Russia Emerging Stronger

We’ve been watching Market Vectors Russia (RSX) since last August, and had a buy price target of $10 on it. Since we began watching, it fell from $40 in August to $10.34 in January when it barely missed our price target, rose to $26 at the beginning of this month, and closed last Friday at $21.31.

Having witnessed that wide range, I asked myself if there was still a chance that Russia would hit newer, harder times to send the ETF down to the $10 level again. In pursuit of the answer, I dove back into our Russia folder for the latest reports. What I found was interesting, as it revealed how Russia will manage its politics and business together to control its energy economy. Remember, it’s the “R” in the BRICs, the future of the world economy as defined by Goldman Sachs: Brazil, Russia, India, and China. Its economic strategy is an important one to understand.

Russian President Dmitri Medvedev warned CNBC viewers of “alarming figures” when talking about his economy on June 2. His alarming figures were rising unemployment and falling industrial production — and those two figures are fairly alarming everywhere we look, not just in Russia.

In Russia, however, they’ve taken an especially large toll and put GDP on track for somewhere around 7.5% this year, a level not experienced since the fall of the Soviet Union twenty years ago. It fell almost 10% year-over-year in the first quarter alone. Foreign investment plunged 30% and that referenced unemployment figure is on its way to double-digits, as it is in the U.S. as well.

The near term, then, is far from rosy in Russia.

One group that doesn’t mind, though, is the Kremlin. Credit has always been hoarded by the Russian government, so private businesses headed by the famous oligarchs turned to foreign sources of capital for funding. When the credit crisis spun out of control last year, private corporations in Russia were more starved than their counterparts in other countries, most notably the U.S. where the credit crunch became a bonanza for the financial industry that found itself swimming in taxpayer capital.

In Russia, the relative balance of power shifted from the private entities, which were already under attack by the government, to the Kremlin. Foreign investors pulled out of Russia en masse, sending the ruble down in value, and bringing the Kremlin into currency markets to buy rubles in an effort to stave off another currency crisis like the one the ruble caused in 1998. The plan worked, the ruble stabilized, but private banks found themselves holding foreign-denominated loans that they couldn’t repay.

No problem, said the Kremlin, and it has been merrily consolidating the banking system to its liking and under its influence. The elite business leaders who survive this weeding out process will be pawns of the Kremlin, dependent on credit extended by state-controlled banks and subject to centrally-planned economic directives.

You can be sure that those directives will focus on managing political relationships around the world to maximize Russia’s economic benefit. Energy exports as a share of overall exports rose from 50% in 2000 to 66% last year, and the two components are crude oil and natural gas. Europe is trying to diversify its natural gas dependency away from Russia, and Russia is already working hard to limit that diversification through political wrangling.

For example, the Kremlin forced aluminum magnate Oleg Deripaska to give some $33 billion of his personal $36 billion fortune to boosting his aluminum company RUSAL and supporting the Kremlin directly. In return, Deripaska was given management of a state-controlled metals corporation where he can carry out other ideas from the Kremlin. The first was participating in a partnership between state-controlled Sberbank and Deripaska’s GAZ auto maker to buy German auto maker Opel. It also involved Canadian auto parts company Magna, and will result in Opel cars being made in Russia.

That kind of business web involving the Russian government, a Russian oligarch with business connections to the West, and Western businesses themselves is precisely how the Kremlin sees itself maneuvering through the coming decades of commodity scarcity and political sensitivity. The Opel buy — which was a kind of bailout, really — gave a big boost to German Chancellor Angela Merkel just ahead of her bid for re-election. The timing was no coincidence, of course, and brings both Merkel and Germany closer to Russia and farther from the United States. That will come in mighty handy when Europe discusses where to get its natural gas in the future, Russia or the U.S. At least one powerful voice, Merkel’s, will be suggesting Russia.

That type of government is not the type that runs through my blood as a U.S. citizen, but it’s one that looks appealing to me as a potential investor. I think the Russia that emerges from this credit crisis will be in far better position than the one that went in. The Kremlin has taken control of its currency, acquired the country’s most savvy international business people, and has already used those new assets to begin managing the political connections it will need to get the most out of its natural resources in the coming energy crunch.

Therefore, I doubt we’ll again see the $10 level on RSX. There’s too much relief in the air, too much anticipation of recovery, and too many smart investors on to the new teamwork happening between private companies and the Kremlin. On the latter, most seem to think the partnerships will be good for business, even if they result in government skimming as much profit off as it wants. That profit will assure that the state-connected businesses will have access to endless credit and a pretty tough partner on the world stage. In any event, there’s no longer doubt about government’s involvement in enterprise in Russia, and that alone helps investors quantify risks. At least it’s not an unknown anymore.

What I think could happen, however, is that the coming dip in oil prices that we expect could lessen the enthusiasm for the Russian economy, giving us a chance to get RSX at around $15. Therefore, I’ve changed our target price from $10 to $15.

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