Sample Economic Case Study of Russia Recent Trade / Fdi Policy

Today, national economies are tightly knit within the global economy. The integration of the global economy has improved international relations and increased the flow of capital among nations. Capital inflow in the form of foreign direct investment (FDI) increasingly plays a pivotal role in national development. Russia is one of the countries that shows the essential role of FDI in development as it has, along with other emerging economies such as Brazil, India, and China (BRIC), been a major recipient of FDI. Russia’s attraction of FDI in the 2000s hinged on the developing economy, a better performing ruble, and improvement in the general working conditions in the country from the time that the country’s socio-economic crisis and hardships kept away most FDI inflows. Recently Russia has changed its FDI policy to attract more capital inflow. Russia’s FDI policy has pursued the improvement of local economic conditions, structural reforms, and improvement of the business environment. Moreover, the policy has also included reforms in tax application and regulations in line with international practices, a transition to a market economy, as well as liberalization of external economic affairs that have opened individual regions to international markets. The impact of the new FDI policy has been greatly increasing FDI into the country as well as Russia’s FDI outflows. Additionally, there has been an increase in exports, although opening up different regions has caused an imbalance in FDI inflows and development. Russia’s FDI regime has been instrumental in its current economic resurgence, making it one of the most powerful emerging economies.

Overview

FDI into Russia has a long history dating back to the 19th century. According to Akgun, Hopoglu, and Kunu (2015), “Active influx of FDI into the Russian economy started in the 1870s” (p. 173). Inflows continued through this period into the 20th century. At the beginning of the 20th century, most European countries, including England, Belgium, France, and Germany, had seen the promise of the Russian economy and had invested heavily in the country. Most FDIs during this period were channeled into energy, railroad construction, and mechanical engineering sectors. At the time, these sectors were among the most active and profitable across the world, thus the need for heavy investment.

After the early period of investment, Russia lost its attraction to foreign investment. The period after 1917 saw a great decrease in FDI inflows into the nation, to the point that FDI had lost its importance in the Russian economic development (Akgun, Hopoglu and Kunu 2015, p. 173). Part of the reasons for the decline and loss of importance of FDI to Russia’s economic development was an FDI policy regime that discouraged FDI through legislative restrictions on investment. These limitations were particularly protective of local investment at the expense of FDI inflows.

A few years later, the country changed its FDI policy as a way of attracting more investment. Akgun, Hopoglu, and Kunu (2015) inform that there were concessions in Russia’s FDI policy in the 1920s, and they improved FDI inflows into the country, albeit minimal. The FDI regime introduced was, however, not attractive enough throughout the period, until the 1990s when the government began pursuing a different regime aimed at attracting more investment (Akgun, Hopoglu and Kunu 2015, p. 173; Tar and Volchkova 2013). The ‘90s saw a slight spike in FDI inflows, thanks to a change in government stance on FDI (See graph 1). Despite the change in the FDI regime, Russia’s FDI inflows remained low, particularly due to the prevailing socio-economic crisis and general hardships experienced in the country.

Graph 1. FDI into Russia 1992-1999. Source: World Bank (2019)

Relative to its large potential in natural resources and educated human resources, the FDI inflows, as shown in Graph 1, show dismal performance. The educated manpower and the sheer great number present a potentially great market for both locally produced and imported goods. The record from the graph is, however, discouraging given the little amount of FDI inflows in the period between 1992 and 1999 relative to Russia’s economy. Cumulatively between 1992 and 1999, the country’s FDI totaled $16 billion (World Bank, 2019). Relative to other transition nations adjusted for population size on per capita basis, for the same period, these countries, including Poland, the Czech Republic, and Hungary, had far better FDI inflows. The three countries had a total of $84, $118, and $221 billion in FDI inflows, respectively, for the same period that Russia had a cumulative total of $16 billion (Bergsman, Broadman, and Drebentsov 2001). The amounts of FDI during this period show an inherently flawed policy towards FDI.

In the first decade of the 21st century, Russia has experienced a great change in FDI inflows. According to the World Bank (2019), the republic saw a spike in FDI inflows between 2000 and 2010, peaking at $74.78 billion in 2008 (see graph 2). The increase in FDI inflows can be attributed to a change in FDI policy, which improved the relations between Russia and other countries. The spike in FDI inflows has remained relatively high even after 2010, dipping in 2015, yet not reaching the low levels experienced in the early 21st century.

Graph 2.  FDI into Russia 2000-2018. Source: World Bank (2019)

The change in FDI policy has increased the sources of FDI inflows into Russia. While previous sources were largely from European countries, the change in FDI policy has morphed the sources to a more heterogenous form, to a wide range of continents and countries, including Europe, North America, and Asia. Bershidsky (2019) informs that recent data from Russia Central Bank shows that some countries, such as Cyprus, the U.S., China, Japan, and Korea, among others, are among the sources of FDI inflows into the country (see table 1). Increased sources point to better FDI policies and improvement in relations between Russia and the rest of the world.

Table 1. Russia’s FDI sources. Source: Bershidsky 2019 (Bloomberg)

Russia FDI Policy

The turn of the century has seen a change in Russia’s FDI regime, which has been instrumental in improving the country’s FDI inflows in many ways, such as tax exemptions. It is important to note that an appropriate investment climate that includes an interaction of political, social, legal, and economic factors is important for investment. Investors extensively look into the four factors before deciding on their investment in a particular country (Akgun, Hopoglu, and Kunu 2015). Over the years, Russia has been undertaking an overhaul into its systems to attract more foreign investment. Since one of Russia’s weaknesses (consequently resulting in low FDI inflows) has been its legal system, the system has undergone some changes. Amended in June 2001, The Law on FDI in the Russian Federation exempted investors from all taxes apart from social security and regional taxes (Akgun, Hopoglu, and Kunu 2015; Tar and Volchkova 2013). The tax breaks also include tax deductions for investors in different sectors and income tax exemptions in different regions. By exempting foreign investors from paying taxes, Russia hopes to attract even more investors, who will take advantage of the tax breaks.

Related to the Law on FDI in the Russian Federation, yet contradicting it in some ways is the Tax Code Act on taxation. According to Akgun, Hopoglu, and Kunu (2015), the law provides for taxation of investors in two ways. The first one is that “the investors would be exempt from all payments and taxes (except value-added tax, income tax, taxes pertaining to natural resources, land taxes, and customs duties)” (Akgun, Hopoglu, and Kunu 2015, p. 178). Legislation, in this case, applies to investors during the course of their contract in the country. Secondly, the Tax Code exempts foreign investors from all federal taxes, inclusive of local and regional taxes. However, it does not exempt foreigners from paying value-added tax and social security tax. The idea here is that while it aims at attracting foreigners through tax breaks, it also hopes to cash in on the foreigners through taxation.

The tax exemption regime also involves non-taxation of profits for foreign companies operating in Russia. According to KPMG (2018), Russia has tax exemptions following the CFC (controlled foreign company) rules. The rules apply to foreign legal entities (FLEs) with Russian tax residency, where the resident owns at least 25% of the capital. For these entities, the CFC is subject to only a 20% profit tax if “the controlling person/entity is a Russian-resident company” in comparison to 30% profit tax for locally owned companies (KPMG 2018, p. 33). Moreover, under the CFC rules, the individual entity is subject to a personal income tax of 13% if the entity is a Russian-resident individual in comparison to the normal 20% rate. These tax exemptions are meant to not only encourage foreign entities to invest in Russia but also take up Russian residency to enjoy the enhanced tax breaks.

Aside from the CFC rules, there are tax breaks for special economic zones. Kuznetsov and Kuznetsova (2019) inform that Russia’s special economic zones (SEZs) were established by federal authorities in 2005. There are 28 zones divided into four categories for FDI, including industrial and production; technology and innovation; port; and tourist and recreational zones (Maslikhina 2016). Compared to other countries, foreigners investing in Russia in the SEZs enjoy up to 30% less in start-up costs. The reduced costs come from breaks in the income tax rate for investment in these zones ranging from 0 to 13.5% in comparison with the normal 20% income tax (Maslikhina 2016). The tax exemptions also cover foreign investors purchasing a property in these zones. According to Kuznetsov and Kuznetsova (2019), foreigners enjoy a 10 to 15 years tax exemption for the purchase of property in the zones. Additionally, there is a 5 to 10-year tax exemption for foreigners for lease or purchase of land applied at the federal level. Another attraction for investors to the specialized zones is a favorable special custom regime. The regime does not require foreign investors to pay customs duty and VAT for foreign goods used in the zones, particularly Kaliningrad, Nakhodka, Ingushetia, and Magadan, which have been termed as free economic zones (Kuznetsov and Kuznetsova 2019). The breaks targeting the zones are aimed at attracting not only foreign but local investments as well within these zones to spur economic development.

Impact of Russia FDI Policy

The introduction of tax exemption for foreign investors in 2001 had a great impact on Russia’s GDP.  Between 2001 and 2008, Russia’s FDI grew from $2.7 billion to $74.8 annually, and there was a simultaneous growth in the country’s GDP (graph 3). The growth in GDP, aside from being an effect of a change in the country’s FDI regime and more investment, was also caused by rapid growth in consumption among consumers (Mutanga and Simelane 2016).   A better tax regime for investors and opening up of the Russian market meant that investors had access to the huge number of consumers in the country, particularly for manufactured goods. Additionally, the Russian domestic industry retained its Soviet-era features and did not produce high-quality goods, making it even easier for foreign products’ penetration.

Graph 3. GDP and inward FDI to Russia 2001-2013. Source: Mutanga and Simelane (2016)

The bulk of Russia’s foreign investment in Russia goes to manufacturing, then real estate and mining of natural resources, and the tax exemption has especially been instrumental in attracting investment in these areas, which have shown continued growth. Mining, particularly of crude oil, has shown great improvement in production thanks to continued investment by both the government and FDI under the joint ventures program. Since the passage of the legislation setting up the Joint Venture Fund in 2001, which saw an increase in FDI inflows (Mutanga and Simelane 2016), Russia has seen tremendous improvement in crude oil production. Data from CEIC (2019) shows that in 2002, Russia’s crude oil production was at a meager 7,400 barrels a day: through FDI in the sector, the country’s production has grown to more than 10,500 barrels a day (See graph 4).  FDI has therefore been instrumental in spurring growth in crude oil production.

Graph 4. Russian crude oil production from 2002-2018. Source: CEIC (2019)

Along with the increased crude oil production was the increase in natural gas exports and imports. In the years that FDI has increased in Russia, there has been a significant increase in natural gas exports (graph 5). Between 2002 and 2018, the overall production has averaged 203,940.000 Cub m mn a year and has steadily increased in subsequent years. Growth in production has followed the FDI inflow pattern, augmenting with an increase in FDI inflows and vice versa. However, while natural gas imports began to increase at the start of FDI inflows, peaking in 2008 at 70,000 Cub m mn, they have since drastically reduced to 19,000 Cub m mn in 2018 (graph 6). The decrease in imports can be attributed to increased crude oil and natural gas production stimulated by both government and FDI investment in the sector

Graph 5. Russia’s natural gas export. Source: CEIC (2019)

Graph 6: Russia’s natural gas imports 2002-2018. Source: CEIC; 2019

Russia’s contradicting laws on its FDI policy have not done much good for it in FDI flows. While the Law on FDI in the Russian Federation exempts foreign investors from paying taxes, the Tax Code slaps value-added tax and social security tax on investors. Such a contradiction in its tax regime has not been good on the country’s investment climate. According to Vercueil (2010), these “inconsistencies and frictions among formal institutions and between formal and informal institutions and between different legal policies produce uncertainty in the economic environment” (p. 4). It is perhaps the contradictions in the law that saw Russia ranking position 39 in FDI inflows (table 2) in 2001, signaling a dip in investor confidence in the laws that govern investment.

Table 2. Russia’s ranking by GDP and FDI inflows. Source: Mutanga and Simelane (2016)

Conclusion

Nations across the world have come to accept the reality that is globalization. The interdependence of the global economy has seen capital move from different countries to others in investment through FDI. For a long time, Russia’s FDI policy has been a hindrance to the country’s economic growth and development through FDI. However, a new FDI regime has seen an increase in FDI inflows in Russia. Tax breaks and exemptions, Joint Fund, and joining WTO are among the FDI policies implemented by the Russian government to attract FDI. These measures have had a great impact on crude oil production, natural gas exports, and imports. FDI has been instrumental in boosting crude oil production and consequently, natural gas exports. Russia has become more reliant on its produce, as seen from the dip in natural gas imports. FDI is likely to continue to impact Russia positively as it has done to the country’s GDP as long as the policy remains open to encourage inflows and make more concessions, opening other sectors for investment. At present, the nation’s vast natural resources, educated human resource, and huge potential market ascertain its position as an attractive candidate for FDI inflows; it, however, needs to do more to improve its FDI regime to make to attract more attractive to potential investors.

References List

Akgun, L., Hopoglu, S., and Kunu, S. 2015, “Foreign Direct Investment in Russia: Unfavorable Investment Climate, Uneven Distribution,” International Journal of Academic Research in Business and Social Science, vol. 5, no. 8, pp. 172-183.

Bergsman, J., Broadman, H.G., and Drebentsov, V. 2001. Improving Russia’s Policy on Foreign Direct Investment. Washington, DC: World Bank.

Bershidsky, L. 2019, “Where Russia’s Foreign Investment Really Comes From,” Bloomberg.

CEIC, 2019, Russia Crude Oil: Production. CEIC. Available at: <https://www.ceicdata.com/en/indicator/russia/crude-oil-production>. [Accessed 25 April 2020]

KPMG. 2018. Doing Business in Russia: Your Roadmap to Successful Investments. KPMG. Available at: <https://assets.kpmg/content/dam/kpmg/ru/pdf/2018/07/ru-en-doing-business-in-russia-300718.pdf>.  [Accessed 23 April 2020]

Kuznetsov, A. and Kuznetsova, O. 2019, “The Success and Failure of Russian SEZs: Some Policy Lessons,” Transnational Corporations, vol. 26, no. 2, pp. 117-139

Maslikhina, V. Y. 2016, “Special Economic Zones in Russia: Results, Evaluation and Development Prospects,” International Journal of Economics and Financial Issues, vol. 6, no. 1S. Available at: <https://www.econjournals.com/index.php/ijefi/article/view/2398>. [Accessed 25 April 2020]

Mutanga, S. and Simelane, T. 2016, Regional Dimension of Foreign Direct Investment in Russia. Economic Policy Forum. Available at: <https://economic-policy-forum.org/wp-content/uploads/2016/02/Regional-Dimensions-of-FDI-in-Russia.pdf>. [Accessed 25 April 2020]

Tarr, D., G and Volchkova, N. 2013, Russian Trade and Foreign Direct Investment Policy at the Crossroads. Oxford: Oxford University Press. Available at: < https://www.oxfordhandbooks.com/view/10.1093/oxfordhb/9780199759927.001.0001/oxfordhb-9780199759927-e-022>. [Accessed 26 April 2020]

Vercueil, J. 2010, “Changing Investment Climate in Russia: An Institutional Approach,” Journal of Euro-marketing, vol. 19, no. 2-3, pp. 115-138. Available at: <https://halshs.archives-ouvertes.fr/halshs-01419891/document>. [Accessed 24 April 2020]

 

 

 

 

 

 

 

 

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