (Hoskisson, Eden, Lau and Wright, 2000). Some might argue that the relatively low Russian FDI levels have been caused by the rising influence of the Russian state over the economy. Others attribute it to mistrust of investors due to a poor record on transparency (Mulino, 2002) and corrup- tion (see Figure 6), as well as the negative influence of the Russian oli- garchs (Menshikov, 2004).

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Figure 6: Corruption perception index in Russia and other countries in 1996-2006

Russia Poland Ukraine China Brazil

Source: Transparency International

Others disagree and say that - as so often is the case with Russia - the common perception in the West is a good deal removed from reality. The most pressing problem foreign investors in Russia face is connected nei- ther with criminality, nor corruption, but simply an inadequate and ever changing tax law as well as problems with property and creditor rights, customs, the risk of political change, macroeconomic instability, a weak banking sector, the Russian accounting system, and only then corruption (Rudiger, 2000). In other words many possible causes are somehow re- lated to uncertainties and risks, derived from government policies, as is also argued by Martin (1998).

At the same time many experts regard FDI to be a very powerful engine in moving away from state socialism and towards integration into the global economy (Bandelj, 2002). It is therefore very important to understand how FDI levels in Russia have been influenced by the institutional environment, and more specifically by risks that have emerged from government poli- cies. However, one can not ignore the fact that both FDI and political risks have a measurement problem. In countries like Russia, the shadow econ- omy is very substantial and thus a great deal of official statistics are not entirely accurate. Many times, experts are forced to make estimations because little reliable data is available. There is also the risk of data ma- nipulation: in many parts of the world, including Russia, it is not unusual to discover that certain data has been manipulated for political purposes. As a consequence it is extremely important not to trust all statistics that one comes across. Most of the data used in this master thesis comes from international organizations, but partly from the most reliable Russian sources, as well.

1.1.2 Political Risk

In recent years more and more politicians and business people both in Russia and other emerging markets have been trying to explore ways of increasing FDI in their respective countries. For many experts, the advan- tages of FDI are not just about extra money for the development of the economy in exchange of ownership (Smith, 2000). For the absolute major- ity of emerging countries, at least as important is the transfer of know-how and the access to industrial networks which take place before, during and after the period of conducting an investment. In addition the experience from other developing countries shows that a substantial increase of FDI also leads to more investments from inside a country. Therefore it could be a part of the solution for another very important Russian problem, an enormous flight of capital abroad (see Figure 7).

Figure 7: Russian capital flight and external borrowing in 2001-2004, in US$ billion

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Source: Fitch Ratings based on the Russian Central Bank data, June 2005

Even though in January 2003 Russia was removed from the OECD list of countries failing to co-operate in the international fight against money laundering, the problem of capital flight remains. According to the more reliable sources, the average capital flight from Russia in the last ten years ranged between US$ 10 and 35 billion per year. Many Western estimates put the cumulative Russian capital flight around US$ 100 billion (Bush, 2005) whereas Parker and Raj (2005) from FitchRatings estimated over US$ 250 billion only in the period 1994-2004. Regularly, most of this capi- tal is washed to make it “legal” and therefore could return to Russia if its owners trusted the local government and the banking system and believed in the economic prospects of the country. In more recent years, many Russians continue to move capital out of the country, but money has also been flowing in the opposite direction as Russian companies borrow from abroad. As a matter of fact, in the year 2005, private sector external debt became larger than the public sector debt (see Figure 8).

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Figure 8: Russian public versus private debt in 1999-2005, in US$ billion

Public Sector

Source: Russian Ministry of Finance, Fitch Ratings

In fact, in very recent years, the lack of money has not been one of the most pressing Russian problems, per se. As just one example on the 21 April 2006 the Financial Times (FT) wrote an article about Russia’s new crisis which was headlined: “[Russia] has more cash than it can handle”. Attributable to the high oil prices, the country has been running trade sur- pluses for over a decade (see Figure 9). However a very high percentage of those earnings has regularly been both legally and illegally transfered abroad, making Russia a net capital exporter (see Figure 12). Without this problem and with oil price levels over US$ 30 per barrel, Russia would theoretically have had substantial resources for the modernization and diversification of the local economy.

Despite the capital flight and thanks to the high oil and gas prices, the reserves of the Russian Central Bank have been rapidly growing and the Russian state was able to pay its foreign debt ahead of schedule. In addi- tion, in the year 2003, the Russian government established a so-called Stabilization Fund. Today this fund receives revenues which come from the high oil prices. As of 2007, those were incomes from oil prices higher than US$ 27 per barrel. After reaching US$ 104 billion as of 1 March 2007, the Stabilization Fund is expected to top US$ 160 billion by the end of 2007. The direct consequence of the positive macroeconomic processes was that, in January 2003, Russia’s Sovereign Credit Rankings became investment grade again based on the evaluation of the three most influen-tial rating agencies in the world: Standard & Poor’s, Moody’s, and Fitch. This was a notable development since it happened only four years after the country defaulted on its foreign debt. Meanwhile, the Russian govern- ment and the Central Bank felt so confident that on 1 July 2006 they even made the rouble fully convertible again removing all major restrictions for capital flow from and to Russia.

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Figure 9: Correlation between Russian exports and average yearly oil prices 250

Source: Worldbank and WTRG Economics

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Figure 10: Foreign-exchange and gold reserves in the Russian Central Bank at the beginning of the year in 1993-2007, in US$ billion

Source: The Economist Intelligence Unit and the Russian Central Bank

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Figure 11: Reserves of the Russian Stabilization Fund in 2004-2007, in US$ billion

Source: Russian Ministry of Finance

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Figure 12: The largest exporters of capital in the world in 2005, in % of world total

Source: The World Factbook 2005

Despite some considerable macroeconomic progress many serious and urgent problems remain. Today, more than ever, Russia needs the growth of Small and Medium-sized Enterprises (SME) and a structural develop- ment of other industries besides oil and gas. One must bear in mind that most Russian industries are outdated, structurally under invested and therefore unable to compete internationally. In some developed countries, for example Japan and Korea, the development of innovative technologies began after the adaptation of technologies which initially came from abroad, and this is just one reason why more FDI is urgently needed in order to assist Russia’s transformation into a competitive market economy.

Figure 13: Russian Trading System Index in current US$ terms as of 9 March 2007

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Source: RTS Stock Exchange, Moscow

In the year 2005 the Chartered Financial Analyst Institute (CFA Institute) carried out a survey among over 1,000 investment professionals in the BRIC countries. One of its main goals was to learn more about what the largest concerns are of the experts when it comes to investing in the four countries. On 23 January 2006 a Financial Times (FT) article summarized those findings as following:

“Bullish sentiment prevails among investors in the big four emerging economies… political risk was [however] the top concern in all four coun- tries, cited by 74 per cent of respondents in Russia and 66 per cent in India”.

The logical questions for every party involved are therefore: what are ‘po- litical risks’ and in which way can they influence the decisions to invest in a particular country, in our case in Russia? Simon (1982, p. 68) defines ‘political risk’ as "governmental or societal actions and policies, originating either within or outside the host country, and negatively affecting either a selected group of, or the majority of, foreign business operations and in- vestments."

Another definition can be found in Campbell R. Harvey's Hypertextual Finance Glossary. There ‘political risk’ is described as “the possibility of the expropriation of assets, changes in tax policy, restrictions on the ex- change of foreign currency, or other changes in the business climate of a country”. However, Oseghale (1993) surveyed ‘political risk’ definitions and concluded that Simon's (1982) definition provides "a more complete conceptualization of the political risk facing MNCs in their respective busi- ness environments" (p. 24). That is why we have chosen his definition as the basis for our investigation.

Today, there are numerous services measuring country risks. Many of them were first created after the oil crises in the 1970s. That was the mo- ment when numerous Western companies, for the first time, encountered severe problems which were mainly caused by political decisions after the Organization of the Petroleum Exporting Countries (OPEC) artificially lowered the supply of oil. Some of the most trusted research and statistics provided today come, for example, from Political Risk Services (PRS Group), Business Environment Risk Intelligence (BERI), Control Risks Information Services (CRIS), Economist Intelligence Unit (EIU), Euro- money Institutional Investor, Standard and Poor's Rating Group and Moody's Investor Services.

Figure 14: Political risk index for Russia and other countries in 1992-2000

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Source: Euromoney

Most of the political risk research is done by Western or international or- ganizations and consulting firms. For obvious reasons many of those evaluations are sometimes biased, however, no one could actually ignore the impact of those indices and reports on the international investment community. In fact, many investment decisions, especially in relation to less touristically popular destinations, are frequently made behind a desk of an office somewhere in a Western country rather than during or after a visit to the ultimate investment destination. That is why clear policies and a good image abroad can help a country to improve its attractiveness for FDI.

According to the founder and chairman of the Monitor Group, who on 18 November 2005 gave an interview to Vedomosti, an influential Russian business newspaper, in the Western media there were only three subjects reported about Russia: first, the War in Chechnya, second, Putin is not a real democrat, and third, Yukos. He concluded by saying that in relative terms Russia is much more interesting for investments than, for example, China; but its image is not.

Last but not least, political risks have the same problem as FDI, namely the problem of measurement. Of course, there is no unanimity among experts and therefore political risks are measured differently depending on the organization. Frequently, also, highly subjective opinions are used, making the overall political risk evaluations less trustworthy. Nevertheless, many people around the world continue to use what is available. We are no exception, though we try to bear in mind that a great deal of information available remains very subjective.

1.2 Prior research (literature overview)

Fitzpatrick (1983) has argued that in the literature the definition of political risk tends to be divided into four categories. These include: government interference, political events or constraints at industry or firm level, unan- ticipated discontinuities in the business environment as a result of political change and risk to international business generated by the political envi- ronment. Kobrin (1979) makes the argument that all of these definitions, except for the last one, focus on discontinuous change, and fail to incorpo-rate other elements of the political environment. Another critique on the existing literature is that its emphasis on the negative consequences of government interference is a normative assumption that is unlikely to be universally valid (Kobrin, 1979; Fitzpatrick, 1983; Ting, 1988). It is also suggested that political risk should be considered from a more extended perspective than just being about the government-company relations (Simon, 1984). Kobrin (1979) has found that political risk and market op- portunities are considered to be the most important factors in foreign in- vestment decisions by executives. Other publications, however, say that no empirical evidence has been found that would point to a link between political risk and actual FDI flows (Rivoli and Salorio, 1996). Kobrin (1979) also found that most firms do not have any systematic political risk evalua- tion; instead, most judgments are based on incomplete, outdated and often erroneous information and are rather casual and subjective in na- ture. Still, there is no lack of suggestions about how to make an effective assessment of political risks in the academic literature (Chevalier and Hirsch, 1981).

The literature on political risk examined so far has presented us with some interesting findings on this subject. Nevertheless, their cross-disciplinary nature complicates its integration into business research (Fitzpatrick, 1983; Simon, 1984). Rivoli and Salorio (1996) suggest that in economies facing high uncertainty the ‘when’ of FDI is of particular importance. Their argument is that in case of a politically uncertain or risky environment firms are very careful in deciding when to invest. They can postpone the in- vestment decision and simply await more information. When firms have this option to delay, countries can hardly have any influence on the in- vestment decision (Rivoli and Salorio, 1996).

Hoskisson, Eden, Lau and Wright (2000) hold a different view; they sug- gest that emerging markets that are still characterized by uncertainty and risks are greatly affected by institutional forces. They suggest applying an institutional perspective since emerging markets are still heavily regulated and therefore firms are bound by the rules of the game set by the institu-tional environment (Hoskisson, Eden, Lau and Wright, 2000).

A great deal of available literature regarding political risk was written in the early 1980’s. In the mean time, many things have changed, especially in the case of Russia, which no longer is a communist country with a state planned economy. However, being in the process of transition creates many risks and uncertainties of a political nature which have a major influ- ence on the economy (Hoskisson, Eden, Lau and Wright, 2000). Some academic literature about the political difficulties Russia copes with inter- nationally is also available (Martin, 1998). This can partly be explained by the fact that numerous problems with respect to Russian policies became more visible after it applied for Word Trade Organization (WTO) member- ship (Sabelnikov, 1996).

Therefore, it can be concluded that extensive literature is available on political risk, and also, but to a lesser extent, on investment in the uncer- tain and risky Russian political environment. No detailed research con- cerning how the Russian political environment has been influencing the level of FDI is available at this point in time. Although some research has been conducted with respect to FDI in particular to Russian industries, for example in the oil sector, and what role political risk plays there (Watson, 1996). However, such publications only described specific industries with their very distinct characteristics. With this research we aim to fill this gap that currently exists in the literature. Our investigation is about how FDI is affected by political risk in Russia in general, without narrowing it down to industry-specific elements. However, we also thoroughly understand that it will be necessary to study different sectors of the Russian economy in order to make some sound conclusions. The entirety of the research will involve the integration of two different concepts, from two different disci- plines (Fitzpatrick, 1983), namely political risk and the investment in an uncertain and risky institutional environment.

1.3 Research questions, objectives and relevance

The primary question for the research project is: How do political risks affect FDI in Russia?

The formulation of the main research question indicates the assumption that political risks regularly have an influence on the decision to invest in a particular country. Whatever the outcome of this research, it is also obvi- ous that political risk can not be the only factor influencing the inflow of FDI.

For this question to be investigated, several sub-questions have to be answered as well. First, we need to determine what exactly constitutes political risk, and how it can be assessed. Furthermore, we need to distin- guish the aspects of political risk that are of particular importance to in- vestment decisions by foreign companies, and how they relate to those decisions.

Therefore, the sub-questions are as follows:

1. How is political risk assessed?
2. Which aspects of political risk are of particular importance for invest- ment decisions of foreign firms?
3. How strong do these aforementioned aspects influence the investments of foreign firms?

New findings on the issue of FDI in connection to political risks could be very interesting and useful for governmental organizations which can use the gained insights for future policy making. They will be at least as impor- tant for Western companies that are seriously considering or currently planning to invest in Russia. These findings should help them to under- stand better and to prepare for future challenges and risks both in Russia and other emerging markets.

Today there is a growing consensus in Russia among its politicians, the business community and increasingly among the local population that more FDI is urgently needed in order to develop the country into a com- petitive economy and to increase the standards of living for average peo- ple. That is why this topic receives a great deal of attention in public dis-cussions, business forums, and so on.

Both local and foreign experts agree that Russia’s potential for FDI has been significantly larger than actual foreign investments (see Figure 15). In that calculation, both potential and performance are adjusted to the current GDP, the size of the total population, level of education, availability of natural resources, the infrastructure etc. of the respective countries.³ For some reason, since the dissolution of the Soviet Union the independ- ent Russian state has not been able to live up to the expectations of the international community. This research is therefore urgently needed in order to better understand some aspects of this complex and important issue. A deeper knowledge of the interplay between the Russian politics and FDI might eventually contribute to improving the situation in the future.

Figure 15: FDI potential vs. performance in Russia, Poland and Ukraine

Abbildung in dieser Leseprobe nicht enthalten

Figure 16: Cumulative outward and inward FDI around the world, in US$ bn

Source: UNCTAD

1.4 Research methodology

Through this research, we aim to develop a better understanding of what political risks in Russia are based on previous studies of political risk, for example Fitzpatrick (1983); Kobrin (1979). We will then analyse how these risks relate to FDI in Russia. Since FDI can be measured in different rela- tions -- for example, as percentage of the GDP or in units of money per capita -- it will be very important to take that into account. Different meas- ures will make it possible to show different aspects and make comparisons between Russia’s regions and industries more meaningful. Making com- parisons between Russia and other emerging markets will also be neces- sary in order to create a better understanding of the issue. Again the work will be based on the literature available, especially the research related to FDI into Central and Eastern Europe (Martin, 1998; Bandelj, 2002) and research related to investing in an uncertain or risky institutional environ- ment (Rivoli and Salorio, 1996; Hoskisson, Eden, Lau and Wright, 2000).

The methodology for this research is based on the phenomenological paradigm with the ultimate goal to provide the best possible answers to the main question of this master thesis. A quantitative study in positivistic style would only be able to give very superficial answers. We believe that on this particular subject it is unrealistic to find valid answers by using a hypothesis with dependant and independent variables. There are simply too many other factors which have an impact on the level of FDI in a coun-try like Russia. Many of them are interrelated and too difficult to measure in terms that are necessary for a positivistic approach.

The project will be carried out through an exploratory desk-research of the academic literature. Additionally, all relevant information from other reli- able sources available has to be considered, including the Internet and business magazines and newspapers. Since a great number of general academic literature about FDI, emerging markets, political risks (etc.) already exists it will be extremely important and challenging to filter out all the relevant information which can help to explain how Russian politics has been influencing the decisions of Western companies to invest in this country. The desk-research of the literature could be complemented by interviews of selected individuals. By interviewing representatives from business, academia and government one can further enlarge his or her understanding of the research topic and come to a better conclusion about the way political risk in Russia relates to the country’s FDI. This triangula- tion should also further increase the reliability and validity of this research, since it would not rely exclusively on previous research findings.

There is no doubt that one of the major keys for the success in this project is the familiarity of the researcher with the cultures and the languages both of the Western world and Russia as well as relevant working experience in both regions. In fact, the author has cultural and linguistic backgrounds both from the West and Russia, as well as many years of living, studying and working experience in both regions. That will certainly contribute to a deeper understanding and interpretation of all the relevant aspects of this research and eventually provide a maximum objective evaluation of the collected information.

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¹ Commonwealth of Independent States (CIS) is an international alliance, currently consisting of 11 former Soviet Republics: Armenia, Azerbaijan, Belarus, Georgia, Kazakh- stan, Kyrgyzstan, Moldova, Russia, Tajikistan, Ukraine, and Uzbekistan. Turkmenistan discontinued permanent membership as of 26 August 2005 and has become an associate member. Despite several CIS crises which in the future could further split this organiza- tion, for the purpose of our research we are using the CIS term only with one single objective, namely, to refer to all republics of the former Soviet Union, except for Estonia, Latvia and Lithuania. The latter ones have never been CIS members and on 1 May 2004 became full members of the European Union.

² In this context CEE includes the following countries: Albania, Belarus, Bosnia and Her- zegovina, Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Moldova, Poland, Romania, Russia, the former Serbia and Montenegro, Slovakia, Slovenia, Mace- donia and Ukraine

³ FDI Performance Index = (Country FDI inflows / World FDI inflows) / (Country GDP / World GDP) For more information visit: www.unctad.org