Russian Revival

As things look up in Moscow, one crucial ingredient remains missing: foreign direct investment 

MOSCOW – Only four years ago, Russia was an international pariah, defaulting on its debt, its currency in free fall. Now, in a world buffeted by corporate scandals, bankruptcies and crises in emerging markets, it’s a relative model of respectability.

As economies around the world are slowing, Russia has seen three straight years of robust growth. Buoyed by high oil prices and the 1998 ruble devaluation, which drove up the price of imports and made local manufacturers more competitive, Russia’s budget is in surplus and its foreign-exchange reserves at all-time highs. It’s paying off its debts on time and in full, its Eurobond yields are falling and its credit rating rising. Last year it had the world’s best-performing equity market after China.

The stock-market boom also has been fueled by changed perceptions of Russia, which under President Vladimir Putin is now a partner in the West’s war against terror. Its efforts to mend fences with old Cold Ware adversaries have been richly rewarded by a bigger role in the NATO alliance, membership in the G8 industrial nations and recognition by both the U.S. and the European Union as a market economy, The upshot: Russia is being seen by foreigners as a less risky place to invest.

But some skepticism remains. Foreigners may be returning to the Russian equity market, but are proving slow to set up their own operations here or buy Russian businesses. And that may put a crimp in Mr. Putin’s plans for accelerating economic growth.

Ugly-Duckling Economy
“Russian assets are simply not attractive,” says Olegy Vyugin, deputy chairman of Russia’s Central Bank. Foreigners, he says, are put off by the preponderance of corruption and government bureaucratic controls and a deep distrust of outsiders among Russian industrialists – especially in the provinces.

“You have to fight for investment, and Russia didn’t understand that for a long time,” says Mr. Vyugin. “The government always told foreigners, ‘Here are the conditions: If you don’t want to work here, then don’t.'”

The result is that renewed interest in Russia has yet to translate into big inflows of foreign direct investment. FDI stood at a minuscule $1.9 billion in the first half of this year – down 25% from the year earlier period. In contrast, China reeled in nearly $47 billion in foreign direct investment in 2001.

The lack of FDI is a problem for Mr. Putin, who came to power saying Russia’s economy needed to grow 8% a year for the next 15 years just to catch up with Portugal, let alone leading economies like Germany or the U.S. He was determined to lift his country out of poverty by raising economic growth and attracting Western capital flows.

So far, that’s a pipe dream. Earlier this year, Mr. Putin chided government ministers for their unambitious targets – they expect the economy to expand by 4% this year, compared with 5% last year and 9.1% in 2000 – and told them to aim higher. Economists believe much more fundamental changes are required if Russia is to see real, sustained growth – and more foreign investment.

The fact that changing sentiment toward Russia has so far failed to generate big inflows of foreign capital shows the uphill struggle Russia still faces in trying to convince the world it’s really changed. Under Mr. Putin’s predecessor, Boris Yeltsin, the country was renowned for its lawlessness, political chaos and thuggish business practices. Mr. Yeltsin’s Russia was best known for the way a group of tycoons, the so-called oligarchs, used their connections to snap up state-owned assets at giveaway prices. Foreigners’ mistrust of Russia peaked in 1998, when many emerging-markets hedge funds were wiped out in the country’s financial crash.

Meeting Resistance
Since entering the Kremlin in 2000, Mr. Putin has worked hard to put Russia’s house in order, pushing through changes aimed at cutting into the oligarch’s power and improving the country’s business environment. His government has slashed taxes, setting a 13% flat-rate levy on income, Europe’s lowest; allowed the sale of agricultural land for the first time since the Bolshevik Revolution of 1917; liberalized Soviet-era labor laws; and introduced a Western-style judicial system better able to protect property rights.

But other, more far-reaching changes that could mark a definitive break with Russia’s communist past and deliver the economic growth Mr. Putin wants are proving slow to get off the ground. A bold plan to reduce government interference in business has encountered tough resistance from the very bureaucracy it was supposed to curb. A socially painful plan to end state subsidies of energy and housing costs has been put on hold and is unlikely to go ahead before next year’s parliamentary elections. A long-promised root-and-branch overhaul of the civil service, a revamping of the banking sector, and the restructuring of Russia’s gas and electricity monopolies are all moving too slowly for some.

The lack of reform and foreign interest means Russia’s economic success remains largely dependent on something beyond its control: the price of raw materials, especially oil. When oil prices are high, Russia, the world’s No. 2 oil exporter, after Saudi Arabia, thrives: Investment increase, wages and living standards rise, and consumer demand surges. When oil prices are low, the economy sputters.

‘Like an Addict’
“Russia is like an addict, and oil is the drug,” says Yevgeny Gavrilenkov, chief economist at Moscow investment bank Troika Dialog.

Moscow’s efforts to wean itself off its dependence on raw-materials exports have been erratic. Industry is still dominated by a handful of big energy companies, while small businesses that have powered growth in other post-communist countries are underrepresented.

Yet in some ways, these energy giants are emerging as a key driver of economic change. Over the past few years, a handful of huge financial-industrial groups have emerged with their roots in raw-material exports, often compared with South Korea’s “chaebols,” or industrial conglomerates. These companies are often run by a new breed of corporate boss – young, profit-minded businessmen with ambitious plans to expand into all aspects of the country’s economic life.

The process began in the late 1990s when Russia’s oil, gas and metals tycoons, flush with cash from high commodity prices, began repatriating profits squirreled away for years in offshore tax havens. They bought up industrial assets across the economy at fire-sale process and welded them into huge, vertically integrated corporations.

Such a trend was almost inevitable in a country with no normal banking system. In the absence of financial institutions moving cash around the economy, only the big exporters were able to raise enough cash for acquisitions and investment. At the same time, they were big enough to counteract the “state mafia” – the name often given to the corruption and bureaucracy of government agencies that suffocate smaller firms.

The result has been an extraordinary concentration of ownership and wealth. According to a recent study by two Moscow-based economists at investment bank Brunswick UBS Warburg, Peter Boone and Denis Rodionov, 85% of the value of the 64 biggest private companies in Russia is controlled by just eight groups of shareholders.

Some economists worry this development could distort Russia’s economy, with the tycoons using their dominance of the market and influence with government to keep newcomers out. “There’s no place for new players in this system,” says Mr. Gavrilenkov, the bank economist.

But Messrs. Boone and Rodionov say the new owners are often a force for good. They say they tend to be young, financially oriented individuals keen to sell stakes in their companies to foreign strategic buyers. So to improve their market capitalization, many have restructured their holdings, boosting transparency and shareholder rights. In the process, they’ve become a “key lobby for strengthening property rights and implementing policies that improve Russia’s investment climate [and] reduce sovereign risk,” the study’s authors write.

A Change for the Better?
Perhaps the best example is Russia’s second-biggest oil producer, OAO Yukos, a private company owned by 39-year-old Mikhail Khodorkovsky. Under Mr. Khodorkovsky’s leadership, Yukos has improved productivity and boosted corporate governance and disclosure. That has sent the company’s share price soaring, as investors rewarded its high output growth, falling production costs and improved relations with minority shareholders. Others in the industry have begun to follow its lead.

Meanwhile, the new Russian bosses are filling the void where foreign investors should be. FDI is dwarfed by the huge capital expenditure of domestic companies, many of which are borrowing abroad to finance expansion. While FDI has dropped this year, portfolio investment in Russian equities and credits from Western banks to Russian entities actually grew. In the first half of the year, loans to Russian companies rose 60% to $6.3 billion.

The shift shows corporate Russia tentatively returning to international capital markets it was firmly shut out of after the 1998 crash. Companies like oil major OAO Sibneft and cellular-service providers OAO MTS and OAO Vimpelcom have raised funds on Western bond markets. OAO Gazprom, the natural-gas giant, issued $500 million in bonds this month, and is planning to tap U.S. investors with a $750 million bond issue next year.

Word Travels

The news about Russian companies’ new way of doing business does appear to be trickling down to investors. “We’ve seen a jump in interest from foreign multinationals who are sending big fact-finding missions to Russia,” says Niclas Sundstrom, an economist at Citigroup in London. He cautions, though, that “it usually takes 18 to 24 months for this interest to translate into domestic FDI inflows.”

Oil multinationals such as BP PLC and ExxonMobil Corp. are already making substantial investments in oil and gas exploration in Russia. Retailers like Swedish furniture group Ikea and the French supermarket chain Auchan are also making inroads. Renault SA is considering investing around $250 million in a new assembly plant in Moscow, and the first car produced by a joint venture between General Motors Corp. and Russian carmaker AvtoVAZ drove off the production line last month.

The change in perception of Russia has yet to show up in a big rise in figures for direct investment. But economists say there is clear evidence that corporate turnaround stories, structural reforms and Mr. Putin’s pro-Western orientation may be changing the minds of investors – even those with clear memories of 1998.

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