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The Fatal Offshore: Deoffshorization and Russia’s Infrastructure Crisis

 
 

Visiting Sunny Isles, Londongrad, Limassol, and elsewhere may be good for Russian money, but home is better if Putin’s latest attempt to bring offshored wealth is to be believed. The process of trying to return Russian wealth stashed abroad had its roots in decrees and talk in 2012, before the pressures of Russian adventurism in Crimea and the Donbas brought new challenges with the imposition of financial sanctions and encouraged capital flight. Even with sanctions pressure on business, the share of companies carrying out large transactions under Russian legal jurisdiction has grown from 10 percent to 34 percent. But businessmen living more than six months abroad every year can still dodge most taxation and information disclosures, despite new laws that allow companies to remain registered abroad but require certain taxes on profits or personal incomes.

Putin held a notable pre-election meeting on December 21st, during which he officially proposed the issuance of special Eurobonds to businessmen with money abroad so that they could return capital to Russia. The bonds would be tax exempt, part of an ongoing amnesty on capital stashed abroad as the Kremlin looks for ways to help its allies insulate themselves against sanctions risks and return their wealth to Russia. The extension of the broader amnesty for those returning offshored wealth was reportedly proposed by Alexander Shokhin of the Russian Union of Industrialists and Entrepreneurs (RSPP) and then taken up by Minister of Finance Anton Siluanov. Beyond the proposed bonds, Putin proposed exempting any money returned from abroad from the 13 percent national income tax.

The logic is pretty basic: money in Russia can’t be seized or frozen by sanctions. The country also faces systemically threatening underinvestment into its own infrastructure and desperately needs capital for the Far East. To emphasize just how bad the situation is, several years ago it was estimated that Russia would have to invest 15 percent of its GDP into infrastructure for years to have a significant effect on the economy. Developing economies – arguments remain as to where to place Russia on the spectrum between developed and developing – generally soak up close to 8 percent of GDP annually into infrastructure to meet needs.

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Structural needs are quite clear, but it remains incredibly difficult to ascertain what economic demand actually calls for in remote, underpopulated regions. Russia’s poor infrastructure is significantly hindering its ability to profit off of China’s Belt and Road Initiative (BRI) sending more container freight overland to Europe. But a massive influx of foreign capital in search of profits in Russia could actually be a large problem for Moscow, as needed as it may be. The billionaires being induced to bring their money back will look for opportunities in Russia. Whether they exist or not is the question. One focus area could be Russia’s Far East, which is in desperate need of investment and development.

Profits of Doom and Gloom

The recently released national transport development plan for 2018-2021 calls for roughly 7.75 trillion rubles (roughly $136 billion) in spending. Just over three trillion is supposed to come from the federal budget, 2.73 trillion from consolidated regional budgets, and 1.87 trillion from sources outside the budget. Anyone who scrutinizes how that figure is achieved will likely be left scratching their head as misrepresenting infrastructure spending is a leisure pastime in Moscow when it comes to divvying up federal money for contracts. But a large influx of private investments would be necessary to sustain the likely myth these figures portray.

Project costs generate profits for businessmen rather than efficient construction of sustainably operable projects. Furthermore, state backing is needed for the biggest projects and state subsidies prop up infrastructure concessions and rail projects in particular. The more that costs can overrun for whoever wins the contract with the guarantee of state money, the more profitable the project becomes. The procurement of state contracts to build projects that receive some kind of financial support from the federal budget is key to the dispensation of favors and influence.

The development issue is compounded by the Ministry of Finance’s support for concessions for road and rail projects in which the expenditure from the concessionaire is 100 percent refunded by state money. Forty projects worth 270 billion rubles were organized using such concessions. These projects are generally located in remote areas east of European Russia, integral to any future trade agenda with Asia. As Putin seeks to bring money back from abroad, interest in concessions for projects in Russia is declining due to regulatory uncertainty over how they are to be administered. The number of tenders announced for concessions declined one-third from 1,836 to 1,138 last year. In other words, Moscow will have to provide more budget guarantees to convince anyone bringing considerable capital back into Russia to invest into the country’s eastern regions.  

The Bondsman Dialectic

The deoffshoring of wealth could then actually strain the budget further if that returned capital is committed directly into projects unless new finance mechanisms are developed, perhaps even with the proposed Eurobonds. However, the Eurobonds saddle Russia’s rich with the reverse problem of squirreling money away from sanctions exposure: their money is in Russia where it can be raided by others who can bring state resources to bear and good investment opportunities are few. Further, no one yet has any sense of how the bonds would function since the Kremlin would be using bonds in a foreign currency to repatriate capital at home.

Businessmen won’t jump at the chance to buy these bonds unless they can redeem their money with a state guarantee, likely putting pressure on the ruble if the investors have to be paid out in the currency denominating the bonds. Because taxes would be waived, it’s quite likely that most of those who bought the bonds would want the money in cash and dodge capital gains taxes in Russia entirely and, most likely, try to find ways to filter it out again after acting out a patriotic farce. All that is known for certain is that up to $3 billion in Eurobonds would be issued and no special conditions would be entailed with their issuance. In short, onshoring wealth does little to produce real benefits aside from creating a new pool of money to pilfer based on state needs and personal animus. As of yet, the date for their issue has not been announced.

Bear Market Traps in the Far East

Since deoffshored wealth is unlikely to flow into concessions for needed infrastructure projects or else will be recouped via the bond mechanism, the question remains as to what Russia’s business elite would sink their cash into in Russia itself. Russia’s Far East comes to mind as it occupies a special place in the country’s strategic outlook; its lack of development is a long-term threat to the country’s presence in Asia. The distribution of rents from Moscow — major initiatives led by oil and gas giants Gazprom and Rosneft — have spawned billions of dollars of projects.

Special Economic Zones (SEZ) have come to represent Moscow’s failed attempts to improve the attractiveness of the investment climate in the Far East. Results have been awful aside from targeted projects with foreign partners. Vladivostok and various other Far East ports have been sewn together into a strange configuration as the collective “Free Port of Vladivostok,” a zone with tax exemptions and other benefits meant to encourage foreign investment. As of last September, 393 billion rubles of investments were planned. There are reportedly over 700 projects planned, 400 of which together amount to around 1 trillion rubles. Eight projects in extractive industries and petrochemicals amount to 1.8 trillion rubles followed by 17 transport and logistics projects worth 172 billion rubles. But only 20 percent of the region’s investment has come from abroad with the rest often coming from Russians through intermediary offshore havens like Cyprus. As expected, state support in the form of financial guarantees or federal investments is a determining factor as to whether anyone invests.

The SEZs lay out special conditions designed to lure investors. In particular, five year windows were established which waived income taxes and other taxation completely for the first five years followed by reduced rates for the next five. But these have failed to generate interest, with hopes falling on so-called territories of accelerated development (TAD). The SEZ in Vladivostok was liquidated in December with more likely to follow. Unfortunately, TAD have also thus far failed to make up for the shortcomings of SEZs. Progress largely exists on paper.

Collectively, TADs and SEZs account for 0.2 percent of Russia’s foreign direct investment (FDI). Instead of preparing one TAD for real investments, it’s more common that new TADs are created to further spread the illusion of opportunity on paper and guarantee that investors will sign up as residents without offering investors any sense of what the window of time to receive a return on their investment will actually be. The worst part is that the basic infrastructure needed to encourage such investments such as proper roads are lacking to begin with, prompting a vicious budgetary circle where more state funding is needed to back infrastructure projects that would then enable TADs or SEZs to have an impact. Any money sunk into a project is basically lost. This prompts those looking for short-term means of stashing money beyond the Kremlin’s reach to find ways to register as residents of a TAD or SEZ, protect money via tax exemptions that otherwise wouldn’t be granted, and retain room to then pull money out of said projects before anything is substantively built or costs realized.

Deontological Deoffshorization

The startlingly poor quality of projects available to anyone onshoring their wealth back into Russia from offshore havens highlights the real value of bringing money back into the country for the Kremlin: it can be raided by the state.

Given that roads, rails, bridges, and the basics needed to sustain development outside of European Russia rely so heavily on guaranteed returns, an influx of capital for infrastructure development will paradoxically starve the budget. Reports that Putin supports initiatives from former Finance Minister Alexei Kudrin that would seek to prioritize long-term investments into sectors like infrastructure to boost Russia’s productivity and competitiveness are unlikely to solve the underlying issue for the sector: quality.

The only real reason to bring money back to Russia, whatever the circumstances, is an abstract sense of political duty and obligation. There’s a thick fog hanging over reform prospects for 2018, since no one really knows what to expect once Putin is re-elected in March. Something must be done, but there’s no clear consensus on how to better fund and construct infrastructure. Without that infrastructure, the development projects that will enable Russia to play a greater economic role in the Asia-Pacific will not get off the ground.

It should be no surprise that in 2017, only 3.27 percent of contracts linked to state-owned enterprises and state procurements went to small businesses. The 3.27 percent was depicted as a successful increase from the even lower 1.6 percent as of 2013. Siluanov and the Ministry of Finance found last July that only 5.6 percent of state procurements were competitive. Whatever the reform agenda, it’s unlikely to widen the circle of prosperity when it comes to these projects. Any wealth brought back from offshore havens will belong to businessmen who benefit from an unreformed system that protects their ability to use federal money for their own gain. The increasingly closed system surrounding major projects whereby the investment climate is too toxic for anything big to be built without large guarantees poses a strategic risk to Russia’s Asia-Pacific aspirations. Money from Cyprus or elsewhere won’t help Russia build anything without reform. Whoever Putin picks for prime minister and his cabinet will be the next signal as to whether or not Russia’s wealth can be put to better use.

Nicholas Trickett holds an M.A. in Eurasian studies through the European University at St. Petersburg with a focus on energy security and Russian foreign policy. He is a columnist and contributor for the Bear Market Brief, a blog and daily news brief on Russia’s politics and economy, and contributes to other outlets like Global Risk Insights, Oilprice, and Newsbase.

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