Russian Institutional Development: Challenges to Inbound Investments and Implications

Russian Institutional Development: Challenges to Inbound Investments and Implications for Government Policymakers

Dr. Andrey Yukhanaev*

Newcastle Business School, Northumbria University, City Campus East, Newcastle-upon-Tyne, NE1 8ST, UK E-mail: [email protected] * Corresponding author

Dr. Áron Perényi

Swinburne Business School, Swinburne University of Technology, John Street, Hawthorn, VIC 3122, Australia E-mail: [email protected]

Dr. Grahame Fallon

Brunel Business School, Brunel University, Uxbridge, UB8 3PH, UK E-mail: [email protected] Dr. Joanne Roberts Winchester School of Art, University of Southampton, Park Ave, Winchester, Hampshire, SO23 8DL, UK E-mail: [email protected]

Abstract: This paper sets out to contribute to the literature by investigating the institutional arrangements facing investors in Russia, the extent to which they had been reformed, and the resultant impact on the willingness of foreign-owned TNCs to commit inbound foreign direct investment (IFDI) to this high-risk transition economy. The degree to which institutional factors explain Russia's persistent underperformance in terms of IFDI is assessed through the review of the academic literature and other documentary sources. Making use of the Corruption Perception Index, Ease of Doing Business, World Governance Indicators and Index of Economic Freedom (IEF) data, we analyse the provenance of Russia’s IFDI-related institutional reforms since the late nineteen nineties until the end of 2013. Given the international isolation of Russia after its annexation of the Crimea and the collapse of the oil price, the paper argues that in order to achieve a sustainable economic development, the Russian government must implement substantial shifts in the design and functioning of its national institutions.

Keywords: Institutional transformation; Economic development; New Institutional Economics; NIE; transition economies; emerging markets; path-dependence; inbound foreign direct investment; IFDI; Transnational Corporations; TNC; Index of Economic Freedom; IEF; ease of doing business; Reforms; Distrust; Russia.

1 Biographical notes: Dr. Andrey Yukhanaev is employed within Faculty of Business and Law of Northumbria University. His current role is a Senior Lecturer in Strategic Management and International Business and he is also responsible for development of collaborative ventures with Russian universities and organisations. He holds a Master of Business Administration degree from Northumbria University and PhD from the Russian Presidential Academy of National Economy and Public Administration. Andrey is an active researcher and his main academic interests are in the areas of international business strategies in emerging economies, institutional economics, corporate governance, transnational corporations and international development. Dr. Áron Perényi is a tenured academic in international business at the Department of Leadership and Management, Swinburne University of Technology, and adjunct to the Department of Economics, Budapest University of Technology and Economics. His research interests are small firm life cycle and growth, leadership, ethics and economic development. His projects involve the Australian and Hungarian small business communities, the Victorian Indigenous community, senior entrepreneurs in Australia; and businesses, governments and civil society across Central and Eastern Europe. His professional memberships include AIB, AIB-CEE, ANZAM, EURAM and the Hungarian Economic Association. He is active in PhD supervision and scholarly peer-reviewing.

Dr. Grahame Fallon is a Senior Lecturer in International Business in Brunel Business School, where he is also MSc in Management Course Director. He has been working in the UK university sector since 1984, holding lecturing posts in international business and related subjects at Glamorgan, UWIC and Northampton universities, and a range of external examiner roles. His research interests include the causes and economic effects of inward and outward foreign direct investment in the EU, Eastern Europe, Russia and China, and the impact of business on peace-building in Europe and Asia.

Dr. Joanne Roberts is Professor in Arts and Cultural Management at Winchester School of Art, University of Southampton, UK. She gained her doctorate at the Centre for Urban and Regional Development Studies, Newcastle University, UK, and she has held academic posts at Durham University, Newcastle University, and Northumbria University, UK. Her areas of expertise include international business, innovation, and knowledge production and transfer. Joanne has an international research reputation in the internationalisation of services and knowledge pertaining to the luxury branding sector. She is an active member of several national and international scholarly networks, including the Academy of International Business, the Critical Management Studies network, the British Academy of Management and the European Dynamics of Institutions and Markets in Europe Network of Excellence.

2 1. Introduction Institutional transformation, both formal and informal is at the heart of the current policy debate on how to promote economic, political and business development and to attract increasing flows of inbound FDI (IFDI) to Russia. The existing international business literature has recently placed an increasing emphasis on the importance of institutional theory in exploring the impact of environmental uncertainties on the location and performance of IFDI by foreign-owned transnational corporations (TNCs) (Bevan, Estrin and Meyer, 2004; Peng, Wang and Jiang, 2008; inter alia). However, research on the impact of imperfect institutions on IFDI location in the emerging market and transition economy context still remains relatively underdeveloped. Demirbag et al. (2007, p. 311) highlight the potential significance of new contextual contributions to this field, by pointing out that …‘a better understanding of the way that host country specific …and institutional factors impact on TNC [location and] affiliate performance in emerging economies will assist officials in setting policy and TNC managers and their local business partners with strategic decisions…’.

The Russian Federation – as one of the renown BRICs countries (Wilson and Purushothaman, 2003) – has demonstrated a unique path in terms of the development of its institutional configuration, since its embarking on the process of economic, social and political transition (Kornai, 2000). The importance of evaluating the performance of the Russian institutional framework in terms of economic development, and particularly through the impact of incoming foreign direct investment (IFDI) is twofold: (1) it gives a basis to evaluate the criticism received by Russian government actions and (2) it explores the evolution of an institutional alternative to market and investment based open (liberal) economic development models. The research question addressed is ‘whether and how institutional evolution moderated the ability of IFDI in Russia to further economic development?’

Specifically, this paper sets out to contribute to the literature in this field by investigating the formal and informal institutional arrangements facing inward investors in Putin’s Russia up until the end of 2013, the extent to which they had been reformed since the late nineteen nineties, and the resultant impact on Russia’s inward investment climate. The implications for future IFDI-related institutional reforms by the Russian government are also explored and debated. In so doing, the need to create a sustained coalition of support on the part of Russia’s bureaucratic and business elites is highlighted as a necessary condition for the successful implementation of these reforms, and the significant increase in IFDI flows that such reforms could stimulate. Research studies of this kind have been relatively few in number, yet institutional challenges still face inward investors in Russia, and the issues facing the Russian government regarding institutional reform makes such an analysis and debate potentially interesting and provocative. Notwithstanding the events of 2014, including Russia’s annexation of the Crimea and her support for pro-Russia separatists in the Ukraine - resulting in increased international isolation, together with the depreciation of the Rouble against the US dollar by 50% due to the collapse of the oil price (Evans-Pritchard, 2014), there remain lessons to be learned from the evolution of Russia’s institutional structures for academic researchers, government policymakers and international business practitioners.

The paper begins with a discussion of Russia’s political economy, its recent inward investment record, and its advantages and disadvantages as a location for IFDI. It goes on to explore the institutional issues affecting IFDI in transition economies such as Russia, using a conceptual framework derived from new institutional economic (NIE) theory. The paper next

3 considers Russia’s distinctive institutional framework, its communist-era origins and the resultant influences and constraints on domestic businesses, foreign-owned TNCs and IFDI during the post-communist era. Making use of published longitudinal Index of Economic Freedom (IEF) data the provenance of Russia’s institutional reforms, together with their impact on the development of the country’s inward investment climate since the late nineteen nineties is assessed. The paper concludes by arguing that, in order to achieve a substantial increase the quantity and quality of IFDI, the Russian government must implement substantial neo-liberal economic shifts in the design and functioning of its national institutions. These structural reforms should be aimed at radical increasing of innovative capacity within the economy, labour productivity and freedom of enterprise together with eradication of financial market and regulatory inefficiencies, government interventionist, trade restriction and overbureaucratisation policies. Sustained support must be secured from Russia’s bureaucratic and business elites if these reforms are to be implemented successfully and extensively.

2. Economic development in an evolving institutional framework

There is broad and detailed literature on the various facets of economic development (Grabowski, Self and Shields, 2006; Griffin, 1999; Nafziger, 2012; Roy, Blomqvist and Clark, 2012; Todaro and Smith, 2009), including the role of foreign direct investment, institutions and regulations (see Figure 1). Regulations and Institutions are inevitable and inseparable elements of the global economic framework. Their effects on FDI and economic development are illustrated by a wide range of conceptual and empirical studies (El Said and McDonald, 2002; Espana, Nicholson and de Pineres, 2000; Jung-Chin et al., 2008; Witherall, 1997).

------Put Figure 1 here ------

Chang (2004) specifically highlights the controversy in relation to foreign investment regulation and economic development of countries today considered to be highly developed ‘…during their early stages of development, now-developed countries systematically discriminated between domestic and foreign investors in their industrial policy’ [Chang, (2004), p. 688]. It is within this context, that Lall and Narula (2004) urge the re-thinking or re-conceptualisation of the way economic development is impacted by FDI. Kennedy, Bardy and Rubens (2012) identify a set of hypernorms (various freedoms, transparency, security, participative decision making, etc.), which result in spillovers that enhance the impact of FDI on economic development. Meyer and Sinani (2009) for example point out that FDI is a source of advanced technologies and managerial knowledge, but the impact of these can be moderated by the host country development level. This results in a unique investment development path (IDP) for every country (Alcaraz, Vargas and Molina Martínez, 2012). Narula and Dunning (2010) identify five stages of the IDP, characterising countries at different development levels. The spillovers and developmental effects of IFDI in Russia – as a middle income country – hinge upon local companies acting as competitors to foreign businesses (López Castellano and García-Quero, 2012) so spillovers are less in relation to the technology gap (Borensztein, Gregorio and Lee, 1998) or financial markets (Alfaro et al., 2004), but more related to the institutional parameters (Meyer and Sinani, 2009). The role of foreign firms (through IFDI) conveying positive impact on economic transformation is argued by Choong (2012) in developing and by Akbara and McBride (2004) in transitional

4 economies, through institutional factors (Kennedy, Bardy and Rubens, 2012). In fact, Chang (2011) suggests reciprocal relationships between economic development and institutions.

Dobusch and Kapeller (2012) place institutionalism and evolutionary approaches at the boundary of mainstream economic development theory centred around neoclassical orthodoxy. Upon reviewing the institutional paradigm, López Castellano and García-Quero (2012) distinguish between two different schools of thought: the New Institutional Economics (NIE) and the Institutional Political Economy (IPE). NIE is generally viewed as the offspring of the ‘Western’ market economy based schools of thought, whilst IPE has been presenting an alternative understanding branded by Karl Marx, Thornstein Weblen or Karl Polanyi (López Castellano and García-Quero, 2012).

3. Russia – The unique case of institutional evolution

This section provides an overview of Russia, from the institutional perspective, particularly investigating the impact of IFDI on economic development. In order to understand this effect, IFDI in Russia is reviewed from the perspective of Institutional Political Economy. In the following, as an important component of Russia’s development trajectory, the effect of transition on Russian institutions and development is addressed. This is followed by the evaluation of the institutional framework from the perspective of the individual actors of IFDI: multinational companies. In particular, the role of institutional inefficiencies – such as corruption – is presented within the case of Russia, to demonstrate how IFDI and MNCs are impacted. The case concludes with the evaluation of the reforms Russian institutions have undergone, in an endeavour to demonstrate what changes have subsequently befallen Russian IFDI, and prospective economic development.

3.2 Russia - political economy and inbound IFDI The Russian Federation is currently undergoing transition towards advanced market economy status, characterised by what some commentators see as increasing political stability, growing institutional trust, regulatory efficiency, transparency and an increasingly investor friendly business environment (Castiglione et al., 2012). Economic and institutional reform in Russia can still most accurately be viewed as work in progress, having been constrained by Russia’s history, culture and path-dependencies following on from the communist period, as well as by the political and economic realities faced and programmes pursued by presidents Putin and Medvedev during their years in power (Sakwa, 2007; Aslund, 2010; Gaddy and Ickes, 2010). Leading international commentators (including the World Bank, 2013) therefore argue that further structural and institutional reforms are needed to improve Russia’s investment climate and to raise future inflows of FDI.

For many foreign direct investors the country continues to have a controversial image. Despite the numerous reforms and substantial socio-economic realignment in the past two decades, Russia continues to be perceived by many as a riddle wrapped in a mystery inside an enigma (Churchill, 1939). With its growing economy, enormous mineral and human resource potential, emerging industries and burgeoning consumer markets, Russia represents a potentially attractive location for inward investors, yet one still seen as high risk by many commentators (PWC, 2011) owing to its problematic institutional and regulatory environment (Badunenko and Tochkov, 2010). Russia’s institutional arrangements and their impact on international businesses also remains a complex phenomenon for researchers, institutional investors, and foreign-owned TNCs (McCarthy and Puffer, 2013). The daunting complexity of the institutional challenges that face such TNCs in contemporary Russia,

5 together with the resultant impact on the strategic behaviour of their Russian subsidiaries, and on their willingness to commit IFDI to Russia therefore provides the central focus of this paper. Russia has performed relatively well in terms of economic growth since 2000, fuelled largely through sales of oil and gas to world markets (UNCTAD, 2013), but the essential underpinnings for its continued market-led transition and long-term economic development are not yet fully in place (Heritage Foundation, 2013). This is borne out by the detrimental impact of the significant oil price decline in 2014 on the country’s insufficiently diversified economy. Russia’s economic conditions are reflected in the scale and characteristics of its FDI inflows. The period from 2000 until the onset of the global economic crisis saw a considerable growth in both inflows and outflows of FDI, enabling Russia to become one of the leading inward investment locations in the world, and the fourth largest in Europe (Ernst and Young, 2011; UNCTAD, 2011). By 2013, Russia’s IFDI stock was eighteen times larger than at the end of 2000 (Bank of Russia, 2013), whilst it also became the second largest recipient (after China) of inward investment flows among the BRIC economies, over the same period (see Figure 2, below), when it accumulated a relatively high stock of IFDI (see Table 1). ------Put Figure 2 and Table 1 here ------

The Russian Direct Investment Fund (RDIF) (2012), a recently established institution charged with collecting and disseminating information among prospective foreign investors, argues that the country possesses a range of distinctive competitive advantages in attracting inbound FDI, reflecting the location, structure and performance of the country’s economy. Russia’s possession of the largest global landmass, the greatest share of the world’s natural resources and a geographical position making it a potentially valuable transport corridor between the East and the West all constitute significant advantages in attracting IFDI, in the RDIF’s (2012) view. Leading government and business commentators based outside Russia provide a less sanguine estimation of Russia’s attractions to IFDI. World Economic Forum (2013), for example lists a series of disadvantages faced by foreign-owned TNCs when undertaking inward investment in Russia, including its institutional weaknesses, limited innovative capacity, insufficient labour productivity, financial market inefficiencies and a lack of market competition. These perceived shortcomings, combined with the country’s underdeveloped anti-monopoly policies, continued restrictions on trade and foreign ownership and a lack of business confidence in its financial system, contribute to inefficient resource allocation, reducing productivity levels and thus limiting the growth in Russia’s IFDI flows (WEF, 2012).

Substantial amounts of market-seeking IFDI have nonetheless been drawn in to Russia over the past decade, as a result of its status as one of the fastest growing domestic markets in the world for much of this period, with high levels of growth in per capita income, improving living standards and disposable household incomes, and growing private consumption (Yukhanaev et al., 2014a). Russia’s role as a transport corridor between East and West, together with its geographical location in close proximity to the EU, Asia and the United States (the world’s largest markets) has also encouraged many foreign-owned TNCs to use it as a platform for inward investment and for the expansion of international trade (WEF, 2012).

Resource-seeking is the second major motive for IFDI in Russia, reflecting the fact that the country is still heavily dependent for its economic growth and development on natural

6 resource extraction, fossil fuel production, hydrocarbon revenues, and world energy prices (Puffer et al., 2007; Pestova et al., 2010). Substantial volumes of IFDI continue to be directed towards the primary sector of the Russian economy, particularly the extractive industries (Rosstat, 2013) (see Table 2). The Russian balance of trade is heavily dominated by exports of raw and semi-processed materials such as oil and gas (Figure 3), with oil, gas and metals together accounting for 73% of the country’s exports (Evans-Pritchard, 2014).

------Put Figure 3 and Table 2 here ------

Efficiency seeking IFDI is far less prominent in Russia, although the large size of its domestic market and that of the adjacent markets of the Commonwealth of Independent States (CIS) can contribute towards increasing production efficiency, by enabling foreign- owned TNCs to realize economies of scale and scope. However, Russia struggles to compete effectively for such IFDI, owing to its failure to match the goods and labour market efficiency of its BRIC country rivals, and its inability to equal the financial market development and technological sophistication that characterises many of the world’s more developed economies (Desai and Goldberg, 2007).

Russia might be expected to attract substantial amounts of strategic asset-seeking IFDI, owing to its legacy of highly educated human capital from the Soviet era, possession of the best educated labour force among the BRIC countries, and almost universal literacy (Ernst and Young, 2011). These conditions do indeed combine to make it a prospective provider of research innovations, technological know-how and scientific inventions for inward investors (WEF, 2012). However, Russia is still some distance from exploiting its potential in this area, since it continues to struggle to turn these advantages into commercial innovations (Michailova and Jormanainen, 2011). Foreign-owned TNCs’ problems with Russia’s institutional framework, and the resultant difficulties that they encounter in doing business in Russia (explored in greater detail below) also continue to deter potential strategic asset- (and, indeed efficiency-seeking) IFDI from entering the country (Kouznetsov, 2009) (see Figure 4).

Although IFDI flows into Russia fell steeply at the start of the global economic crisis of 2008-9 (UNCTAD, 2011) growth in annual inflows has since resumed. Although this represents a considerable achievement in difficult international economic times, there should also be a clear understanding that the continued dominance of market and resources seeking IFDI has inevitably led to a restriction of the resultant positive spill-over effects, transfer of management expertise, technological know-how transfer and the dissemination of superior knowledge into the wider Russian economy (Michailova and Jormanainen, 2011; Koveshnikov et al., 2012).

3.3 Institutional perspective on IFDI into transition economies such as Russia The importance of safe and reliable institutions, and institution-based attractiveness has received increasing scholarly attention in international business research following the rise of new institutional economics (Coase, 1937, 1960 and 2000; North, 1990; North and Thomas, 1973; Williamson, 1995 and 2000). There has been a recent focus on the role of institutions,

7 and related interactions between host countries and foreign investors in the transitional and postcommunist economy contexts (Bevan et al, 2004; Fabry and Zeghni, 2006). The effectiveness of institutional arrangements, their quality, and their implications for information flows, rational decision making and transaction costs figure prominently in the contemporary debate over the nature and determinants of FDI location in these settings (Meyer 2001; Ingram and Silverman, 2002; Jackson and Deeg, 2008; Portes and Smith; 2010).

However, there is no consensus on whether TNCs consider institutional underdevelopment as a factor that prevents them from doing business in a country or as an opportunity that can be exploited to their advantage (Jasson, 2007). Along the same lines, Bevan et al. (2004, p.47) argue that ‘while there is strong support for the proposition that institutions matter, there is little agreement on their relative importance when it comes to attracting inward investors’.

Nonetheless, the majority of studies agree that the quality of the institutional environment cannot be underestimated and is essential for legitimacy, reducing uncertainty, minimizing investment risks, and, improving interactions between policy-makers and other economic agents (Meyer, 2001; Kwok and Tadesse, 2006; Kouznetsov, 2009; Cantwell et al., 2010;). This view is also supported by the results of Ernst and Young’s (2011) global investor survey, which shows that among the most conducive conditions for FDIs is the transparency of political, legal and regulatory environments. Similarly, the World Economic Forum (2012), in an attempt to determine the most important factors that influence national competitiveness and incentives for FDI attraction, underlines the effective interplay between institutions, policies and the level of a country’s productivity.

North (1991, p. 97) defines institutions as ‘the humanly devised constraints that structure political, economic and social interactions. They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights)’. Elaborating on this further, Scott (1995, p. 33) argued that ‘institutions consist of cognitive, normative, and regulative structures and activities that provide stability and meaning to social behaviour. Institutions are transported by various carriers – cultures, structures, and routines – and they operate at multiple levels of jurisdiction’. Grogan and Moers (2001) argue that national institutions consist of two main elements- a set of state-driven formal institutions (including the rule of law) and a parallel set of informal institutions based on social conventions. Building on this classification, Ingram and Silverman (2002) propose a taxonomy comprising four different types of institutions: public-centralized - to do with state legislation, private-centralized - relate to organizational rules, public-decentralized - amounting to culture, and private-decentralized -concerning societal norms. At a more micro level, Portes and Smith (2010, p. 587) argue that ‘institutions represent the symbolic blueprint for organizations - they are the set of rules, written or informal, governing relationships among role occupants in organizations like the family, the schools and the other major areas of social life: polity, economy, religion, communications and information and leisure’.

Institutions play a very important role in the provision of market efficiency and facilitation of the low risk and low transaction cost business environment, that in turn, impact on the value creation process and business competitiveness (Ingram and Silverman, 2002; Meyer et al., 2009). They can be viewed as being deeply rooted in the geographical and cultural characteristics, social conventions, historical backgrounds and path dependencies to be found in different countries (Ghauri and Holstius, 1996; Fabry and Zeghni, 2006). National

8 institutions are as a result highly diversified, and may indeed prove difficult to change over time, globalisation and international business involvement notwithstanding (Rodrik et al., 2004). Cross- country variations in institutional frameworks lead to major implications for domestic and international businesses, since they impact on the relative ease of information flows, market transactions and the quality of interactions between economic agents and regulators. Efficient institutions can thus help to ensure a low risk and low transaction cost business environment, with benefits for value creation and business competitiveness on the part of foreign-owned TNCs and IFDI, whereas weaker institutional arrangements are likely to lead to greater risk and higher transactions costs (Ingram and Silverman, 2002; Meyer et al., 2009).

In the case of developed economies, well-functioning markets and efficient institutional arrangements tend to be taken for granted. In emerging market and transitional economies such as Russia, however, consideration of the quality of institutions is essential for effective IFDI location analysis and decision making on the part of foreign-owned TNCs (Meyer and Peng, 2005). Here, many of the formal institutions are still at a rudimentary stage of evolution, suffering from inefficiency, complexity and unpredictability (Demirbag et al., 2007; Yukhanaev et al., 2014b).

3.4 Russian institutional framework: challenges for TNCs and IFDI

Rent flows are a central feature of the modern Russian economy, governing and constraining not only social, economic and business relationships, but also the pace and limits to formal and informal institutional development (Aslund, 2004; Boone and Rodionov, 2002; Yakovlev, 2011). Hindrances to business and IFDI also include …‘resistance to change in the bureaucratic-administrative business culture, an undeveloped legal and financial infrastructure, excessive administrative discretion and corruption in government offices, restrictive taxation, high interest rates, inflation, and lack of management expertise’ [Puffer and McCarthy, (2001), p.29]. These institutional handicaps, together with the state’s inability to establish transparent, constructive and supportive ‘rules of the game’, continue to exert a direct influence on the ease of doing business, and to restrict information flows, transaction costs, investment risk estimation and political certainty in contemporary Russia (Fabry and Zeghni, 2006) thus creating a problematic environment for foreign-owned TNCs and IFDI.

The communist legacy of totalitarianism, ideological utopia and central planning in resource allocation and distribution has made a major contribution to the development of this environment, by creating path-dependencies that shape Russia’s contemporary institutional environment and its underdeveloped institutional architecture (Glinavos, 2010). An excessive government presence in today’s Russian economy has the result of perpetuating a large public sector, a lack of market competition and onerous regulations for business (Demirbas and Yukhanaev, 2011). The malfunctioning of public-centralized and public-decentralized institutions results in the continued state ownership of many key industries, regulative complexity and over-regulation, and constant bureaucratic interference with businesses (Heritage Foundation, 2013), including foreign-owned TNCs’ Russian subsidiaries.

Considerable institutional misalignments also arise from the sluggishness of ideological change in Russia’s society and inadequate systemic adjustments to the new, postcommunist economic realities of liberalism, market mechanisms, free choice and enterprise, industrial productivity and commercial effectiveness (Herasymovych and Norreklit, 2006). The

9 incumbent institutional forces still ‘reflect both the heritage of communist ownership and the need to build market interactions from scratch, including private ownership, a system of private property, capital markets and an appropriate legal and institutional infrastructure’ [Bevan et al., (2004), p. 44].

Attracting greater levels of inbound FDI to Russia would therefore entail creating not only a politically and economically stable business environment, but also an inward investment climate characterised by more foreign-owned TNC-friendly formal and informal institutions, together with transparent, trustful and non-discriminatory regulatory arrangements (Ledeneva, 2000 and 2009). In reality, however, Russia still possesses numerous governmental structures, public policies and institutional norms that have a deterrent effect on such IFDI (Kouznetsov, 2009; Puffer and McCarthy, 2011).

According to Polanyi (1992), institutional trust, which is one of the main prerequisites of an efficient market, can be achieved through a set of fair and credible rules, laws and other relevant regulative arrangements. Indeed, trust is an essential element in Russian business culture (Michailova and Jormanainen, 2011), yet its scarcity appears to be a key barrier to environmental certainty, business growth and IFDI (Puffer and McCarthy, 2011). One of the most influential international consultancies, Edelman Trust (2012), which measures public attitudes about the state of trust in business, government, NGOs, and media across the world, reports that Russia consistently demonstrates one of the worst results among the surveyed countries. Most state bureaucracies, federal law enforcement agencies and institutions are highly distrusted by businesspeople in Russia who, from ‘oligarchs to owners of small shops, are convinced that the authorities can use many different strategies, from re-nationalization to invented tax debts, to send them into bankruptcy and transfer their property to people close to the government, local or national’ [Shlapentokh, (2006), p.159]. Figure 5 illustrates the unique configuration of the Russian institutional setup, particularly falling short of control of corruption amongst the BRICs countries, and only underperformed by accountability of the government by China.

Owing to the lack of institutional trust, Russian society has become deeply fragmented and the contemporary business environment has been severely undermined, with consequent deterrent effects for IFDI. Yet, despite these fundamental difficulties Russia has seen a paradoxical growth in new businesses that have learnt to survive in a low-trust and unstable environment (Radaev, 2003). Here the author also suggests that one possible explanation for this puzzle is the apparent ability of Russia’s businesses to adjust to the non-transparent and non-predictable conditions by implementing ‘intensive informalisation’ and aggressive government engagement strategies (Ledeneva, 2000 and 2009). Therefore, the omnipresent weaknesses of the institutional environment in Russia lead a growing number of businesses to persistently rely on ‘svyazi’ (connections), ‘blat’ (from German das Blatt - a piece of paper) and excessive networking to circumvent operational difficulties and minimize possible expropriation risks (Aidis et al., 2008). Moreover, during the years since the fall of communism in 1991, the Soviet term ‘blat’ has become transformed into the modern idea of an ‘administrative resource’ reflecting new economic realities. Under the communist regime ‘blat’, literally a note from personal contacts, would enable individuals to enjoy priority in gaining something in short supply, ranging from consumer goods to special favours to get

10 something done (Michailova and Worm, 2003). For businesses in modern Russia, availability of ‘administrative resource’ can be seen not just an indicator of special relations with empowered bureaucrats, but as a safeguard against selective law-enforcement and extortions as well as a source of business immunity and possible competitive advantage. Figure 6 illustrates the prevalence of corruption throughout the economy, in comparison to other BRICs countries.

The creation of personalized, informal relationships with high-ranking officials and the ability to build effective networks can create major advantages for domestic businesses and even well-placed TNCs in Russia, provided that they work proactively to exploit these conditions (Aidis et al., 2008). Markus (2007) argues, for example that all types of businesses should mobilise their external relations forces, pursue collective actions and resort to proactive corporate political strategies with engagement of their national governments in order to restrict the negative potential effects of informal exchanges between individual bureaucratic agents and atomistic firms. One way in which to address Russia’s institutional deficiencies would be to direct ‘an organization’s resources to integrate objectives and to undertake coherent actions directed towards the political, social, and legal environment in order to secure either permanent or temporary advantage and influence over other actors in the process’ [Mahon, (1989), pp.51-52]. Arguably, ‘if firms remain passive and only react to government policies, they can be assured that other interest groups are proactively working to shape government policies in a direction that benefits other interests - which may or may not coincide with those of the firm’ [Hillman and Hitt, (1999), p.827].

The widespread use of informalisation strategies may appear functional given Russia’s distinctive economic and business conditions. It is likely nonetheless to entail restricted information flows and substantial transaction expenses for many (domestic and foreign- owned) businesses, favouring the rent-creating opportunities of the existing elite, whilst facilitating the widespread abuse of economic power by leading domestic businesses and government officials (Levin and Satarov, 2000; Djankov et al., 2002). Pervasive government corruption, continued over-regulation and law-enforcement variability also continue to contribute to these adverse effects, by debilitating market efficiency and productivity, thus leading to a further reduction in business competitiveness (Tanzi, 1998; Barkhatova, 2000; Aidis and Mickiewicz, 2006; Aidis et al., 2008). The continued weakness of Russia’s formal and informal institutions, associated in particular with the gap that has emerged between the extensiveness and effectiveness of legal reform (Bevan et al., 2004) can therefore be seen as creating a continuing deterrent to additional TNC commitment to Russia, and thus as a persistent barrier to IFDI.

3.5 Recent institutional reforms and impact on IFDI

A number of steps have been taken in recent years with a view to reforming and modernising Russia’s institutional arrangements, enhancing the country’s productivity and competitiveness, and transforming its economy into one that is diversified, knowledge-based and innovation-driven (Russian Federation, 2012). Accession to the World Trade Organisation, the simplification of taxation and customs laws, the facilitation of the free

11 movement of the labour force and ease of migration, and the reduction of bureaucratic and administrative obstacles to business have all been introduced with these aims in mind.

Taken together, these new initiatives signal a growing realisation of the importance of IFDI to Russia’s transition and development on the part of the Russian government. This advance in understanding follows a period during which unfavourable institutional conditions have continued to hold back business and IFDI in Russia, despite a proliferation of government reforms and reform proposals. Recent commentators (notably Yakovlev, 2006, 2011 and 2013) argue however that the impetus to reform has been by no means consistent since the late nineteen nineties, consisting rather of a series of interrupted stages, characterised by sharply contrasting government policy regimes and objectives, shaped by varying political and economic circumstances, and a changing balance of power between government and business.

The Yeltsin presidency of 1991-2000 comprised a period of political, economic and business instability (Mitra and Selowsky, 2002) during which informal rent-seeking became increasingly widespread, whilst business leaders colluded with government officials, making use of barter and non-market prices in order to achieve beneficial but informal property redistributions and to minimize tax payments (Gaddy and Ickes, 1998 and 2002). The government eventually responded to this crisis (towards the end of the nineteen nineties) by limited institutional reforms, based on agreement with the bureaucratic and business elites that they would simplify tax administration and tax rates and reduce social taxes in return for renewed payment of taxes by the business community (Yakovlev, 2006). New mechanisms for dialogue between the government and business were also set up once Putin came to power in 2000 (Sakwa, 2007), facilitating agreement on a government programme of improved legal support for business and infrastructure investment, and the reduction of risks and uncertainty for business (Yakovlev et al., 2013).

However, government policy and the balance of power between the state and business underwent a considerable change following the Yukos affair, which involved the expropriation by the state of one of Russia’s biggest and most successful companies in the early 2000s. Following a tax reassessment in 2003, the government froze the company’s assets and presented it with tax claims amounting to US$27 billion, after which it was declared bankrupt by a Russian court, with its owner, Mikhail Khodorkovsky being jailed for more ten years (Yakovlev, 2013). The result was the replacement of dialogue between government and business with a period of state dominance over business (Hanson, 2005; Sakwa, 2009). Taking the view that increased economic growth could undermine social stability, the government sought to increase business taxes, overcoming business resistance by the use of the newly re-empowered security services and law enforcement agencies (or ‘siloviki’). Rents were therefore transferred to government from business, with the latter becoming a junior economic partner, less powerful than the Russian state (Yakovlev, 2013).

Russia’s new balance of power created temporarily increased confidence on the part of foreign-owned TNCs regarding the perceived ‘consistency and predictability’ of government policy [Yakovlev, (2013), p.7], resulting in increased commitments of IFDI to Russia between 2006 and 2007. The onset of the global economic crisis in 2008, led to a sharp decline in inward investment flows. This decline in IFDI was intensified by the growing view that the government was unaware of the damage now being done to the real economy (and was therefore unable to take appropriate remedial actions) (Mankoff, 2010). A growing sense of business uncertainty and negative expectations (domestically and on the part of foreign-

12 owned TNCs) allied to increased fears of corruption and coercion by the elite (Hardt, 2003; Sakwa, 2007), led to increased outflows of capital from Russia (Jeffries, 2010), and to increased government awareness of the need for further reform. A further switch in government policy then resulted, involving renewed dialogue between the state and business under the presidency of Dmitry Medvedev.

Russia’s increasing emphasis on the importance of IFDI-related institutional reform was underlined by Medvedev in a landmark speech of 2010, during which he declared that…‘investor confidence is the main condition of innovative development and successful modernisation of the economy in this country. Russia needs a real boom of investments. Our major priority is to create desirable and favourable conditions for investors.’ The Russian government subsequently put forward a set of steps for achieving these aims, including: improvements in the functioning and efficiency of state agencies and public service providers; the elimination of contradictory laws and unpredictable governmental decisions that hamper investment; improved procedures for addressing complaints regarding corruption; the reduction of social insurance tax for businesses; reductions in the restriction of inward investor access to Russia’s strategic sectors and industries; the creation of private equity funds aimed at co-financing foreign investment; and the appointment of investment representatives (Ombudsmen) throughout Russia, tasked with assisting the implementation of private investment projects (Kremlin, 2011).

This initiative was followed in 2010 by the instigation of a new, ‘Doing Business in Russia’ project with World Bank support, aimed at improving conditions for establishing businesses, property registration, acquiring construction permits and securing access to electricity in the country’s regions (World Bank, 2011). Business- and inward investor-friendly amendments to the county’s criminal code and law enforcement practices were also introduced, followed in 2011 by the creation of a new ‘Agency for Strategic Initiatives’ (ASI), charged with identifying and solving problems hindering the development of domestic and foreign-owned businesses in Russia (Kremlin, 2012). A ‘100 step’ programme designed to improve business and investment conditions in Russia was then put forward in 2012, followed by a series of ‘roadmaps’ aimed at reducing barriers to the acquisition of construction permits by businesses, improving customs regulations, promoting exports from Russia, and providing more attractive investment climates for business in the Russian regions (Yakovlev, 2013).

However, despite over a decade of institutional reform, and this recent proliferation of governmental initiatives, and proposals, there is still a great deal of skepticism amongst many leading international and even Russian-based commentators, whose dominant perception is that Russia still represents a semi-closed, complicated and adventurous location for doing business (Puffer et al., 2007; Kuznetsov and Kuznetsova, 2003; Hanson, 2010). The Russian economy is still struggling with its central planning addiction and nearly half of the national gross domestic product being controlled by the country’s bureaucratic and state business structures, with consequent limits to the extent of any real change in the country’s investment climate (Yakovlev et al., 2013), resulting in a continued burden on business dealings (Aidis et al., 2008) and a consequent deterrent to IFDI (Fabry and Zeghni, 2002; FIAC, 2010). Russia is, indeed still widely viewed (see for example, Hitt et al., 2004; Castiglione et al, 2012) as being institutionally unattractive, corrupt and unpredictable for long-term investments, forcing many domestic businessmen and foreign-owned TNC strategists to consider only short-term investments, which enable them more readily to estimate and mitigate the effects of environmental and institutional hazards and to withdraw their capital from Russia if changing circumstances dictate.

13 Russia’s institutional strengths and weaknesses are summed up succinctly by the Index of Economic Freedom, published by the Heritage Foundation (2013). Disappointingly, an analysis of the latest published Index shows that Russia performed worse than the other three BRIC countries in 2013 in ‘economic freedom’ terms, lying 139th place out of 189 listed countries. Indeed, the country’s overall environmental index fell marginally from 52.8 in 1998, to 51.1 in 2013 (placing the country below the global average throughout, and keeping it within the Heritage Foundation’s “mostly unfree” category).

------Put Table 4 here ------

Turning to the detailed criteria comprising the Index for Russia, Table 4 shows that, worryingly, a number of key environmental indicators have deteriorated over the period from 1998 to 2013, including property rights and freedom from corruption, indicating a diminution in the rule of law. Fiscal freedom has risen, reflecting Russia’s low tax rates, but also the government’s access to large oil and tax revenues, which have enabled it to reduce government spending as a proportion of GDP between 1998 and 2013 via the medium of State Owned Enterprises (SOEs). Regulatory efficiency has remained below the global average throughout this period, leaving much room for improvement, with an upturn in business and monetary freedoms being countered by a recent deterioration in labour freedom. Russia has also performed poorly in opening markets to competition, with a substantial worsening of investment and financial freedoms constituting a continued deterrent to IFDI and the key obstacle to economic development, despite an improvement in trade freedoms since 1998.

Progress with institutional reforms has clearly been patchy, reflecting the changing balance of power between Russia’s bureaucratic and business elites (Yakovlev, 2013; Heritage Foundation, 2013). Decomposing the period since the late nineteen nineties into the government policy eras discussed above (see Table 4), it would seem that Putin’s government struggled initially to overcome the environmental disadvantages for business and IFDI inherited from the years of chaos and virtual economy under Yeltsin. Russia’s overall economic freedom index actually fell from 52.8 to 50.8 between 1998 and 2003, despite dialogue and interaction between government and business, reflecting a worrying deterioration in rule of law and open market terms, in particular. The overall index then remained unchanged during the ensuing period of government policy domination, from 2004- 9, when improvements in four of Russia’s ten environmental indicators were offset by declines in property rights, and in the fiscal, business and investment freedoms available to businesses. The period of renewed government dialogue with business, from 2010-13 saw a marginal improvement in the overall index, from 50.8 to 51.1, during which time freedom from corruption, fiscal, business, monetary and trade freedoms rose, whilst government spending, labour, financial and investment freedoms fell.

4. Discussion The research question addressed is ‘whether and how institutional evolution moderated the ability of IFDI in Russia to further economic development?’ The analysis has highlighted several aspects of the institutional characteristics of Russia. Transition, corruption, need for a systematic (government and business) adaptation are the primary characteristics of the Russian institutional context. Primary features of Russian institutions include a constant

14 notion of change, the presence of other informal coordination methods besides bureaucratic and market based, and the unique position which the government takes in this context.

It has been identified, that the adaptive nature of the Russian institutional framework on one hand creates a constantly changing environment, which is perceived as increased risk by IFDI decision makers. On the other hand, the changes pointing towards making the economy more investor friendly help adaptation of foreign firms to local conditions, thereby supporting IFDI. This controversial situation can be understood within the institutions, regulations and IFDI. Regulations – the primary vehicles of government intervention – react to the spontaneous institutional development of the economy. This spontaneous institutional development creates institutions, that display rent seeking behaviors, and capture value added to sustain themselves. However, IFDI regulates this spontaneous situation negatively, and sends warning signals to the broader society, which experiences the lack of economic development. The government sector – by definition primarily motivated to satisfy popular demand and hence establish its position as a government – addresses the institutional development by introducing regulations that ‘fix’ the problems that emerged. However, by doing so, it gives further drive to spontaneous institutional development, triggering reactions from MNCs, the drivers of IFDI.

It has been demonstrated, that institutional reform – implemented through government regulations – has attempted to address the sources of systemic inefficiencies. This resulted in reduced economic freedom, introduction further tax and administrative barriers, and subsequently a reduced ease of doing business in the country. The effectiveness of government regulations has been traditionally and continuously dampened by corruption and illegal rent seeking behaviors. SOEs as a more secure and robust avenue of exercising control over the various rent sources available in the economy emerged, and became important part of the institutional framework. However this – along with the increased burden of regulation – erected further barriers to MNCs endeavoring to access the Russian market. IFDI has continuously disadvantaged by this development trajectory.

The positive changes of Russian IFDI shown in 2013 reflect the sum of two substantially opposing forces: an increased institutional resistance to foreign businesses and a reduced risk level caused by the conclusion of an intensive period of institutional evolution. In other words, Putin’s Russia has greatly lost out on IFDI and its economic developmental impact, and subsequently became more closed than before, but because of the solidified framework of institutions and controls as a consequence of the reform, became a less risky investment destination (compared to for example the other BRICs economies) attracting more IFDI. Further challenges are presented however to the Russian economy by imposition of political risks originating from external sources, which can ultimately negate the positive effects of institutional reform, but allow for the negative effects to cause full impact.

5. Conclusions This paper has sought to contribute to the literature by investigating institutional arrangements facing inward investors in Putin’s Russia, the extent to which they had been reformed since the late nineteen nineties up until 2013, and the resultant impact on the willingness of foreign-owned TNCs to commit IDFI to this high-risk transition economy country. A tentative reading of the findings suggests that Russia has achieved only limited improvements in her inward investment climate since the late nineteen nineties. Institutional

15 reforms have clearly been patchy, and these have continued to prove capable of being held up or even reversed by the struggle of power between Russia’s bureaucratic and business elites.

The paper’s discussion and analysis clearly indicates that a lack of an efficient, effective and rule-based legal framework still remains highly problematic for business and IFDI in Russia, as does the persistence of widespread corruption (Levin and Satarov, 2000), the extensive state presence in many sectors through SOEs (Demirbas and Yukhanaev, 2011), and the maintenance of what is still essential an obstructive and oppressive regulatory environment (Puffer et al., 2007; Heritage Foundation, 2013). Omnipresent institutional distrust, collaborative tensions and conflicts of interests between regulative authorities and the business community result in greater risk, increased transaction costs, volatile legitimacy, excessive informal networking and a need for ‘special value-laden relationships’ building accompanied by a variety of sophisticated corruption schemes and rent-seeking activities (Alon and Banai, 2000; Fabry and Zeghni, 2002). Overall, these factors undermine the business environment and deter the inward FDI so much needed for sustainable economic development and institutional transformation (Feng et al., 2009; Castiglione et al., 2012).

The paper’s findings show that, in order to achieve a substantial increase the quantity and quality of IFDI, the Russian government must initiate and implement substantial neo-liberal shifts in the design and functioning of its national institutions. Therefore, we argue that there is an urgent need to carry out a holistic transformation of national economic policies by expediting further privatization of state assets and transferal of the economic power from the public to the private sector, abolish all rudimentary government initiated market control measures and intervention policies, intensify complete trade liberalization and deregulation by removing all fiscal, monetary and regulatory barriers preventing economic freedom, constraining entrepreneurship and business competition. Sustained support must also be secured from Russia’s bureaucratic and business elites if these reforms are to be implemented successfully, enabling a significant increase in IFDI to be achieved in future. However, it is clear that Russia’s government must prioritise the effective management of power relations between the country’s bureaucratic and business elites in order to pave the way for the successful agreement on, and implementation of IFDI-related institutional reforms. By 2013 the renewal of dialogue between Putin’s government and Russia’s domestic businesses and foreign-owned TNCs, allied to increased responsiveness to their views and wishes may at last be beginning to lay the foundations for a future move towards comprehensive and broadly based institutional reforms supportive to future IFDI. However, this still looks like being a long-term project for Russia, dependent for its success on the maintenance of government determination to develop and maintain a much-needed coalition of elite support for more rapid regulatory and neo-liberal economic reforms. Recent geopolitical developments concerning Russia’s annexation of the Crimea and support for Ukrainian rebels, resulting in the imposition of sanctions and Western isolation, together with the significant decline in the price of oil, are likely to have a negative impact on IFDI in the near term as recession takes hold of the economy. However, in the longer term the attractions of Russia as a FDI destination are bound to re-emerge as the country with transparent, investor-friendly and rule- based business environment.

Although the focus of this paper is on Russia, it has attempted to provide a macro-level perspective for government policy makers in other transition and emerging market countries, in terms of the political and economic as well as the business issues that may be raised when undertaking IFDI-related institutional reforms. There is now a need, however to extend the analysis and debate underpinning the current paper by further related research. A comparative

16 study into the nature of the prevailing, IFDI-related institutional arrangements in all now five BRICS countries, the extent of their recent reform and the resultant impact on inward investment flows, making use once again of published data analysis would help to broaden out the lessons for policymakers contained in the current paper. A multi-case study based, empirical exploration into the changing strategic responses of foreign-owned TNCs to institutional conditions and reforms in Russia, including their willingness to commit IFDI to this high-risk transition economy country, and their strategies for managing risk once they do so, would also constitute a useful contribution to the literature from the academic, policy making and practitioner perspectives. Further empirical exploration of the changing relationship between Russia’s bureaucratic and business elites, together with different scenarios for such collaborations between TNCs and governments in the developing institutional and transitional environments would also offer an interesting area for further related research.

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24 Figure 1. A holistic framework of economic development

Economic development

Regulatory Institutions framework

Figure 2. Annual Foreign Direct Investment Inflows in BRICs, 2000-2013 (US$ million)

Source: UNCTAD (2013)

25 Table 1. Russia: inward FDI stock, 2000-2013 (US$ billion)

Economy 2000 2005 2006 2007 2008 2009 2010 2011 2012 2013 Russia 32 180 266 491 216 383 491 455 496 576

Brazil 122 181 220,6 310 288 401 682 686 745 724,6 China 193 272 293 327 378 473 588 712 833 957 (without Hong Kong) India 16 43 71 106 125 171 206 206 225 227 Hungary 23 62 80 95 88 99 91 85 103 103 Poland 34 91 126 178 163 183 216 203 235 235 Source: UNCTAD (2005-2013)

Figure 3. Oil and Gas Exports, 2005-2013 (US$ billion)

Source: authors’ calculations based on Bank of Russia; Rosstat.

Table 2. FDI Inflows in Extractive industry, 2005-2011 (US$ billion)

FDI 2005 2006 2007 2008 2009 2010 2011

26 inflows Bln USD % of Bln % Bln % of Bln % of Bln % of Bln, % of Bln % of total USD of USD total USD total USD total USD total USD total tot al Total 13 100 13,7 100 27,8 100 27 100 15,9 100 13,8 100 55 100 FDI in 4 30 4,5 33 14 50 5 18,5 3,2 20 2 14,5 13,8 25,1 extractive Industry Source: authors’ calculations based on Rosstat , Bank of Russia

Figure 4. Ease of Doing Business Ranking 2013 (total of 189 countries)

Source: World Bank (2013)

Figure 5. World Governance Indicators: Russia amongst the BRICs (2012)

27 Source: World Bank (2013), World Governance Indicators show the country level performance on a scale of -2.5 to +2.5.

Figure 6. Corruption Perception Index in BRICs, 2013-2014

Source: Transparency International (2013, 2014). The corruption Perception Index (CPI) measures corruption perceived in a country by various stakeholders on a scale to 0-100, with 100 demonstrating the complete lack of corruption.

28 Table 4. Russia, Changes in index of Economic Freedom Rankings between government policy eras from 1998-2013

Index Overall Rule of law Limited government Regulatory efficiency Open markets year score

Property Freedom Fiscal Govern- Business Labour Monetary Trade Invest- Financial rights from freedom ment Freedom freedom freedom freedom ment freedom corruption spending freedom 1998 52.8 50.0 26.0 74.2 67.3 55.0 N/A 24.3 58.6 50.0 70.0 2003 50.8 30.0 23.0 90.6 64.5 55.0 N/A 57.0 57.4 50.0 30.0 2009 50.8 25.0 23.0 78.9 70.6 54.0 60.0 65.5 60.8 30.0 40.0 2013 51.1 25.0 24.0 86.9 54.4 69.2 52.6 66.7 77.4 25.0 30.0

Source: Derived by the authors from Heritage Foundation (2013)