A SUPPLEMENT TO EUROMONEY/APRIL 1998: EASTERN EUROPE
Bankers talk a lot about Russia’s potential to attract massive foreign investment. But, with only around $10 billion having been committed so far, foreign direct investment (FDI) has been slow in coming to Russia.
Part of the reason is that, to date, direct investments – as opposed to portfolio investments – in Russia have generally failed to produce returns for foreign investors, largely on account of the punitive tax regime. A string of high-profile disasters has also left would-be investors asking whether the slender rewards justify the very real risks.
Last year British consultancy Control Risks Group ranked Russia as the most corrupt country in the world. In its last “Transition” report, the EBRD paid particular attention to corruption, warning of the substantial cost to investors and the economy as a whole.
But the tables may, at last, be turning in Russia’s favour. The country is just edging out of a 10-year recession. “Given the natural resources and human capital, one unit of capital invested in Russia should produce some of the best returns anywhere in the world,” says Roland Nash, a senior economist at MFK Renaissance.
Last year foreign direct investment in Russia hit $4 billion, surpassing that in both Hungary and the Czech Republic. “The good news is that FDI doubled last year,” says Neil Parison, head of the EBRD in Moscow. “The bad news is that it is still very low.”
As smaller eastern European economies become increasingly saturated with foreign investment, there is a very real possibility that investors may finally turn to their gaze to the vast potential offered by Russia.
The biggest leap in foreign investment has come from the promise of unprecedented billions to Russia’s energy sector and the building of ever more factories to meet growing consumer demand. “Economic growth could trigger a wave of similar foreign investments,” says Nash.
President Boris Yeltsin’s decision to abolish the 15% ceiling on foreign ownership in the oil sector may be a sign that the government is at last serious about attracting foreign capital. Increasing pressure to cut this year’s budget will be an added incentive for the new government to encourage foreign investment. To do this, the government needs to convince existing investors that the problems of the past will not be repeated in future. A series of investor-friendly decisions in Russia’s commercial arbitration courts has helped to convince investors that they can get internationally acceptable verdicts. But a lot more needs to be done.
“The government has done little to help foreign investors,” says Tom Adshead, director of research at United Financial Group. Time and time again, foreign investors have seen projects stifled by any one of a hundred government bodies capable of strangling a foreign venture with red tape or surprise taxes. One foreign owner was told hours before opening a factory that it was, in fact, in breach of regulations, despite an earlier agreement. The owner was told either to wait three months for a further investigation into a possible breach of fire-exit regulations, or pay a small contribution to a local charity.
In the past 12 months there has been a slew of more public disasters as one high-profile joint venture after another has fallen apart. US oil company Exxon was dumbfounded when Russian officials withdrew its licence to develop an Arctic oil field. Local companies had lobbied the government, arguing that the concession was too lucrative to give to a foreign company. By this time, Exxon had spent millions of dollars on preliminary production. Meanwhile, German building-materials manufacturer Knauf and US-Russian cable venture Kosmos TV both spent most of last year battling through the courts for management control of companies which, on paper, they already owned.
While western investors lobbied the Russian government through their embassies and even heads of state – Knauf through German chancellor Helmut Kohl and Exxon through US vice-president Al Gore – obscure courts and regional officials proved that they could bring multi-million-dollar projects to their knees, regardless of the commitments from the federal government.
Many investors have found to their cost that deals negotiated with the federal government have not been recognized by local authorities. In 1992, Australia’s Star Mining negotiated a deal to extract gold in eastern Siberia. Despite agreements signed by then prime minister, Yegor Gaidar, and his successor, Victor Chernomyrdin, Star Mining was asked “who is Gaidar?” when they presented the terms to the local authorities. Last year a Russian court retroactively declared the mining project void. Star Mining had spent $72 million in development costs and the decision prompted three of the UK’s largest institutional fund managers – Mercury Asset Management, M&G and Robert Fleming – to complain to the Russian government in writing, threatening to withhold investment in Russia.
In December, Lennart Ahlgren, president of forestry-industries company AssiDoman finally pulled the plug on a $100 million pulp and paper mill in which AssiDoman owned the majority stake. Ahlgren claims red tape brought the project to a standstill. Legal action by the local authority had dogged the mill from the beginning. Local officials accuse AssiDoman of purging Russians from the management and trying to sabotage the plant in order to increase imports from the company’s factories in other countries. When funds intended for renovating the plant were impounded by local government officials, the company complained to Yeltsin.
For the moment, AssiDoman is left nursing a potential $71 million write-off after a court decision questioned the legality of AssiDoman’s ownership of the mill in the first place. Analysts say that the failure of AssiDoman has sent worrying signals to all potential investors.
“Russians are still ambiguous about foreign ownership,” says Adshead. “Here they think they’re doing you a favour if they let you build a factory. Everywhere else it’s the reverse.”
Some regions, particularly Moscow, St Petersburg and those along the river Volga, have done better than others in attracting foreign investment. While these more progressive regional authorities are competing aggressively for foreign investment, it is not clear that individual tax deals will be watertight under the country’s planned tax code.
Investors fear that the new code, due by the end of this year, may be retroactive, nullifying previous agreements they may have negotiated with regional authorities. Scott Antel, a partner at accountants Arthur Andersen in Moscow, thinks that “sweetheart” deals, made on a one-off basis, will not be legal under the new federal law, which aims to create a level playing field for all companies.
“Investors don’t need tax incentives,” says Antel. “The market is here. What they need is stability and reliability in applying the existing system and fine-tuning to recognize ordinary business expenses.” Bankers say the process must be made simpler. The hundred or so taxes that may be levied on any foreign venture must be cut to a reasonable number. They also want to see the number of conflicting official bodies involved in each project reduced and the gap between federal and regional authorities bridged. “There is still no clear, unambiguous package for foreign investors,” says the EBRD’s Parison.
Despite these problems, there have been some notable successes. The current maxim bandied about by investment bankers and other advisers is: “Only invest in Russia if you can afford to and can’t afford not to.” Climbing over all the obstacles takes financial strength. Says Bruce Bean, managing partner at US-Russian law firm Coudert Brothers: “If you don’t have deep pockets, stay out.”
Consumer-goods companies including Coca-Cola, Cadbury Schweppes, Mars and BAT have all fought hard to gain a strategic foothold. Russian advertising campaigns for companies such as Unilever and Procter & Gamble run into several tens of millions of dollars each year.
Coca-Cola and Pepsico’s global brand war took them into Russia long before most investors ever thought of Russia as a consumer market. Pepsi has been made in Russia since 1972 while Coca-Cola has poured $650 million into Russia and now boasts over 20% of the soft-drinks market.
Western consumer-goods firms are still expanding. In October alone Coca-Cola opened three plants while Pepsico has outlined a $550 million five-year investment plan to build a further six factories.
McDonald’s plans to double the number of cities in which its fast-food restaurants operate and has outlined investment plans of $70 million for 1998. Its 700-seat Pushkin Square venue in Moscow is its busiest outlet in the world, serving an average of 40,000 customers each day.
Other western brands have also won a significant market share. Foreign confectionery companies have about half the Russian market. Last year Cadbury Schweppes spent $120 million on its plant near Novgorod, while Mars has invested a total of around $500 million in the country. Cigarette maker BAT has invested more than $150 million in the past three years to reconstruct two tobacco factories, one in Moscow and one in Saratov.
Investment in car making is also beginning to take off. General Motors, Ford Motor Company and Daewoo all now build cars in Russia. By last December, 10,0000 Chevy Blazers had rolled off General Motors’ plant in Yelabuga, Tatarstan. At the end of last year, French car maker Renault announced that it would invest $350 million to save ailing Moscow car maker Moskvich. Despite financial problems at home, Korea’s Daewoo has also outlined investment plans of $1 billion. In the past few months, Fiat and General Motors have negotiated strategic alliances with two of Russia’s leading car makers, Gaz and Avtovaz (see box).
But perhaps the biggest investment so far comes from the opening up of Russia’s natural-resources sector to foreigners. Timan Pechora Company, a consortium of Texaco, Exxon, Amoco and Norsk Hydro, says it will spend $10 billion to explore deposits in the Timan Pechora basin north of Moscow. In mid-March, Lukoil and US oil major Conoco announced that together they would invest $2 billion to develop four oil and gas fields in the region.
Larger projects in western Siberia and in Sakhalin Island north of Japan demand even larger investment. Alongside Russian oil company Sidanko, British Petroleum plans to spend $170 million on evaluation work at Kovykta in the Irkutsk region. Reserves on this deposit alone are three times the UK oil company’s entire current reserves. Including pipeline costs, development costs could exceed $10 billion.
Development costs for the Sakhalin oil and gas fields are estimated at somewhere in the region of $50 billion. A series of foreign and Russian consortiums are involved. Sakhalin Energy operates one of the oil projects; Sakhalin 2 comprises US company Marathon (37.5%), Royal Dutch/Shell (25%), Mitsui (25%) and Mitsubishi (12.5%).
But unless parliament can pass adequate legislation governing production-sharing agreements, multinational oil companies could abandon Russia for opportunities elsewhere.
Car makers reach out
Although Russia’s leading car manufacturers are still a long way from achieving western standards of comfort, performance and safety, two leading companies have negotiated alliances with multinational car makers to produce western-style cars in Russia. In September, Gaz president Nikolai Pugin signed a deal with Fiat to create a $850 million joint-venture, Nizhegorod Motors, in which Fiat and Gaz will each take a 40% stake, while the EBRD takes the remaining 20%.
The aim is to reach production of around 150,000 Fiat cars a year within five years and encourage roughly 20 more suppliers of parts from Europe and the US to set up factories in Russia. Production at the Nizhny Novgorod plant is planned to start by the end of this year.
Says Patricia Isaeva, an analyst at United Financial Group: “If any joint venture is going to work in Russia, it is going to be this one.”
At the beginning of March, Avtovaz, Russia’s largest car maker, also teamed up with General Motors subsidiary Opel which plans to invest $80 million in a venture to assemble 35,000 Opel cars a year in Togliatti on the Volga. Although it was Fiat which built Avtovaz’s main factory in the 1960s – and the two companies had discussed reviving their old relationship – Avtovaz eventually plumped for a deal with General Motors.
If all goes well, General Motors will invest a far greater sum to build a new factory to produce up to 250,000 cars a year in a joint venture of a scale similar to that between Fiat and Gaz. Nikolai Kossov, general director of AVVA, Avtovaz’s main shareholder, says that GM’s taking an equity stake has not been ruled out.
It is Kossov’s ambition to see Avtovaz cars relaunched “around the world”. The company already supplies parts to Finnish company Valmet, which produces a restyled western version of the Russian Samara model.
Although Avtovaz has produced more than 30 million cars in the last 30 years, it still lags behind younger companies like Gaz in terms of the transparency of its management and accounting methods. “This is perhaps their greatest barrier to becoming internationally recognized,” says Isaeva. “If they stick with the Opel deal they may survive.”
Truck maker Kamaz may also regain its international reputation eventually. Based in Tatarstan, Kamaz once supplied most of Russia’s trucks. Although it is teetering on the verge of bankruptcy, a restructuring package engineered by Kohlberg Kravis Roberts (KKR) could bring the once mighty manufacturer back to life.
