Which country is the biggest investor into Russia? It’s Cyprus. At least that is according to the official figures from the Central Bank of Russia (CBR). But of course it isn’t really. Cyprus is a widely used financial vehicle for investing into Russia thanks to its convenient double taxation treaties and, more importantly, the fact that the Russian authorities cannot expropriate assets in Cyprus. But the use of Cyprus, and other financial staging posts such as BVI, Bermuda and even the Netherlands, makes knowing where Russia’s foreign direct investment (FDI) actually comes from very difficult.

That has changed. The United Nations Conference on Trade and Development (UNCTAD) has published first-ever estimates of FDIs into the economies based on Ultimate Investing Country in 2017, Ivan Tkachev, economics editor at RBK, recently wrote in a piece in the Riddle entitled “A Quiet Revolution in the Analysis of Foreign Investments.”

Thanks to various quirks in the way Russia calculates its FDI numbers, several sources of FDI get missed out from the official figures. The most glaring omission is the money that foreign companies make in Russia that they reinvest into their production is not counted as FDI, but is actually one of the largest sources of all foreign investment. Little or no new FDI has been arriving in Russia since the start of the sanctions regime in 2014 following the annexation of Crimea, but those foreign investors already in Russia are very happy and reinvesting every kopek they make, CEOs of these firms have told bne IntelliNews in multiple interviews.

But Russia has never been a popular investment destination. Inward FDI to Russia over 2014-2018 averaged 1.3% of GDP, the lowest levels for 20 years when reinvestment is factored in, and even Russians are reluctant to invest in their own country.

As bne IntelliNews reported in a piece last year, “Capital flight figures to make your eyes water”, in the last three decades Russia has only had two years with a net inflow of capital in 2006 and 2007 at the height of the boom years when a surplus of $131bn of capital entered the country. For those two short years domestic investors were optimistic about the country's future and were willing to invest. When the economy collapsed in the wake of the 2008 global crisis that entire amount left again and Russia has been bleeding money ever since as capital has flown.

“Russians’ reluctance to invest at home is visible in the dominant oligarchic business model based on commodity exports rather than on developing supply chains or downstream value-added activities, alongside the preference for extracting company profits in cash. Russian corporates’ dividend yields at 7.9% are 4.6% higher than the MSCI Emerging Markets Index average and among the highest for the corporate sector of a large emerging market economy, according to Bloomberg,” Germany’s Scope Ratings said in a note.

Balmy havens responsible for most FDI

Like most countries, the CBR relies on its balance of payment figures to calculate foreign investment. However, these only capture the last step on the investment journey of cash from the coffers of an investor into Russia, not where the money started its journey.

Thanks to the perennial “Russia risk,” FDI into Russia has always been below par given the size of the population and richness of the resources on offer. However, in the last three decades Russia has accumulated a total FDI stock of just over $407bn as of the end of 2018, according to the CBR.

According to the CBR data two thirds of this investment (68%) comes from offshore havens and 30% alone comes from Cyprus, or $124.6bn.

“It is obvious that those investments – made through transit financial jurisdictions – have been carried out by someone else. Perhaps they may have been made even by Russians themselves, who have long used such schemes of investment through foreign jurisdictions, under foreign law. For them it is often a way to optimise taxes, as well as to protect Russian investments from extortions and raids by security services,” Tkachev said.

Conversely, investment from more obvious partners is very low. The US accounts for a mere $2.6bn and China for $3.1bn of the total stock of FDI, according to the CBR figures, or under 2% of the total each.

UNCTAD research attempts to get a better handle on the origin of investment money and estimates that between 30%-50% of all investment from countries such as Germany and the US also arrives via a transit country and so their official FDI numbers are badly understated.

UNCTAD released its still incomplete data set at the end of 2017, using information supplied by a few participating countries that try to determine the country of origin for inbound FDI.

Identifying where money comes from is becoming increasingly important as governments try to fight money laundering and interest has been heightened by the sanctions showdown, not just with Russia, but the countries of the Middle East and places such as North Korea as well. But government’s biggest motivation of all is simply to stop companies from using international jurisdictions to dodge tax payments in this increasingly globalised world. In Russia, for example, the Kremlin launched the clumsily named de-offshorisation campaign to bring home more tax revenues from assets actually based in Russia but legally domiciled somewhere else.

As the data is incomplete UNCTAD results are actually an analytical estimation, “calculated under a probabilistic model based on Markov chains,” says Tkachev without going into the technical details. However, the resulting distribution of FDI fits with intuition and is clearly a better guess of what the actual geographic distribution of FDI is.

And some of the results are surprising. The US turns out to be the big winner and the biggest single investor into the Russian economy, which also has political implications in the current environment. According to UNCTAD the US invested $39.1bn into Russia, or 8.9% of the total FDI stock – that is more than 12 times greater than the CBR figures and makes the US a much more important investor than first appears.

The US’ own estimates of American companies' investment into Russia are lower. Cumulative investments of American businesses into Russia amounted to $13.9bn at the end of 2017 (based on the historical cost of the investments made), according to the US Department of Commerce, says Tkachev. But this is three times more than the CBR balance of payment estimates for US investment into Russia.

The real number is almost certainly higher than either of these estimates. Russia has all but given up on maintaining its own domestic automotive production and the sector is dominated by foreign car producers, many of them American. Yet apart from the initial investment most of the subsequent investment is made from retained earnings or local borrowing. As revenues are in rubles it makes sense to reinvest retained earnings and raise funds locally in rubles. That means little of the investment activity by car companies turns up in the FDI figures.

However, the Russian statistical agency Rosstat did have a stab at estimating this kind of foreign investment in 2014, when it submitted an FDI report to the central bank, which switched to the internationally accepted methods at the time, so there are some estimates.

One attempt to take into account this “re-invested FDI” was made by a joint study by the American Chamber of Commerce in Russia and EY in May that estimated US companies had invested a total of $85bn in Russia, or over 20% of the total FDI stock, which makes the US by far the most important foreign investor in Russia.

The second-largest direct investor into Russia, according to UNCTAD, is unsurprisingly Germany with $33.2bn, followed by the UK with $31.3bn, says Tkachev. Together these three countries account for over a quarter of the total FDI stock in Russia, or more than $100bn compared with the official CBR figure of $40bn.

Again, other estimates for German investment into Russia are lower. According to the Deutsche Bundesbank, the stock of investments from Germany into Russia totalled €21.3bn at the end of 2017 ($25.6bn at the then exchange rate), while the Central Bank of Russia’s estimate is $18.1bn.

Germans have always been a fan of Russian investment. This was championed by former Chancellor Gerhard Schroeder, who actively lobbied on behalf of German national champions such as Siemens while in office, before taking a job with Gazprom after his term in office ended.

And they still are. Since 2014 trade between Russia and the European Union has fallen by about a third to circa €268bn in 2018, up slightly from a low of €228bn in 2016, according to Eurostat, while German trade increased by 8.4% in 2018 year on year to €62bn, making it Russia’s second-biggest trade partner after China.

Moreover, German (officially identified) investment into Russia hit its highest level in a decade of €3.3bn in 2018, according to the Russia-German Chamber of Commerce, as cited by the Moscow Times.

However, the nature of this German investment is changing, as at the same time the number of German companies registered in Russia has shrunk from a high of circa 6,000 to around 4,500 now. The barriers to entry have become higher and the operating environment more difficult, which is squeezing out the smaller Mittlestand companies that had expanded to Russia. Increasing size matters when it comes to Russia.

The same is true to a more extreme extent with the UK, which long counted itself the biggest European investor into Russia, but the lion’s share was in the single investment of oil major BP which has major holdings in the Russian oil and gas sector.

The story is similar with France, which has $20bn invested in Russia, according to official figures, but again, a big chunk of that is in the oil and gas sector: the French energy company Total recently acquired a 10% stake in a $21bn gas project in Russia’s Arctic, in addition to its existing 20% stake in a neighbouring $28bn gas project in the region, the Moscow Times reported.

The new kid on the block in Russia’s FDI story is China. Trade turnover with China has soared from around $5bn a year in the early 90s to top $100bn last year and is on track to hit the new target of $200bn by 2024. Good trade relations is the basis of FDI, as typically two countries start trading with each other but at some point they begin to set up production in the host country to reduce costs once there is a decent volume of sales. The rule of thumb is that every $8 increase in trade leads to $1 of FDI, which implies China’s FDI into Russia should be $12.5bn.

In reality the political nature of the Sino-Russian relationship – most of the deals so far have been government-to-government such as the massive investment into the Power of Siberia gas pipeline – distorts the investment relationship between Russia and China. A study by Skolkovo’s Institute for Emerging Markets Research estimates China’s direct investment into Russia at $36bn, Tkachev reports, which is more than would be expected from a purely commercial relationship between the two countries.

“China’s investors are no different from others and they too have been extensively using Cypriot or BVI jurisdictions when structuring their investment projects,” says Tkachev, citing Oleg Remyga, who heads the China section at Skolkovo.

The big losers from UNCTAD calculations are unsurprisingly the offshore havens, although identifying where the money passing through these intermediaries really comes remains at the end of the day largely guesswork.

Offshore havens demoted

The Netherlands is a big Russian investor and since the 2012 Cypriot financial meltdown has become an increasingly popular domicile for Russian offshore companies.

According to UNCTAD, the Netherland’s share of the FDI stock has shrunk from $41bn, or some 10% of the total, to $29bn, or 7%. But the situation is confusing, as both real foreign investment into Russia, such as the Russian-French joint venture of Rostec and Renault, and pure Russian companies, for example Yandex.Taxi, are registered in the Netherlands.

It has always been assumed that a large share of money coming into Russia via these offshore havens is just Russian money “round tripping” – money held offshore to avoid Russian taxes (and appropriation) – but it has never been clear just how much of the cash invested by Cyprus or the Netherlands is actually Russian.

UNCTAD estimates that 6.5%, or $28.9bn, of the money invested from the Netherlands is actually of Russian origin. The same is true of Cyprus, where the majority of the money is clearly round tripping: Russian investment stock into Cyprus is $172bn, according to the CBR, but the stock of Cypriot investment into Russia is $125bn as of January 1, 2019, says Tkachev.

A better understanding of the FDI dynamics is important, as it has political consequences. The stereotypical picture of Russia is that it is nothing more than a giant petrol station that produces nothing of value but imports lots of Bentleys and Christian Dior dresses for its oligarchic class.

The demonising of Russia that has dominated international politics for much of the last decade is a result of the calculation that began when Gordon Brown took over as British Prime Minister that being tough on Russia earns political kudos by making you look tough but comes at no cost, as there are few business interests to hurt.

However, if FDI is actually much higher then the calculation changes, as sanctions will boomerang back and hurt your own economy, provoking a domestic lobbying reaction against the sanctions by your own businesses.

This is exactly what happened when the US Treasury Department (USTD) introduced its punitive April 6 round of sanctions last year that specifically targeted oligarch Oleg Deripaska’s Rusal amongst other companies. It led to chaos on the international metals market and threatened to cause hundreds of millions of dollars of loses for leading US investment banks, as in effect their would have to mark their investments into Rusal’s stocks and bonds down to zero overnight. As the significance of the sanctions rapidly became clear the USTD backed off before dropping the sanctions entirely at the start of this year – the first sanctions on Russia to be withdrawn since 2014.

The UNCTAD study only fleshes out the lesson the Rusal sanctions debacle taught: that Russia’s economy is much more deeply integrated into the global economy than the stereotype suggests.

Indeed, the Ministry of Finance seems to have embraced this aspect of integration with a string of record ruble-denominated OFZ treasury bill sales this year. The high-yielding and almost unsinkable OFZ are already widely held by US investors such as pension funds and insurance companies, but the idea seems to be to make them even harder to sanction by casting the net as widely as possible. The more US investors hold OFZ the harder they become to sanction. And indeed, in new sanctions issued this week that targeted Russia’s sovereign debt, only new issues on the primary market were targeted, while OFZs were excluded completely.

For its part Russia has tried to sanction-proof its economy with a series of laws to reduce dependence on the outside in sensitive sectors, but with limited success. The defence sector reported orders to use only Russian made inputs were impossible to implement and Russia remains heavily dependent on imported machinery. Germany’s Siemens, for example, dominates the gas turbine and high speed train business in Russia.

The one place Russia has made a lot of progress towards autarky is in agriculture, where imports have fallen by a third in the last five years. But here too, Russia remains dependent on the outside. Siberia’s famous Camembert business was started with imported moulds from France and the Department of Agriculture recently called for an effort to produce a Russia broiler chicken as currently, poultry farmers remain entirely dependent on imported eggs.

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Ivan Tkachev, economics editor at RBK, contributed to this article

Inward FDI Stock in Russia, end-2017:
	UNCTAD estimates by ultimate investor / CBR reported data by direct investor
Rank		UNCTAD, $bn	Bank of Russia, $bn	UNCTAD, share of total stock
1	US	39.1	3.1	8.9%
2	Germany	33.2	18.1	7.5%
3	United Kingdom	31.3	18.6	7.1%
4	Netherlands	28.7	40.6	6.5%
5	France	19.6	15.1	4.5%
6	Switzerland	19	12.8	4.3%
7	Singapore	12.7	16.3	2.9%
8	Ireland	12.1	5.5	2.7%
9	China	7.1	3.6	1.6%
10	Austria	6.7	5.6	1.5%
	Russia	28.9	0	6.5%
	Confidential/unspecified	124.4		28.2%
	TOTAL	441.1	441.1	100%
Sources: UNCTAD, Bank of Russia / investing countries ranged by UNCTAD ultimate investor's estimates