Foreign direct investment (FDI) inflows to the Russian Federation have been modest by any standard: according to the State Statistics Committee, the gross flow of financial capital to Russia’s corporate sector was $11 billion in 2000, about 40 percent of which (or $4.4 billion) was FDI. The accumulated stock of all financial capital in Russia between 1993 and 2000 amounted to $32 billion, about half of which was FDI. In per capita terms, the FDI stock in Russia is among the smallest in European transition economies. A hostile business climate and prohibitive controls efficiently bar access to Russia in general and to the energy sector in particular. In fact, only about 10 percent of last year’s FDI went to the energy sector.

Production-sharing agreements (PSAs) were designed to attract foreign investment in the energy and raw material sectors. These agreements also seek to ensure Russian control and at least 70 percent involvement in the exploitation of natural resources, with corresponding benefits. These rules and the prevailing business climate explain why only three, or possibly four, of the 28 PSA contracts approved since the introduction of the PSA regime in 1996 are operational.

Although the Ministries of Economy and Energy recently agreed on modification of the tedious authorization procedures, doubts have already arisen about the tax rules introduced in the draft of the new PSA law (that is, concerns over the possibility of double taxation). The PSA regime reflects the psychological or political ambivalence that Russian officials, policymakers (particularly at the regional and local level), and citizens feel toward FDI, which helps finance exploration but may exploit national assets and wealth to Russia’s disadvantage. The Russian government, however, acknowledges that foreign capital and technology are necessary to modernize the energy sector and calculates that friendlier treatment of foreign investors could bring in $60–$70 billion in foreign investments during the next 10–15 years.

Russia will need substantial amounts of financing to explore, extract, and transport oil, natural gas, and electricity to be able to meet expected Western European demand. IEA and Russian estimates indicate that investments of $5–$7 billion a year will be needed in the next 20 years simply to sustain the current level of oil production. About $2 billion a year is needed just to maintain production in depleting gas fields. Estimates of investments needed in the power sector are in the range of $5–$9 billion a year. Thus during the coming 20 years about $15 billion a year will be needed to keep the Russian energy sector in business.

The scant FDI is bound to slow development of Russia’s energy sector. Low, regulated domestic energy prices and nonpayment of energy bills increase strain on the sector. Russian energy production and investments, burdened by high capital costs, must also compete with lower-cost energy from elsewhere.

Time is running out. Exploration and construction of production facilities, pipelines, and related infrastructures takes years. It takes even longer to create market institutions and behavior conducive to a healthy business climate. Perhaps a more liberal and permissive PSA regime would serve Russian interests better by attracting FDI to Russia’s energy and raw materials sectors.

Juhani Laurila is an economist at BOFIT. This is an abridged version of his article "FDI and the Russian Energy Sector: An Ill-Managed Partnership," published in BOFIT’s Russian Economy: The Month in Review, April 6, 2001.

In an environment of high inflation and excessive exchange rate volatility, the ability of a domestic currency to provide the basic functions of money can be significantly distorted. Such conditions can motivate a country to substitute a more stable foreign currency for its domestic currency. This shift to a foreign currency as a store of value and unit of account is often referred to as dollarization. In the context of macroeconomic stabilization, the evolution of dollarization can serve as a direct indicator of the credibility of the domestic currency and the overall success of stabilization efforts.

In the earlier stages of transition, Lithuania, like other transition economies, experienced a flight from its domestic currency, triggered by near hyperinflationary levels of inflation and a substantial devaluation of the domestic currency. The U.S. dollar increasingly became the store of value, unit of account, and medium of exchange. The currency reforms of 1992–93 and the subsequent tightening of monetary policy and stabilization of the exchange rate helped restore public trust in the domestic currency and significantly reduced dollarization. The introduction of a national currency, the litas, in June 1993 led to a dramatic decline in the dollarization ratio in the second half of 1993.

Additional stabilization measures—including adoption of a currency board arrangement and the pegging of the litas to the U.S. dollar in April 1994—did little to reduce the dollarization of the economy, however, perhaps because of the low initial level of confidence in the currency board arrangement. Rumors of an impending devaluation of the litas persisted throughout the first half of 1995. As a result, the dollarization ratio hit a peak in the summer of 1995, rising to 50 percent over its 1994 level.

The Russian crisis in the second half of 1998 again increased dollarization in Lithuania— although, given the circumstances, the increase was surprisingly small. The big surge in the ratio came in the second half of 1999, when dollarization reached its highest level since 1995, probably in response to the rise in interest rates paid on dollar-denominated assets abroad. The continuing rise in the dollarization ratio may be related to the approaching repegging of the litas to the Euro, due to take place in early 2002, according to the Bank of Lithuania.