By Robert Skidelsky and Pavel Erochkine
Is capital flight a problem for Russia? Most people would say “yes” and would regard the recent reversal of capital flight as a positive sign for the Russian economy. But there is another school of thought that believes that capital movements should be a matter of complete indifference and certainly not the object of government concern.
In the decade following the fall of communism, money poured out of Russia. Although unreliable, estimates suggest that, in the 1990s, capital flight was $20 billion to $30 billion per year on average. The Economic Development and Trade Ministry, for example, thinks that $210 billion to $230 billion left Russia during the reforms, approximately half of which was “dirty” money, linked to money laundering or organized crime. The IMF’s estimate is that $170 billion escaped the country between 1994 and 2001. Other sources suggest that around $300 billion of assets in the West belong to Russian citizens, almost half of which were bought on money from “uncertain” sources.
This has been usually interpreted as a vote of no confidence in Russia. Investing money in Russia was just too risky. Poorly protected property rights (particularly for equities), a punitive and highly unpredictable tax system, uncertainty, the need to legalize legal or semi-legal money and so on encouraged people to find ways to move money abroad. Thus, Russian capital went to countries with better conditions for secure holding of assets and for profitable and reliable investments. According to this view, 1990s capital flight was largely caused by country-specific risks.
During the past year or two, there have been some signs of a reverse flow (although the latest data is not so promising) – a sign of growing confidence in the Russian economy. Interestingly, in the first half of 2001, almost 20 percent of money invested in the Russian economy (excluding the financial sector) came from Cyprus (which has a double-tax treaty with Russia and is used as an offshore center by many Russian companies and individuals), 13 percent from United States and 10 percent from Switzerland.
Why is capital returning? One of the reasons is that the risk-to-return ratio in Russia has improved as many of the country-specific risks have been minimized and new opportunities for investment have appeared. Also, it is very difficult for Russian businesspeople to invest money in new businesses abroad because, in the West, competition is strong, markets are complex and Russian entrepreneurs lack Western business experience. Thus, money can only be put in cash, equities, bonds or property and, on average, it is very difficult for an investor to earn more than 5 to 10 percent interest per year. Finally, it still makes sense for some people to take money abroad and then reinvest it as a foreign investor, which can provide anonymity and better security.
The second school of thought, which is well represented in the Kremlin, argues that one should be indifferent to what happens to the capital account. As a technical matter, savings and investment must always be equal, and net capital flows simply represent a balancing factor. Russia has more savings than can be absorbed by domestic investment, so it is natural that Russian savings are invested abroad, where they can earn a higher rate of return. The most recent data offers some support for this point of view: An influx of export revenues to Russia, it is argued, caused a rise in capital flight in the fourth quarter of 2002 simply because an improvement in one sector of the current account (oil) leads either to an offsetting deterioration in the rest of the current account or to an offsetting deterioration in the capital account.
The basis for saying that Russia has more savings than it can absorb is similar to the argument used for Saudi Arabia. Russia, it is said, is an oil economy and, apart from investments in the energy sector, the rest is like sand. But any comparison between Russia and Saudi Arabia is completely mad.
Russia is far more diversified than Saudi Arabia, with many potentially lucrative sectors (retail, foods, manufacturing). Russia needs an enormous amount of investment for modernizing its manufacturing sector and infrastructure. To say that investment in Russia on the scale needed may be currently unprofitable is not to say that the investment is not needed.
People who argue that investments are not needed if they are unprofitable confuse private and social rates of return. The social rate of return is the benefit of an investment to the society as a whole. In other words, it is return to the investor plus net effect of that investment on anyone else. Russia is a classic case where private rates of return are significantly below social rates of return, which means that many things like infrastructure are seriously undercapitalized. In the long run, this situation could develop into a self-reinforcing negative spiral, which would leave everyone worse off.
Capital controls are not an answer, not only because they could never be implemented, but because they will not deal with the underlying problem and will only distort financial markets. The focus should be on measures that will voluntarily attract both Russian and foreign money. What the government needs to do is to change the structure of incentives in a way that would bring the private rate of return closer to the social rate of return.
Some economists might suggest taxing oil companies, who are the biggest single source of capital. In theory, a one-off windfall tax on oil companies, justified by the acquisition of oil company assets at bargain-basement prices, could be a good move. This worked in Britain, and allowed Chancellor of the Exchequer Gordon Brown to raise revenues for his training-and-employment program. But, in Russia, any such tax would only encourage more capital flight.
The way forward is gradually to abandon open and hidden subsidies to unprofitable private and state-owned enterprises in order to let them die and to free resources, which could be invested in the infrastructure. Better infrastructure, supplemented by institutional reforms, will make it easier and more profitable to do business, and would thus attract investments to industries other than oil and gas. Once this process is started, it will be in business’ own interest to keep investments into infrastructure and the real economy flowing, strengthening the Russian economy further.
Any such measures must be complemented by the development and enforcement of property rights, particularly with regard to equity investments, the area most visible to foreign investors and policy-makers. And, in this, the authorities should definitely take a more active approach, starting with Unified Energy Systems and its planned restructuring.
Robert Skidelsky 