Market Forces Will Limit Russian Expansionism

An end to the war in Georgia will come more from economic forces than from threats or diplomacy.

By Andrew C. Schneider, Associate Editor, The Kiplinger Letter

September 3, 2008

Capital flight may prove the most effective check on Russian aggression in Georgia, as well as a means to prevent similar moves by Russia elsewhere in the “near abroad” of former Soviet republics. Moscow will ignore diplomatic efforts by the U.S. and Europe to persuade it to back off and give its neighbors room. But it’ll be harder for the Kremlin to ignore the more immediate and harsh discipline of the market.

“This has not been a free exercise for the Russians,” says James Collins, U.S. ambassador to Russia under President Clinton and director of the Russia and Eurasia program at the Carnegie Endowment for International Peace. “All sorts of negative economic indicators suggest this has not been a good thing from the businessman’s point of view.” Moscow’s foreign reserves fell $16 billion in a week. Stock values on the Russian Trading System have gone down 15% over the past month. The value of state energy giant Gazprom, Russia’s largest corporation, fell $16 billion in a single day. The ruble is down 5% against the dollar. Risk premiums for doing business in Russia are soaring, making it more difficult for firms to obtain insurance or credit for operations there.

Russian and foreign investors alike have been growing increasingly nervous over the Kremlin’s behavior in the past few months. Prime Minister Vladimir Putin’s veiled threats against Russian firm Mechel in late July caused the metals and mining company to lose half its market value in a matter of days. The politically connected Russian co-owners of energy company TNK-BP are using a full-scale campaign by Russian law enforcement and government inspection agencies to force out their British partners. For many investors, the war in Georgia was the last straw.

U.S. firms that haven’t fled already might want to wait it out. Russian soldiers certainly won’t leave Georgian territory overnight, but any real sign that they intend to make a significant move would be a go-ahead signal for investors. “People who thought doing business with Russia was going to be easy have already left,” says Toby Trister Gati, a senior international adviser with law firm Akin Gump Strauss Hauer & Feld. Gati notes that firms looking to break into the market for the first time face the biggest challenges. Those that have been operating there for a while are in a better position to cope with the uncertainty. “Russia looks a lot scarier from a boardroom here than for a rep on the ground.”

Moscow can’t turn a blind eye indefinitely to investor discontent. Its growth plans depend on access to foreign capital and the ability to expand into foreign markets. Whether or not the European Union can act collectively to impose sanctions, its members will be far less willing to go along with Russian investment in their energy sectors.

Russian trade with and investment in the U.S. is minuscule compared with its trade with Europe, but Russian businesses have been hoping to change that. In recent months, for example, Moscow-based steel producer Severstal has acquired Wheeling, W.Va.-based Esmark Inc., Warren, Ohio-based WCI Steel and the Sparrows Point steel mill in Baltimore, Md., formerly owned by ArcelorMittal. Future Russian investments in U.S. firms will come under the microscope in Washington, providing a fresh test of the 2007 reforms to the Committee on Foreign Investment in the United States (CFIUS).

Moscow and Washington are wielding double-edged swords in this situation. The U.S. won’t give the nod to Russia’s joining the World Trade Organization until Moscow stops playing the bully at home But Washington wants Russia in the trade organization so that it and others can check unfair trade moves. The WTO, Collins notes, “is a forum in which members have to behave in certain ways. Having them outside the WTO means they don’t have to care what those rules are.” Russia has announced it will ban imports from 19 U.S. poultry firms, allegedly on health and safety grounds but almost certainly in response to U.S. condemnation of the Georgia war.

Putin and new Russian President Dmitry Medvedev are in a tight spot. If they feel too much pressure from the U.S. and others to back down in Georgia, they could turn down the natural gas and oil spigots. The country’s gross domestic product has grown by more than 7% for four of the past five years, and its international reserves have climbed to $580 billion, almost entirely due to the high price of its oil and gas exports. That gives it something of a cushion. But the Russian economy is more fragile than its rapid growth suggests.

“'Dutch disease’ is the problem,” says Anders Åslund, senior fellow at the Peter G. Peterson Institute for International Economics. The phenomenon is a trap that often afflicts economies that have become too dependent on income from natural resources, as the Netherlands did after its discovery of natural gas in the 1960s. Dramatic inflows of foreign currency drive up prices and wages, making it that much more difficult for businesses outside the natural resource sector to develop. Russia is already experiencing inflation of 15%. If its domestic economy deteriorates too fast, political unrest in Moscow will make the Georgia situation the least of its cares.

Unfortunately, Washington has few other weapons to draw. Neither President Bush nor his successor is likely to risk open confrontation by sending the Sixth Fleet into the Black Sea, let alone redeploying U.S. ground forces from Iraq or Afghanistan to Russia's border. The fact remains that Russia has the capacity to be a much bigger nuisance to the U.S. than it is now. The Kremlin’s cooperation in efforts to keep Iran from gaining nuclear weapons has been slim, and Russia has maintained the lowest profile among the six parties to talks aimed at ending North Korea’s nuclear program. It could be more obstructive in both cases if it chose to. As it is, tensions will set back U.S. and Russian efforts to reduce their own nuclear stockpiles, which will be critical to both countries’ work on averting further nuclear proliferation.

What will help is that Russia’s leaders risk feeling the pain in a very personal way. Putin's replacement of Yeltsin-era business oligarchs with compatriots from the security services and other allies means that Russia's political and business leaders are often the same individuals. When Russia's economy takes a hit, they take a hit in their own bank accounts. To the extent they shield themselves by sending their money to overseas tax havens, they risk investigations and asset seizures by foreign law enforcement and courts. That's a card the U.S. and the EU will likely play with increasing frequency.

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