Russia’s main stock markets remain closed this morning after a slump in equities prompted the authorities to suspend trading. Falling commodity prices and financial turmoil have hit Russian investors hard. But Money Morning’s Jason Simpkins says Putin-lead Russia has itself to blame for scaring away foreign investment with its heavy-handed policies.

In its haste to reclaim its status as a military superpower, Russia almost completely neglected to forge a coherent economic policy.  Moscow has relied too heavily on its energy exports, veered away from the principles of a free market economy, and ostensibly transformed itself into a rogue nation – isolated from the support and capital, of Western nations.

The dramatic rise in oil prices provided Russia with the world’s third-largest stockpile of currency reserves, as well as a national budget surplus. But rather than channel that money back into infrastructure for the nation’s booming energy and agricultural sectors, the Kremlin funneled the vast majority into the military.

Russia’s revenue for the first half of 2008 amounted to approximately $176.5 billion, according to figures recently released by the State Committee for Statistics. And while expenditures totaled $120.9 billion in the first half, the Russian government is projected to spend roughly $278.6 billion under the full-year 2008 budget.

At least 25% of Russia’s expenditures during that time – or about $31 billion – went directly into defense and security, and that’s before Russian troops flooded into Georgia. The budget also includes $15 billion for discretionary spending, which means the amount allotted to national security could end up being closer to 30%-40% of overall spending.

Meanwhile, a paltry $133 million went into infrastructure for the country’s breadwinning energy sector. And the agricultural sector, which employs a large share of the Russian population, received just $363 million. Combined, those amounts equate to less than 1% of the budget for the first six months of 2008.

In addition to neglecting infrastructure improvement’s for its two most profitable sectors, Russia also failed to shore up what is proving to be an unstable banking sector.

“The Russian banking system is not developed enough to provide the long-term financing that companies need to grow,” Douglas Rediker, a Russia specialist and former investment banker at the New America Foundation, told the Washington Times.

“If the Chinese were to stop lending to the United States tomorrow, it would have a severe impact, but we would still have a pool of domestic funds available,” Rediker said. “In Russia, they don’t have the means to replace [global lenders.]”

That is precisely the problem now, as Russia’s recent military incursion into Georgia, and political interference in the private sector, have scared foreign investment out of the country.

Capital outflows totaled $21 billion in the two weeks ended Aug. 22 – the two weeks following Russia’s Aug. 8 invasion of Georgia – according to Goldman Sachs (NYSE:GS). Estimates of capital flight over the past four weeks range between $15 billion and $20 billion.

“At least in part because of the Georgia crisis, Russian financial markets have lost nearly a third of their value, with losses in market capitalization of hundreds of billions of dollars,” William Burns, undersecretary of state for political affairs, told a Senate hearing. “Capital is fleeing Russia, with $7 billion leaving on Aug. 8 alone.”

In a note to investors, UBS AG (ADR:UBS) reduced its price targets for Russian assets by an average of 20% acoss the board, based on increased political risk.

Putin’s Domestic Agenda Drives Off Investment

However, the military action in Georgia isn’t the only reason foreign investors are fleeing in these times of uncertainty. Over the past several years, and particularly the last few months, the Kremlin has been anything but a gracious host to foreign companies.

Two years ago, the government seized OAO Yukos Oil Co., formerly Russia’s largest oil producer, on trumped-up tax charges, and put its chief executive in jail. Soon after, Royal Dutch Shell (RDS.A, RDS.B) was forced to relinquish control of its Sakhalin-2 oil and gas project to OAO Gazprom for $7.45 billion, after the Russian government threatened to block investment plans by canceling building permits on environmental grounds.

Earlier this month, BP PLC (ADR:BP) finally conceded to the demands of its Russian partners over a dispute involving joint venture TNK-BP. BP gave in to demands by its Russian counterparts to replace TNK-BP’s chief executive, Robert Dudley.

This decision came after Russian authorities raided the venture’s Moscow offices in July, and arrested one employee for espionage, and after the government refused to renew visas for 148 employees, forcing Dudley to flee Moscow.

Finally, in July, Prime Minister Vladimir Putin criticised mining firm Mechel for selling coal cheaper abroad than on the domestic market. Referring to the company’s CEO, who had been taken ill, Mr Putin advised him to get better soon, “or we will have to send him a doctor and clean up all the problems.”

This resulted in an investigation by the Russian Federal Anti-Monopoly Service, and cost Mechel $5 billion in market capitalization.

Events such as these make it apparent that rather than encouraging private enterprise in Russia, policymakers are intent on nationalizing what parts of the energy sector they can, and dissolving what they can’t. This, as much as the war with Georgia and a policy of increasing isolationism, has driven investors from Russia’s market.

“Putin’s comments on Mechel made the initial impact, then after Georgia everyone started pulling out of the stock markets,” a British lawyer working in Moscow, who has seen deals cancelled and business dry up over the past few weeks, told the Independent.

“Add in to the mix that energy and commodity stocks have been falling worldwide on fears of a worldwide recession and you have a fairly bleak picture,” the unnamed lawyer told the newspaper. “If Putin knew how to behave, the crisis would be a lot less serious, as investors had until very recently seen Russia as a good place to weather the global economic storm.”

Source:  Russia’s Politics of Isolation Leave it Economically Stranded in a Time of Crisis