Foreign investors in Russia are feeling the squeeze

By Eurasia Group analyst Alexander Kliment

On July 9, Aman Tuleyev did a remarkable thing. The governor of Kemerovo province in central Russia sent a telegram to global steelmaker ArcelorMittal, which operates three coal mines in the region, demanding that the company continue to operate the mines even if they lose money -- or surrender them to the regional government with zero compensation. This story underlines an important emerging trend for foreign investors in Russia: fear among Russian public officials of rising unemployment has reached a level of urgency that is pushing some of them to extraordinary lengths to stop it.

Faced with dwindling demand for coal this year, ArcelorMittal wanted to cut production and headcount at the mines, which employ about 6,000 people. But in his telegram, Governor Tuleyev warned that his first responsibility was to local workers and that he would not allow closure of the mines under any circumstances. Tuleyev, well known in Russian political circles as a volatile and outspoken crusader for workers, has called in the past for the prosecution of factory owners and the nationalization of their assets. Two days before his warning to Arcelor Mittal, his government seized control of a shuttered electrochemical company after unpaid workers asked for his help.

But this is not a story about one populist governor determined to play the role of friend to the working man. Tuleyev can't do anything with ArcelorMittal mines without (at least) implicit support from Russia's top leadership, and Federal authorities haven't yet weighed in on this issue. In the end, outright expropriation of foreign-owned assets remains unlikely; it would do too much damage to Russia's investment reputation. But the risk for investors in some areas -- especially labor intensive sectors like metals, mining, manufacturing, and automotive -- is becoming increasingly obvious: to preserve social stability, they may be pushed to operate factories or enterprises at a loss under threat of takeover by local authorities. Similar risks could arise even for regional retail and consumer-oriented sectors.

But these governors are responding to increasing political pressure coming from Moscow. Prime Minister Vladimir Putin and President Dmitry Medvedev have pushed governors to deal with rising unemployment and unpaid wages within their provinces without asking federal authorities for help. They can't afford more episodes like the one that took place last month in Pikalyovo, a beleaguered monogorod (a town in which one company employs virtually the entire workforce), where Putin arrived in person to rebuke the owners of shuttered local factories. The prime minister made a show of standing up for the workers and demanding that the factories reopen... before the central government quietly cut the owners -- including well-known oligarch Oleg Deripaska -- a sizable bailout check.

Federal officials can't afford to stage the same show in hundreds of towns and cities and doesn't want responsibility for local economic performance. It's also important to remember that Russia's regional governors are not elected by their constituents. They're appointed by the Kremlin. If a local official like Tuleyev wants to keep his job, he must first please his political masters in Moscow.

Beyond the risks for foreign investors, the seizure of businesses and factories would be bad news for the efficient operations of the companies concerned -- since regional bureaucrats don't usually make effective business managers -- but also potentially for the federal budget. Regional budget revenues, particularly in the regions hardest hit by economic recession, are in freefall this year. Cash-strapped local officials can squeeze regional banks and oligarchs only for so long. Eventually, they will have to turn to Moscow for the money they'll need to keep workers in their jobs. With the fall in prices for oil, gas, and other commodities and the global credit crunch, Russia's economy contracted by about 10 percent over the first half of 2009, and federal budget revenues are falling sharply. More demands from the regions will exacerbate an annual budget deficit already projected at about 8 percent for 2009.

Broadly, Moscow's key political objective of maintaining social stability despite dwindling revenues could begin to place regional officials between a fiscal rock and a political hard place. As that pressure mounts, foreign investors may be among the first to feel the squeeze.