You can put new clothing on a formerly communist nation, but it's hard to change what's under its skin. Russia has really awful bones beneath its fairly unattractive surface, but what's scary is that China, which has managed to stitch together a far more appealing outfit, has terrible bones too.

Unfortunately for the world, China's skin-deep appearance is convincing many investors to put their cash there. But you should know the risks before investing in either one.

The fate of Russian tycoon Mikhail Khodorkovsky highlights the challenges facing any investor in that country. As The New York Times reported, Khodorkovsky ran the most efficient of Russia's oil companies, Yukos, by following Western standards of corporate governance. Yukos even got a clean audit from PriceWaterhouseCoopers. But he ran afoul of then-President Vladimir Putin, and Russia's legal system convicted him on multiple sets of trumped-up charges that eventually resulted in a 14-year jail sentence. Yukos was forced into bankruptcy, and its pieces were sold off at a discount to Putin allies.

To understand why it's hazardous to invest in these countries, it helps to think about the concept of a country's entrepreneurial ecosystem (EE). As my co-author Srini Rangan and I described in our book, Capital Rising: How Global Capital Flows Are Changing Business Systems All Over The World, the EE -- consisting of a country's corporate governance, financial markets, human capital and intellectual property (IP) regime -- helps explain why capital flows more to some countries than to others.

Calculating Russian and Chinese Capital Receptivity

Both Russia and China have similarly poor EEs. To measure just how poor, we applied a concept called the Capital Receptivity Index (CRI) that measures an EE using 23 specific factors -- distributed among the four elements listed above. Countries are scored on each factor from 1 (world's worst) to 5 (world's best), which makes the maximum possible score 115. Tallied as a percentage, the CRI of the U.S. is 82% (94/115), Russia's is 38% (44/115) and China's is 46% (53/115).

These numbers are subjective but were based on input from experts in each country -- lawyers who have worked on business-related legal matters in Russia and China for decades. With their input, the CRIs for Russia and China were calculated as follows (the numbers represent the how many points the countries get compared to the maximum):
  • Corporate governance. Russia (11/30) scored poorly due to tight government control of companies and poor protection of minority shareholders -- offset slightly by the absence of restructuring barriers. China (11/30) arrived at the same score as Russia, but it has slightly better protection of minority shareholders, with very little transparency and tight government control of companies.
  • Financial markets. Russia (11/40) scored poorly due to low valuations, no market for initial public offerings, weak transparency, absence of long-term shareholders and limited depth. China (17/40), while sharing some of Russia's weaknesses, got a higher score due to its higher valuations, limited IPO market and greater depth of market participants.
  • Human capital. Russia (18/25) scored well due to excellent technical skills, training and labor rates -- offset by weaker management skills. China (20/25) scored even better than Russia, sharing its technical skills, but enjoying more competitive labor rates and better management training and skills.
  • Intellectual property regime. Russia (4/20) scored poorly due to weak IP laws and lack of enforcement. China (5/20) arrived at a slightly higher score because it has some IP laws -- but they aren't enforced.
Capital, though, moves in response to more than just the entrepreneurial ecosystem: The simple reality is that investment flows to growth, and China, with its 10% 2010 GDP growth, is growing faster than any large economy in the world. Russia simply isn't growing as rapidly -- just 4% in 2010 -- and it has hired two dozen investment banks to help it raise desperately needed capital from foreign investors, according to The New York Times.

But in 2010, investors would have been better off in U.S. stocks despite America's slower, 2.8% GDP growth. The S&P 500 rose 13% in 2010, while China's Shanghai Stock Index lost 14.3% of its value. Surprisingly, Russia's Micex was up 22% in 2010.

Will Investors In Russia Get Fooled Again?

Unfortunately, Russia is under the illusion that it can use PR spin to dissipate investors' concerns about its past abuses of capital providers and convince new suckers to invest there. The fate of Khodorkovsky is one particularly unpleasant example. In Capital Rising, we discussed three cases of Russia's hostility to outside investors:
  • How Russia used its legal system to kick out BP executives, including Bob Dudley (now BP CEO), from an energy joint venture
  • How Russia offered the founder of Hermitage Capital, an investment firm that had placed capital in Russia, the option of his life or his money
  • How Sawyer Research, a small Cleveland, Ohio, company, lost its $8 million investment in a Russian quartz plant to "creeping expropriation"
Of course, China has its own EE Achilles heels -- like weak IP protection and little transparency or market depth for publicly -traded stocks there. Here are a two quick examples:
  • In Capital Rising, we discussed the case of a Boston-based venture capital investor, Michael Greeley, who grew up in Hong Kong. He concluded that it wasn't profitable to invest in Chinese ventures that hoped to compete based on unique technologies, due to the country's weak IP protection. Instead, he opted into Chinese ventures that used business models established in the U.S. to serve Chinese customers.
  • As I wrote on DailyFinance's sister site, BloggingStocks in May 2007, stocks on the Shanghai exchange have trading numbers rather than letter symbols. In China, an 8 is a lucky number, so people borrow money to buy stocks with lots of 8s in their trading numbers. In 2006, a Chinese citizen, Yan Caigen bought 30,000 shares of a cement company because of its lucky ticker code, 600881, which contains a double-eight. Yan's shares in the cement company, Jilin Yatai (Group) Co., promptly tripled, earning him about $50,000. Yan believes that the two "8s" in its ticker symbol were the good luck charm that made him money. A stock market that behaves on principles like those seems a bit too much like a casino for my taste.
The simple reality is that investors may get seduced into a country by high growth rates, but if that growth should slow, the country's bones will poke through. And in the cases of Russia and China, those bones have some serious flaws. If forced to pick one of the two to place my money in, I'd choose China -- but not without trepidation.

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vcgh2000

Peter...You still haven't convinced me to read your book.

January 07 2011 at 9:49 PM Report abuse +1 rate up rate down Reply
Gumby

Peter yougot to start learning to respect nations ... we have diplomats flying back and forth and there is nothing more we can do..

January 07 2011 at 6:17 PM Report abuse +1 rate up rate down Reply
Gumby

Why cannot you allow Russian or Chinese investors worry themselves? If we are invited to do business there, wonderful! If not, this is their country not ours... We would never allow them to invest too much here , let alone buy our T bonds.. What gives you the right to question them?? NOne!!

January 07 2011 at 5:59 PM Report abuse +1 rate up rate down Reply