From BRIC to BIC? Is Russia worth the emerging market status?

It took me a while to get back behind my desk and write for this blog. Too many projects have diverted some of my attention elsewhere although the topics over which to share my humble views are a lot.

Numerous times over the past few weeks I had the opportunity to share with clients, investors and friends alike my negative opinion about Russia's future economic outlook.

I went back to substantiate some of my qualitative comments with data gathered from the recent World Economic Forum report.

The data from the report is not encouraging, following is a summary that I have provided in an earlier post:

Russia: 63th position, same as last year. After the significant slide of the previous year, Russia maintains its position. While infrastructure, health, education and technology improves significantly other components of the index suffer. The major area of concern highlighted in the report are market competitiveness and efficiency of the goods markets. Competition is hindered by inefficient anti monopoly laws and restrictions on trade and foreign ownership. One of the main issue highlighted further in the report remains the weak institutions that translate in weak property rights (126th rank) and weak corporate governance standards (119th rank).

In spite of the large amount of natural resources available for development the country doesn't seem to be able to attract large amount of foreign capital due to poor market efficiency and regulatory frameworks able to give proper guarantees to foreign investors. 

Further to the contingent stagnant situation I believe there are some more fundamental weaknesses of the system that is worth outlining:

• very negative demographic trends;
• limited communication skills in the international arena as most of the business people tend not to be able to speak basic English.
• weak and non competitive SME sector

The first is the most worrisome of the trends. It has been recognized by the local government as a serious problem and some measures have been taken to stimulate the natality rate.

Low birth rates and abnormally high death rates caused Russia's population to decline at a 0.5% annual rate, or about 750,000 to 800,000 people per year from the mid 90s to the mid 00s.

The population peaked in 1991 with 148,689,000 and it is now at 141,927,000 as of January 1, 2010.

The language aspect is more difficult to quantify in its impact but in my opinion remains an important one. While the Indian subcontinent for example presents clear difficulties in regulatory frameworks and infrastructure among others remains a lot more dynamic and integrated with the global economy due to the pervasive use of the English language among the average business person.

On the other hand Russia remains insulated as most of the business people, even of young age, are barely able to speak basic business English.

Russians have developed their own set of social network website separate from the rest of the world: Vkontakte (www.vkontakte.ru) and they are trying to develop their own set of domain names in cyrillic: Russian domain names. 

In a world where being connected and communication is the underlying basis for all business it is hard to imagine how big is the cost of this type of "isolation".

The SME sector is undersized for this nation as the entrepreneurial class has only a very brief history. During the entire Soviet Union time there was a systematic dismantling of the entrepreneurial spirit and only after the break up and the savage deregulation following SMEs have found a reason to exist. 

In both emerging markets and developed countries SMEs often tend to be the most resilient during an economic downturn as well as a consistent source of innovation. Without such developed strata of companies combined with some of the difficulties outlined above the Russia economy appears lacking a necessary component to long term prosperity. Please note that to support the claim above according to the latest World Bank's survey (Doing Business, 2009) Russia ranks 120 out of 181 economies in 'ease of doing business'.

Overall, my position remains that given the existing economic issues and moreover due to the long term demographic trends currently in place Russia no longer belongs to the emerging market economies in spite of the large natural resources available on the territory.

Too many changes are to be applied at the same time to reverse the situation. It would be at least necessary to create a more favorable set of predictable rules to favor and regulate foreign investment in the country such to develop and modernize further the natural resources industries.

Swift and deep additional efforts are to be made to integrate additional foreign workers in the country to be able to reverse some of the underlying demographic trends and more importantly collect the related taxes.

As many friends and clients come from this beautiful country I hope to assist to a swift reversal of such trends.

Emerging markets, by choice or mandatory evolution?

As I am immersed in my daily work at the Free Zone I come face to face with more and more European entrepreneurs that are relocating their business in the United Arab Emirates as a vehicle to take advantage of the emerging markets promise.

Over the last couple of years, and especially after the latest financial turmoil, the motivation behind their desire to relocate have changed considerably. While originally the motivation was a desire to explore and diversify their investment portfolios it has now become a matter of survival.

European business owners have to face two serious questions to which they need to find suitable solutions:

1. How do I protect the assets that I have acquired during these years? In some cases the assets have been accumulated in a matter of generations as is the case with many family owned businesses in Italy, the country where I am originally from.
2. How do I position my business in such way that it can thrive in the future? and therefore: how do I take advantage of the growth in the emerging markets?
   

Question (1) is purely a matter of asset protection dictated by the fact that all G7++ governments are to collect as much taxes as possible to sustain the spending spree that governments have been undertaking recently to face the economic downturn. The trend is to be sustained long term as the same governments are facing mounting costs from the welfare systems in place all the while the population grows on average older an older. Nevertheless answers to question (1) vary in the level of sophistication and opportunities, new tax free jurisdiction become more appetizing versus others are under pressure from the OECD. I will leave analysis of this matter to another posting as the topic deserves additional exemplifications.

Question (2) is more business driven and that is where I am going to spend a little bit more time.
As the world becomes more and more connected it has become easier for individuals and small organizations to pack their bags and relocate. The new generation is better equipped with language skills and therefore when opportunities arise elsewhere the barriers preventing shifting have become lower and lower.
This substitution effect seems to be ignored completely by the European press, and much of the academic world, which instead tends to build long term development projections banking on a "closed" system. A system whereby businesses and individuals are static.

I recently came across notes from a convention held in Bucharest last Oct 2007: Work Session on demographic projections. Some papers were really interesting and fundamentally pointed out what was obvious already 30 years ago: Europe (& the world in general) was going to enter a period leading to a DECREASING population, starting with the Western countries and then reaching the entire world.

The element that I propose is that most of the assumptions are too optimistic because they don't take in consideration the substitution effect, therefore the ability of many Europeans to transfer their activities elsewhere, or the ability for many immigrants to go back "home" in fact accelerating the decline of relevance of European countries to the global GDP.

Following are some relevant observations from the paper of David S. Reher, Universidad Complutense de Madrid, “Towards long-term population decline: a discussion of relevant issues,” European Journal of Population 23 (2007): 189-207

"Not only is this period of growth ending, there are also real perspectives for prolonged population decline in many of the world’s regions during the twenty-first century. There can be little doubt that this process has started in Europe and in other developed nations. It may just be getting under way in many of the lesser developed countries of the world as well."

"Extremely low fertility has been around for too long for it to portend anything other than major long-term social change. It gives every indication of having become a structural aspect of the developed world."

"The trend towards population decline has been building for many years now. In some areas where this process is further advanced population will decline by as much as 20 percent in the next 50 years. Should present trends in fertility continue, decline by the end of the century will be much greater. Since this upcoming period of decline will hinge on low fertility, populations will tend to be loaded with elderly persons, and children and working age populations will be shrinking."

"As for the society of the future, expectations are not nearly so optimistic. Severely skewed age structures, an unavoidable by-product of the process underway, will have important consequences for all aspects of social welfare that depend on the redistribution of resources."

"Economists are well-acquainted with the issue of aging and grapple with potential solutions ranging from later retirement to increasing women’s labor force participation, large-scale immigration, or reducing pensions and dismantling what is left of the welfare state. While certain doubts exist as to the economic expediency of many of these mechanisms or whether or not they will bring with them unwanted side effects, especially in the case of international migration, it is unquestionable that they represent a safety valve for rapidly aging societies. If current trends persist, however, over the long run none of them may prove to be more than partial remedies. (emphasis added by the author of this blog)
International migration itself, the focus of much current attention and concern, is unlikely to represent more than a temporary and rather inadequate solution for skewed age structures and population decline." (emphasis added by the author of this blog)


In the face of these irreversible trends I consider the choice of few SMEs to explore emerging markets more of a matter of survival than anything else. The next challenge for emerging markets economies is to create the appropriate environment to facilitate this transition and create the necessary framework to welcome foreign direct investment from the old Europe.

Full notes from the Eurostat Work Session available at:
http://epp.eurostat.ec.europa.eu/cache/ITY_OFFPUB/KS-RA-07-021/EN/KS-RA-07-021-EN.PDF