The energy sector, most notably oil and gas, plays a predominant role in the Russian economy (as the source of over half of exports and the vast majority of their foreign currency reserves) and is the focus of a significant percentage of FDI inflows. The two main episodes of declining FDI (2009 and 2014) happened at a time of collapse in the price of oil, which on both occasions lost over 50% of its value within the span of a few months. Furthermore, in 2011 (which represents another instance of declining FDI), the price of oil declined by almost a third, even though it recovered fairly quickly.

The fall in oil price during these episodes (especially in 2009 and 2014) was driven by declining global demand, which since 2014 appears to be structural (the oil futures market would indicate there is little expectation of a recovery, as evident in Fig. 3). This, combined with an ambitious pledge to turn towards green energy in the EU (the premier consumer market for Russian oil and gas), presents a discouraging medium-term outlook for FDI into Russia. Even though FDI flows saw some level of recovery in 2016 despite the new (lower) equilibrium oil price, this recovery appears to have since partially subsided.

Fig. 3.

Brent crude oil price (U.S. dollars per barrel).

Note: Values after October 2019 reflect the futures market. The Brent benchmark is employed as a proxy for the oil market. In March 2020, after the submission of this paper, the price of Brent declined further. Source: Bloomberg.

Beyond these overall patterns, sectoral and regional distributions of FDI provide a greater insight into the role played by the energy sector. Fig. 4 shows data by the central bank on the sectoral distribution of FDI inflows for the four major sectors (while data for 22 sectors is provided, the remaining ones play a fairly negligible role and are all grouped in other). These four sectors are wholesale and retail trade, mining and quarrying (which according to the guidelines consists almost exclusively of fossil fuels), manufacturing and financial and insurance. It should be noted that the growth rate of the Russian GDP fluctuates quite substantially, contributing to some of the volatility seen in the graph.

Fig. 4.

Gross FDI flows per sector (% of GDP).

Note: Quarterly FDI figures are divided by quarterly FDI. Sources: Bank of Russia; IMF (2019).

This picture is complemented by additional central bank data which distributes FDI inflows regionally. Excluding the wider Moscow area and, to a smaller extent, St. Petersburg, the oil and gas heavy Tyumen region (without its autonomous provinces) and the autonomous province of Yamalo-Nenets (Gazprom’s main hub) accounted for 45% of all remaining FDI in the first quarter of 2019 (the rest is shared between the remaining regions). These regions are fairly small, with little other economic activity. Other regions such as Sakhalin Island and Krasnoyarsk Krai, where oil is also an important part of the local economy, also rank highly. This indicates that sectoral data could underestimate the importance of the energy sector when contrasted with regional data. Some of the non-mining and quarrying investments appear to be going into the businesses directly related to oil and gas extraction. After all, the extraction process is made up of many other required activities beyond explicit mining and quarrying, yet these are reflected in different sectoral categories and as such are very hard to disentangle.

The previous data indicates that a large proportion of overall FDI into Russia is directed to the oil and gas industry, especially when Russia’s two large cities are excluded. This has important implications. Studies have shown that the concentration of FDI into natural resource sectors negatively affects the GDP of the Ultimate Host Country (UHC). Poelhekke and van der Ploeg (2013) not only show that FDI into natural resources crowds-out FDI into other productive industries, but also that this can be magnified to the extent of resulting in lower overall FDI. The impact is particularly poignant when natural resources are first discovered. Hayat (2018) finds that natural resources reduce the growth effect of FDI to the point that it can become negative. At the same time, there is a low spillover effect associated with natural resource extraction given that it is typically an activity that requires few local inputs. Thus the growth potential is low, in contrast with FDI into manufacturing and technology.

At the same time, these values underestimate the extent of FDI activity that enters and exits Russia regularly. Ultimately, gross inflows represent the net acquisition of assets by foreigners in Russia and as such can be negative (net flows would be the net acquisition of assets minus the net acquisition of liabilities).⁹ Given that FDI represents a medium to long term investment, this typically provides an accurate depiction of overall FDI activity. However, in the case of Russia, there is a fair amount of short-term FDI that partially stems from the fact that a non-negligible percentage of FDI into Russia ultimately originated in Russia itself, but was previously re-routed through foreign entities, as well as the nature of FDI into sectors like oil which can be more volatile. Fig. 5 thus presents the gross acquisition of assets in Russia by foreign investors and gross sale of assets in Russia by foreign investors for the same time period (which net out to the values in Fig. 4). The size of these values is very large while the extent of financial sector activity (both in gross acquisitions and gross sales) in 2010 and 2011 stands out.

Fig. 5.

Gross foreign acquisition (a) and sale (b) of Russian assets per sector (% of GDP).

Notes: Quarterly FDI figures are divided by quarterly FDI. Source: Bank of Russia; IMF (2019).

Finally, the “Dutch disease” effect of natural resource exploitation played a key role in the Russian economy. This term describes the phenomenon that arises when a natural resource windfall results in a rapid real appreciation of the currency, worsening terms of trade for other exports and reducing the competitiveness of other industries, hurting the wider economy. This took place in Russia during the early 2000s, when increases in the price of oil resulted in a gradual real appreciation of the rouble reducing investment into non-fossil fuel sectors (as they became increasingly uncompetitive in international markets).

Furthermore, beyond the immediate damage, the effects of this period persisted after the currency appreciation was reversed. The IMF (2017) reports that the bursting of the resource bubble has not led to a reversal of the Russian Dutch disease. Even though oil prices and the rouble periodically collapsed in the last decade, by then a crowding out of manufacturing industries had taken place (enhanced by an incomplete economic transition in the 1990s and 2000s where state aid was ubiquitous). This concentrated economic activity in the resource sector. This could not be reversed easily when the terms of trade improved.¹⁰ The damage caused to other industries by years of concentration of economic activity and investment in resource extraction meant many could not be salvaged.

At the same time, the volatile macroeconomic environment and monetary policy have affected FDI flows. In this regard, it is first worth noting that FDI flows are traditionally considered less volatile than other forms of international capital flows, as they represent a much more substantial level of involvement in a particular entity that will be harder to exit and as such, less prone to speculation. That said, the role of the macro environment is not only relevant but heightened for FDI into the oil sector, as this remains more speculative given the degree of volatility in oil markets.

The rouble has been heavily affected by changes in the price of oil in recent decades. After all, oil exports contributed the largest share of dollar reserves for a country that until 2015 regularly intervened in foreign exchange markets in order to manage the exchange rate. This volatility of the rouble has heightened many of the FDI effects of fluctuations in the oil price, although monetary policy has helped mitigate the volatility of certain episodes. This section explores two different impacts of monetary policy: firstly, the efforts of the central bank and their mitigating effect; secondly the change from exchange rate management to inflation targeting that was formalized in 2014 and its consequences.

The Russian Central Bank has actively participated in foreign currency markets in the past two decades, and used monetary policy to pursue both exchange rate and inflation objectives. Between the year 2000 and today, the rouble exchange rate has evolved from being very tightly controlled (2000–2005) to being free-floating in an inflation targeting regime.¹¹ That said, even in its current state, the central bank reserves the right to intervene in foreign exchange markets and to prevent undue volatility. In this capacity, they have mitigated the worst effects of exchange rate fluctuations, often driven by movements in the oil price.

Following the GFC of 2008, the Bank of Russia identified downward pressure on the rouble caused by capital flight and the erosion of the country’s current account balance. They allowed the gradual depreciation of the rouble by progressively widening the currency band and simultaneously supporting the rouble through market operations, depleting a third of central bank reserves in three months in the process¹² (this is not fully reflected in Fig. 7 as it exhibits yearly data; the fall was not only recorded between 2008 and 2009 but the periods preceding and following it saw reserve growth). Similar actions were taken in 2014, when intervention played an even larger role. This is because the announcement of exchange rate flexibility had increased pressure on the currency, already weakened by the oil price collapse and sanctions (as described below). During this episode, it became important for the central bank to assuage market fears that they had allowed the currency to float freely, both by supporting the currency with reserves but also by aggressive use of interest rate policy. Their aforementioned efforts during the rouble collapse of 2008–2009 and 2014–2015 are evident in the data, both from the point of view of the main policy rate (as can be seen in Fig. 6) and in direct intervention in foreign currency markets, that caused the reduction in reserves (Fig. 7).

Fig. 6.

Euro-ruble exchange rate.

Source: Bloomberg.

At the same time, greater flexibility and the announcement in 2014 of the pursuit of a fully floating exchange rate and an inflation-targeting system had the opposite effect to the previously described policies. These announcements took place at a time when pressure on the currency was mounting and likely contributed to the heavy depreciation of the rouble. The implication that the central bank would allow the currency to float freely naturally weakened the rouble’s credibility and caused a (mild) episode of capital flight. In fact, in the ensuing months the central bank went to great efforts to support the currency, partially subverting monetary policy to this end. While officially the exchange rate target was given up in November 2014, the central bank intervened heavily to prevent the collapse of the currency up to the end of 2014 and in the first weeks of 2015. Indeed, while the decline in reserves is the evidence of central bank efforts (its reserves fell by close to 30% between 2013 and 2015, see Fig. 8), this episode is characterized by the rapid rise of the policy rate as can be seen in the graph (see Fig. 7).

Fig. 7.

One-week repo rate, percentage points

Source: Trading Economics; Bank of Russia.

Overall, the effects of the currency’s collapse (and ensuing negative effects on FDI) were undoubtedly mitigated by the rapid and largely thorough actions of the central bank. Furthermore, the fact that the Russian currency fared fairly well throughout 2018 and was not heavily affected by turmoil and capital flight in other emerging economies is a testament to the credibility of this inflation-targeting system (especially as these times of turmoil coincided with new rounds of sanctions as will be explored below).

Fig. 8.

Russian reserve assets (billions U.S. dollars).

Note: Reserve assets according to BMP6 (monetary gold, SDR holdings, reserve position in the IMF, currency and deposits, securities, financial derivatives, and other claims). Source: IMF, International Financial Statistics.

Finally, it is worth qualifying this analysis by pointing out that while the impact of these effects is substantial, it is important to understand that the oil sector in Russia remains fairly dollarized — many contracts (both commercial and investment) are concluded in foreign jurisdictions and denominated in foreign currency. As such, they are not affected by fluctuations in the rouble. At the same time, energy companies hold fairly large shares of dollar debt (for largely dollar revenues). Therefore, FDI into the energy sector can remain relatively detached from movements in the currency, at least from the point of view of daily operations. However, the insecurity that foreign exchange volatility poses to value chain management of multinational enterprises does cause a certain degree of uncertainty, while the associated political tensions deter foreign investors. Indeed, it is worth noting that energy companies still depend on domestic revenues and costs. As such, an excessive degree of dollarization and, more specifically, a very large share of dollar debt will make companies vulnerable to large fluctuations in the rouble by raising their probability of default. At the same time, there has recently been an evolution among Russian oil giants who are widely concluding euro-denominated contracts. Indeed, Rosneft, one of the world’s largest oil companies controlled by the Russian state, announced all contracts will henceforth be in euro.¹³

The drivers of turbulence in Russian FDI are established throughout this paper. However, when analysing the environment of only one country, one can get lost in its inherent idiosyncrasies and lose sight of the wider picture. This paragraph seeks to avoid that by looking at how other emerging economies fared during the same time period: how their FDI inflow evolved (especially from the European Union) and how they were affected by the global macroeconomic environment (chiefly the aftermath of the financial crisis and the commodities prices collapse of 2014).

Firstly, it is worth laying out our choice of comparison countries. Besides the broader discussion of emerging markets, this section will establish a comparison between the situation in Russia and that of Brazil, India, Turkey and South Africa. These countries have been chosen for their similarities with Russia in several different general macro metrics; three of them are also members of the BRICS while Turkey shares Russian dependence on the EU and similarly close economic ties. All chosen countries have substantial commodity exports although, according to UNCTAD, Russia is the most dependent on commodities, which made up 76% of exports in 2017 (compared to around 60% for Brazil and South Africa, 39% for India and 22% for Turkey). The predominance of oil further enhances vulnerability to the oil price.

Secondly, it is worth looking at the overall evolution of emerging markets in the past decade. In this regard, it is important to note that this is thought to encompass a period of relative calm with no excessive contagion across countries or regions. In fact, Dabrowski (2019) finds former Soviet Union countries to be the only ones which seriously experienced “intra-regional” contagion, both in 2008–2009 and in 2014–2016. While average annualized growth of Russian nominal GDP (in dollars) was slightly negative throughout the period, it was in low single digits in Turkey, Brazil and South Africa. India vastly outperformed the others.

Thirdly, the relevance of the GFC remains significant throughout emerging markets, even though they were proportionately less affected than during past episodes. After all, the decline in global demand hurt commodity prices and the global surge towards safe assets caused large capital outflows from emerging economies, causing widespread depreciation. Turbulence in financial markets further raised risk premiums on emerging market debt. Dabrowski (2019) finds the former Soviet Union and Latin America to have been particularly affected, as was Turkey. Indeed, Russia, Brazil and Turkey saw significant falls in FDI inflows (as can be seen in Fig. 8 and will be explored below).

Additionally, the collapse in commodity prices in 2014–2016 had an important impact on emerging market economies, where commodity exports are on average a much larger percentage of economic output. While this signifies a period of important shock, Dabrowski (2019) does find that the economic fallout was more reduced than following previous episodes of oil price decline, largely given stronger macroeconomic fundamentals and the development of systems more adapt at dealing with these episodes (build-up of reserves, less constrained exchanged rates, etc.). That said, the shock was most severe for exporters of oil, which made Russia increasingly vulnerable.

Finally, these episodes had an important effect on FDI inflows into these countries; a closer look at the data is warranted. This analysis will focus on FDI from the EU for the sake of consistency. As is evident on Fig. 9, India and South Africa enjoy a much less developed investment relationship with the EU (in relation to their GDP) than Russia. This is unsurprising; the geographical and cultural ties between the EU and Russia have allowed for stronger commercial and investment flows. What remains more striking is the role played by Brazil. As of 2017, Brazil and Turkey remained en par in terms of EU ownership of their FDI stock, both above Russia. In fact, while Brazil and Russia were at around the same values in 2009, Brazil has now surpassed Russia by around 7 percentage points (or over 30 percent). More generally, of the five countries, Russia is the one that sees the lowest growth in FDI stock. It grew by only 83% between 2008 and 2017, in comparison to 222% for Brazil or 303% for India.

Fig. 9.

EU FDI flows (a) and EU FDI stocks (b) (% of GDP).

Note: Data for Brazil, India, Russia, Turkey and South Africa. Source: European Commission Finflows (Joint JRC-DG ECFIN database).

At the same time, while the volatility of FDI flows can cloud underlying trends, of all the countries examined Brazil is the only one that receives positive gross flows every single year; values for the rest fluctuate with periods of negative flows (especially South Africa and Russia). This can explain Brazil’s build-up vis-à-vis the rest. Finally, this comparison allows for an analysis of the relative volatility of FDI flows into Russia. By calculating the standard deviation of FDI flows, we can see that Russia (at 13.2 billion) ranks second in terms of volatility after Brazil (at 17.4 billion) and much higher than India or Turkey which stand at 4 billion.

Furthermore, the effects of the GFC of 2008-9 are evident for all the examined countries. Russia’s values are fairly standard in this regard (albeit more pronounced in stocks than in flows). As was explained below, the effects were more strongly felt in EMEA (Europe, Middle East and Africa) and Latin America, which partially explains why India was the least affected. In contrast, Russia appears to be the most affected by the commodities price collapse of 2014. Given their much higher reliance on oil exports, this is unsurprising, especially when in tandem with the other previously described drivers. Only India also experienced a fall in flows that year, a fall which was much more limited. That said, South Africa did see a significant fall in 2016 which is thought to be partially attributable to the same episode. It is worth noting that their reliance on commodity exports is also high, albeit smaller.

Finally, FDI is only one category of investment, which in itself is only one aspect of bilateral economic relations (the other prominent category being trade). Economic relations are further affected by institutional structures, or the lack thereof, that facilitate cross-border operations. This sub-section thus explores the relation between FDI and other economic ties, chiefly trade, as well as how FDI has been affected by the institutional obstacles to a deeper relationship.

Firstly, it is important to mention that FDI and trade generally enjoy a deep level of interrelation, which has been widely established. After all, FDI provides foreign players with a domestic infrastructure that facilitates operations and can even serve as a substitute for trade when regulation so dictates. FDI can thus signal an investment into the medium-term commercial relation. Lukewarm FDI numbers between the EU and Russia are thus related to the fact that trade in goods between them has been falling for the past decade, with both gross imports and gross exports decreasing by almost a quarter between 2008 and 2018. Furthermore, in 2018 oils and mineral fuels¹⁴ (one of the 97 categories established by the World Bank) accounted for over three quarters of Russian exports to the EU. This is in line with FDI patterns and another sign of the existence of few other areas of competitive economic activity in Russia.

At the same time, in the economic literature, the growth effects of FDI have been found to be mostly originating from knowledge transfers and spillovers.¹⁵ A wide concentration of both trade and FDI in the energy sector indicates foreign players are clearly focused on this area. They are concerned almost exclusively with extraction, i.e. the acquisition of access to a raw material. This form of FDI rarely provides spillovers and as such has a much more limited effect on growth. On the contrary, FDI into manufacturing by multi-national enterprises could incorporate the Russian economy into global value chains and result in tacit transfers of knowledge and technology, for considerable growth benefits. Furthermore, FDI into other industries is likely to be less volatile as it will not be as heavily determined by the performance of the oil markets (as such, it should make a positive contribution to macroeconomic stability). It would further diversify exports from oil into higher value-added (and differentiated) sectors. Deepening trade relations in these sectors would then provide an opportunity to attract other forms of FDI, continuing the virtuous circle. However, Russia has high barriers to trade, mainly of non-tariff character, which means it offers little incentive for wider investments.

With that in mind, it is worth looking at the more institutional obstacles to economic relations. Overall, the environment is characterized by a lack of institutional infrastructure and recent hostility, complicating the development of closer ties.

Firstly, the Russian Federation only entered the WTO in 2012. It has also only concluded trade agreements with 10 countries, mostly from the Commonwealth of Independent States (CIS). In 2017, these free trade agreements covered only 11% of Russian exports, while EU-28 trade accounted for more than half of Russia’s exports. The comparative advantages of the other members of the CIS are very similar to Russia’s, with economies mostly exporting natural resources, reducing the economic value of mutual trade.¹⁶ More importantly, given the context of this paper, there is virtually no opportunity for knowledge transfer through FDI from these economies. Furthermore, according to the World Bank’s Doing Business report of 2018, Russia has the highest cost of border compliance in its region, which is 6.7 times the EU average for exports and as high as 17 times the EU average for imports.¹⁷ These trade impediments together with poor protection of property rights, exchange rate volatility, and the very high level of corruption mean that Russia, despite its generally high level of education, post-Soviet industrial base, and relatively large internal market, is often not an attractive market for foreign investment into global manufacturing.

Secondly, recent years have been characterized by political hostility between Russia and the West resulting in damaging economic sanctions (and the looming threat thereof) that reduced the attractiveness of the Russian market for foreign investors at a time that was presenting important opportunities for diversification. This was both because of the growing practical difficulties of investing (medium and long-term financing has been targeted), increased barriers to trade that make Russia a less attractive manufacturing hub and the overall damage to the growth potential of the Russian economy. Sanctions and ensuing tensions have a negative effect on FDI, especially beyond the energy sector, both reducing overall FDI and raising the importance of this sector further.

It is difficult to disentangle the effects of Western sanctions introduced following the annexation of Crimea in 2014 from the other factors. Nonetheless, the IMF (2015) found their immediate effect to be a 1–1.5% drag on GDP with a possible cumulative drag of 9% in the long-term (which others have estimated to be around 6%). Similarly, World Bank (2016) estimates indicate the removal of sanctions would have resulted in 0.9 pp. higher growth in 2017. Furthermore, the impact on the financial system was undoubtedly larger: the closure of international capital markets at a time of currency crisis for Russian banks aggravated the financial situation, resulting in large bailouts by the central bank and the National Wealth Fund.

The new rounds of US sanctions in 2018 had a limited effect but were targeted at Russian elites. Both episodes were followed by minor rouble depreciation, which nonetheless coincided with a time of generalized capital outflow from emerging markets. Finally, the possibility of future sanctions deters investors given the potential legal uncertainty.