Russia recently had a big victory over the Georgia. Russian tanks and aircraft easily defeated the Georgian armed forces. The Russian attack was apparently a response to a Georgian assault on the breakaway province South Ossetia. Commentators have written that this war is not about a small piece of mountain real estate run by a provincial mafia with Russian support. It is more about Russian pride. It was punishment to Georgia, which Russia considers its near abroad; its sphere of influence; an important remnant of the lost Soviet Empire. Russia certainly won the battles. It crushed the Georgians and humiliated the West that could offer no response. But it lost the war.

Russia’s oil fueled economy has been running at full speed over the past few years. Personal incomes have been rising. It boasts some of the most expensive and profitable real estate in the world. Until recently, its stock market had reached new highs. These triumphs masked deeper problems.

Russia for all of its recent successes has not managed to build the institutions, specifically the legal institutions, to protect citizens and foreign investors from government interference. The result is a fragile state and economy that will suffer extensive problems during the worsening global down turn.

Over the past several years the world has been awash in liquidity. This mountain of cash not only fueled the US real estate boom, but the economies and stocks of emerging markets. Russia is no exception. The demand for its oil and other commodities looked like it would continue indefinitely. With all of this success, Vladimir Putin and his band of siloviki felt there were no limits to their power either in Russia or internationally. Russia and the power of government were resurgent and there was little anyone could do about it. Not true. There is something that will do something about it, the market.

Investors are a timid lot. They want a return on their investments, but more importantly they want their investments returned. If it looks like there is a threat to their money, they will flee like frightened sheep and are loath to return. What appeared to be easy Russian profits have turned into a minefield.

Originally when Putin destroyed Yukos and chief, Khodorkovsky, most investors wrote it off as a local political power play. It wasn’t. With the decline of Yukos, went the growth of Russian oil production. Since Putin wasn’t punished for this attack he repeated the process; first against Shell and Exxon in the Sakhalin projects, and then against BP-TNK and the steel maker, Mechel. It appeared that the market did not care, but the reality was different. Foreign investment, the real fuel of sustainable economic growth, began to decline. Foreign investment fell 42% in the first quarter of this year. The stock market, no longer buoyed by sky high oil, has lost a third of its value.

The main economic growth is now inflation. It is up 16% this year and rising. Even Russia’s leaders understand its problems. According to President, Mr. Medvedev, Russia’s biggest problems facing Russia are "endemic corruption and a dysfunctional legal system". Its finance minister Alexei Kudrin has pointed out that growth in central Russia would lead to the "collapse of the railway and transportation infrastructure". Even Putin himself has stated that business owners deserve medals for trying to operate in a dysfunctional environment. According to the Moscow Times, more money is paid in bribes in Russia than the government collects in taxes. Even the Russians understand that the problems have not been solved. According to a survey by an EU-Russia Centre 50 per cent of Russia's best-educated and most prosperous citizens would emigrate if they could.

Russia’s handling of the problem in Georgia will make these issues infinitely worse. Whatever the success of their forces on the ground, they have certainly lost the publicity war. Russia has been painted as an unreformed bully invading a democratically elected sovereign state. This sort of story sends chills down the spine of every citizen of a former Soviet republic or satellite and adds weight to arguments that Russia should be treated as a pariah rather than a partner.

The arrogance of Russia’s leaders and the economic consequences are hardly unique. The benefits of globalization have been extensive, but the leaders of many emerging markets have taken the credit rather than understand that it belongs to free trade, protection of people, property, and capital markets. Economists have projected unlimited growth for developing parts of the world. Investors have rewarded their economies. But due to the miscalculations of their leaders and the lack of institutional limits, this is about to change. The real losers will be like the unfortunate citizens of Gori. It is not necessary for anyone to punish Russia. They have already done that to themselves.

I am William Gamble, JD, LLM, Ex MBA, KSC, a consultant specializing in emerging markets. I have been quoted or interviewed by ABC, CNN Asia, Bloomberg, Fox, CNBC, NPR and other television and radio stations around the world. I have published 24 letters in Financial Times and articles in Foreign Affairs, and Harvard International Review. I have been quoted USA TODAY, The Far Eastern Economic Review, The International Herald Tribune, The South China Morning Post, Sankei Shimbun. I have written two books Investing in China and Freedom: America’s Competitive Advantage in the Global Market. In the past year I have spoken to CFA societies in 10 countries and 9 US cities as well as other conferences all over the world.

William Gamble
Author: Freedom: America’s Competitive Advantage in the Global Market
EMERGING MARKET STRATEGIES
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