Another BRIC Bites the Dust

08/21/2008 12:00 am EST

Focus: GLOBAL

Howard Gold

Founder & President, GoldenEgg Investing

When Russian troops and tanks streamed into the republic of Georgia two weeks ago, they damaged more than a sovereign nation and their mother country’s reputation.

They also probably finished off one of the hottest trends in recent years—BRIC investing.

BRIC—a clever acronym for Brazil, Russia, India, and China—became shorthand for a whole way of investing: avoid the mature, boring markets like the US and go for the rapidly growing, emerging global powerhouses of the future.

And indeed, they gave investors eye-popping returns for a few years. China rose 500% over two years, while in the ten years since the Russian ruble crisis of 1998 India soared nearly 600%, Brazil skyrocketed more than 1,000%, and Russia advanced sixtyfold (that’s no typo) from its lows below 40.

Mutual fund companies and the exchange traded funds (ETFs) industry obligingly rolled out new funds so investors could capitalize on the trend.

But China and India have both plummeted from last year’s highs as soaring oil prices crushed these big energy consumers. Then energy-independent Brazil and big producer Russia got clobbered when oil began its big reversal in July.

The invasion of Georgia, coming on the heels of many troubling incidents, has made Russia persona non grata among investors.

“The bottom line is at this point, I would just stay away from it,” says Nicholas Vardy, the London-based editor of The Global Guru and Global Stock Investor.

But that follows an astonishing reversal of the country’s fortunes under former president (now prime minister) Vladimir Putin.

Marshall Goldman, professor emeritus at Wellesley and senior scholar at Harvard’s Davis Center for Russian Studies, is a leading US expert on Russia. He told me that Putin, whom he has met several times, has had a master plan to revive Russia’s stature since the mid-1990s. The former president had called the collapse of the Soviet Union “the greatest geopolitical catastrophe of the 20th century.” Amazing!

Goldman’s new book, Petrostate: Putin, Power, and the New Russia, traces how Putin, the head of the KGB’s successor agency, joined the faltering government of president Boris Yeltsin in 1999, a year after the Russian economy had hit rock bottom. The stock market had lost 93% of its value, the ruble was almost worthless, and the country was bankrupt.

Putin became president in 2000 just as oil prices began to recover. Russia is blessed with enormous oil and gas reserves—it became the world’s largest producer of petroleum in 2006. Putin was determined to harness those resources to promote a return to what he saw as “the greatness of the Czarist Empire and Soviet Union,” Goldman told me.

How did he do it? By focusing on a number of “national champions,” like Gazprom and Lukoil—companies in vital industries whose interests were aligned with the state’s. “Instead of allowing the country’s oligarch-controlled corporations to focus exclusively on making a profit, Putin proposed that they should be used to advance the country’s national interests,” writes Goldman.

That meant reversing the privatization of the 1990s. Putin’s regime squeezed out foreign owners and crushed the billionaire oligarchs who didn’t play ball. Result: “When [he] took over as president in 2000, the state’s share of total crude production was 16 percent; by late 2007, it had increased to about 50 percent,” Goldman writes.

Some executives of major companies were arrested, while others went into exile. Putin cronies often replaced them. Everyone knows what happened when Mikhail Khodorkovsky, then the richest man in Russia, openly opposed Putin: he was arrested and imprisoned for years for tax evasion, fraud, and extortion. His oil company, Yukos, was seized and bankrupted by the government. Three dozen people associated with the company or Khodorkovsky’s bank, Menatep, were jailed or forced to flee the country.

Meanwhile, Putin was consolidating power on the political front:

  • He launched a brutal second Chechen war that crushed Chechnya’s separatist movement.
  • Russian special forces killed dozens of their own citizens in an attack on a Moscow theater seized by Chechen terrorists.

  • The ability of opposition parties to operate was limited and the right of free assembly curtailed.

  • Control of the media was concentrated in state-friendly hands, and prominent journalists like Paul Klebnikov of Forbes were assassinated in the streets.

  • Former KGB officer Alexander Litvinenko was assassinated in London using radioactive polonium-210, and he and some friends accused Putin of direct involvement.

And now, of course, comes the invasion of Georgia, ostensibly to protect Russian nationals in the provinces of South Ossetia and Abkhazia. Despite many assurances, Russia shows no sign of withdrawing its forces to date.

And why should they, really? As Goldman sees it, the West has little leverage over Russia now. Maybe one quarter of Europe’s natural gas and 42% of Germany’s comes from Russia.

“There’s almost no place else Western Europe can turn for natural gas,” he says. If Russia turned off the spigot, “for the Germans it would be worse than the oil embargo of 1973.” 

So, add it all up and what have you got? “ With its natural gas and oil pipelines that tie Europe to Russia like an umbilical cord, Russia has unchecked powers and influence that in a real sense exceed the military power and influence it had in the Cold War,” Goldman writes.

And oh, yes, it still has an estimated 5,000 tactical (short range) nuclear weapons—maybe ten times what the US has in its arsenal.

And yet that power is based on a fragile premise: high oil prices. Energy accounts for a third of Russia’s GDP and almost two-thirds of exports. As oil prices tumbled, so did Russia’s RTS index—down more than 14% in July, even before the invasion of Georgia.

Meanwhile, wages are growing by more than 20% a year and inflation is 15%. And if oil prices fall below $110, says Vardy, “the ostensible budget surplus disappears.”

The government’s interference in the economy also makes this a dicey place to do business. A veiled threat by Putin sent shares of mining and steel company Mechel OAO (NYSE: MTL) plummeting nearly 40% in one day. And BP (NYSE: BP), one of the world’s most powerful oil companies, is being pushed out of joint venture TNK-BP by its Russian “partners.”

No wonder even Dmitry Medvedev, Putin’s figurehead president, complained earlier this year about Russia’s “legal nihilism”!

These days, investors have many ways to play oil or other commodities while avoiding Russia’s political and economic baggage. That’s why they’re voting with their wallets: They’ve pulled some $20 billion out of emerging market equity funds in the past ten weeks, the largest outflow in any similar period. Russian funds alone have seen $373 million in redemptions during that time.

So, BRIC investing now looks like just the latest in a long line of marketing gimmicks that promise investors instant riches but deliver only heartache. And emerging markets are so 2007. Clearly, for at least the next couple of years, this style of investing is over. 

Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own and do not necessarily reflect the views of InterShow or MoneyShow.com.

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