Bhanu Shandilya

The culmination of my Political Risk Analysis course, taught by Pamela Starr, at the University of Southern California is a report composed by me and two others, on the risks and uncertainties of investment in Russia. The report consists of a base case, three possible scenarios, and a recommendation to the client, a major political risk insurer. Throughout the course we explored drivers of political stability in different sectors of a country including the government, society, security, and the economy. My team did extensive research on the structural and temporal drivers of instability and their potential for impact on the value of foreign investment in Russia, a country heavily dependent on FDI. Some of the most relevant factors were the strength of the executive branch, societal divisions, and the structure of the economy. Through the course, and especially the compilation of this report, I gained great insight into the process of analyzing political risk and its importance on investing in emerging markets. Since in emerging markets, more so than in developed ones, political risk is very significant, this project is very relevant to the topic of this blog. Some of the issues raised were covered in a previous post titled Privatization Drive: Road to a Balanced Budget?, and many new topics were also discussed. Moving forward, I hope to be able to apply these skills in addition to my training in economics to shape well-informed investment strategies in emerging markets, or give advice to foreign investors through a consultancy. The assessments made in this report are an attempt to simulate real world prescriptions that would be given to a client looking to insure foreign investment in Russia, but can be used more generally to gain a clear picture of the potential risks and rewards to be had from investing in Russia and emerging markets in general. The report can be found below.

Final Project.doc

Brazil is the only one of the BRIC (Brazil, Russia, India, China) nations that has been left unaddressed so far in this blog, and here I look to address that omission. This rapidly-growing country, both in wealth and global presence, has received much-deserved publicity for its successful bid to host the 2014 FIFA World Cup and 2016 Olympics, but the recent wave of violence between Rio de Janeiro's drug traffickers threatens to erase the gains in international stature made by the city. Rival gangs engaged in a gunfight in the "Hill of Monkeys" slum in Rio's northern zone, shooting down a police helicopter and setting several buses on fire (pictured below). The violence resulted in the deaths of two police officers and ten members of the Comando Vermelho and Amigos dos Amigos gangs that initiated the violence, and left many more injured. A recent Economist article points to the presence of three major drug trafficking gangs and various militias in Rio, in contrast to other

The current administration understands the severity of the situation and has seemed motivated to take action. The tack the government has taken will however, be quite ineffective. Creating a greater police presence in the favelas, and arming them more heavily is not an effective answer to the problem, especially given the rampant corruption in the police force and its involvement with Rio's militias. Instead, it would be more effective to boost funding of social objectives, such as the government has done with the Favela-Bairro program, and better regulate the weapons trade. The government could spend the money much more effectively to legitimately provide social services instead of allowing the drug gangs and militias to do so. Cutting into their supplementary income that these groups generate through social services in the favelas would significantly diminish their profit margins. The government should also address the ease with which weapons are able to be procured by these gangsters. A large portion of these weapons are produced in Brazil and exported to Paraguay where they end up on the black market and are illegaly brought back into Brazil. Much more needs to be done to regulate the sale of small arms, which has become a lucrative business in countries like Brazil and Argentina. Greater cooperation and information exchange between  government agencies, and effective regulation will make it much more costly for drug gangs to procure weapons. This would have two major effects. First it would reduce the already slim profits experienced in the drug trade, and secondly it would reduce the incentive to engage in turf violence. The reduced profitability, limited means of encroaching on territories of other gangs, and the removal of supplementary income earned from offering social services, would leave the drug gangs in a precarious financial position with very slight profit margins, making it a much less alluring career for youngsters. Instead of aggressively fighting the drug gangs and militias, the military and federal police would be much better served in taking away their means to make profits and wage war amongst each other. The combination of these two policy actions would bring about the most effective change in terms of impact per dollar spent. The $50 million dollars President Lula has promised to law enforcement in Rio de Janeiro for the purchase of an armored helicopter, among other things, would be better spent funding social programs. The political obstacles to this are many corruption is rampant and eliminating these elements of society would cut a significant source of income for government officials. Not to mention that many of these officials were elected through strong-arming of voters by these groups.

The economic impact of the stabilization of crime and violence related to the illicit drug industry in Rio cannot be overstated. Firms are increasingly taking political risk into account in investments and anything the government can do to mitigate those risks would create a much friendlier environment for investors, bringing in much-needed capital and technology. Greater employment of the population in legitimate enterprises would also generate greater tax revenues which could be recycled back into social programs to aid the slum-dwelling populations. Government revenues from social services for the slum dwellers would also ensure that the programs are sustainable, and become a long term solution. The eradication of drug violence and exploitation of the slum-dwelling populations would reduce victims' healthcare costs, and the ability of drug traffickers and militias to engage in rent seeking and promote corruption in the police force. If these issues are addressed Rio could be able to attract much more investment, both foreign and domestic, to its major metropolitan areas, thereby improving the overall economic situation for its several million residents.

In an effort to move away from the Sino-Indian focus this blog is inadvertently taking, in this post I chose to comment on Russia's new drive for privatization in the wake of the country's first budget deficit in over a decade, as can be seen in the graph below. The expected sale of stakes in many important industries including oil, telecommunications, aviation and finance, could yield up to $2.3 billion. This newfound commitment to the market economy and relaxing of government controls comes as the state faces deep recession and a decline in oil prices, upon which the Kremlin relies heavily to fund its fiscal budget. These factors have been discussed widely following the announcement by Deputy Prime Minister Igor Shuvalov. However, Izabella Kaminska of the Financial Times Alphaville blog explores another interesting angle on the issue. She argues that it is "probably just as much a... public relations exercise as a state-dash for capital." Following the fiasco with the expulsion of William Browder, Russia's largest foreign investor, and the government disputes with TNK-BP and Shell, the Kremlin needs to drastically improve its image to attract more foreign investment. If the government is unable to respond adequately to these developments and investor sentiment doesn't improve dramatically, the resulting capital flight would be disastrous for Russia and its potential for future economic growth. In my comment on Kaminska's entry titled "Privyet Privatization," I attempt to examine further the Kremlin's aims in privatizing some of their crucial industries, and the potential outcomes if Russia is unable to address these issues in the near future. My comment can be found below and at the original Financial Times Alphaville entry linked above.

Comment:

This post raises some interesting questions about the motivation behind the Kremlin's move to privatize key industries and the timing of the announcement. As the yield from the sale of public assets would hardly dent the deficit if estimates of the deficit reaching 7.8% of GDP for the year hold, it definitely would seem that there must be other motives prompting the government to initiate this second round of sell-offs. It is clear that the Russian economy is very dependent on foreign investment and technology for growth and the further development of key industries.What is less clear however is how much this round of privatization will actually do to assuage investor fears and convince the West of Russia's new liberalism in the economy. Additionally, I am interested to hear your opinion on whether selling public assets during a recession is in the best interest of the state. How will the state justify selling $2.3 billion worth of assets at bargain prices when it will have at best a minor impact on the current deficit, especially when Russia is expected to face an only slightly lower deficit in 2010? In your opinion, will this privatization drive truly restore investor confidence in Russia going forward?

Another important issue is whether Russia will be able to reign in the fiscal deficit in the next few years. With the recent technological advances in "horizontal drilling which allows companies to extract gas... from shale," of which there are large fields in Poland and Estonia, the prospects for Russia's natural gas industry are grim. If Europe reduces its dependency on natural gas from Russia, which has historically been a concern for energy security anyway, government revenues from oil and gas would be significantly impacted. These revenues account for over 40% of total state revenues, depending on the estimates used. If the natural gas from shale fields proves to be viable, the Russian government will undoubtedly need to make significant changes in its budgetary policy with the projected drop in natural gas revenues. Still, it will be difficult to cut down spending during a recession and further privatization is unlikely to completely address the issue. With these developments in mind, what do you think is the likelihood of continued deficit spending, and will it lead to a crisis on the scale of the one in 1998, or will this round of privatization be enough to prevent capital flight?

This week I have chosen to explore the World Wide Web for resources and sites that would be valuable in further interrogating the issues raised in this blog. Since not all sites and blogs are created equal, in this entry I have sought to compile a list of the most reliable, accurate and stimulating resources I was able to find on the Web that relate to policy and economics in emerging markets. A compilation of these links can be found in the "Recommended Sites" section. Of greatest assistance in locating these sites were directories, meta-engines, and blog search engines. The Librarians' Internet Index, Metacrawler, Technorati and Blog Flux yielded the most fruitful results when evaluated against the Webby Awards and the 21st Century Information Fluency criteria. The former provided a framework to judge the content, structure, visual design and functionality of the sites, while the latter has a very useful methodology for evaluating the blogger, his or her influence and bias, and the depth and timeliness of the blog content. Using these search tools and guidelines, I found that AmosWEB was the most helpful and easy-to-use economics reference site. This site is good for a quick tutorial or simply a refresher of key concepts and terms so that a proactive reader could fully utilize the information available on the Web dealing with this subject. The Economist, Financial Times, Portfolio (formerly Condé Nast Portfolio) and The Wall Street Journal are a great places to begin the exploration of current trends and market-shaping events in business and finance. These are all major publications that can serve as a portal to deeper examination of the global political economy. For sites with excellent data and analysis focused more on up-and-coming economies, take a look at EIN Emerging Market News, Forbes Emerging Markets, Goldman Sachs BRICs, and 2point6billion. The Asian Development Bank and the World Bank provide exceptional resources for more advanced research on financial institutions, market data and statistics, with economic outlook and predictions. Further scouring of blog engines and various "Blogrolls" yielded the following four blogs that I found most relevant: Emerging Markets EconoMonitor, Foreign Policy Passport, NPR's Planet Money, and Ambrose Evans-Pritchard's Commentary page at Telegraph.co.uk. These blogs host a substantial amount of relevant and timely material that will broaden the readers' views in the subject. Hopefully these sites and blogs will provide the reader with adequate resources to engage in the discourse I wish to create on this site and propagate interest in emerging economies and their growing importance.

Mark Crosby's post at the Core Economics blog raises some valid points regarding the different development paths that China and India have experienced while starting from a very similar base 30 years ago. While both nations have experienced extraordinary growth, Crosby assesses several factors that have led to the growing income gap between China and India. China has experienced an average of 9.9% growth in GDP since the late 1970s when economic reforms began to take place, whereas India has experienced similar growth only in the past decade. As Crosby points out, "today China's per capita purchasing power is more than double the level in India." The disparity does not end there. Exports from India account for only 1% of the world total compared to 6% for China, and India's foreign exchange reserves are less than a sixth of China's. For more comparisons take a look at Deutsche Bank's visual essay comparing China and India's economies. It is a little dated, but still very interesting to see how two states with similar characteristics such as population, natural resources, climate, and even history could enter such varied trajectories of development. Inspired by Crosby's post, this week I consider some of the core differences between China and India, from the systemic to the cultural in comments that can be found below or at the Core Economics blog entry, which I would definitely recommend reading.

Comment:
This entry raises a very interesting question. Why has China's economy so significantly outpaced that of India's in the last several decades? The levels of education, infrastructure and openness to trade have clearly played a major role in the widening income gap between India and China. Your example of miles of roads built is particularly striking. As one who has traveled by car in both countries I would also point out that the quality of roads in China are far superior as well. Then there is the issue of openness to trade. India offers relatively high levels of protection to many major industries and still eschews the virtues of a self-sufficient economy. High tariff levels and domestic subsidies are quite popular with Indian politicians. Anecdotally at least, the Indian politicians' penchant for protectionism is evidenced by the fact that in the second half of 2008 India initiated the most anti-dumping investigations in the WTO.

As you point out, India's political systems has played a major role in the level of infrastructure and openness to trade. I am interested to learn your thoughts on how dramatic economic growth can be achieved without sacrificing democratic principles as China and Russia have done. It is worth mentioning that though some have come to blame India's liberal political system as a hindrance to economic growth, it is precisely the reason Yasheng Huang and Tarun Khanna, of M.I.T Sloan School of Management and Harvard Business School respectively, write India will eventually overtake China economically in their Foreign Policy article. Personally, I think it would be best to deal with corruption, reduce the size of the enormous bureaucracy and improve the efficiency of tax collection. Granted, short term economic costs of such actions would be significant, but they would invite greater FDI and reduce the fiscal deficit. However, these changes are unlikely to come with the current survivalist mentality of Indian politicians and difficulties of implementing long term infrastructure projects will likely still remain. For these reasons I would like to ask what is your outlook for the near term for India's growth, or more specifically, will the necessary improvements in infrastructure and education be made? And if so, how will this be possible given the political obstacles?

Analysts have been predicting a boom in Chinese consumption for years, but scenes such as the image on the right of bustling marketplaces, have yet to sweep the nation. In fact consumption growth has remained stable or even declined. The government's ineffectiveness in boosting consumer demand is due in large part to a severe underestimation of the underlying economic factors. Michael Pettis' and Patrick Chovanec have outlined these factors in great detail in several articles. Pettis points out that consumption has been suppressed due to low interest rates on deposits, limitations on consumer financing, as well as low wages. The state-run banks have been so engrossed with lending to the manufacturing industry that consumer financing is not easily available and the economic stimulus has done little to rectify this situation. Funds have merely been diverted from a manufacturing sector that is facing serious problems of overcapacity to construction of infrastructure with only a small percentage of funds going towards subsidizing consumption. Another problem Chovanec points out is that little of what is produced in China actually ends up on the domestic market as Chinese manufacturers are deeply embedded in global supply chains. While China accounts for 12% of total world production, it only consumes around 3%.  They do not have their own domestic sales and distribution channels, and even when domestically produced goods do make it to the Chinese market, they are often more expensive because they have to be re-imported.

Both Pettis and Chovanec correctly assess the underlying economic factors that contribute to low consumption and predict that the stimulus will fail to boost domestic demand in the long term. However, it is important to recognize the political factors behind China's inability to spur domestic growth. The government's immediate concern leading up to the announcement of the stimulus was not to alter long-term consumption but to maintain the status quo. Fearing political instability and social unrest as a result of high unemployment and the crashing Shanghai Stock Exchange, politicians in Beijing moved quickly to introduce a stimulus package that created jobs and boosted liquidity in the market. The dramatic structural upheaval of the sort espoused by several analysts, including Chovanec and Pettis, was never actually feasible for a government preoccupied with maintaining stability and preventing social unrest. For the near term, government policy will to continue to promote rapid growth even at the cost of heavy dependence on foreign markets. Officials in Beijing have reported that at minimum, 6% annual growth is needed to "prevent major social disruptions," and that threshold is likely to remain the target for the near future. For the long term, this plan is not without merit. If China is able to sustain growth for the next 10 to 15 years, the social and political unrest that will theoretically accompany reforms in the economic system will be much more manageable. Ian Bremmer makes a similar argument in his book The J Curve. The curve, pictured below, illustrates the positive correlation between stability and a state's openness, except at the extreme left of the curve where a state is able to maintain stability by having an extremely closed society, much like the China or Cuba.

The argument goes on to state that as a nation moves towards greater openness in society and the economy, it will go through a stage of great instability, before eventually reaping the benefits of openness. One important thing to note is that the whole curve can move up or down based on factors such as income. This implies that with greater income a country can achieve higher stability at every level of openness on the graph. In applying this model to China, it becomes apparent that the optimal path for the government to maintain stability while implementing the necessary changes to the economic system necessitates that it maintain high levels of economic growth first, as it has done with the economic stimulus. Once the curve is moved sufficiently high, the transition period Bremmer warns of will be made much more stable. As the government becomes more confident in its ability to maintain order during transition, it will be much easier to make the structural changes promoted by many experts on China's economy.

The reality remains that political reform and increased openness are highly improbable in the short term. Hope for significant change must rest on continued growth in national income for the short-term. In achieving this goal the economic stimulus has been a resounding success. The international community's best hope is that as the population becomes richer and more educated overall, it will be less tolerant of economic policies favoring large industries and manufacturing. Just as Pettis, Chovanec and several others have pointed out, the banks will have to move away from asset-heavy financing which favors the manufacturing over the service sector, and consumer lending must become easier and more widely available. Shifting away from export manufacturing will make goods more readily available in domestic markets at cheaper rates. Combined with more widely available and cheaper consumer financing, consumption will be poised to grow at unprecedented rates. None of these changes are likely to come in the short-term and the process is sure to be long and arduous, but one that is absolutely necessary if China is to unlock its full economic potential.