Russia During President Putin's Second Term: A Business and Investment Review (Business & Investment Review)

Russia During President Putin’s Second Term:

A Business and Investment Review

Consultant Editor: Marat Terterov

Russia

Publisher’s note Every possible effort has been made to ensure that the information contained in this publication is accurate at the time of going to press and neither the publishers nor any of the authors, editors, contributors or sponsors can accept responsibility for any errors or omissions, however caused. No responsibility for loss or damage occasioned to any person acting, or refraining from action, as a result of the material in this publication can be accepted by the editors, authors, the publisher or any of the contributors or sponsors. Users and readers of this publication may copy or download portions of the material herein for personal use, and may include portions of this material in internal reports and/or reports to customers, and on an occasional and infrequent basis individual articles from the material, provided that such articles (or portions of articles) are attributed to this publication by name, the individual contributor of the portion used and GMB Publishing Ltd. Users and readers of this publication shall not reproduce, distribute, display, sell, publish, broadcast, repurpose, or circulate the material to any third party, or create new collective works for resale or for redistribution to servers or lists, or reuse any copyrighted component of this work in other works, without the prior written permission of GMB Publishing Ltd. GMB Publishing Ltd. 120 Pentonville Road London N1 9JN United Kingdom www.globalmarketbriefings.com This edition first published 2006 by GMB Publishing Ltd. © GMB Publishing Ltd. and contributors Hardcopy ISBN 1-846730-08-2

E-report ISBN 1-846730-09-0

British Library Cataloguing in Publication Data A CIP record for this book is available from the British Library.

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Contents 1. Editor’s introduction: a case of bringing the state back in? – Dr Marat Terterov, Senior Editor, GMB Publishing

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„ Back in the USSR: the encroachment of the state in the productive sectors

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„ Growth of the state and growth of the private sector

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„ Establishing guidelines, interpreting signals

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„ Does Russia want (foreign) investment, do investors want Russia?

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„ Institutional/macroeconomic framework

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„ FDI performance, corporate ratings and outlook

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„ The ensuing report

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2. Russia’s investment climate in 2005: one step forward, two steps back? – Peter Westin, Chief Economist, MDM Bank and Kim Iskyan, Head of Research MDM Bank

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„ Introduction

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„ The economy remains strong

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„ Legislative improvements

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„ Russia’s business and investment climate

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„ Foreign direct investment

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„ The stock market and new share issues

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„ The threat of re-nationalization

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„ Conclusion

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3. Recent legal developments – KPMG

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„ Corporate and antimonopoly legislation

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„ Real estate regime and land relations

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„ Arbitration and dispute resolution

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„ Employment law and work permits for expatriates

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4. Expert opinions: analysing some recent trends in Russian business legislation – Pepeliaev, Goltsblat & Partners

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„ Corporate legislation: the law so needed by major investors has still to be adopted – Andrey Goltsblat, Managing Partner of Pepeliaev, Goltsblat & Partners, JD

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„ Stakeholder construction – Vitaly Mozharowski, Partner, Pepeliaev, Goltsblat & Partners

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„ Intellectual property issues – Tom Stansmore, Head of Pepeliaev, Goltsblat & Partners, St Petersburg office 44 „ Tax issues: the establishment of Interregional Tax Inspectorates – Tom Stansmore, Head of Pepeliaev, Goltsblat & Partners St Petersburg office and Maria Andreeva, Head of Tax Department, Pepeliaev, Goltsblat & Partners 46 „ An overview of Russia’s Code of Corporate Governance – Anton Sitnikov, Partner, Head of Corporate Practice and Nikolay Zhdanov, Senior Attorney, Corporate Practice, Pepeliaev, Goltsblat & Partners 48

5. Basic changes in the Russian tax system in 2005–2006 – Denis Schekin, Partner, Pepeliaev, Goltsblat & Partners, J.D. „ Fundamental tendencies of change in the Russian tax system

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„ Changes in individual rules for the calculation and payment of taxes in 2005–2006

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6. East-West Institute Global Security Program – Danila Bochkarev

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„ The new legal environment in the Russian energy sector

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„ Gas transportation issues

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„ Russian gas reserves and production

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„ Russian oil reserves and production

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„ Oil transportation issues

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„ Conclusion

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7. Trends in the Russian telecommunications and IT sector during 2004–2005 – RBC Consulting

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„ The IT market

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„ Telecoms

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8. Key trends in the Russian automotive industry – Andrei Kouzmin and Maxim Andronov, Deloitte

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„ The Russian car market overview

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„ Domestic production

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„ Major FDI projects

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„ Prospective FDIs

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„ Conclusion

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9. Key trends in the Russian brewing industry – Andrei Kouzmin and Maxim Andronov, Deloitte

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„ Market overview

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„ Competition

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„ Market consolidation

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„ Distribution channels

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„ Production

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„ Conclusion

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Author biographies

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1. Editor’s introduction: a case of bringing the state back in? Dr Marat Terterov, Senior Editor, GMB Publishing Russian business continued to draw substantial media attention during 2005. Major corporate acquisitions such as Gazprom’s buyout of Roman Abramovich controlled oil company, Sibneft, for $13 billion in October 2005, and the nomination of the armaments export agency Rosoboronexport’s executives to a majority position on the board of directors of AvtoVAZ, Russia’s giant car producer, followed Rosneft’s acquisition of Yuganskneftegaz (the core production asset of Yukos oil company) at the end of 2004. The country’s economic performance has maintained a robust growth rate throughout the year, with energy exports both leading the way and underpinning Russia’s recent sense of macroeconomic stability. The country’s economic stability is reflected by the government’s (oil) stabilization fund peaking at around $50 billion by the end of 2005. Russia’s energy sector has helped create a sense of strategic significance over the country’s present standing in the international economy and, with oil revenues spilling over into other spheres of the economy, has ensured that investors retain substantial interest in the Russian market. However, despite the impressive magnitude of the M&A activity taking place in the Russian corporate sector, as well as the fact that the economic spillover effects of high oil revenues

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have ensured that investors remain attracted to Russia, much of the foreign interpretation of the Russian business environment has been increasingly critical of the growing nature of state intervention in the country’s economy. Concerns from foreign governments and the investor community initially raised over the Russian state’s sequestration of the assets of Yukos oil company following the arrest of the company’s chief shareholder, Mikhayil Khodorkovsky, have only been compounded during 2005. The European Bank of Reconstruction and Development (EBRD), in its annual transition report for 2005, has suggested (of Russia) that state intervention in the economy and centralization of (economic) decision-making has increased during the year, whereas the scope of the private sector has been scaled back, with the state reasserting control over Gazprom, Gutabank and the bulk of the remaining assets of Yukos oil company. The World Bank, in its November 2005 economic report on Russia, suggested that the Russian investment climate continued to suffer from a high degree of uncertainty, particularly in relations between the government and business in the so called ‘strategic sectors’. Furthermore, at a recent investment conference held in Moscow by the British think-tank, Chatham House, it

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was not just foreigners criticizing the encroachment of the state in the Russian economy. Russian (so-called) liberals such as Economic Development and Trade Minister, German Gref, spoke highly critically of Gazprom’s purchase of oil firm Sibneft, claiming that the state would not make the most optimal choice for the management of market sectors of the economy. Minister Gref added that it was his belief that the state would be better off channelling resources into modernizing infrastructure, rather than purchasing private companies. The Kremlin’s outspoken economic advisor, Andrei Illarianov, mentioned at the same conference that quasi-nationalizations were not just limited to the energy sector, and that the heavy machinery firm, OMZ, and the helicopter maker, Kamov, had also recently become ‘the prey of the same process’. While the EBRD has sought to impress on the Russian government that a return to market-based reform and private initiative is crucial in order to strengthen business confidence and attract investment, several analysts, both in Russia and abroad, have argued that the country does not really need – and is not looking to attract – foreign direct investment (FDI). Proponents of Russia’s current ‘take it or leave it’ attitude towards foreign investment argue the point that the country’s leaders are being lulled into a sense of complacency by an oil price boom that has brought cash flooding into the economy, sapping their drive to attract FDI into key productive areas. However, to analyse Russia’s current investment climate solely through the prism of increasing state intervention in the country’s economy would be only half the story. While the government’s re-capturing of some of the country’s vital assets in the state’s everexpanding interpretation of what it considers as ‘strategic sectors’ continues to grab the headlines, the real

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private sector is growing at a no less impressive pace. In sectors such as retail, consumer goods, food and beverages, banking and finance, as well as other ‘non-strategic’ sectors, private sector activity is rapidly accelerating and foreign investor participation is often significant. The brewing industry, for example, is now dominated by global players, with Heineken making $750 million in acquisitions in 2005 alone. Coca-Cola recently acquired Multon, a major Russian juice producer for $500 million, while global retailers such as Turkey’s Ramstore and Sweden’s Ikea continue to expand their investments in the country. Foreign banks have continued to increase their levels of exposure in the Russian banking sector, with Société Général, Banca Intesa and GM Finance amongst the newer of the foreign players to buy into the market during the year. Furthermore, established foreign players in the Russian banking sector, such as Citibank, Raiffeisenbank and BNP Paribas, have expanded organically during 2005 and announced plans to open numerous retail branches throughout the country in the ensuing years. Russia’s economy is going through a positive growth experience at present, but the rules of doing business – as is the case with many emerging countries – are still evolving, adapting to institutional and consumer trends, and defining themselves further. What does seem increasingly in evidence, however, is that the economicbusiness model emerging in Russia during president Putin’s second term is one where a mixed approach has been adopted, with strong elements of state involvement in strategic sectors, parallel to rapid, private sector induced growth in a variety of other industries. In the ensuing chapter, we will present an overview of the areas of the present Russian economy where the presence of government increased

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noticeably during the course of 2005. We will also look at the expansion of the private sector, as well as examining current investor perceptions of Russia and Russia’s perception of investors. The final part of the chapter will examine the institutional and macroeconomic context for investment in Russia, look at Russia’s volumes of foreign investment stock during 2005, and consider some assessments made about the country by international ratings agencies.

Back in the USSR: the encroachment of the state in the productive sectors The energy sector The resurgence of the Russian government’s economic role during the last 12–24 months has been predominantly seen in the country’s vital oil and gas sectors. The Russian oil industry, in particular, has been the primary driver behind the Russian economic recovery since the August 1998 financial crisis. The sector’s impressive increases in oil production since that time, and Russia’s increasing market share in the global oil markets, has predominantly been driven by dynamic and home-grown private sector oil corporations, including Yukos, Sibneft and others. During 2004–2005, however, Russia’s oil and gas industry has witnessed arguably as dramatic a reorganization as the very privatizations of the mid-1990s that created Russia’s energy sector blue chips in the first place. It is barely two years ago that the Khodorkovsky controlled Yukos was set to merge with the Abramovich controlled Sibneft in what would have potentially been one of the largest oil

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groups in the world. The combined group would have controlled roughly one third of Russia’s oil output, and a significant stake in the new corporation was to be sold to the likes of ChevronTexaco or ExxonMobil. However, as recently pointed out in the Western media, the Kremlin soon turned the tables on any such possibilities. Oil industry assets privatized in the dubious auctions of the mid-1990s are moving back under state control. The new order in the energy sector has been primarily achieved via three administrative and corporate developments, as reflected in the following comment from a recent analysis of the Russian oil industry by London’s leading business newspaper, The Financial Times: ‘First, the government dismantled Yukos and through a series of legally dubious machinations sold the largest part of it to Rosneft, the state oil company run by people close to the Kremlin. Second, it spent $7.5 billion on increasing its stake in Gazprom, Russia’s largest company, to 51 per cent. Third, it allowed Gazprom to buy Sibneft, the country’s fifth biggest oil company, in the largest deal in Russian corporate history. The result: the state has the majority control of Gazprom, which last year produced 20 per cent of the world’s gas. It has tripled the size of Rosneft and directly controls 30 per cent of Russian oil output. In addition, the state controls oil and gas infrastructure.

What implications do the recent sectoral reorganization and state’s reconsolidation of the Russian energy industry have for the country’s economy, for foreign companies looking to operate in the sector and for global energy supplies? Energy accounts for 40 per cent of Russia’s GDP and, in 2003, oil (40 per cent) and gas (14 per cent) were together accounting for over half the volume of Russia’s total

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exports. As would be the case with a major fall in the global price for its major energy exports, noticeable reductions in Russia’s production and export of oil and gas would potentially have enormous, and harmful, ramifications for the country’s economy. Since the state began to tighten its controls over the sector, however, most sources point out that production in the oil industry has been falling noticeably. In roughly the year that Yuganskneftigas (Yukos’s core production asset) has been under the control of Rosneft, for example, oil output has slowed significantly, despite the fact that oil prices have continued to rise rapidly during 2005 and the global supply of oil has remained tight. During the period 2000–2004, in contrast, Yuganskneftigas had been increasing production by an average of 14 per cent annually. For the Russian oil industry as a whole, the picture for 2005 was not looking any better. The Russian Federal Energy Agency recently stated that Russia’s five year long oil boom is showing signs of a major slowdown, with the country’s growth in oil output heading for its lowest yearly increase since 1999. The Agency confirmed that production growth for the oil industry would be around 2.5 per cent in 2005, with a similar figure expected for 2006. Output had previously been increasing by around nine per cent annually for the past five years. In a similar vein, annual growth in the export of oil has also been falling, with Russian government sources confirming that oil exports were expected to grow by 4.3 per cent in 2005, compared to 13.9 per cent in 2004. The majority of analysts cite the lack of investment in the industry resulting from the tightening of government control over the sector, together with higher taxes, as the main cause of the slump. Others point to the inefficiency of state energy companies, such as

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Rosneft and Gazprom, as a factor contributing to the slump in production and export figures. As far as the investment environment in the energy sector is concerned, although Russia still possesses massive potential for the discovery and exploitation of further reserves of oil and gas, recent times have been characterized by weak investment levels in the industry. Close observers of the Russian energy sector will recall British Petroleum’s acquisition of a 50 per cent stake in the Russian oil company TNK two years ago, in a deal hailed as Russia’s biggest ever foreign investment. It was assumed that the BP-TNK joint venture (JV) would lead to other JVs in the Russian energy sector, which was peaking at the time. However, it now appears that the BP-TNK deal seems to be more of an exception than the rule, and under the current regulatory climate no foreign company is likely to acquire more than a 25 per cent blocking stake in any major Russian oil company in the foreseeable future. Furthermore, other regulations currently being introduced by the Russian government will restrict companies with majority foreign holdings from bidding for licences to explore oil fields that are known to have more than one billion barrels of reserves or that are situated near sensitive defence sites. Under the current investment climate in the Russian energy sector, therefore, the rules of the game are shifting towards a similar regulatory regime to those prevailing in Saudi Arabia, Venezuela and other members of the OPEC cartel. Foreign participation will remain welcome, but to a limited degree, and under a regime where Russian state entities will hold the trump card in exploring the most lucrative opportunities in this crown jewel of Russia’s resourcerich economic sectors.

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Other sectors Although many analysts of Russian business have now succumbed to the state’s seemingly inexorable appetite for bringing the majority of the country’s genuinely strategic oil and gas industry back under the Kremlin’s control, there is concern within analytical circles that the state’s definition of industries/assets that it considers to be strategic, continues to widen. The Kremlin’s widening level of economic interventionism is aptly summed up in the following comment, by an analyst from the Moscow-based investment bank, Renaissance Capital: ‘Following on from its success in renationalizing much of the oil industry, the state is moving into new industries. It had been hoped that the state would need some time to digest its acquisition of Yukos and Sibneft. It appears instead that success has emboldened further action, particularly through the mechanism which allowed the nationalization of Sibneft. Last week’s push to gain state control over the Board of AvtoVAZ follows on from the recent acquisition of Power Machines by state controlled UES (the electricity monopoly). Rumours continue to circulate about the state’s interest in Norilsk Nickel, (as well as further enterprises in the sectors for oil, gas, metals, heavy machinery, cars and trucks). It seems difficult to avoid the conclusion that the post-Yukos scenario of an ever-widening definition of the state’s strategic interests is becoming a reality.’

The case of the state’s initiatives to take control of the board of directors of AvtoVAZ, which was taking place at the time of writing, is particularly interesting. AvtoVAZ is Russia’s leading automobile producer and one of the country’s largest private corporations – originally a stateowned enterprise dating back to the

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Brezhnev years, before the company was transferred into a private corporation in the post-Soviet period. Following the resignation of the company’s long-term chief executive, Vladimir Kadannikov, last October, a controlling stake in the auto giant was acquired by the state-owned arms export agency, Rosoboronexport. A majority stake in the company was previously held by AvtoVAZ top executives. As suggested by analysts of the Russian automobile sector, from this point on, and seemingly in line with current Kremlin policy, AvtoVAZ will operate under direct state control. It is thought that the government might seek an investor for its stake in the company, but no concrete details of this were available at the time of writing. Also during the month of November 2005, Gazprom confirmed it had purchased a controlling stake in OMZ, one of Russia’s largest heavy machinery firms. There have been suggestions that the creation of a major state-controlled national engineering corporation is in the making, based around the state’s recent acquisition of Power Machines and OMZ, which have been acquired by RAO UES and Gazprom respectively. Furthermore, the privately held conglomerate, Sistema, very recently announced that it was selling its Kamov Holding to Oboronprom, a state-owned industrial investment group. Acquiring these assets and appointing individuals loyal to the Kremlin to senior executive positions will go a long way to adding to the impressive array of senior executive positions already held by Kremlin loyalists in some of Russia’s largest companies, including Gazprom, Rosneft and Aeroflot. Clearly, such trends are contrary to what many foreign observers have been expecting in relation to Russia’s transition towards a market economy, and what one may refer to as ‘a retreat’

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away from economic liberalization appears in evidence.

Growth of the state and growth of the private sector Although the role of the state is clearly consolidating in the Russian economy during Putin’s second presidential term, we would not be doing total justice to an in-depth analysis of the prevailing Russian investment climate to simply concentrate on the growing economic role of the state. While Russia still has considerable (if not infinite) distance to travel before it satisfies the aspirations of Western proponents of economic liberalizlation, a consumer culture – not too dissimilar to that found in mature market economy states – has been taking root in Russia, and market institutions have been emerging. While the big, statesponsored corporate takeovers are currently stealing the headlines, the less spectacular, day-to-day business of conducting private enterprise is expanding in Russia at an arguably even more impressive rate of knots than the role of the state in the so-called strategic sectors. Both Russian and foreign private enterprise is active and thriving in numerous consumer sectors of the country’s market economy, including retail, finance, construction and trade, while some sectors, such as brewing, are practically dominated by global multinationals. Such trends are once again aptly summarized by Moscowbased analysts who are somewhat closer to the Russian investment climate than some of the foreign Russia watchers:

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‘The progress (being made by) the (Russian) private sector is continually underestimated. The opening of another Ramstore or Kopeika supermarket franchise in the regions, or the acquisition of Russia’s 10 millionth consumer credit customer is not of itself particularly dramatic. But every time somebody takes out an auto loan and is thereby enabled to buy a better (foreign) car, there is an increase in the vested interest to broaden the market economy. Retail loans have more than trebled in size since January 2004 to $35 billion, banking assets have increased from 30 per cent to 45 per cent of GDP in five years. Moreover, the expansion of the private sector is in some ways more impressive than the growth in the role of the state. Retail, finance, construction and trade are where the (economic) growth is most rapid, not oil, gas, heavy machinery or metals. The next big wave of support for the private market will come as the mortgage market takes off, creating a new set of vested interests in private property and competition for credit.’

We have already mentioned private investor (particularly foreign investor) activity in the beverages sector. In the financial sector, the private sector has been very active and foreign players have been particularly active during 2005. Some of the main acquisitions made into the Russian banking system by foreign banks and their Russian JV partners have included: „ Société Générale’s acquisition of 100 per cent of Delta Credit mortgage lender for c.$100 million; „ Banca Intesa’s acquisition of 75 per cent of KMB-Bank for $90 million; „ Rusfinance’s (a JV between Société Générale and Baring Vostok Capital Partners) acquisition of

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100 per cent of Samara-based Promek Bank for c.$40 million; „ DnB NOR’s acquisition of 97 per cent of Murmansk-based Monchebank for $21 million; „ GE Consumer Finance’s acquisition of Delta Bank, a Moscowbased consumer lending bank, for $100 million from Delta Private Equity Partners. Despite these acquisitions, foreign banks still only control eight per cent of total Russian banking system assets, although no formal limits on foreign ownership in this sector are in place. State banks still dominate the system with Sberbank, Vneshtorgbank and Gazprombank ranked one, two and three respectively.

Establishing guidelines, interpreting signals The main problem as far as the majority of mainstream investors are concerned, is not so much the conflict that president Putin’s administration has had with the owners of Yukos oil company, or the fact that the Kremlin has come to an agreement with Roman Abromovich over the buy-out of the oil company Sibneft, but rather how to interpret the intentions and subsequent actions of the Russian political elite, be it at the federal or regional levels. Given the state’s very recent movements facilitating takeovers of enterprises in the automotive, machinery and other industrial sectors, investors are finding it increasingly difficult to ascertain which industries (or even which enterprises) are a ‘safe’ destination for their capital. Whilst during much of 2004–2005 it seemed that only the ‘national jewels’ in the energy sector were becoming increasingly off limits to all but a select few strategic investors, the recent

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round of state-sponsored takeovers in other sectors has further aroused investor concerns. Hence, it may not have been overly surprising that when ConocoPhillips bought an eight per cent stake in Lukoil in 2004, it was limited to increasing its holding in the Russian oil major to a stake not exceeding 20 per cent, given the recent regulatory trends in the energy sector. However, in a more surprising recent development for the business community, Siemens was blocked from acquiring a controlling stake in the major Russian engineering group Power Machines (Siloviye Mashiny) on the grounds of national security. It is not surprising, therefore, that at a recent meeting of senior Russian government members with the Foreign Investment Advisory Council (FIAC), an umbrella group representing the major foreign investors in Russia, FIAC’s shopping list of concerns relating to the country’s business climate was substantial. It included many of the familiar (to investors) thorny issues including taxation, customs and tariffs, administrative barriers to market entry, access to natural resource deposits, government-defined strategic enterprises, etc. The top concern, however, as voiced by the President of the American Chamber of Commerce in Russia, was ‘clarification of the limits on foreign participation in strategic industries’ and other sectors, since investors now clearly realized that such limits would exist. President Putin has ordered his government to clarify the guidelines in the light of investor perceptions about lack of clarity on which sectors are ‘open’ for investment, and a recent cabinet re-shuffle may lead to such clarification from the government. The establishment of clear guidelines on which sectors are strategic and those which are open to the private sector, however, is an issue that investors have faced for numerous

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decades in many emerging market environments, where the political risk to investment has always been higher than that prevailing in mature market environments. In Russia’s case, however, the rhetoric from the government, or at least its liberals, has in fact been one of promoting the market and retrenching the role of the state – as is evidenced in some of the statements of Economic Minister, German Gref, mentioned earlier. This, in itself, has served to encourage investors, though it is axiomatic that markets tend to react more to actions rather than words. Even in the strategic sectors, despite the most recent trends, there is evidence suggesting that the government is courting investors. In September, for example, after the Minister for Industry and Energy Victor Khristenko told President Putin that the government should lower taxation in the oil and gas sector, the president indicated the Kremlin would be prepared to give oil companies tax breaks in order to encourage investment in exploration and development of new and difficult fields. Furthermore, Gazprom has recently announced that it is seeking a foreign investor to take a 30 per cent stake ahead of a planned IPO. However, with every major corporate shake-up involving the government – be it Yukos, AvtoVAZ or M&A activity involving Gazprom, UES or the big Russian oil majors – the markets tremble. As summed up by the well-known Russian economist, Evgeniy Yassin: ‘they (investors) are wary of the actions of the ruling establishment. Every time it moves, they suspect that the number of strategic sectors where foreigners will come under state pressure will increase. These are sectors such as telecommunications, power machinery, construction and the like.’

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Does Russia want (foreign) investment, do investors want Russia? So does Russia want, or need foreign investors, recent press headlines seem to be asking? Whether investors want Russia, on the other hand, is a question that has been debated continuously by analysts since the country commenced its arduous path along economic transition. The relative attractiveness of Russia’s investment climate has been the subject of constant debate ever since. However, given the state’s recent flexing of its economic muscles, coupled with the government’s much improved fiscal position on the back of high oil revenues, voices are being raised as to whether Russia actually needs foreign investment. According to one Moscowbased press source: ‘The country’s leaders are being lulled into a sense of complacency by an oil price boom that has brought cash flooding into the economy, sapping their drive to attract FDI into key productive areas. The country has never been so flush with cash. Foreign exchange reserves have shot up to a record $164 billion as billions of dollars are flowing into the stabilization fund, due to hit $50 billion by the year’s end. Economists (however) say Moscow’s increasing coolness towards foreign investors, especially in the oil and gas industry – now seen as the preserve of Russians, with outsiders (being left) in a subordinate role at best – could cost it dearly in the future. The hardening attitude marks Russia out from other top emerging economies, which have made attracting FDI, especially in manufacturing, a top priority.

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Analysts suggest that Russian’s new mood of investment self-sufficiency was summed up by Prime Minister Mikhail Fradkov’s recent failure to show up at the press conference of the recent biennial World Economic Forum in Moscow. This was quite a turnaround from the previous Forum of October 2003, where President Putin actively fielded numerous questions from foreign investors anxious about what, at the time, was the beginning of the demise of Yukos oil company. In more recent times, the President’s comments have been somewhat more pragmatic, and although he recently supported the Energy Minister’s initiative to lower taxes in the energy sector, he likewise added that investors must not abuse any potential tax breaks. Others, such as Yevgeniy Yassin, allude to the fact that Russia’s current economic environment may be creating a situation where investors are more attracted to Russia than Russia itself is attracted to investors. Given that the Russian economy is still riding the wave of its oil boom, investors are increasingly taking the view that this is a good time to come to Russia to make money. Investors do not come to Russia to stay for good (although many indicate their long-term intentions) and are enticed by the big earnings that the prevailing conditions in the country promise them for doing business there. While much of Yassin’s position is more relevant to portfolio investors seeking to make a quick profit on Russian equities, most analysts agree that it is unrealistic for the situation to continue, given the fragility of this formula’s dependence on the energy paradigm. Therefore, it is more than likely that longer term projections of economic stability and attractiveness of the Russian investment climate will involve measures to move away from heavy energy dependency and encourage

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the development of sectors such as manufacturing and IT, as well as consumer oriented sectors capable of feeding into growing domestic demand within the country. We have already mentioned here that sectors such as retail, food and beverages, brewing and financial services are experiencing substantial development in Russia at present, with significant volumes of FDI realized. Russia’s liberals, such as Gref, Illarianov, and Anatoly Chubais, Chairman of the country’s electricity monopoly RAU UES, augment this view and have constantly voiced their support for FDI and economic diversification away from energy dependence. The moves by Gref’s ministry to introduce special economic zones to encourage the IT sector, for example, has been welcomed by investor bodies such as FIAC, which has suggested that these could help further open the door into Russia for smaller investors. Anatoly Chubais, has made continuous public calls on foreign investors to help develop Russia, and, despite the recent slowdown in electricity sector reform, there is, presently, substantial foreign holdings in the UES electricity monopoly.

Institutional/macroeconomic framework Despite the recent ascendancy of the Kremlin into the ‘commanding heights’ of the Russian economy, the country’s outlook for business and investment remains largely stable. During the period of Russia’s recent economic recovery (roughly1999– 2004), the Russian economy grew by 48 per cent, which equates to a yearon-year average of some 6.75 per cent. As suggested by the chief economist of the Moscow investment bank Troika Dialog, these years of ‘easy

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growth’, which have been fuelled by favourable international commodity prices, are unlikely to continue. However, while an economic slowdown has already been in evidence during 2005, Russian economic growth remains strong. The country’s macroeconomic stability is not only reflected by the increased volumes of oil revenues flowing into the oil fund and high levels of the Central Bank’s currency reserves (currently estimated to be $50 billion and $165 billion respectively), but also by the fact that the government is ahead of schedule in paying off its debts to its international creditors such as the Paris Club and the IMF. Furthermore, the government has been running a healthy surplus in the federal budget for each year since president Putin has been in office. Russia’s sound macroeconomic fundamentals have also reduced the urgency to implement further structural economic reforms, which have been ongoing throughout Russia’s transition to a market-based economy. Experts now predict that no serious reforms will take place until after the 2008 presidential elections, since the authorities are primarily concerned with maintaining social and political stability, hence ensuring a smooth transfer of power within the framework of the Kremlin’s plans for the country’s president post-2008. However, at the regional level, many of Russia’s governing entities are planning to launch far-reaching and ambitious reforms of local selfgovernment, scheduled for 2006. The federal government, for its part, has placed a priority on increasing the activity of the state in the economy in partnership with private investors through PPPs, special economic zones as mentioned previously, and concession agreements. Real GDP growth in Russia for the first half of 2005 was 5.6 per cent, with the highest growth rates being

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achieved in retail (11.7 per cent), construction (8.3 per cent) and industry (four per cent – although this was down from 7.4 per cent in 2004). Russian economic growth in 2005, according to a recent economic report from the office of the World Bank in Moscow, has been influenced by three factors – a continuing rapid expansion of domestic incomes and demand, improvements in the expectations of investors, and growing competitive pressures from the real appreciation of the rouble. In fact, economists add that changing patterns in Russian consumer demand are likely to cause an alteration in the structure of the Russian economy, where it should become less dependent on oil and other commodity exports, and more on domestic consumer confidence, the attractiveness of the prevailing investment climate, and other similar drivers. In short, the country’s economy will start to resemble the type of economic models prevailing in the OECD countries. At the present time, Russia still remains an economy largely dependent on commodity exports and favourable global prices for its chief commodities. The country’s chief sources of export revenues remain oil and gas, metals and chemical products. However, as recently suggested by the president of the EBRD in relation to Russia, there have been but a handful of successful economies built on oil and gas. Analysts allude to the fragility of the current Russian economic policy being predominantly centred around the oil and gas industry, and we have already shown here that growth and investment in the energy sector has slowed considerably during 2005. The ensuing 12–24 months are likely to be critical for Russian economic diversification and the shift in the country’s economic model to one that is more reflective of the OECD countries. A continued slowdown in growth and

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investment in the sector, or a negative adjustment in global energy prices, will most likely pressure the Kremlin’s policy-makers to promote diversification and encourage investment in the economy more broadly.

FDI performance, corporate ratings and outlook Similarly, regarding the situation with Russia’s macroeconomic and institutional outlook, many analysts also tend to agree that the general outlook for investing in Russia remains positive. Despite the Yukos affair and the state’s active engagement in the economy, investor bodies such as FIAC point out that Russia has become Europe’s second most attractive investment destination after Poland – though further improvements in the investment climate are still necessary, FIAC sources acknowledge. Indeed, according to the recent economic report on Russia from the World Bank’s Moscow office, the Russian government has been taking steps to improve the business environment for both portfolio investors and FDI, as is reflected by the country’s improved outlook in the eyes of the international ratings agencies: A combination of explicit efforts by the government to calm investors and even higher expectations of oil prices have made the Russian market more attractive. After the difficult years of 2003 and 2004, attitudes of foreign and domestic investors have unquestionably improved. In this context, Russia received credit rating upgrades for Fitch (August 2005) and Moody’s (October 2005).

Net inflows of FDI have been increasing during 2005. During the first

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half of the year, FDI totalling some $4.5 billion had made its way into the Russian economy – an increase of around 30 per cent on the first half of 2004. While this is no doubt a positive indicator for investor confidence in the Russian economy, Russia still rates a poor second to other major emerging market economies, as well as East European economies in transition. China, rated by many as the world’s top emerging market, attracted FDI totalling $5.25 billion in September 2005 alone, whilst Brazil’s cumulative FDI for the first nine months of 2005 was just short of $12 billion. Around 40 per cent of Russia’s total FDI during the first half of 2005 can be associated with Dutch investment made into the Sakhalin II energy sector project in the Russian Far East. Outside of this project, leading Russian sectors that have attracted noticeable volumes of FDI are trade, food and beverages, real estate and the financial sector (some of which we have already discussed in this chapter). Leading investors into the Russian economy during 2005 have come from Cyprus and Luxembourg (which is, of course, Russian offshore capital making its way back into the country), followed by the Netherlands, Germany and the United Kingdom. Portfolio investors, badly shaken by the Yukos crisis during 2003–2004, have been returning to Russia in 2005 and the Russian Trading System Cash Index (RTS) has risen by over 70 per cent in 2005. Analysts tend to conclude that investors now tend to believe that Yukos was a one-off, politicized event unlikely to be repeated in the current business cycle. On a further positive note, according to a recent study by the World Bank ranking the ease of doing business around the world, Russia has become a significantly easier place to do business than both Brazil and China, as well as a host of other emerging

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Russia

market economies. As a place to start up and operate a business, Russia ranked 79th out of 155 countries, well ahead of China (91st) and Brazil (119th), although well below the OECD countries. The study points out that Russia is improving in areas such as business start-ups (less days and less bureaucratic procedures required to establish a corporate presence), registration of real estate (Russia ranks amongst the top 10 countries with the lowest cost to register real estate) and ease of hiring new employees. However, the study also revealed some negative developments, including an increase in the amount of days required to register real estate (52 days, as compared to 37 days in 2004), and obtaining licences for industrial projects remains extremely difficult in Russia, while it has also become more difficult for investors to fire workers. A further negative development in 2005 was the fact that Russia fell by 30 places on Transparency International’s Corruption Perceptions Index (CPI), down to 128th position. It was revealed by a Transparency International representative during October’s World Economic Forum in Russia, that according to perceptions of corruption levels in the country, Russia is in the same group as Nigeria, Albania and Sierra Leone. The dramatic worsening in Russia’s CPI was predominantly due to ‘the huge gap between the anticorruption rhetoric of the authorities and the actual situation at business sites’. Persistent and high levels of corruption in Russian business have not been aided by the actual levels of transparency in Russia, corporate culture, which have remained low by international standards. The majority of Russian companies remain guarded and often highly secretive about their ownership structure, and corporate governance practices acceptable to Western investors are seen in only a handful of leading

12

Russian corporates. Russian banks, in particular, remain highly secretive about their ownership structures and asset base, according to a recent study by the ratings agency Standard and Poor’s. Several individuals control Russia’s banking sector according to the study, but their identity is off limits to the general public or outside investors. Furthermore, in a rating of the overall corporate openness of Russia’s largest companies, Standard and Poor’s found that such corporations are significantly less transparent than their British counterparts. Although the study revealed that Russian corporates have become more transparent during the period 2003–2005, Standard and Poor’s attributes the improvement to the least transparent companies catching up to the more transparent ones, rather than those who have already showed some levels of transparency becoming comparable to British firms.

The ensuing report In the ensuing pages of this report, the reader will be able to gauge the opinions of economic, legal, tax and other leading specialists on the major key trends taking place in Russia’s business and investment environment during the period roughly corresponding to President Vladimir Vladimirovich Putin’s second presidential term thus far (ie early 2004 to end 2005). The report is presented here as an analytical and updated resource for the foreign investor, designed to complement GMB Publishing’s foundation product, Doing Business with Russia (4th edition), published in December 2004. The latter publication, comprised of over 400 pages of in-depth information provided by over 20 authoring companies and individuals, continues to provide a comprehensive range of

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analysis pertaining to Russian business legislation, the political system, economy, investment climate, taxation regulations, sectoral analysis and regional overview. As a follow up to the mainstream Doing Business with Russia publication, the current report is intended to bring international investors adequately up to date with the major

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developments in the Russian business and investment environment during the last 12–24 months, and examine the level of changes in commercial legislation impacting on investor strategies. It is designed to be read both independently, as well as in follow up to the mainstream Doing Business with Russia publication.

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2. Russia’s investment climate in 2005: one step forward, two steps back? Peter Westin, Chief Economist, MDM Bank and Kim Iskyan, Head of Research MDM Bank

Introduction 2004 was considered a good year for investing in Russian fixed assets, especially in retail and other consumerrelated sectors. Twelve months ago there were big hopes that 2005 would be a great year. Many large foreign companies looking to invest in Russia were waiting in the wings for the Yukos affair to come to some sort of conclusion before committing their capital. Equity investors also had high hopes for 2005. At the very least they expected better performance than in 2004, when most only managed modest returns. At the beginning of 2005, political risk was still an overriding concern. However, with the remarkable growth witnessed this year in Russian and CIS markets (and not only the oil sector) the question for foreign companies has moved from being ‘should we enter the market?’ to ‘when should we enter?’ and ‘how can we successfully manage the risks associated with the market?’ Russia is a very attractive market with substantial investment potential, but investors need to be aware of the problems associated with investing here. The most commonly cited problems include tax risk, corruption, a constantly changing and opaque

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regulatory environment, government bureaucracy and weak enforcement of contracts. The banking system is underdeveloped, so businesses face difficulties obtaining financing. The domestic business and investment climate improved drastically in 1999–2002, but the government’s reform programme stalled in 2003 and has yet to get back off the ground. A number of surveys, such as the EBRD’s ‘Business Environment and Enterprise Performance Survey’ and Transparency International’s corruption index, indicate that the business climate actually deteriorated in 2005. At the same time, according to consultancy firm A.T. Kearney, Russia is now the sixth most attractive investment destination in the world (China occupies first place). To uncover the reasons for this difference of opinion, we have to weigh the risks against the potential. Furthermore, we need to make a distinction between direct investment and mergers and acquisitions on the one hand, and portfolio investment on the other. „ Direct investment opportunities differ between sectors. Strong economic growth and the consumer boom have created significant scope for direct investment

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Russia

into projects with exposure to consumer demand. As the state increases control over the natural resources sector, opportunities for direct investment in this sector are diminishing. „ Portfolio investors were clearly shaken by the Yukos affair in 2004, but the issue finally fizzled out in 2005. Investors came to the conclusion that Yukos was a one-off, politically motivated issue, and they began to return en masse. At the same time, new companies were coming to the market. In 2005, $5.1 billion worth of IPOs were held, which helped boost the equity market: the RTS rose by more than 70 per cent during the year. Following a brief discussion on Russia’s economic strength, we will look at the legislative environment and describe the most important laws passed in 2005. Then we gauge Russia’s business and investment climate by analyzing some key findings from well-established surveys. The following two sections are devoted to key developments for direct investors and portfolio investors, respectively. The

final section discusses the major threat to Russia’s prosperity – the widespread re-nationalization of assets.

The economy remains strong Russia has made tremendous economic progress since the August 1998 crisis. In 1999, GDP amounted to $200 billion and GDP per capita was $1,345. Six years later, GDP has ballooned to $750 billion, and per capita GDP now stands at $5,200. The year 2005 was another year of strong macroeconomic performance. GDP grew by more than six per cent, both the fiscal and current account enjoyed a healthy surplus, and domestic demand continued to soar. The major boon for the Russian economy has been the continuing strength of global oil prices, which have been on an upward trend for almost seven years but really took off in 2005, reaching a new record high. From 2000 to the end of 2005, the price of Urals Med averaged $30.7/ bbl; in 2004 the average was $34.1/bbl; and in 2005 it was more than $50/bbl. A snapshot of some key economic data (see Table 2.1) comparing Russia’s

Table 2.1 Key economic indicators* 1992–1998

1999–2005(f)

GDP growth

-6.8

6.7

Industrial production growth

-9.1

7.3

Real disposable income growth

-4.3

6.7

Fixed investment growth

-17.7

9.2

Inflation

544.6

18.0

-8.1

2.7

1.8

11.5

16.4

28.5

Budget balance, %/GDP Current account balance, %/GDP Urals Med USD/bbl, period average *average per year, unless otherwise stated Source: Rosstat, Central Bank, Bloomberg, MDM estimates

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economy between 1992–1998 with that of 1999–2005 tells a story of what looks like two different countries. GDP declined on average by 6.8 per cent per year between 1992–1998, while in the seven years following the crisis, GDP grew 6.7 per cent on average. Over the last seven years, Russia has had the 15th fastest growing economy in the world (out of 172 countries featured in the IMF’s database). A similar pattern of strong decline vs strong growth is visible for all variables. The most crucial difference, however, is the fiscal balance, which during 1992– 1998 was strongly negative but turned positive in 2000 and has remained in the black ever since. Similarly, the current account surplus averaged 11.5 per cent of GDP in 1999–2005 vs 1.8 per cent in 1992–1998. Russia’s strong macroeconomic position provides substantial support for the real economy and the capital markets. A strong current account and fiscal surplus is a reflection of strong domestic liquidity, which partly supports the domestic capital markets. The high oil price has led to solid profits in the oil sector, despite it operating under a high tax burden. Also, strong and growing consumer demand bodes well for telecom stocks and other consumer-related companies. In a similar fashion, strong economic growth has boosted electricity consumption and hence stocks such as UES and local energos. More importantly, growth has spread throughout Russia; indeed we expect regional growth to outpace that of Moscow and St Petersburg – especially those with large urban centres and/or significant raw material reserves. The fact that Russia’s economy is so fiscally secure has helped to reduce risk. In fact, all three major rating agencies – Moody’s, Fitch, and S&P – have largely based their decisions to grant Russia investment grade on the country’s strong financial position,

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though they have expressed wariness over the lack of progress on the reform front. A key factor when rating a country is the risk of default. Russia’s external debt fell from 74 per cent of GDP in 1999 to a mere 12 per cent in 2005. A debt/GDP ratio of 40 per cent or above is considered critical, so Russia is currently well within the comfort zone. Furthermore, the country’s fiscal position and the safety cushion of the Stabilization Fund, which has so far been well managed, have also added to increased confidence. As the economy expands, companies in all sectors are working to expand along with it, and hence IPOs and private placements are becoming more prevalent. In 2005, more than $5 billion worth of IPOs were held, compared to a total of $1.3 billion in 1992–2004. This figure is set to rise further in 2006, when some major companies should come to the market, such as Rosneft (a state-owned oil company) and Vneshtorgbank (a stateowned bank). Although the economy has shown few signs of diversifying, the market for portfolio investors certainly is. IPOs – both executed and planned – involve mainly companies in the non-oil sectors.

Legislative improvements The improvements in the business and investment climate since the 1998 crisis can be attributed to legislative reform undertaken between 1999 and 2002. Perhaps the most important of these was an overhaul of the tax regime. In 2001, income tax was set at a flat rate of 13 per cent, and in 2002 corporate tax was set at a flat rate of 24 per cent. The government also introduced a simplified tax regime for small businesses, allowing companies with fewer than 100 employees and annual revenue of less than RUR15 million ($520,000) to pay either a

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Russia

15 per cent profit tax or six per cent of their annual turnover. During this period, other legislation was also passed to reduce the bureaucratic burden on businesses. This has had a particularly positive impact on small and medium-sized businesses. But although it has become easier to set up a business, and the number of licences and frequency of inspections have been cut, and public officials still break the law. Moreover, laws are passed but not always implemented to the letter. However, the Duma elections in late 2003 and the presidential election in early 2004 caused the reform programme to stall. The situation was not helped by the Yukos affair, which was unfolding at the same time. Although the Duma has passed much legislation since, the focus has mainly been on amending existing laws. Sadly, a number of laws and amendments have had a negative impact on the business climate, for example a law that introduced more regulations for foreigners to receive Russian visas, and laws aimed at restricting foreign participa-

tion in certain industries that are being drawn up. However, there have been some positive developments: in 2004 a deposit insurance law was passed, and a draft law that would allow the Central Bank to withdraw licences from undercapitalized banks is currently under discussion in the Duma. This law is expected to come into effect in 2007. With the Central Bank’s poor record of pushing ahead with banking reform, the bill is a fresh addition to the introduction of deposit insurance, as well as the ruling of setting the minimum capital requirement for banks at $5 million – the latter to come into effect in 2007. The Central Bank has hinted that it may introduce a grandfather clause for existing banks, and thus make the law applicable only for banks created after 2007. This would be a mistake, in our view. The current minimum capital requirement is $1.0 million, and as many as 400 of Russia’s 1,390 banks do not even meet this requirement, according to Central Bank statistics.

Table 2.2 Legislation passed to remove red tape Law

Effective from

Comment

Law to simplify business registration

July 2002

Limits registration fees and stipulates that registration should be completed within five days of application and handled by a single agency.

Law to regulate inspections

August 2001

Limits inspections by government officials to once every two years.

Law to regulate licences

February 2002 Reduces the number of business activities requiring licences from 800 (1,600 including those illegally imposed by some regional authorities) to 100. Reduces the waiting period for licences. Sets an average licence fee and extends their validity for a period not less than five years.

Source: CEFIR, media reports, Russian government

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The Duma has also passed a law to establish special economic zones, which will grant favourable conditions for taxes and investments. So far, six regions have been chosen to host such zones: four will focus on new technology, and the other two will focus on industrial production. Investment in these zones is expected to begin in 2007. A new batch of economic zones could be created during 2006, as the government would also like to

establish some in eastern Siberia and the Far East. As a concept, special economic zones have worked well in India and China, and in more industrialized countries like Ireland and the UK (specifically Wales). However, this does not mean that success is guaranteed – after all, shortly after the 1998 crisis Russia actually scrapped economic zones that it has established, including one in Kaliningrad, citing a lack of progress.

Table 2.3 Positive legislation passed in 2005 Law

Status (as of 10 December 2005) Comment

Law on revoking licences for undercapitalized banks

Passed by the Duma in second reading

Law on establishing free economic zones

Signed into law by the president Two types of free economic zone are to be created, one type focusing on industrial production and the other on the development of new technology. Residents in these zones will not have to pay import duties, but will have to pay export duties in full.

Law on minor out-of-court tax fines

Signed into law by the president Allows the collection of minor fines for underpaid taxes without a court ruling, applicable to fines of less than RUR50,000 ($1,700) imposed on companies and organizations and less than RUR5,000 ($170) imposed on individuals.

Law simplifying agricultural land deals

Signed into law by the president Simplifies delimitation procedures and allows farmers to buy land from the government at market price or at a price set by regional law after they have rented the land for at least three years or occupied and improved it for an extended period.

If a bank’s capital adequacy ratio falls below 2% or remains below 8% for more than three months, the Central Bank can withdraw its licence. If the ratio remains below 10% the Central Bank can take action to prevent the bank from going bankrupt. Expected to come into force 2007.

Source: Media reports

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Russia desperately needs to focus on improving the overall investment and business climate, and focusing on special economic zones could draw attention away from the bigger picture. Having said that, initiatives aimed at fostering high-tech industries should be welcomed, as this is an area with substantial potential. This is particularly the case in Russia, which can draw on a well-educated workforce.

WTO membership within sight Joining the WTO is one of the government’s major goals. The target date for accession has been set for 2006. At the time of writing it looks as if Russia’s negotiations with the United States are heading for deadlock. The sticking points for the United States are Russia’s 20 per cent import tariff on new aircraft, restricted access to the financial markets, intellectual property rights, and hygiene standards in agriculture. Russia has made it clear that it will not budge on aircraft import tariffs or relaxing access to the financial services markets. Washington complains that to get a foothold in the Russian market, foreign banks are restricted to opening branches, as they cannot own subsidiaries. In our opinion, it appears as if Russia will enter the WTO in late 2006 at the earliest. WTO membership would foster greater economic integration with the rest of the world and provide a boost for the investment climate. Although the benefits of membership for natural resource rich Russia are likely to be fewer than they were for manufacturing intensive China, it should have a particularly positive impact on small and medium-sized businesses, which gain from greater foreign direct investment and export growth. Russian businesses in general would benefit from access to the WTO’s arbitration mechanisms. Furthermore, entry

20

could also be a catalyst for banking reform.

Russia’s business and investment climate The European Bank of Reconstruction and Development (EBRD) periodically produces so-called transition indicators that attempt to estimate the state and progress of reforms in Central and Eastern Europe. The bank rates issues such as privatization, enterprise restructuring, competition policy, banking reform, etc, on a scale from 1 (no reform) to 4+ (representing the standard seen in an industrialized market economy). Converting the EBRD indicator into a fully numeric scale (for presentation purposes)1 places Russia in the middle of the pack of transition countries, although it is one of the more advanced in the CIS. While this indicator shows that Russia made some progress between 1999–2004, the recently released indicator for 2005 shows that no progress was made during the year. Russia was the only country in the index to witness a deterioration in its transition indicator. The EBRD downgraded Russia’s mark for largescale privatization from 3+ to 3 following what it described as the ‘re-nationalization of large private companies in the oil and gas sector’ – a clear reference to Yukos and Gazprom. However, the EBRD upped Russia’s mark for banking reform and interest rate liberalization from 2 to 2+ on the back of improved regulations and increased intermediation. The EBRD’s 2005 Business Environment and Enterprise Performance Survey (BEEPS)2 also found that Russia’s business and investment climate suffered during the year. The EBRD compared this result to that of

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4.5 4.0 3.5 3.0 2.5 2.0 1.5

Tu rk m

en is t B U el an Bo zb a sn ek rus Se ia H Ta ist rb er jik an ia ze ist M go an on v i Az ten na er eg b ro M aija ol n d U ova kr a Ka Alb ine a z Ky ak nia rg hs yz tan FY R e R M Ru p. ac ss ed ia G on eo ia Ar rgi m a R en om ia Sl an ov ia Bu eni lg a C aria ro at ia Li Lat t Sl hu via ov an ak ia R Po ep la . C Est nd ze on ch ia H Re un p ga . ry

1.0

Source: EBRD, MDM estimates Figure 2.1 Reform progress, 2005 5 4 3 2

Serbia & Mont.

Armenia

Ukraine

Poland

Moldova

Lithuania

Hungary

Georgia

Czech Rep.

Uzbekistan

Tajikistan

Romania

Estonia

Bulgaria

Slovak Rep.

-2

Bosnia & Herz.

-1

Russia

0

Azerbaijan

1

Source: EBRD Figure 2.2 Change in the EBRD’s Transition Indicators, 2005 vs 2004

2002, which itself showed a distinct improvement on 1999. The result from 2005 was distinctly disappointing in comparison. The 2002 BEEPS survey showed a clear improvement in all aspects3 compared to 1999 (see Figure 2.3). In the left-hand graph, this is represented by the dark line (1999) falling inside the light line (2002). The most significant improvements were seen in accessibility to financing and a reduction in crime and corruption. The quality of infrastructure (telecommunications,

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power, railways and roads) had also improved sufficiently by 2002 to pose almost no obstacle to growth anymore (although this did not indicate that they were not in need of improvement). The EBRD’s comparison of the 2002 and 2005 BEEP surveys was not a direct one: the criteria used in 2005 were slightly different4 to the 2002 study. This explains why the 2002 line in the right-hand graph has a different pattern than in the left-hand graph. In the right-hand graph the lighter

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line represents a benchmark of no change, while the dark line represents the actual change between 2005 and 2002. A line falling inside the benchmark represents an improvement, and a line falling outside the benchmark represents a deterioration. The graph clearly shows that under the EBRD’s criteria there was almost no change from 2002 to 2005. Other surveys have backed up this finding. In December 2005, Transparency International released its latest World Corruption Index, which showed that in terms of corruption Russia is now placed a lowly 126th out of 159 countries. This is Russia’s lowest level since 2001.

slowed. While it is reportedly easier to register a business and inspections are less frequent, small businesses still have to deal with officials who are sometimes prepared to violate the law.

Foreign direct investment Although the general perception is that Russia’s investment climate made little progress in 2005, FDI reached record levels. The Central Bank reported an inflow of $11.4 billion in 1H05, up 145 per cent on 1H04, and net FDI worth $3.5 billion, up 180 per cent on 1H04. For the full year, we expect an inflow of FDI of $17 billion, and a net inflow of about $5 billion. Gross inflows of FDI have increased every year since 2001, even during the Yukos affair. This indicates that while Yukos had a clearly negative effect on portfolio investors, it had less of an impact on fixed investment. In 2005, the list of countries investing in Russia was topped by Cyprus (18 per cent of the total) and Luxembourg (17 per cent) – a clear indication that flight capital is returning to Russia and being invested back into the economy. Russians are clearly beginning to trust Russia again – possibly the best indicator of investor confidence.

Small businesses The World Bank and the Centre for Economic and Financial Research (CEFIR), a Moscow-based think-tank, have, since 2002, conducted a survey to monitor the administrative barriers to the development of small business in Russia. The survey covers 2,000 small businesses in 20 regions and in all sectors. Each survey published so far has shown evidence of further improvements. This was also the case with the latest survey, which covered 2H04 and was released in November 2005. However, the rate of progress 1

1999

1

1.5

2002

4

1

7 3

7

2

2

0.5

2

0 6

1 6

3

3 5

4

2002 benchmark 5

4

Change between 2002 and 2005

Source: EBRD Figure 2.3 Changes to the business climate under the EBRD’s criteria

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Russia

20

USD bn

15

10

5

F

04

05 20

20

03 20

02 20

01 20

00 20

99 19

98 19

97 19

96 19

95 19

94 19

93 19

19

92

0

-5 Inflow

Net FDI

Source: Central Bank of Russia Figure 2.4 Foreign direct investment, gross inflows and net inflows

Although this increase is very positive, the expected net inflows of $5 billion in 2005 represent a mere 0.7 per cent of GDP. Net FDI for all 27 Central and East European countries is expected to average six per cent of GDP, so Russia has, in fact, one of the lowest levels of FDI of all the former communist economies. Setting net FDI against the size of the population further highlights this point. Since 1989, when Russia began its transition towards a market economy, it has received net FDI equal to $89 per capita. This compares with

5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0

close to $5,000 per capita for the Czech Republic and Estonia, and $4,000 per capita for Hungary. Furthermore, two other natural resource rich countries in the CIS, Kazakhstan and Azerbaijan, have received net FDI of $1,600 and $1,300 per capita, respectively. Of all these countries, only Uzbekistan and Tajikistan have received less net FDI than Russia. Setting cumulative net FDI against GDP per capita, with the latter acting as a proxy for a country’s level of economic development, shows, perhaps not surprisingly, that more developed

USD

USD89

.

C

ze

ch R Es ep t H on . un ia ga ry C ro a L tia Sl atv ov ia e Ka Po nia za lan k d Buhsta Li lga n Az thu ria Se er an rb ia R bai ia Bo FY Mo om jan sn R M nte ani ia a ne a H ce gr er d o ze on go ia Al vina b G an eo ia Tu A rg rk rm ia m en en ia M ista ol n d Be ov l a Ky Uk aru rg ra s yz in R e R ep. u Ta ss U jiki ia zb st ek an is ta n

ep

ak

R

ov

Sl

Source: EBRD, MDM estimates Figure 2.5 Cumulative net FDI per capita, 1989–2005

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transition economies have attracted a larger amount of FDI. Figure 2.6 shows that Russia, set against the trend line, is a significant outlier. Moreover, the EBRD’s transition indicator (see Figure 2.7) shows that countries that have achieved more in terms of structural and institutional reforms have also attracted more investment. Russia, again, is revealed as an underachiever. Russia’s inadequate investment climate, which is strongly associated with the insufficient progress in structural and institutional reforms, is clearly to blame for Russia’s inability to attract significant capital. But the government’s unwillingness to open up strategic sectors, particularly the

financial sector, to foreign investors is also to blame. This becomes more apparent when we look at exactly which sectors are attracting foreign investment (see Figure 2.8). Since the August 1998 crisis, foreign investment has mainly been going to the retail, wholesale and catering sectors, which account for 34 per cent of total investment. These sectors are strongly linked to Russia’s ongoing consumer boom. In contrast, given Russia’s dependence on oil, gas and metals, foreign investment in these sectors remains relatively low. Only 16 per cent of total investment has gone into oil and gas, with 13 per cent going into metals. A paltry two per cent has been invested in Russia’s financial sector.

FDI per capita, USD

6,000 Estonia

5,000

Kazakhstan

4,000 Azerbaijan

3,000

Czech Rep. R2= 0.55

Hungary

Slovenia

2,000 1,000 Russia 0 0

5,000

10,000

15,000

20,000

GDP per capita, USD

Source: EBRD, Rosstat, Central Bank of Russia, MDM estimates Figure 2.6 Cumulative net FDI and GDP per capita 6,000 Czech Rep.

FDI per capita, USD

5,000 Estonia 4,000 3,000

R2= 0.50

Kazakhstan

2,000 Poland

1,000 Russia 0 -1,000

1.0

1.5

2.0

2.5

3.0

3.5

4.0

EBRD transition indicator

Source: EBRD, MDM estimates Figure 2.7 Cumulative net FDI and reforms

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Russia

16%

Fuel (16%)

30% 13%

Metals (13%) Transport and communication (6%) Trade & catering (34%) Finance (2%)

2%

6%

Other (30%)

34%

Source: Rosstat Figure 2.8 Foreign investment in Russia by sector, 2000–2005

Table 2.4 lists some of the most significant FDI projects during 2005. What is encouraging is a noticeable increase in investment in the banking sector, which is a sector we expect to attract increased attention. A large share of FDI is attributable to companies such as IKEA, Ramenka and Metro, which have had a significant presence in Russia for several years. Increased investment in the banking system should be welcomed. By dissecting the EBRD’s transition indi-

cators we get an indication of which reforms matter most for FDI, which is indicated by the highest R-square (see Figure 2.9). With an R-square of 0.67, financial sector reform has the strongest relationship with FDI. However, causality cannot be established, so we cannot say whether FDI is dictated by the state of a country’s banking system or whether FDI in fact assists banking reform. Nevertheless, given the progress made in bank reform during 2004 and 2005, Russia’s

Table 2.4 Selected direct investment projects in 2005 Investor

Amount, $ milions

Target

Industry

Coca-Cola HBC

501

Multon

Food

ALCOA

257

BKMPO SMZ

Metals

First National Holding (FNH) and Emergent Telecom Ventures (ETV)

215

Peterstar

Telecoms

SUN Interbrew

200

Tinkoff

Brewing

Sanoma Magazines

185

Independent Media

Media

GE Capital

150

Delta Bank

Banking

Orkla

120

Sladko

Food

Societe Generale

105

Delta Credit

Banking

Banca Intesa

90

KMB Bank

Banking

Orient-Express Hotels

85

Grand Hotel Europe

Hotel

Heineken N.V.

60

Baikal brewery

Brewing

Heineken N.V.

60

Patra brewery

Brewing

Handelsbanken

60

Greenfield investment

Banking

Source: Media reports

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attractiveness to foreign investors should seen an improvement, albeit a modest one. A sector breakdown of FDI in Central Europe shows a different story, partly because these countries are not large producers of natural resources (see Figures 2.10 to 2.12). Nevertheless, it is interesting that a large proportion of FDI has gone into the financial sector. In both the Czech Republic and Poland, financial sector investment accounts for 20 per cent of

the total, and in Estonia it accounts for 55 per cent. As these countries began to implement wide-scale reform, they not only privatized their banking system but also allowed foreign banks to participate in the privatization process. As we have already mentioned, Kazakhstan has attracted more FDI than Russia. Kazakhstan has more or less completed reform of its banking and pension systems, whereas Russia has been a laggard on these issues.

6,000 Czeck Rep. FDI per capita, USD

5,000 Estonia 4,000 2

R = 0.67

3,000 Kazakhstan 2,000

Poland

1,000 Russia

0 -1,000

1.0

1.5

2.0

2.5

3.0

3.5

4.0

EBRD banking reform indicator

Source: EBRD, MDM estimates Figure 2.9 Cumulative FDI per capita and financial sector reform Trade & catering (12%)

12%

23%

Transport & communication (21%) 21%

Finance (20%) Real estate (7%) Food processing (5%)

11% 5%

Machinery & equipment (11%) 7%

20%

Other (23%)

Source: Czech National Bank Figure 2.10 FDI breakdown for the Czech Republic, 1993–2003 4.5%

11%

Finance (47.4%)

8.4%

Real estate (15.7%) 47.4%

Manufacturing (13.3%) Trade & catering (8.4%) Transportation & communication (4.5%)

13.3% 15.7%

Other (11%)

Source: Bank of Estonia Figure 2.11 FDI breakdown for Estonia, 1993–2005

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Russia

Machinery & equipment (10%)

10% 9%

33%

food processing (9%) Finance (21%) Trade & catering (13%) 21%

Transport & communication (10%) Construction (5%)

5% 10%

13%

Other (33%)

Source: Polish Agency for Foreign Investment Figure 2.12 FDI breakdown for Poland, 1989–2003

Also, Kazakhstan’s economy has been growing faster than Russia over the last five years. Both countries are heavily dependent on natural resources and had similar starting points, but whereas Russia insisted on protecting its oil and gas industry from foreign companies, Kazakhstan opened up to foreign investors. Of total FDI made in Kazakhstan, 60 per cent has gone to crude oil and gas (see Figure 2.13). For Russia, Kazakhstan’s experience is striking in that it shows the rewards of adopting an investor friendly attitude in combination with pursuing reforms.

The stock market and new share issues The arrest of Yukos owner Mikhayil Khodorkovsky back in October 2003

sent a collective shudder through portfolio investors, and the effects of this lasted for more than a year and a half. However, after Khodorkovsky was handed a nine-year prison sentence in May 2005, investors began to look beyond the Yukos issue. Following a prolonged period of Russian underperformance against other emerging equity markets, investors, both domestic and foreign, began to pile back in during the summer of 2005. The RTS grew by only eight per cent in 2004, but in 2005 it rose by more than 70 per cent. Investors appear to have concluded that the Yukos affair was a politically motivated event, but more significantly they have come to view it as a one-off. A combination of a maturing and growing stock market, strong economic expansion, and rising global interest rates led Russian companies to set their sights on going public in 2005. A total of $5.1 billion worth of IPOs were completed, with most

11.3% Oil and gas (59.8%)

16.6%

Trade & catering (2.8%) Financial (0.9%) Metals (8.7%) 8.7%

59.8%

Real estate (16.6%) Other (11.3%)

0.9% 2.8%

Source: National Bank of Kazakhstan Figure 2.13 FDI breakdown for Kazakhstan, 2000–2004

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attracting huge interest among investors (see Table 2.5). In 2006, we expect equity placements to top $20 billion, of which as much as $15 billion could be in the form of IPOs. The list could be topped by the planned Rosneft IPO, which could be worth approximately $10 billion, and a Vneshtorgbank IPO, which could be worth $1.5 billion (see Table 2.6). With the majority of IPOs being planned by companies outside the oil and gas sector, this will help to diversify the stock market. Furthermore, companies preparing for an IPO are obliged to improve transparency and reporting standards, thus corporate governance is set to improve significantly.

The threat of re-nationalization A key worry regarding Russia’s business and investment climate relates to the threat of further re-nationalization following the purchase of Yukos’ main asset, Yuganskneftegas, by state-owned Rosneft at the end of 2004. In 2005, the government gained majority control over Gazprom, which subsequently bought a majority stake in Sibneft, the country’s No. 5 oil company by output. Although it has been expected that state intervention will be limited to sectors involved in mineral extraction, two developments in late 2005 caused a certain amount of concern. In November, Gazprom purchased a controlling stake in OMZ, an engineering company, and Sistema sold its stake in

Table 2.5 Russian IPOs in 2005 Company

Amount, $ millions

Sector

Sistema

1,550

Telecom, retail

Novatek

966

Oil & gas

Novolipetsk Steel

609

Metals

Pyaterochka

598

Retail

Evraz Group

420

Metals

Amtel Vredestein

300

Tiers

Lebedyansky

151

Retail

Severstal-Avto

137

Automotive

IBS

109

Technology

Urals Energy

112

Oil & gas

Seventh Continent

80

Retail

Rambler

40

Technology

Talion

15

Retail

8

Food

Khleb Altaya Total

5,095

Source: Bloomberg, media reports

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Kamov Holding, a helicopter manufacturer, to a state-owned industrial group, Oboronprom. It is also widely expected that Vladimir Kadannikov, who resigned as board chairman at Russia’s largest car manufacturer, AvtoVAZ, in October 2005, will be replaced by a government official. A further increase in state involvement would deal a blow to the business and investment climate, in our opinion, as well as severely damage the economy as whole. Evidence from decades of economic research is conclusive: state-owned/managed enterprises perform much worse than private companies. Indeed, Russia’s high-profile stateowned companies – Rosneft, Transneft

and Gazprom – have performed worse than their peers, and increased state interference has acted as a drag on growth. With the oil price surging further in 2005, reaching record-high levels, we could have expected oil producers to capitalize on their increased revenues by investing more into production and transportation capacities. Disturbingly, from the beginning of 2004 to March 2005 there was a consistent slowdown in growth of fixed investments (see Figure 2.14).5 As 70 per cent of domestic investment is financed from retained earnings and state handouts to state-owned companies, and oil companies are major contributors, this development was not

Table 2.6 Expected IPOs in 2006 Company Rosneft

Expected mount, $ millions

Sector

10,000

Oil & gas

1,500

Banking

Comstar-UTS

500

Telecom

Magnitogorsk Metal Plant

500

Metals

TMK

500

Metals

Rosbank

400

Banking

Smarts

200

Telecom

Izmashauto

200

Metals

STS Media

200

Media

Severalmaz

150

Metals

Kopeika

150

Retail

Ritzio

100

Gambling

Razgulyai-UkrRos

100

Agriculture

Vneshtorgbank

Arbat Prestige

80

Retail

Inprom

60

Metals

Energomash

50

Metals

Sibirian Cement

30

Construction

Total

14,720

Source: Bloomberg, media reports

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unexpected. In fact, Yukos’ investment fell by 40 per cent and Sibneft’s by 30 per cent in 2004. This situation was compounded by the government increasing the tax burden on oil companies at the beginning of 2004. Plotting the development of the mineral extraction sector reveals a prolonged slowdown in output growth despite the rise in oil prices (see Figure 2.15). Taking the oil industry in isolation reveals the same picture. Comparing Gazprom’s production figures to those of independent producers provides another good indicator of the impact of state ownership on 16%

a company’s performance. Although Gazprom’s production increased during 2002–2004, it remained below 1999 levels. In contrast, independent gas producers (such as Novatek), which have no access to export markets, almost doubled production between 1999 and 2004 (see Figure 2.16). The state is clearly increasing its role in the oil and gas sector, but we hope that this trend will not spread to other areas of the economy. Such a development would seriously damage Russia’s attractiveness as a destination for investment, both domestic and foreign. Not only would this slow growth,

%, y-o-y

14% 12% 10% 8% 6% 4% 2%

05

5 Se

Ju

p-

l-0

5 ay

-0

5 M

ar M

nJa

-0

05

4 N

ov

-0

04 pSe

Ju

l-0

4

4 M

ay

-0

-0 ar M

Ja

n-

04

4

0%

Source: Rosstat Figure 2.14 Fixed investment growth 12

%

$/bbl

70

10

-2

Mineral extraction, LHS

Sep-05

0 Jul-05

20

May-05

2

Mar-05

30

Jan-05

4

Nov-04

40

Sep-04

6

Jul-04

50

May-04

8

Mar-04

60

Jan-04

10

0

Urals Med, RHS

Source: Rosstat, Bloomberg Figure 2.15 Oil price vs production of natural resources

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Russia

Gazprom 550 bcm

Independent gas producers 100 bcm

540

80

530

60

520

40

510

20

500

0 1999 2000 2001 2002 2003 2004

1999 2000 2001 2002 2003 2004

Source: Institute for Energy Policy Figure 2.16 Gas production: Gazprom vs independent gas producers

it would most likely also lead to renewed capital flight. There are still several liberal economists in key positions in both the government and the presidential administration who should be fully aware of the potential danger. However, it is uncertain how well these people can effectively resist further moves to bring assets under state control.

Conclusion Few improvements to the business and investment climate were observed in 2005. In fact, several indicators point towards a deterioration. Reform of the banking sector was the only area in which some positive developments were seen. Although the investment climate has improved dramatically since the August 1998 crisis, most of this progress took place between 1999 and 2002. Nevertheless, FDI reached a new record high in 2005, and the equity market enjoyed a rallying of more than 70 per cent. In 1H05 alone, Russia attracted $11 billion in FDI, an increase of 145 per cent year on year, and for the full year it could reach as much as $17 billion. This can be mainly put down to continuing strong economic growth and consumer demand. While there are

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still significant risks associated with investing in Russia, there are also plenty of opportunities. Investors appear to be willing to deal with these risks, and are voting with their portfolios. With the Yukos affair having drawn to a close, the sentiment among portfolio investors has improved. The RTS grew more than 70 per cent in 2005, and new IPOs reached a record $5.1 billion, with most of these many times oversubscribed. An even greater volume of IPOs is expected in 2006: not only will this help diversify Russia’s financial markets away from oil, it will help to considerably improve corporate governance. The main threat, not only to Russia’s investment climate but to the economy as a whole, is increased state involvement in business, and renationalization of the country’s natural resources. The evidence that stateowned/managed firms perform worse than other companies is irrefutable. Going forward, there is hope that changes at the grass roots level can help improve the business environment. IPOs and corporate bond issues dictate improvements in corporate governance. The Central Bank is moving slowly on bank reform, but many banks are cleaning up their balance sheets and changing their behaviour, and this is likely to be greatly

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encouraged by the recent wave of interest shown in the sector by foreign banks. Foreign banks active in corporate lending are putting additional pressure on domestic banks to compete.

Notes 1. We converted the EBRD’s grading system (1 to 4+) to a numeric scale so that 1 = 1, 1+ = 1.33, 2- = 1.66, etc. 2. BEEPS covers more than 9,500 firms from 26 transition countries (plus Turkey).

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3. The axes in the left-hand graph represent 1. access to finance, 2. quality of infrastructure, 3. taxation, 4. regulations, 5. quality of judiciary, 6. crime, 7. corruption; the index ranges from 1-4, where 1 (centre data point) indicates no obstacle, and 4 (outermost data point) indicates a major obstacle. 4. The axes in the right-hand graph represent 1. labour market, 2. taxation, 3. institutions and property rights, 4. infrastructure, 5. finance, 6. macroeconomic environment, and 7. business regulations. 5. On a positive note, growth in fixed investment began to pick up in April 2005.

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3. Recent legal developments1 KPMG

Corporate and antimonopoly legislation Russian corporate legislation has not undergone significant changes since 2003. However, certain amendments and addenda to the corporate regulations of the Russian Federation should be taken into account. Russian antimonopoly legislation has been amended in an attempt to reduce bureaucracy hindering the performance of business activity.

Recent changes in the governmental structure When applying to the Russian state authorities on issues regulated by corporate and antimonopoly legislation and doing business in Russia, foreign investors should take into consideration that since 2004: „ the Federal Tax Service (formerly the Ministry for Taxes and Levies) has been the state authority responsible for the registration of legal entities and private entrepreneurs, as well as tax and levy collection; „ the Federal Antimonopoly Service (instead of the Ministry of Antimonopoly Policy and Support of Entrepreneurship) has been the 1

state authority responsible for state control over observance of antimonopoly legislation, prevention and termination of monopolistic activity and other actions restricting competition; „ the Federal Service for the Financial Markets (instead of the Federal Securities Commission) has been the state authority responsible for registration of securities, including shares in joint stock companies, and licensing on the securities market (eg of registrars – companies maintaining shareholders’ registers).

Corporate law Business structures in Russia Liberalization of dividend payment procedure Under current corporate legislation the general shareholders’ meeting of a joint stock company may take a decision on dividend payments every three months (at the end of the 1st, the 2nd and the 3rd quarters, and at the end of the financial year), whereas previously the regulations prescribed such a possibility only once a year. This facilitates cash flows to parent companies from their Russian subsidiaries.

As at 15 December 2005.

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Regulations on the Board of Directors The latest amendments to the regulations on corporate governance prescribe that generally the number of directors elected to the Board of Directors (hereinafter, the Board) of a joint stock company may not be less than five persons. Candidates for membership of the Board should be elected by cumulative voting. This procedure entails the number of votes of each shareholder (attributable to the shares belonging to the shareholder) being multiplied by the number of candidates to the Board. The total number of votes so obtained may be cast by the shareholder entirely in favour of one of the candidates, or may be shared between two or more candidates. This new voting procedure provides minority shareholders with an increased chance of influencing the formation of the Board. It has also been stipulated that should the Board take a decision with legal defects, a member of the Board who did not participate in the voting on the relevant issue or who voted against such a decision, may challenge it if his rights were infringed by that decision. Changes in the procedure for maintaining registers At present, if a joint stock company has more than 50 shareholders (previously 500) the register of shareholders is required to be kept by an independent registrar duly licensed by the Federal Service for the Financial Markets. This provides additional guarantees for minority shareholders. Securities emission amendments Generally, a joint stock company is not permitted to issue bonds until its share capital is fully paid. Nevertheless, in accordance with the latest amendments to the Law ‘On Joint Stock

34

Companies’, this restriction does not apply if the bond obligations are guaranteed by mortgage of real estate.

Establishing a presence Accreditation of representative offices of foreign companies Depending on the type of activity performed by a foreign company, its representative office in Russia shall be accredited with the State Registration Chamber (in the vast majority of cases) or in certain cases with the Chamber of Industry and Commerce of the Russian Federation, the Federal Agency on Air Transport or other relevant state authority. Please note, however, that the State Registration Chamber is still solely responsible for maintaining the State Register of Representative Offices of Foreign Companies Accredited in the Russian Federation. Therefore, it is necessary to apply to the State Registration Chamber for inclusion in the Register even when a Representative Office is accredited by another state authority. In addition, generally a representative office must be registered with the local tax inspectorate, the federal state statistics service and three state nonbudgetary funds. The documents submitted to the State Registration Chamber shall not be dated earlier than one year prior to submission, except for the reference letter from the head office’s bank, which shall not be dated earlier than six months prior to submission. State registration of Russian legal entities On 19 June 2002, the Russian government established mandatory requirements with respect to the form of documents to be submitted to the registration body for state registration of a Russian legal entity:

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„ the blank spaces in the officially approved templates of applications and notifications, as well as appendices thereto, should be completed in block capitals; „ each document containing more than one page should be numbered and all the pages of each document shall be bound together; „ the applicant’s signature affixed to an application or notification shall be certified by a notary.

Antimonopoly/competition law Major changes to Russian antimonopoly legislation occurred in Spring 2005. On 7 March 2005, Federal Law No. 13-FZ ‘On Amending articles 17 and 18 of the Law on Competition and Limitation of Monopoly Activity on the Commodity Markets’ was adopted. This Law established new criteria for determining whether mandatory pre-approval from the Federal Antimonopoly Service (FAS) is required for a transaction or whether the latter should be notified of the transaction: „ If the total value of the assets of all founders of a newlyincorporated legal entity according to the latest balance sheets exceeds two million minimum statutory monthly wages (at present RUR200 million, which is currently approximately $7 million), the FAS should be notified of the incorporation of such a company within 45 days of the date when it undergoes state registration. „ Should it be decided to acquire shares in the share capital of a Russian legal entity in which the total share of the purchaser and persons of the same group as the purchaser will become more

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than 20 per cent of the share capital, the purchaser is required to obtain the relevant preliminary approval of the FAS prior to concluding the Share Purchase Agreement if the total value of assets of the purchaser, or persons (ie companies and private businessmen) of the same group as the purchaser, and of the target company exceeds 30 million minimum statutory monthly wages (at present RUR3 billion, which is currently approximately $104 million). Alternatively, if the value of the total assets of the parties mentioned above is between two million and 30 million statutory monthly wages (at present between RUR200 million, which is approximately $7 million and RUR3 billion, which is approximately $104 million), it is necessary for the purchaser to inform the FAS of the conclusion of the Shares Purchase Agreement within 45 days. The liberalization of the antimonopoly legislation was aimed at reducing bureaucracy hindering the performance of business activity. However, Russian antimonopoly legislation may still be rather onerous for foreign investors doing business in Russia. This is because the assets of the whole of the group to which a purchaser belongs are taken into account as well as the assets of the target company, and the new asset thresholds (stated above) are still rather low.

Real estate regime and land relations Generally legislative amendments ratified since 2003 with regard to real estate regulations may be summarized

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Russia

as being aimed at simplifying the procedure for acquiring and exercising rights to real estate. However, some innovations have had the opposite effect.

Transfer of the authority to register real estate Starting from January 2005, the authority to register real estate transactions and titles thereto was centralized by means of transferring it from the regions of the Russian Federation to the Federal Registration Service (hereinafter, the FRS). The latter generally performs its activity through its local branches. The appropriate authority in Moscow is the Central Administration of the FRS of Moscow, and in St Petersburg it is the Central Administration of the FRS of St Petersburg and Leningrad Region. This amendment was intended to unify, and as a result simplify, registration procedures. Whereas previously each local registering authority had its own regulations, it was expected that now the FRS would apply a unified approach. However, certain amendments had quite the opposite effect. For example, while prices for registration were increased, in some Russian regions periods of registration have been significantly extended. Also, if St Petersburg is any indication of general trends, the reorganization of the registering bodies and the subsequent reduction of their financing have resulted in the resignation of many of the registering body’s most professional staff and consequent delays in the process.

Payments for real estate Russian currency legislation in relation to real estate transactions has been liberalized. The previous legislation required special individual permissions for performing payments in

36

foreign currency for real estate (including land plots) between Russian and foreign legal entities (and/or individuals). In contrast, under the new regulations effective from 18 June 2004, such payments may be performed without restriction, which simplifies the procedure for foreign investors acquiring rights to real estate.

Legislative reform regarding residential premises In 2005, several acts entered into force in relation to residential premises. Their adoption led, in particular, to the simplification of the eviction procedure in relation to bank credit defaulters and their family members, as well as the simplification of the procedure for the conclusion of mortgage agreements. The requirement for certification of mortgages of immovable property (land plots, buildings, residential premises etc) by a Russian notary was abolished. Consequently, now the parties to a mortgage agreement only have to draw it up in a written form and register it with the FRS.

Conversion of land plot categories The new Federal Law ‘On conversion of lands and land plots to other categories’, which came into force on 5 January 2005, unified the procedure for the conversion of land from one category to another and established certain procedures for specific categories of land. For example, previously farmland could, in general, only be converted if the land was of inferior quality or unfit for farming. Now the requirements for the conversion of farmland have been relaxed. However, farmland of considerable value may still not be converted to other land categories

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except in a limited number of cases directly stipulated by the above Federal Law.

Prolongation of the term for reregistering rights to land plots The deadline for re-registering the permanent right to use a land plot was prolonged from 1 January 2004 to 1 January 2008.

Arbitration and dispute resolution Since 2003, a number of amendments have been introduced to Russian legislation regulating arbitration and dispute resolution. The most notable are the establishment of a new structure of the state arbitration courts, the change in the requirements in relation to representation in the state arbitration courts and the adoption of a new Civil Procedural Code (regulating legal proceedings in the courts of common jurisdiction).

State arbitration courts New structure of the state arbitration courts In order to enhance the impartiality of the state arbitration courts, in July 2003 a new type of court (the arbitration appeal court) was established in Russia. Previously, legal proceedings of first and second (appeal) instances were both performed by the regional courts. In contrast to the former practice, now each appeal court independently considers appeals against decisions of a group of regional courts, which themselves only act as courts of first instance.

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Representation in the state arbitration courts The new Arbitration Procedural Code of 2002, which stipulated that companies may only be represented in the arbitration courts by their employees or barristers, came as a shock for consulting and legal firms, which previously not only advised their clients but also represented them in court. The provisions on representation in the new Code were considered to be monopolization of litigation services market by barristers and as an infringement of the rights of other companies and individuals. As a result, these provisions were declared ineffective by the Constitutional Court of Russia on 16 July 2004 and then abolished by Federal Law Nº 25-FZ of 31 March 2005. At present, consulting and legal firms may represent their clients in the arbitration courts without restrictions.

Courts of common jurisdiction The new Civil Procedural Code On 1 February 2003, a new Civil Procedural Code of the Russian Federation Nº 138-FZ of 14 November 2002 entered into force. Civil procedural regulation did not change substantially once the new Code became effective. However, it did change several procedural rules as compared to the earlier Civil Procedural Code of 1964, for example: „ in order to increase the professionalism of the courts, the institution of two lay citizen representatives considering cases together with a professional judge was abolished. Now all cases shall be considered only by professional judges (depending on the subject of the litigation

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Russia

and the court instance, by one, three or more judges); „ in connection with technical progress made since the adoption of the previous Code, the new Civil Procedural Code directly stipulates the possibility of using audio and video recordings as evidence. It is, however, important that particular attention be paid to the proper recording and presentation of audio and video records in order to ensure that they are admissible as evidence. The new Civil Procedural Code has not changed the system (the hierarchy) of the courts of common jurisdiction.

Amendments applicable to both state arbitration courts and courts of common jurisdiction Appeal procedure for the Supreme Court and the Supreme Arbitration Court For a long time it was believed that the Russian court system did not comply with European standards for judicial proceedings. This was, in part, because appellate proceedings before the Supreme Court and the Supreme Arbitration Court of the Russian Federation could only be brought by highlevel judges or officials from the Prosecutor General’s Office, while the parties to litigation could only file a petition for appeal to these judges or officials. The situation is now different. Under effective legislation both parties to litigation may independently appeal to the Supreme Court and the Supreme Arbitration Court. However, a case will still not be considered in these courts on the basis of a party’s appeal unless the courts’

38

judges responsible for the preliminary consideration of the case grant a resolution that it shall be heard before the Presidium or the Collegium of the Supreme Court or the Presidium of the Supreme Arbitration Court. The issue of whether a case is heard before the Presidiums (the Collegiums) of the Courts mentioned is to be decided by one judge (for the Supreme Court) or a board of judges (for the Supreme Arbitration Court), based on the substance of a particular case.

New grounds for cases being reopened by the Supreme Court and the Supreme Arbitration Court A significant innovation of the new Civil Procedural Code and the Arbitration Procedural Code of 2002 was the opportunity to appeal to the Supreme Court or the Supreme Arbitration Court against a decision that breaks practice of interpretation and application of the legislation by the courts of common jurisdiction or by the arbitration courts. This innovation undoubtedly increased the importance of court precedents, which do not formally constitute a source of Russian law.

Litigation fees for consideration of cases On 1 January 2005, a new Chapter 25.3 of the Tax Code of the Russian Federation entered into force. This chapter stipulates litigation fees for both the consideration of cases by the courts of common jurisdiction and the state arbitration courts. Maximum litigation fees (which were not previously limited for the courts of common jurisdiction) were established regarding property claims. The litigation fee for filing a claim may not exceed RUR100,000 (approximately $3,500) in the arbitration courts, and RUR20,000 (approximately $700) in

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the courts of common jurisdiction. Another positive aspect of the new regulations is the fact that now when an appeal is filed with the appropriate superior arbitration court or superior court of common jurisdiction, the litigation fee is generally fixed in the amount of only RUR1,000 (approximately $35).

Employment law and work permits for expatriates No significant changes in Russian labour legislation and legislation regulating obtaining work permits have been made since 2003.

Recent changes in governmental structure Since 2004, the Federal Migration Service has been the state authority responsible for issuing work permits for expatriates and performing the registration of foreigners and stateless persons in Russia.

amounts of wages as well as amounts of compensation and other payments under labour legislation, is currently approximately $30 per month. Under the Russian Labour Code, the minimum salary level should not be less than the minimum subsistence level. However, strangely enough the latter is currently established at approximately $85 per month.

Work permits for employees of representative offices and branches of foreign companies in Russia Despite the fact that current legislation regarding obtaining work permits for foreign employees of foreign companies working in Russia is ambiguous and may be interpreted in different ways, the state authorities’ officials are of the opinion that such permissions should be obtained. Since June 2005, the Federal Migration Service has resumed processing and issuing work permits for representative offices and branches of foreign companies after earlier suspending this procedure.

Minimum salary level in Russia The minimum salary level in Russia, which is utilized to regulate minimum

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4. Expert opinions: analysing some recent trends in Russian business legislation Pepeliaev, Goltsblat & Partners

Corporate legislation: the law so needed by major investors has still to be adopted Andrey Goltsblat, Managing Partner of Pepeliaev, Goltsblat & Partners, JD Development and enhancement of corporate legislation (legislation on legal entities) ranks among the top priorities today, so the Russian government has become preoccupied with the issue and is actively discussing ways to improve corporate legislation. The draft concept of corporate law development proposed by the Ministry for Economic Development and Trade in July 2005, outlines a whole series of urgent legislative tasks pertaining to legal support for investments. Some of them, namely amendments to the Law ‘On Joint Stock Companies’, designed to strengthen the position of major investors, have not yet made it into the law. One of the key trends in the Russian economy is a continuing concentration of corporate property, production and capital, as well as investment project consolidation. This is nothing out of the ordinary. Russian business is integrating deeper and deeper

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into the global economy, where highrollers – multinational corporations and holding companies – are of paramount importance. It should be mentioned in this regard though, that this trend in no way downgrades the principal role of small and mediumsized firms, which control a substantial market share (both in the United States and in the EU, where they account for most consumer production). It should be a matter of a gradual movement towards an optimal relationship between large and mediumsized businesses. It is important to emphasise here that major investors are precisely what the Russian economy needs. More and more attention has been focused recently on company protection and support for holders of large blocks of shares in their interrelations with minority shareholders. One of the fundamental tasks for the law-makers is, in our view, to promote the objective trend towards the formation of integrative structures and an increase in the scale of production. This point is, by the way, highlighted in the draft concept for corporate law development. Major direct investors lack adequate legal instruments to handle their relationships with minority

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shareholders when the latter start working towards buying up more than 90 per cent of a company’s stock. Proceeding from Russian law and the long-standing law enforcement practice, holders of very few shares can, by acting not quite fairly, without difficulty create serious problems for majority shareholders. Business reorganizations become easily disputable and legally and economically vulnerable. This poses a certain threat to economic stability. The major investors we so need prove unable to either buy out the shares from minority shareholders or achieve a legally impeccable joint business development agreement with them. The availability of legal instruments entitling investors with 90 per cent of shares to buy out the rest of the stock, would stimulate quite a flow of direct investments, both foreign and domestic. As for the dynamics of the Russian legislation governing this rather narrow but very sensitive sphere of corporate relations, until 2002, a majority shareholder in a Russian company wishing to ‘get rid’ of minorities could push through, at a General Shareholders’ Meeting, a decision to consolidate shares (to convert, using a particular ratio, all the shares issued by the company into a smaller number of shares of a larger nominal value). If, as a result of this measure, a minority shareholder ended up with a fractional number of shares, these became subject to compulsory buyout by the company. Active use was made of this opportunity in building up centralized holding companies and it became the subject of numerous disputes. The described minority squeeze-out mechanism was omitted from the revised version of the Law ‘On Joint Stock Companies’. In February 2004, the Constitutional Court of Russia acknowledged that such a mechanism was in line with

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the Russian Constitution and that the squeezing out of minority shareholders, provided the latter’s rights are respected and given effective judicial control, can serve the interests of the majority. In July 2004, the State Duma adopted, at its first reading, a draft law allowing a shareholder that owns, either individually or jointly with its affiliates, 90 per cent of the ordinary (voting) stock in a company to buy out the other shareholders at a price determined by an independent appraiser. The draft guarantees certain minority shareholder rights. Thus, a buyout decision by a super-majority shareholder is subject to approval by the company’s General Shareholders’ Meeting or Board of Directors and the buyout price determined by the independent appraiser may be challenged in court. In the event that a minority shareholder refuses to sell out or cannot be reached (which is not an infrequent occurrence in companies with a large number of shareholders), the draft allows the majority shareholder to deposit a sum equal to the buyout price in the name of the minority shareholder and then request the registrar to transfer the shares to its account. Thus, the concept of the draft law was actually upheld by the ‘lower’ chamber but then the process stalled. In 2005, the State Duma did not take the draft from the table. This time out was probably used to clarify certain points. For instance, the majority interest prerequisite may be raised from 90 per cent to 95 per cent and other provisions worded more precisely. It is of paramount importance that work on the draft law be continued. As time goes on, the problem of stimulating large direct investments in the Russian economy grows more acute.

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This is just one aspect of corporate law enhancement but, in the current economic situation, it appears to be particularly significant. This is an issue that is relatively easy to resolve by legislative means.

Stakeholder construction Vitaly Mozharowski, Partner, Pepeliaev, Goltsblat & Partners The innovations brought about by the federal law on stakeholder construction projects, introduced on 1 April 2005, have yet to become part of common practice. A developer ready to take the risk of being the guinea pig for a bureaucratic and legal experiment has yet to come forward. The only people likely or able to make the necessary changes are the legislators themselves. A new type of contract has been introduced, which was not originally foreseen by the Civil Code, with essential conditions such as the value, the form of the contract, the guarantee period and so on, also laid out. The contract is regarded as effective from the moment that it is entered in the State United Register of property rights and transactions, at which point the law regards the plot or the leasehold to it as being mortgaged out to the stakeholders. It also offers protection of consumer rights for private individuals who make investments for private, non-business reasons. The law-makers were over-enthusiastic in their efforts to protect private investors and the result is that developers are now doing their level best to dodge the new law. Let me first outline the main legal instruments of protection.

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„ The developer can only start to attract investment once permission has been granted for construction, the designs are published and the freehold or leasehold of the site has been registered. „ The developer should provide investors with, and publish and keep undated in the public domain, certain information and documents. „ The developer is required by law to have a certain amount of capital and to observe regulations governing financial correct practice. These legal requirements and regulations and the executive organ that enforces them are supposed to be established by the government of the Russian Federation, but had yet to be so at the time of writing. „ There is a ‘price list’ of fines exacted from a developer for breaking the law – from 100 up to 5,000 minimum wages (from $350 up to $17,500) – and regulatory bodies have a wide range of powers at their disposal to control or suspend the activity of developers attracting investment and even to liquidate them if need be. „ Any building being built as a stakeholder scheme should be guaranteed for no fewer than five years, although developers object as their own suppliers and contractors provide guarantees for much shorter periods. „ Investors are able to cancel their contract unilaterally, especially in the event of a developer failing to meet project deadlines, substantial changes being made to the design of a building, including the area of the building or the designation of common property, or a serious breach of the construction quality

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requirements being committed by a developer. „ If a developer fails to keep his side of the bargain and observe the conditions of the deal, then the investor has the right to ask for his money to be paid back and for the interest to be paid back (as laid down in article 395 of the Civil Code) twice over or at above the interest rate, as compensation for losses suffered. The new article 14.28 of the Code on Administrative Offences means that the developer carries administrative responsibility for breaking any of the laws relating to stakeholder projects. „ If the developer fails to complete the building on time, then the developer pays the investor a forfeit equal to 1/75 of the Bank of Russia refinance rate for the value of the contract for every day by which the completion is delayed. „ Banks that finance developers are now every bit as accountable to the investors as the developers; hence, a marked cooling off on the part of the banking sector to financing residential developments. Investors are now in an even more vulnerable position than before as developers have now started to offer them alternatives such as promissory notes, preliminary contracts for reserving apartments and so on. This means that a large part of the market for new construction is no longer regulated either by laws on stakeholder development or by laws protecting consumer rights, as these alternatives bring realty transactions down to the level of gentlemen’s agreements and promises founded largely on good faith. As a result, the private investor

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has lost even the minimum safeguards that existed before the new law. The law is principally aimed at regulating stakeholder projects in the residential construction sector. However, the law also applies to stakeholder projects in other sectors – garages, retail, healthcare, etc – with only industrial buildings excepted. Although residential developers may be trying to avoid this law by foul means and fair – and are so far are making a success of it – pressure on developers, principally from international retail chains, is resulting in their adoption of stakeholder schemes, albeit thus far without any great enthusiasm. In the months since the new law came into force, clients of my company alone have dealt with six stakeholder deals, and not just in the city of Moscow and the Moscow area, but also in the regions. In spite of all the problems, the new law is working – and it will do so to its fullest extent if the legislators make the necessary changes.

Intellectual property issues Tom Stansmore, Head of Pepeliaev, Goltsblat & Partners, St Petersburg office Cyber squatting, or the practice of registering someone else’s trade mark as a domain name, in Russia can be traced back to the beginning of the internet. It really caught on, however, in the late 1990s when Rosbank was rumoured to have purchased ‘Rosbank.ru’ for $20,000. Since then, many high-profile cases have brought the problem to the attention of the Russian government. This and other issues related to the protection of intellectual property rights are consistently raised among government officials, as Russia seeks to gain

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admittance to the World Trade Organization. Obtaining a domain name in Russia is a simple registration process involving no checks to determine whether the applicant’s intended use will be misleading to the public. A Russian or foreign individual or legal entity need only enter into a service contract with one of Russia’s domain name registrars. The process is on a straightforward ‘first to file’ basis, and registration fees and annual renewal fees are minimal. Additionally, domain names are freely assignable, based on a simple letter from the ‘owner’ to the assignee. In brief, this is about as tempting a proposition to dishonest acquisition as one can imagine. Additionally, there is nothing in Russian legislation either defining domain names or providing any criteria for denying a domain name to an applicant. To claim one’s intellectual property rights on the ‘.ru’ domain, one must turn to Russia’s law on trade marks. Amendments incorporated into Russia’s Trade Mark Law at the end 2002 expanded the list of unlawful uses to include the unauthorized use of the trade mark on the internet, and specifically mentions domain names. In brief, these few lines represent the entirety of Russian legislation against cybersquatting. Successful prosecutions in domain name actions are therefore closely linked to proper trade mark registration. Prior to this amendment, protecting one’s intellectual property on the .ru domain was sporadic at best. Although there was little base in law for them doing so, Russian courts were typically inclined to rule in favour of the trade mark owners. This was the case for both Russian and foreign instances of cybersquatting, and some of the more highly publicized decisions concerned Kodak, Coca-Cola, Mosfilm (Russia’s premiere film studio) and others. In all these cases, because there was no

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direct legal connection between trade mark and domain registrations, the courts relied on ‘anti-competitive’ and ‘bad faith’ provisions of the law when siding with trade mark owners. In the Kodak case, however, the case went all the way to Russia’s Supreme Court, where it was remanded back to the lower courts. In all, the case lasted over three years before the domain name was recovered. In summary, Russian legislation was slow to adapt to e-commerce and, as a result, cybersquatting became viewed as an easy entrepreneurial way to make money. Indeed, it remains perfectly legal to buy and sell domain names for profit as long as Russia’s Law on Trade Marks is not violated (this is true in many places in the world, and stories of sales for domains such as Altavista.com ($3.3 million), Wallstreet.com ($1 million), Business.com ($8 million) and Wine.com ($2.9 million) help to keep the spirit alive. In fact, one of the deficiencies often cited of the Amendments to the Trade Mark Law is that it specifically discusses the ‘use’ of the trade mark as a domain name and is silent on the issue of registration without use. In brief, the wording of the law means that judges are forced to rely on the previous principles of ‘bad faith’ when deciding cases concerning the recovery of a domain name taken hostage (but not being used). The distinction between entrepreneurship and outright stealing is beginning to take hold, however. The amendments to Russia’s trade mark laws were the first (and to date, the last) instance of domain name protection being incorporated into Russian law. Since the introduction of these amendments, however, Russia’s Trade Mark law has been used by a number of litigants to recover their domain names from less than scrupulous registrants, and the case of audi.ru is one of the latest.

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Granted, the case took over two years to fully resolve, but nevertheless, it should be taken as a sign that the amendments do work for their intended purpose. Russia is an emerging market too large to ignore, and domain name registration is an integral part of intellectual property rights protection. The people are sophisticated and brand savvy, and the internet is often turned to as the primary source of information about a company’s goods and services. Successful domain name enforcement, however, is dependent on proper registration, perseverance and knowledge of the law. This is true for all facets of intellectual property prosecution rights enforcement, but one should realize that the problem is acknowledged at the governmental level and that there is a strong impetus to do something about it. The amendments to the Law on Trade Marks are a good start, but it remains up to the owner of the intellectual property to take the initiative to enforce their rights. During the past year, Russian domain names have been recovered with greater frequency. This growing list of successful prosecutions has encouraged victims of improper registrations to take action and this trend is expected to continue for the indefinite future.

Tax issues: the establishment of Interregional Tax Inspectorates Tom Stansmore, Head of Pepeliaev, Goltsblat & Partners St Petersburg office and Maria Andreeva, Head of Tax Department, Pepeliaev, Goltsblat & Partners

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As St Petersburg has recently earned the distinction of being home to an Interregional Tax Inspectorate, it may be interesting to have a closer look at the institution and the controversy surrounding it. For those of you who are not ‘a major taxpayer’, you may not be aware that the Ministry of Finance in conjunction with the State Tax Inspectorate has now created eight ‘Interregional Tax Inspectorates’, each charged with a specific industry: (1) Oil, 2) Natural Gas, 3) Alcohol and Tobacco, 4) Power, 5) Metallurgy, 6) Transportation Services, 7) Communication Services, and now 8) Transportation Manufacturing). All but the last are located in Moscow. There are, however, fundamental issues concerning the legality of the whole concept. The controversy concerns the very existence of the institution and stems from the law that the Ministry cites to support its creation, namely the first part of Article 83 of the Tax Code, which is devoted to registration requirements for both people as well as legal entities, the governing principle being that they should register where they and their property are located. The last sentence of the first part of Article 83, however, is the subject of different interpretations: ‘The Ministry of Finance of the Russian Federation shall have the right to determine the specific features of the order of registration of major taxpayers.’

In summary, the Ministry of Finance has taken the position that ‘specific features of the registration’ is grounds to establish a separate and distinct body that will have the authority to collect and process tax returns for major taxpayers. Those on the other side of the fence are of the position that the spirit of the law requires that location be the

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determinative factor and that regional registration is the intent of the law. The right to determine the specific features of the order of registration of major taxpayers, refers to the procedural activities of the tax inspectorate in the registration process, but not to the obligations to the taxpayer. There is also a very strong constitutional element to the controversy. Although there are instances where the legislator may delegate some powers to the Executive, this is not one of them. The wording of the law puts it within the prerogative of the Executive to define the registration (procedure) for large taxpayers but may not impose any additional obligations on them. The intention behind the creation of the Interregional Tax Inspectorates, although not debated in court, is at the heart of the matter. Those in favour hold that a group of professionals specializing in a particular industry are more likely to enforce the Russian Tax Code uniformly and consistently. Those opposed fear that the institution will attempt to generate more revenue from already overburdened taxpayers. What is clear, however, is that whatever reading one takes, the creation of the Interregional Tax Inspectorates will not relieve the taxpayer of the requirement to register locally. On 25 November 2004, Russia’s Supreme Court of Arbitration ruled that the obligation (and the right) to register regionally was specified in the Tax Code and could not be changed by registering with the Interregional Tax Inspectorate. Therefore major taxpayers were to be registered both at the place of their location as well as with the Interregional Inspectorate. Recently, the Finance Ministry issued a degree confirming dual registration. The procedure for submitting tax returns to the two bodies has also been going through an evolutionary

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process. Until very recently, those against the Interregional Tax Inspectorates pointed to the gross administrative inconvenience of submitting two sets of rather large tax returns and supporting documents. Anyone who has ever spoken with a tax specialist will testify that if you ask two tax specialists the same question, you will probably get three different answers and the risk of double jeopardy was on everyone’s mind. Current practice, however, indicates a degree of cooperation between the Regional Tax Authorities and the Interregional Tax Inspectorates. Documents need be submitted only once, the portions concerning Federal Tax going to the Interregional Tax Inspectorate, and the portion concerning regional and local taxes filed locally. Moreover, the risk of a large taxpayers being subjected to two separate audits was mitigated by the fact that the Tax Code protects the taxpayers against audits being conducted by multiple authorities of the same level. For those of us who have been watching the evolution of Russia’s tax system, however, the introduction of these Inspectorates fits a pattern of consolidation of Federal power (anything ‘interregional’ is Federal). It does not seem that long ago that I wrote an article describing the New Profits Tax Chapter of the Tax Code and the limitations placed on the ability of the regions to grant investor tax concessions. Simply stated, the Federal government’s argument at that time was that the regions had been competing amongst each other by granting more and more concessions to investors (and turning to the Federal government when they could not make up their budget shortfalls). Likewise, the creation of these Interregional Tax Inspectorates can be viewed as a means for the Federal government to oversee and check up on

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the regions’ enforcement of the tax laws to ensure that they are raising all the revenue that they can. As always there is a very strong element of politics in the creation and location of Federal instructions. There have been a number of rumours concerning the ‘relocation’ of Russia’s Duma or Constitutional Court to St Petersburg. Neither of these have materialized, some would say for the better, and point to the necessity of all three branches being in the nation’s capital. The location of the Eighth Interregional Tax Inspectorate in St Petersburg may be partly political, but as it is intended to oversee large industries in the transportation manufacturing sector (Toyota being the latest to officially announce their arrival in the area), there is also a practical rationale. The legality of these institutions, however, is still pending, with a case scheduled to go before the Constitutional Court this Autumn. The plaintiffs, large oil companies from Bashkortostan, are arguing that the Tax Code itself needs to specify the provisions laying out the criteria for belonging to the category of ‘large’ taxpayer and the registration procedure, not the Executive Branch. In response, it is rumoured that the Ministry of Finance is preparing amendments to the Tax Code that will do just that, and if enacted, may well circumvent the constitutional challenge. Despite the ongoing debate, there is a good chance that the Interregional Tax Inspectorate will continue to develop and evolve. One can take heart, however, in the knowledge that there are large taxpayers that hold that the creation of such a Federal body does indeed provide a degree of stability and predictability in a system that is often accused of being arbitrary and inconsistent. In fact, some companies are actually pleased to work with the industry specialists of

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the Interregional Tax Inspectorate. If the Eighth Interregional Tax Inspectorate can develop a reputation for enforcing Russia’s Tax laws fairly and being selective in the tax lawsuits it brings against taxpayers, its location in St Petersburg has the potential of doing more for the investment climate than tax concessions ever could.

An overview of Russia’s Code of Corporate Governance Anton Sitnikov, Partner, Head of Corporate Practice and Nikolay Zhdanov, Senior Attorney, Corporate Practice, Pepeliaev, Goltsblat & Partners In 2002, the Federal Commission for the Securities Market (FCSM or the Commission) issued a draft Model Code of Corporate Governance recommended for implementation by all Russian joint stock companies. The act represents the second level of corporate relations regulation, which means that companies are not obliged to follow it and failure to comply will not lead to any sanctions on the part of the state. However, backed up by the FCSM’s regulatory acts and the practice being shaped in Russia, certain Code provisions have gained a broader meaning beyond ordinary recommendations. Below we have made an attempt to classify the Corporate Governance Code (CGC or the Code) provisions and look into their legal significance. The CGC is binding for companies whose securities are traded in certain stock exchanges. FCSM recommends trade organizers on the securities markets expand the listing rules to include a requirement that will oblige issuers to disclose information about their compliance with the Code.

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Some trade organizers went even further obliging issuers to provide more than just information but proof of their compliance with the Code provisions. Thus, the RTS listing rules require such documents for securities applying to the ‘A’ quotation list of the first level, while to put securities on same quotation list of the second level and on the ‘B’ quotation list, the issuer has to provide documentary proof of its abidance to the specific part of the Code governing information disclosure. Similar rules have been put in place on the MICEX. Special structures are to be set up within trade organizers to monitor such rules and abidance. There are currently a number of Code provisions identified in the Recommendations as an object of monitoring by stock exchanges, including: „ General Shareholders Meeting – a requirement to notify shareholders at least 30 days prior to the meeting if no longer period is established legally. In most cases the Law provides for at least 20 days notification; „ Board of Directors – it should include at least three independent directors (no similar requirement in the Law); „ Executive bodies – presence of a collegial executive body (eg management committee, etc); „ Internal documents – mandatory provisions governing the Board of Directors’ committees, information policy and use of insider information; „ Disclosures – maintenance of a corporate website with appropriate information regularly disclosed and updated. Any breach of the aforementioned rules can cause the company’s securities to be delisted or downgraded. There are also comply or explain norms

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formulated by the FCSM with reference to annual reports. Thus, all annual reports are required to incorporate data on compliance with the Corporate Governance Code where issued by a joint stock company. However, application of the structure and form of such data as suggested by the FCSM is voluntary. Specifically, the Commission identifies 78 Code provisions where disclosure of compliance data is strongly recommended in annual reports. These include the 13 provisions included by the FCSM in the monitoring scope of stock exchanges. In addition, companies are invited to disclose information about compliance with such provisions as: „ General Shareholders Meeting – mandatory presence of candidates to the company’s steering bodies, shareholder registration in internal documents; „ Board of Directors – right of the Board of Directors to suspend the Director General’s authority and set qualification requirements for key managerial positions, non-participation in the Board of Directors of persons previously found guilty of economic crimes or currently employed with the company’s competitors, requirements on the frequency of Board of Directors’ meetings, availability of risk management, strategic planning, corporate conflict management committees; „ Executive bodies – responsibility to submit monthly activity reports to the Board of Directors; „ Dividend policy – to be fixed in an internal document defining the minimum percentage of total profits to be distributed to shareholders in the form of dividends.

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Companies are recommended to specify in their annual reports whether they comply with each of the 78 provisions and, if yes, to quote the number of the Articles of Association or any other internal document

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provision where the norm is incorporated and to comment on its practical implementation. Otherwise, reasons for non-compliance should be given. Companies are also free to opt for a different form or scope of disclosure.

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5. Basic changes in the Russian tax system in 2005–2006 Denis Schekin, Partner, Pepeliaev, Goltsblat & Partners, J.D. Changes in the Russian tax system in 2005–2006 can be classified into two different categories. First, there are fundamental reform tendencies in the Russian tax system, which are of a long-term and deeper nature. Second, is the change in certain rules regulating the calculation and payment of taxes, which will occur in 2005–2006.

Fundamental tendencies of change in the Russian tax system In analysing tax reform tendencies in Russia, two basic trends in such reforms become apparent. First, is the repeal of a number of unjustified taxes (for example, sales tax) and the lowering of rates of fundamental taxes (profit tax down to 24 per cent, personal income tax to 13 per cent, and VAT to 18 per cent). Reduced rates have been accompanied by the cancellation of tax benefits. High levels of budget receipts from taxes on the extraction and sale of natural resources (in particular, from severance tax) make it possible to expect a continuation of the tendency towards lowering taxes and levies, although such reductions will not be as significant as before.

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However, there is another tendency in Russian tax reform. This is a tendency towards increasing vagueness in tax law enforcement and an increasingly punitive stance in the Russian tax system. The more widespread use in Russian tax legislation of such evaluative notions as ‘economic justification of costs’ (art. 252 of the Russian Tax Code) and ‘estimated price of a security’ (art. 280 of the Russian Tax Code) etc, testifies to the lack of clarity and certainty in Russian tax legislation. However, what contributes most to the lack of certainty in the tax area is the taxpayer’s good faith criterion, which was established by the Constitutional Court of Russia and is now being widely used by judicial and tax authorities, often with unpredictable results. Neither one law nor a decision handed down by higher court authorities has defined the notion of taxpayer bad faith. In legal practice, there are only examples of certain cases in which this criterion was used in resolving issues. The increasingly punitive nature of the Russian tax system is apparent in the fact that in 2004 the concept of ‘active repentance’ was struck from the Russian Criminal Code as a basis for exemption from criminal liability for tax evasion. However, the inclusion of exemption from punishment in connection with a change of situation (art. 80.1 of the Russian Criminal Code) is

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an appropriate replacement, as it depends almost entirely on the discretion of the law enforcers. In addition, more and more often the trend towards an increasingly punitive Russian tax system has been based on conclusions drawn by the Russian Constitutional Court in its decisions. One of the harshest legal positions adopted by the Constitutional Court of the Russian Federation in the fight against tax evasion, is its position regarding the applicability of the notion of deals carried out in contradiction to the fundamentals of law, order and morality (art. 169 of the Russian Civil Code). This article of the Civil Code of the Russian Federation provides for forfeiture of everything obtained in deals carried out with an objective that conflicts with the fundamentals of law, order and morality. In Ruling No. 226-O of 8 June 2004, the Constitutional Court of the Russian Federation approved the application of this article to deals intended to evade taxes. This has resulted in a paradoxical situation in which law-makers have established a sanction for deliberate tax evasion of 40 per cent of the unpaid sum of taxes (clause 3, art. 122 of the Russian Tax Code), whereas the Constitutional Court considers it possible to confiscate the entire sum of the deal, and not just the taxes, default interest and fines of 40 per cent of the tax amount. Another example of the broadening possibilities for the application of sanctions to taxpayers is contained in Constitutional Court Resolution No. 9-P of 14 July 2005. In this Resolution, the Constitutional Court recognizes that the statute of limitations for holding a taxpayer liable (three years), which was established by the Tax Code, can be extended if the court decides that the taxpayer hindered tax inspection. In effect, this means that the Constitutional Court holds up the position that the statute of limitations for

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liability is not applicable to taxpayers acting in bad faith. On the whole, the predominant orientation of conclusions drawn by the Constitutional Court of the Russian Federation towards protecting state interests at the expense of taxpayer rights is reflected in the following. More than once has the Constitutional Court acknowledged, in contradiction to the Russian Tax Code, that levies can be regulated not by the law, but by the executive branch (in particular, Constitutional Court Ruling No.133O of 8 April 2004.) The regulation of field tax audits in terms of deadlines and procedures provided by the first part of the Russian Tax Code in 1999, was to a large extent counteracted by the position of the Constitutional Court regarding the possibility of suspending field tax audits for an indefinite period of time (Constitutional Court Resolution No. 14-P of 16 July 2004). The restriction of ability to arbitrarily change the tax regime within a tax period established in art. 5 of the Russian Tax Code was also revised by the Constitutional Court (for example, in Constitutional Court Ruling No. 159-O of 8 April 2003.) Finally, the Constitutional Court formulated a limitation on the right to reclaim overpaid indirect taxes, although there is no such limitation in art. 78 of the Russian Tax Code (Constitutional Court Ruling No. 317-O of October 2, 2003.) One more example of the domination of public interests over those of taxpayers is the practice of the tax authorities, in accordance with which the taxpayer bears the brunt of responsibility for possible unlawful actions by his contractors in the tax sphere. For example, in the case of VAT nonpayment by a taxpayer’s supplier, it is quite likely that the tax authorities will interpret this as bad faith on the part of the taxpayer who has chosen a tax-delinquent supplier. In this

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manner, although not stipulated by law, tax authorities are ever more frequently trying to shift the burden of tax payment control from their own shoulders to those of the taxpayers. It should be noted that on this point, the taxpayer’s position is not always upheld in court practice, and in a number of cases the courts have found that the taxpayer must exert reasonable care in choosing a contractor in order that budget interests would not suffer. Indirectly, Constitutional Court clarifications suggest the same. These unfavourable changes in the Russian tax system have resulted in a situation in which the taxpayer may encounter unfounded, arbitrary and even preconceived or biased interpretation and application of tax law. Until recently, legal defence of companies from such application of the law by tax authorities in courts of arbitration was fast, effective and competent in the majority of cases (according to statistics for 2003, more than 70 per cent of suits filed by taxpayers were upheld by the courts.) Lately however, according to many practising lawyers, the independence of the judicial branch is in danger, and judges are more hesitantly defending the interests of taxpayers in disputes with the government. It is important to note that the Russian government is adopting measures against such ‘tax terrorism’. In particular, it plans to normalize and legally secure in the Russian Tax Code criteria for delimitation of tax planning and tax evasion, relying on German legal experience in regulating this issue. In this context, the Presidential Administration announced a tender for the development of a draft law addressing this issue. It is possible that the law on delimitation of tax planning and tax evasion will be adopted in 2006. However, the best guaranteed protection for taxpayers’ rights would be not only a legislative solution

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to the problem, but also ensuring the real independence of the judges.

Changes in individual rules for the calculation and payment of taxes in 2005–2006 Profit tax Beginning in 2006, a series of significant changes in the calculation of profit taxes are planned, which are highly favourable for the taxpayer. In particular, companies will be allowed to immediately include 10 per cent of the cost of a building or equipment in their expenses, and to charge off the rest of the cost. In 2006, in the event of a loss, up to one half of profits can be reduced by the size of the loss, and beginning in 2007, the entire accumulated loss can be used to reduce taxable profit. These new legal developments are quite attractive from an investment perspective. From 2006, research and development costs, even if they did not bring about positive results, can be included in profitreducing expenditures. From 2006, another hard and fast rule will be put into effect. It states that if contracts provide for discounts for the purchase of an agreed-upon volume in the course of a year, the difference between the normal price and special discount price in the new year can be included in expenses. There is one more significant point: beginning the 1 of January 2006, the procedure for documenting expenses incurred abroad will be simplified. It will be possible to prove such expenses in other countries with any documents executed in accordance with the normal business practices of that country in which the expenses were incurred.

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VAT Significant amendments to VAT laws are planned from 1 January 2006, so it is necessary to comment on them in detail. 1. A new law has established a tax

base identification rule binding on all taxpayers by date of dispatch. In accordance with the law, taxpayers lose the right to choose the date as of which the tax base may be determined (the date of dispatch or the date of payment). The tax base must now be determined as of the earlier of the two following dates: – –

date of dispatch (transfer) of goods (work, services) or property rights; date of prepayment or partial prepayment for goods to be supplied (work or services to be performed) or property rights to be transferred.

This rule means that received prepayments will continue to be taxable. An exception is made for export prepayments: in accordance with the law, the tax base does not include full or partial prepayments for the supply of goods that are zero-taxed under clause 1, art. 164 of the Russian Tax Code. However, the Law does not establish a mechanism for enforcing this exception. This may cause problems in its enforcement. Provision is also made for exemption from tax prepayments made by enterprises with a long production cycle (more than six months). 2. VAT deductibility criteria have been changed. In accordance

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with the new law, payment for goods (work, services) is no longer a mandatory condition for deducting VAT. In this context, increased attention from tax authorities to the proper manner of executing VAT invoices is to be expected. 3. VAT on non-cash settlements now has to be paid to the supplier in monetary form. Under the new law, the sum of the tax charged by the taxpayer to the purchaser of the goods (work, services) or property rights is to be paid to the taxpayer on the basis of a payment order for the transfer of funds during the performance of barter transactions, offsetting of mutual claims and use of securities in settlements. The rule that has been introduced not only makes nonmonetary forms of settlement considerably less attractive, but also arouses certain doubts from the viewpoint of constitutional law, as it signifies tax discrimination against non-cash forms of settlement. This provision is to come into effect as of 1 January 2007. 4. A new tax payment procedure for foreign organizations with several subdivisions in Russia has been established. From 1 January 2006, foreign organizations with several subdivisions (representative offices, units) in the territory of the Russian Federation are to file tax declarations and pay the taxes on the operations of all subdivisions located in Russia through their chosen subdivision. These changes rule out the possibility of different subdivisions of one foreign company in Russia being viewed as different VAT taxpayers.

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5. Tax agent obligations are now

imposed on intermediaries. In accordance with the new law, organizations and individual entrepreneurs acting as intermediaries participating in settlements and selling goods of foreign entities in Russia on the basis of contracts of delegation, commission or agency agreements are recognized as tax agents.

Unified social tax As of 1 January 2005, the base rates of unified social tax were lowered for different categories of taxpayers and the scale of regression was changed. For organizations, the following scale of tax rates was established: for payments of up to 280,000 roubles per year – 26 per cent; for payments from 280,001 roubles up to 600,000 roubles per year – 72,800 roubles + 10 per cent of the sum exceeding 280,000 roubles; for payments over 600,000 roubles per year –104,800 roubles + two per cent of the sum exceeding 600,000 roubles. Also lowered are insurance premium rates to be paid by insurants for compulsory pension insurance. For organizations, the following scale was established: for payments of up to 280,000 roubles – six per cent; for payments from 280,001 roubles up to 600,000 roubles –16,800 roubles + 2.4 per cent of the sum exceeding 280,000 roubles; for payments over 600,000 roubles – 24,480 roubles.

Other taxes Water tax Since 1 January 2005, a new chapter of the Russian Tax Code has been in force: 25.2 ‘Water tax’. This tax is

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levied on those who use water for industrial purposes, as prescribed by the law.

Land tax Since 2005, a new chapter of the Russian Tax Code has been in force: 31 ‘Land tax’, according to which the tax base is established at a rate between 0.3 per cent and 1.5 per cent of the cadastre value of the land.

Government fees Since 2005, a new chapter of the Russian Tax Code has been in force: 25.3 ‘Government fees’, which provides more precise regulation of fees charged by various government authorities.

New procedure for collecting fines for tax offences From 1 January 2006, there are plans to enforce a new procedure for collecting fines for minor tax offences. This means that if the size of a fine for an individual does not exceed 5,000 roubles, or for an organization 50,000 roubles, such a fine will be collected without a court decision (as is currently stipulated), automatically according to a decision of the tax authorities. Such decisions will have the power of an execution document and will be immediately passed on to court bailiffs. The taxpayer has to right to suspend this fine collecting procedure by appealing against the decision of the tax authorities. Fines exceeding the stated limit will continue to be collected through the courts. These changes are intended to free up the courts of arbitration from a large number of petty lawsuits.

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Russia

6. East-West Institute Global Security Program Danila Bochkarev Energy is currently Russia’s top economic and political priority and is considered to be the basis of the country’s non-military, ‘soft’ power in the 21st century. The main directions of Russian energy policy were drafted by the Presidential Administration in the context of the management of Russian mineral resources and, in contrast to the Kremlin’s position towards the energy sector during the 1990s, has involved the establishment of much firmer levels of state control over energy resources. The Russian president views cooperation in the energy field with major consumers as a primary means of elevating Russia to a position of global strategic significance. Vladimir Putin has enacted a set of policies seeking to make Russia a world energy leader and therefore a strategic partner to the West. Furthermore, it should be added that high international energy prices and rising Russian oil and gas production have assisted the Kremlin in using energy exports both as a foreign policy instrument in its relations with the key world powers, as well as a means of financing the modernization of the national economy. The Russian energy sector is currently at an important watershed. On the one hand we are witnessing a

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substantial increase in the output of oil and gas, and some analysts have spoken of Russia as a reliable, alternative source of energy to the international economy’s traditional dependence on energy supplies from the Persian Gulf. On the other hand, however, there are concerns that the current Russian energy strategy comes closer to the Venezuelan/OPEC ‘energy state-capitalism’ model (Apertura Petrolera), where foreign energy companies are welcome to invest in the Russian energy sector, but only on Moscow’s conditions and in partnership with a state-controlled national energy company. Such strategies, in contrast to private sector led exploitation of the Russian energy sector during the 1990s, have, for the most part, not been always well received by investors, who more often than not prefer a more deregulated business climate.1 However, Russia will continue to play a key role in the international oil and gas supply and to exercise significant influence on the stability of the world energy markets and will be one of the key drivers of global economic growth.

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Russia

The new legal environment in the Russian energy sector The Russian government is reshaping the energy sector by introducing new legal and sometimes informal ‘rules of the game’ and by taking control over the major oil and gas assets. Institutionalization of the energy sector enabled the Kremlin to reassess the state’s control over major oil and gas assets. In the future, private energy companies will have to comply with the Russian government’s major foreign and domestic initiatives. For instance, the ‘Yukos affair’ and the M&A deals of Russian state energy companies Gazprom and Rosneft’ entirely fit the newly ‘directed’ economic policy, revealing one of the true goals of Russian energy strategy – the creation of powerful and state-controlled vertically integrated energy companies that are competitive inside the country and in the liberalized European, Asian and possibly the US energy markets. Henceforth, the swap of assets (20 per cent of Shell-led Sakhalin-2 for a 50 per cent of stake in Gazprom’s Zaoplyarnoe gas field) fits Gazprom’s strategy of entering the Asian LNG and pipeline gas market. Moreover, Russian gas monopoly Gazprom has already entered the gas distribution business in Germany and Italy, two major consumers of Russian gas. For example, the ‘Yukos affair’ was a clear defeat of ‘the rent-seeking model’ in the Russian energy sector: Yukos went against the new ‘energy paradigm’ by excessively lobbying for its own corporate interests and by trying to gain control over the legislative process, a distinct prerogative of the Russian Presidency. The company also did not fit the profile of an ‘exemplary’ oil company, allegedly not paying its taxes and

58

under-investing in exploration and production activities. The new trend of the époque is that the management of the resource base would be controlled by the state. For example, oil reserves (a ‘feeble chain’ in the Russian energy balance) became a state secret on February 2004 – apparently, in order to bring temporary uncertainty to the investment assessment of Russian oil potential. The decision was based on the federal ‘Law on State Secrets’, adopted in November 2003. The question of property rights is another pressing issue: the licensing regime to be established under the new version of the Russian ‘Subsoil Law’ challenges the traditional concept of mineral resources ownership: transferability of the assets and the right to access resources under the current licensing scheme is limited. Moreover, all oil fields with proven reserves of more than 150 million tonnes and gas fields with reserves of over a billion cubic metres are defined as ‘strategic’ and, therefore, the participation of foreign investors in these projects is limited to 49 per cent. However, some exceptions may be possible for some existing projects like Shell-operated Sakhalin II and for the development of large offshore gas and oil fields on the Arctic Shelf.

Gas transportation issues The draft of law ‘On major pipeline transmission’, which regulates the access of independent gas producers to Gazprom’s transportation system, may be another source of a major concern for the companies investing in the independent gas producing projects in Russia. Foreign investors are not expected to have a ‘free hand’ in the pipeline projects. This area remains the cornerstone of the national energy policy. The Russian government has decided to keep control over

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Russia

strategic oil and gas pipelines and, therefore, regulate production and export activities: Gazprom has also managed to establish the single export gas channel for LNG and pipeline projects in Russian Far East by signing agreements with Shell-led Sakhalin-II for coordinated LNG deliveries, and to channel future gas exports from the BP-TNK controlled Kovykhta field in Eastern Siberia to Gazexport’s (a Gazprom-affiliated company) pipeline system. Moreover, in July 2006 the Russian Parliament voted for the adoption of the new Law on ‘Gas exports of Russia’. All gas exports, including ‘condensates’ and LNG, are subject to the monopoly of Gazprom and its affiliated companies. Gazprom may emerge as an exclusive buyer of Central Asian gas: the company bought 19 billion cubic metres (bcm) of natural gas in 2005 and expects to purchase over 25.8 bcm in 2006. Its exclusive contract with Turkmenistan undermined Ukraine’s Naftogaz Ukraini’s attempts to emerge as a potential major supplier to the European gas market. We should, however, mention that Turkmenistan is regularly increasing the prices of its gas exported to Russia. Gazprom even goes international by participating in Iranian pipeline projects, which may bring gas to India and Pakistan and, therefore, eliminate a dangerous competitor on the European gas market. Furthermore, this trend explains Moscow’s reluctance to ratify Energy Charter Transit Protocol, as it allows unrestricted third party access to Russia’s pipeline infrastructure. To proceed with its ambitious gas policy, Russia needs to improve its gas pipeline system. The most significant infrastructure projects are the recently completed ‘Blue Stream’ pipeline bringing 14.35 bcm of gas to Turkey; Yamal-Europe pipeline

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running through Belarus and Poland, reaching its full capacity of 33 bcm/ year in January 2006; and launching the $5.7 billion offshore NorthernEuropean pipeline consortium controlled by Gazprom (51 per cent), EON (24.5 per cent) and BASF (24.5 per cent), and possibly headed up by G Schroeder (see Figure 6.1). The pipeline, operational in 2010, will bring 27.5 bcm of gas to Germany, with the total projected capacity of the project exceeding 55 bcm. The scandalous, though well-prepared designation of the former German chancellor underlines the new tendency of employing high-profile Western lobbyists. Russia is also reconsidering its gas and transportation policy in the Former Soviet Union. During the summer 2005 CIS Summit in Kazan (Russia), the Kremlin made a political volte-face by denying disloyal regimes low gas prices and switching to more ‘pragmatic’ market-based relations. Thus, Moscow forced Kiev to accept higher gas prices: the new price for the Russian/Central Asian gas mix sold to Ukraine reached $95 for 1,000 cubic meters (eg Gazprom gets $265 per 1,000 cubic metres for Russian gas – Central Asian gas is cheaper), while the previous price was $50. However, Gazprom failed to gain control over the Ukrainian gas transmission system, a major transit corridor for Russian gas exports, and is still using opaque intermediary companies in its trade relations with Ukraine. Gazprom also considers LNG an alternative export route: in September 2005 Russia delivered 60,000 tonnes of LNG to the United States on the basis of swap contracts with Shell and British Gas Group.

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Russia

Bal ti

North Sea United Kingdom

cS

ea

Vyborg

Denmark

Estonia Latvia

Russia

Lithuania

Grayfsvald

Netherlands Belgium Germany

France Switzerland

The Main Characteristic of Vyborg Grayfsvald section Annual total capacity - 55 bcm/y Czech Rep. - 1189 km Length - 42 in Diameter - 22 Mpa Pressure Austria

UKRAINE

Source: Presentation of Mr E Zayashnikov, Member of the State Duma at Eurogas/DG TREN conference ‘The European Single Market in the Global Dimension’, www.eurogas.org. Figure 6.1 Northern-European gas pipeline

Russian gas reserves and production Russia continues to be a key world gas player with 148.44 bcm of natural gas exported outside the FSU in 2004 (BP Review of World Energy 2005). Russia’s role is becoming even more important if we take into account the current tendency of increasing gas prices for the consumers inside the CIS. Russian gas production grew to 589.1 bcm, which represents over 21.9 per cent of the world total (BP, 2005). There is a substantial slowdown in production growth (1.8 per cent in 2004 against 4.2 per cent in 2003) due to poor exploration activities and a failure to apply of the energy saving technologies. Russia enjoys a high reserve-to-production (R/P) ratio (81.5 years), and natural gas reserves of 48 tcm (26.7 per cent of the world total), but most of the new untapped

60

fields are situated in the harsh climatic zones, very often in offshore Artic.

Russian oil reserves and production According to the BP Review of World Energy (2005), Russia remains one the world’s leading oil producers and exporters: 9,285 million b/d oil produced in 2004 (or 11.9 per cent of the world total), which represented 8.9 per cent of the annual growth in production (11 per cent growth in 2003). Russia has 72.3 billion barrels of proven resources (6.1 per cent of the world’s total) with a productionto-reserves (P/R) ratio of 21.3 years. DeGoyler and MacNaughton, one of the major auditors of Russia’s oil reserves, estimates ultimately recoverable reserves at 150 billion barrels (World Energy Outlook 2004, Brunswick UBS, 2004) or 10–12 per

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Russia

RUSSIAN OAS SOCIETY

800 665

700 600

595.1

619.8 633.2

71.3 79.6 90.4

110

730

Total

140

Independent gas companies GAZPROM

555

590

542.8

300

540.2

400

523.8

500

2010

2020

200 100 0

2002 2003 2004

Slide 6

Source: Presentation of Mr E Zayashnikov, Member of the State Duma at Eurogas/DG TREN conference ‘The European Single Market in the Global Dimension’, www.eurogas.org. Figure 6.2 Gas production in Russia (bcm)

cent of total world undiscovered oil potential. However, production grows much faster than the proven oil reserves. Moreover, it is estimated that ‘average investment needed per barrel of capacity is higher than in most other parts of the world’ (WEO). The Yukos affair also damaged Russian oil sector investment potential. This trend may, in the long term, represent a serious obstacle for the development of the Russian oil industry. The introduction of new technologies and management practices has helped to raise productivity and output, but many problems, mainly due to poor investment flows, still exist. For example, insufficient growth (0.1per cent per annum) of the national refining capacity (5,412 million b/d) represents a serious challenge for development of the Russian oil industry. The Centre for Oil and Gas Business (Tsentr Neftegazovogo Biznesa) estimates that Russian oil exports outside the CIS will increase

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from 4.2 million b/d in 2004 to 8.8 million b/d in 2012 (Kommersant Oil & Gas, 14.12.05). The International Energy Agency remains more sceptical on the Russian oil boom (see Figure 6.3).

Oil transportation issues Transportation bottlenecks represent a serious challenge for the Russian oil industry: over 33 per cent of oil is transported by rail, which reflects the lack of sufficient pipeline capacity (see Figure 6.4). Moreover, in the long term, rail deliveries may become unprofitable if oil prices fall. To overcome this problem, Russian oil transportation companies are building new and enlarging the existing pipeline capacities: „ by expanding the Baltic Pipeline System (BPS) pipeline’s capacity from 1 to 1.24 million b/d;

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Russia

12 10

mb/d

8 6 4 2 0 1990

1995

2000

Net exports

2005

2010

2015

Consumption

2020

2025

2030

Production

Source: World Energy Outlook 2004, OECD/IEA, 2004, Figure 9.13, p. 301 Figure 6.3 The Russian oil balance

PIPELINE 60%: 4 million bbl/d

BARGE & OTHER 7%: 2 million bbl/d

RAIL 33%: 2.2 million bbl/d

Source: EIA Country Analysis Brief, http://www.eia.doe.gov/emeu/cabs/russia.html Figure 6.4 Russia’s modes of oil transport (January to September 2004)

„ by developing the $15 billion Far Eastern Oil Pipeline to Nakhodka deepwater oil terminal on Russia’s Pacific Coast (total capacity 1.6 million b/d). The Japanese offer of $7 billion for the project and the Kremlin’s fears of China’s demographic and economic expansion in the Russian Far East, may downplay the less expensive alternative route to Chinese Daqing. It is generally believed that the route will stimulate exploration and production activities in Eastern Siberia;

62

„ the Russian government is also pushing the privately-owned Caspian Pipeline Consortium (www.cpc.ru) to increase its pipeline capacity from an initial 22 million to 67 million tonnes a year, in order to add additional volumes of Russian oil into CPC pipeline.

Conclusion The Russian energy sector, accounting for 25 per cent of GDP and dominating national stock exchanges, is

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Russia

expected to increase in political and economic significance. Moreover, energy will remain the Kremlin’s top priority for decades to come and it will enable the Russian presidency to achieve its major strategic goals: economic and political modernization of the regime. Energy will remain both a means and an end of the Kremlin’s foreign policy, and Russia’s instrument of comparative advantage in the 21st century. Apparently, Moscow will use energy as a geopolitical lever in its relations with Europe, the US, Japan and China, use mutual energy interdependence with these countries to establish closer economic and political ties, and use the dialogues with major energy producing and consuming areas as a multiplier of its political and economic power. Moreover, Russia will look for new markets for its oil and gas exports and will diversify its energy exports to avoid political/economic pressure and a high level of dependency on one consumer (eg the European Union). Despite a number of tensions, the EU– Russia energy dialogue will remain Moscow’s key priority. The future of energy cooperation with China is still unclear, while the energy dialogue with Japan would probably lead to rapprochement between Moscow and Tokyo. The US–Russia energy dialogue is a promising area of cooperation, but it may be restricted by political pressure coming from Washington and the uncertain investment and legal climate in Russia. Moscow also wants to play a significant role in maintaining the international regime of security of energy supplies. In fact, the long-term pipeline gas and LNG contracts promote stability and mutual responsibility in the ‘buyer/seller’ bilateral relationship, and can foster regional geo-strategic stability and political partnership between two countries (see, for example, the Japanese utilities

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companies signing long-term contracts with ‘Sakhalin Energy’ for LNG shipping and, therefore, promoting the bilateral relationships between Tokyo and Moscow). However, Russia’s capacity to exert monopoly power on the world energy market is significantly limited by alternative oil and gas suppliers. Inside the country, the Kremlin is implementing a new coherent energy policy that will become a ‘must’ for Russian private and state-controlled energy companies as well as for the foreign investors. The state will keep control of the main export pipelines (via Transneft and Gazprom) and major energy assets in order to have the opportunity to allocate the main export priorities and if necessary to restrict the oil and gas exports. The government will favour M&A and portfolio investment in the energy sector, but will keep strategic control over the fuel/energy complex. Analysts also predict stricter legislation and an increase in the tax burden. Product Sharing Agreements (PSAs) will be tolerated only in exceptional cases such as Sakhalin or Shtokman, where national producers have neither the financial capabilities, nor sufficient technological bases to develop these fields. Henceforth, the difficulties with launching of new PSAs suggest that this tax regime would not be a dominant component of the FDI in Russia unless the country faces low oil prices. The internal energy market will be gradually liberalized and after Russia’s WTO accession, internal energy prices are expected to rise to make investment in internal energy assets profitable (gas production and domestic distribution, power generation, etc).2 At the first stage, it will result in a sound economy and substantial GDP growth as the general climate for portfolio strategic investment in the oil and gas sector will be favourable for foreign investors. Later

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Russia

on, this process will consequently catalyze democratic developments, further liberalization and diversification of the national economy. The positive trends do not, however, exclude a negative one: sooner or later Russia may follow the fate of other resourcebased economies and face a ‘resource curse’ (‘Dutch disease’, economic inefficiency, corruption, etc).

Notes 1. A former Algerian Energy Minister, Sadek Boussena, and one the EU’s leading energy experts, Catherine Locatelli, argued that the choice between ‘OPEC’ and ‘Norwegian’ models for the Russian energy sector would have serious political implications and will

64

determine the Kremlin’s relations with major energy-consuming and energy-producing countries and Russian energy policy in general. For more details, see S. Boussena et C. Locatelli, ‘Vers une plus grande cohérence de la politique pétrolière de la Russie’, Revue de l’Energie, n° 560, octobre 2004, pp. 505–515. 2. Author’s discussion with Ambassador André Mernier, Secretary General, Energy Charter Secretariat (Brussels). For more in-depth discussion on Russia’s WTO accession and energy pricing see Julia Selivanova, ‘World Trade Organization Rules and Energy Pricing: Russia’s Case’, Journal of World Trade, Aug. 2004, p. 559– 602.

Author’s note: The author wishes to make it clear that these comments are made in his personal capacity, and do not necessarily reflect the opinions of the East-West Institute.

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Russia

7. Trends in the Russian telecommunications and IT sector during 2004–2005 RBC Consulting

The IT market The IT market comprises the following segments: computer hardware, software and IT services. According to the Information Technologies and Communications Ministry of Russia, the aggregate volume of the Russian IT market reached $8.85 billion in 2004. The market showed an impressive growth rate of more than 27 per cent. Analysts believe such dynamics are linked to a growth in demand for

Russian software products, the development of consumer credit, and retail chains trading in computer and electronic equipment. The Communications Ministry says the adoption of a package of bills on personal data and amendments to the Tax Code introducing special tax procedures for IT companies will provide a powerful incentive for the IT industry’s development. The IT market’s growth pace is far higher than that of the GDP and real personal income (see Figure 7.1). 180%

10 Russia's IT market

8.85

9

GDP growth

8

Growth in real personal income

140%

6.94 IT market, $bn

7 6 5

124%

5.64 100% 100%

107%

115%

114%

120% 100% 80%

4 60%

3 2

40%

1

20%

Growth rate against 2002, %

160%

0%

0 2002

2003

2004

Source: the Information Technologies and Communications Ministry of Russia, the Russian government’s website Figure 7.1 IT market growth in Russia

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Russia

The IDC company’s estimates say the Russian IT market will reach $12 billion in 2005, constituting approximately two per cent of the global IT market, which amounts to more than $900 billion. However, in terms of their pace of growth (24–26 per cent per year), Russian high technologies far outstrip the world’s average indicators. The main trend in 2005 was the shift in the attitude of foreign investors: instead of hiring Russian IT specialists they have begun to acquire shares in Russian IT companies. According to J’Son & Partners (J&P), foreigners have invested about $700 million in the Russian IT industry in 2005, up 75 per cent from 2004. Analysts expect foreign investments in the IT sector to advance to $1 billion in 2006. The market has high expectations for the creation of a fully-fledged legal foundation, which will make the IT industry a priority segment of the Russian economy and ensure its stable development. For example, the approval of the bill ‘On electronic signature’ will boost the capacity of the IT services market, thus increasing the capitalization value of the companies operating in this sector. Experts believe that several factors favouring the development of the high-tech business have come together in Russia now: growth in state demand for IT products and solutions, a low level of current home PC penetration and global economic growth.

The government will remain the largest IT consumer in Russia. Major federal agencies that can influence the adoption of their own budgets, such as the Customs Committee, the Tax Ministry and the Economic Development and Trade Ministry, will continue to upgrade their IT systems. The expenses of regional administrations will be considerably lower, the only exception being the Moscow government, which will continue to implement various IT projects. Education and retail will enjoy the highest pace of growth in IT and telecommunications expenses due to their current low level of spending in this area. The banking and services sectors will also advance quickly, and banks will rank among the top three IT consumers by 2008. IDC expects total IT expenses in Russia to exceed $17 billion by 2008. According to the Russian Information Technologies and Communications Ministry, the number of computers had reached 15 million in Russia by 2005, with more than a 30 per cent jump in PC sales in 2004 (see Figures 7.2 and 7.3). The largest proportion of supplies (about 88 per cent) was accounted for by desktops, with portable PCs constituting little more than 10 per cent, and x86 servers about two per cent of the market. According to IDC, laptops demonstrated the best sales

20

Number of PCs, mln

15 15 10

11

12

13

10

5

0 2000

2001

2002

2003

2004

Source: the Information Technologies and Communications Ministry of Russia Figure 7.2 Number of PCs in Russia

66

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Sales growth in 2Q04 against 2Q03, %

Russia

6

+31%

Annual PC sales, mln

5

5.1

4

3.9 3 2 1 0

2003

2004

160% 140% 138%

120% 100% 80% 60% 40% 20%

48% 25%

0% Servers

PCs

Laptops

Source: IDC, 2005 Figure 7.3 Growth in PC sales in Russia (million units)

dynamics: sales surged 119 per cent in the second quarter of this year compared to the same period in 2004. According to the Agency of Mobile Marketing, other segments of the computer market have also been growing steadily during 2005. In particular, the market for multimedia devices has jumped by 40 per cent against 2004 and that of computer monitors has surged by 35 per cent.

IDC data proves that today’s IT market growth in Russia outstrips similar world indicators, and its prospects for the next three years are fairly stable (see Figure 7.4). The Russian Information Technologies and Communications Ministry forecasts that the Russian IT market will be worth $40 billion by 2010. At the same time, two thirds of the goods produced in the sector will be IT market growth in different countries in 2004 Russia

IT market growth forecasts in several regions

China

Overall growth (since 2003), %

300

Russia

Central and Eastern Europe

250 Latin America

200

China Central and Eastern Europe

150

Latin America Brazil North America Western Europe

100 2003

Brazil

North America

2004

2005

2006

2007

2008

Western Europe 0

5

10 15 20 25 30 %

Source: IDC, 2005 Figure 7.4 IT market growth in different regions and countries

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Russia

$, mln

consumed by the domestic market and one third will be exported. Only China can compete with Russia in terms of such indicators. Of the Russian IT market’s total volume some $6 billion are accounted for by hardware, with software constituting $1 billion and IT services accounting for approximately $2 billion. The share of the software sector in Russia’s IT market is far smaller than in the West. This is partially explained by the tradition of spending more on equipment rather than on integrated solutions, and of buying software at lower prices or installing it free, thus violating licensing rights. For reference: the Spanish hardware market is 20 per cent smaller than Russia’s, whereas its software market is almost three times larger. This proves that as the Russian market matures (and the piracy level decreases), software consumption and consulting should develop at a higher pace than the IT market in general. According to BSA, Russia is in sixth place in the world in terms of the piracy level and, according to BSA and IDC, ranks among the top ten countries suffering most from piracy ($1.36 billion per year) (see Figure 7.5). That is why piracy has been fought actively in Russia over the past few years. 60,000 29%

Piracy level 50,000 40,000 30,000

IT services

Some 528 cases under Article 146 of the Criminal Code (violations connected with software) were initiated in Russia in 2004, of which 344 were taken to court. The market’s software segment is enjoying the fastest growth: according to J&P’s estimates, it totals at least 30– 35 per cent a year (optimistic estimates report at least a 50 per cent annual increase). The offshore programming market and that of retail products (‘boxed’ software versions oriented towards home PCs, medium-sized and small businesses) are also advancing fast. There is growing demand for Russian-made software, both in Russia and abroad. Market participants estimate that sales of Russian-made software will reach $2.4–$2.5 billion in 2005. According to the Russian Communications Ministry, software exports will exceed $1 billion in 2005 and will account for the largest share of the country’s civil exports (excluding raw materials). The creation of industrial parks will also contribute a lot to the software segment’s development. Such a concept was approved early in 2005, and it is now planned to build IT parks in St Petersburg, the Moscow region and Novosibirsk.

27%

45%

Software Hardware 50%

20,000 10,000

87%

43%

0 Russia

Spain

Italy

France

Germany

England

Source: IDC, 2005 Figure 7.5 IT markets in different countries in 2004 and their level of piracy

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Russia

Table 7.1 Russia’s largest IT companies Company

Business area

Revenue in 2004**, $mln

Revenue in 2003***, $mln

Number of employees

1

Merlion (LC Group)

Computer equipment distribution

769.2

629.8

1,500

2

NCC

Group of companies

613.4

468.8

1,485

3

IBS

Group of companies

595.9

469.8

3,419

4

R-Style

Group of companies

441.5

329.6

2,150

5

TechnoServ A/S

Integration

402.2

296.0

733

6

LANIT

Integration

395.7

257.2

1,600

7

Verysell

Group of companies

370.0

260.0

550

8

CROC

Integration

238.5

183.9

595

9

Open Technologies

Integration

223.3

262.1

306

10 Kraftway

Computer equipment production

153.3

79.2

528

11 CBOSS

Software development

146.9

80.0

2,100

12 Alion

Digital equipment distribution

119.0

74.9

285

13 I-Teco

Integration

116.6

77.6

295

14 Microtest*

Group of companies

115.0

88.3

No data available

15 Optima

Integration

113.0

81.0

438

16 Alliance Marketing Group Computer equipment distribution

106.9

72.0

110

17 Compulink

Group of companies

106.9

75.8

500

18 Infosystems Jet

Integration

101.0

71.0

300

19 1S*

Software development

100.3

65.0

515

20 AMT Group

Integration

97.2

47.3

180

21 RRC

Computer equipment distribution

94.3

73.8

150

22 INLINE Technologies

Integration

89.2

35.2

550

23 BCC

Integration

87.5

51.5

520

24 RoverComputers

Computer equipment production

86.4

78.9

No data available

25 Pirit

Computer equipment distribution

82.1

61.7

188

26 Nienschanz

Integration

77.4

31.4

310

27 RosBusinessConsulting

Group of companies

75.0

49.1

1,300

28 IT Co.

Integration

74.8

55.1

985

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69

Russia

29

Borlas

Integration

73.6

35.8

393

30

Cognitive Technologies*

Software development

73.3

51.5

525

* estimates of CNews Analytics ** dollar indicators have been calculated under the 2004 average nominal rate of 28.81 RUR/USD *** dollar indicators have been calculated under the 2003 average nominal rate of 30.68 RUR/USD Source: CNews100 rating

Telecoms The market for communications services has shown a high growth pace over the past five years: it has advanced by 40 per cent annually. These dynamics are confirmed by data for 2004. The market, according to the Communications Ministry, reached $18.75 billion in 2004, up 37 per cent from the previous year (see Figure 7.6). Revenue of electrical communications operators amounted to more than $17.4 billion. The key event for the industry in 2004 was the approval of the federal law ‘On communications’. The law’s regulatory acts have been designed to considerably decrease the barriers that market participants have to tackle. Such procedures as licensing,

distribution of frequencies and relations between operators have been formalized. As a result, the law has created conditions for further liberalization of the telecommunications market. Implementation of the universal service mechanism has begun this year, which should solve the urgent issue of ‘telephonization’ of remote areas, where a low population density makes it economically inefficient to develop infrastructure. Under this mechanism, all Russian telecom operators have to transfer 1.2 per cent of their annual revenue to the universal service fund. These funds will then be used to cover losses from providing services in remote areas: a payphone and an internet access point have to be introduced in each settlement. In 2005, regulatory acts giving the green light to the liberalization of the long-distance and international communications market were adopted.

30

25 25.3 20

$, bn

18.75 15 12.63

10 8.6 6.65

5 5.16 0 2000

2001

2002

2003

2004

2005

Source: Information Technologies and Communications Ministry of Russia Figure 7.6 Growth in the communications industry’s revenue

70

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Russia

Several companies have already received licences to provide such services. However, governmental regulations outlining procedures for the implementation of the federal law ‘On communications’ were being developed during the whole of 2004, and most of them were approved early in 2005. Reforms of the government’s structure and the slow implementation of regulatory acts brought a degree of uncertainty to the market. This might have been one of the reasons why the industry’s development slackened in mid-2004. Another possible reason for relatively slow growth in revenues of communications companies in 2004 is the pegging of tariffs of leading commuShare, % 100

nications operators (primarily mobile), which generate the industry’s main revenue, to the US dollar. The dollar decreased against the rouble over the whole of 2004, losing 5.8 per cent amid an inflation rate of 11.7 per cent. Moreover, profits received from mobile communications dropped as the most solvent markets of Moscow and St Petersburg became saturated and operators began regional expansion. The share of long-distance and international communication has dropped in recent years, probably due to the increased popularity of IP-telephony. Consequently, the share of new and data transfer services is advancing (see Figure 7.7).

2.1

1.7

1.8

1.4

Other services

8.3

New communications services

45.6

Mobile communications

6.0 10.9

10.3

90 28.0 80

70

13.3

20.0

31.0

38.2

5.4 4.3

5.4 5.3

60

40.3

4.4 5.6

4.1 6.1

4.6 5.2

50

3.5

38.3 36.3

40

36.2

5.3 30.2

3.1 6.5

26.1

30

Radio, TV and satellite communications Data transfer

19.5 16.8

Long-distance telephone communications

19.4

18.2

Local telephone communications

2003

2004

20 25.6 10

22.2

23.8

1999

2000

22.4

22.6

0 1998

2001

2002

Source: Information Technologies and Communications Ministry of Russia Figure 7.7 Shares of the Russian telecom market’s segments

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Moscow is still the largest area in terms of telecom operators’ revenue, though its share has been gradually decreasing over the last few years (see Figure 7.8). Mobile communications has been the main driver of the market. Since 2002, it has been the largest market segment and shown the highest growth. In 2004, its share reached almost 46 per cent of Russia’s telecommunications market. According to IKS-Consulting, the number of subscribers surged by 80 per cent to 120.7 million people, or 84 per cent of the population, over this year. In November 2005, regions accounted for 82 per cent of all mobile subscribers in Russia and growth in the subscriber base slackened from 6.1 per cent to 3.4 per cent, due to the market approaching saturation under the current tariffs. The subscriber base will continue to advance moderately in the future, though no record-high growth rates will occur, except for seasonal bursts. IKS-Consulting forecasts that the communications market will total about $10.7 billion by the end of 2005. J’Son & Partners estimates that the Far East 5% Siberian 9%

number of mobile subscribers will exceed 124 million people, or 86 per cent of the population, by December 2005. Some 34.7 per cent of the public uses MTS, 34 per cent use Bee Line and 18.5 per cent choose MegaFon. The share of these three operators in the aggregate revenue of the mobile communications market amounted to 87 per cent in the first nine months of 2005. There is almost no change in the top 10 companies: SMARTS, which ranked fifth last year, switched places with Tele2, which was in sixth place. IKS-Consulting’s survey of the additional services market has revealed the following trend: this market reached $958.7 million in January to September 2005, of which about half is accounted for by SMS/MMS. The ‘big three’ received 90 per cent of the total revenue from additional services in Russia in the first nine months of 2005. Foreign investment in Russia’s telecom industry has continued to grow during 2004–2005: it reached $1.48 billion in the first half of 2005, having jumped 1,280 per cent since the same period in 2004.

Central (excluding Moscow) 9%

Ural 7%

Volga 13%

Southern 9%

St. Petersburg 8%

Moscow 37%

Northwest (excluding St. Petersburg) 3%

Source: the Information Technologies and Communications Ministry of Russia Figure 7.8 Telecom market’s revenue by federal district in 2004

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Table 7.2 The largest telecoms operators in 2004 No. Company

Revenue from communications services, $mln

2004 as a percentage of 2003

1

Mobile TeleSystems (MTS network)

2,143.9

128.10%

2

Rostelecom (Svyazinvest)

1,301.1

125.20%

3

KB Impulse (VimpelCom network)

1,105.1

247.20%

4

CenterTelecom (Svyazinvest)

866.8

119.50%

5

VimpelCom (VimpelCom network)

843.2

88.50%

6

Uralsvyazinform (Svyazinvest)

836.8

123.60%

7

Sibirtelecom (Svyazinvest)

661.1

121.70%

8

MegaFon (MegaFon network)

646.0

137.80%

9

VolgaTelecom (Svyazinvest)

646.0

126.80%

10

UTK (Svyazinvest)

581.7

124.00%

11

North-West Telecom (Svyazinvest)

533.2

124.50%

12

MGTS

520.2

117.30%

13

EDN Sovintel (Golden Telecom)

383.9

131.00%

14

Sonic Duo (MegaFon network)

332.6

221.70%

15

TransTeleCom Company

314.1

161.50%

16

Far East Telecommunications Company (Svyazinvest)

310.4

130.60%

17

Telecom XXI (MTS network)

300.9

133.70%

18

Mobicom-Caucasus (MegaFon network)

251.3

193.40%

19

Kuban GSM (MTS network)

235.8

129.30%

20

MSS – Povolzhye (MegaFon network)

202.0

178.50%

Source: Information Technologies and Communications Ministry of Russia

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8. Key trends in the Russian automotive industry Andrei Kouzmin and Maxim Andronov, Deloitte

The Russian car market overview From 2003 to 2005, the Russian automobile market’s growth was higher than the world market’s average growth. According to the Russian Ministry of Industry and Energy, over $20 billion was spent on passenger cars in Russia in 2005. The market grew by 17.6 per cent in terms of value, compared to the year before when sales were $17 billion. More than 50 per cent of total spending went on purchasing foreign cars, less than one third on Russian cars, and the rest, less than 20 per cent, on used foreign cars. In total, there were over 1.6 million passenger cars sold in Russia in 2005, compared to 1.52 million in 2004, and around 1.43 million cars in 2003. This suggests that between 2003 and 2005, the Russian car market’s growth was 5.7 per cent on average. We believe that the market will continue to grow by 5–6 per cent over the next five years, reaching over two million car units, worth around $32 billion, by 2010. The Russian car market remains among the most attractive emerging markets. According to industry experts, car ownership in Russia increased from 147 cars per 1,000 people in 2003 to 160 cars per 1,000

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people in 2005. However, car penetration is still somewhat lower than in other European emerging markets, including the Czech Republic, Slovakia, Hungary and Poland, where there are 250–350 cars per 1,000 people. In fact, that is far below major European countries, where car ownership is around 400–550 cars per 1,000 people. Only in Moscow does car penetration reach around 247 cars per 1,000. The Russian automotive market is also characterized by a significant proportion of obsolete vehicles. Statistics show that nearly 50 per cent of all cars in Russia are more than 10 years old. These figures suggest that a significant latent replacement demand exists, which is likely to materialize as disposable incomes grow. As the Moscow car market matures, industry specialists suggest that the major growth will take place in the regions, where car penetration is significantly lower. The development of consumer financing schemes as well as of an efficient distribution system in the regions would definitely support this prospective growth. In July 2002, the Russian government approved ‘The Concept for Automotive Industry Development’, an eight-year programme designed to improve the Russian car sector. The government’s objective was to encourage foreign car-makers to set up domestic production facilities during the

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transitional period, and give domestic producers time to focus on improving the quality and design of their automobiles. Meanwhile, tariffs on new car imports went up to 35 per cent and were supposed to stay at an increased level for five years. Despite high tariffs on the import of foreign cars, Russian car producers continued to lose their market share, as more consumers shifted towards foreign brands. Economic stabilization, an increase in personal incomes, and the availability of consumer financing schemes were among the key reasons for this tendency. Last year between 30–35 per cent of cars were purchased in Russia through bank loans and other financial schemes. More people were able to afford new foreign cars or to trade in their used cars for new foreign brands. Working towards the goal of joining the WTO by 2006, the Russian government decreased tariffs on new foreign cars to 25 per cent in 2004. Experts believe that this move helped to boost foreign car imports in 2004 and 2005. Furthermore, according to information from Russian Ministry of Economic Development and Trade, tariffs on new foreign cars may go down to 15 per cent in 2006. If this happens, it will significantly heat up competition between imported and domestically produced cars on the Russian market.

Table 8.1 shows that from 2002 to 2005, the major growth was in two sectors – new imported foreign cars and new foreign cars produced in Russia. The growth in these two categories continued through 2005. Imports of new cars increased to 410 thousand units (46 per cent up from 2004), while foreign car sales increased by 15 per cent, reaching 150 thousand units. The segment of new foreign cars is projected to grow by more than 20 per cent in 2006. Decline in the segment of used cars has been another market structural trend over the last three years. According to government regulations, in 2003 tariffs on the import of used cars over seven years old were increased from €2 per cubic cm to €2.2 per cubic cm. Consumers from this segment switched to Russian cars or to used newer foreign cars. Additionally, consumer loan and mortgage plans became relatively affordable and widely available for households. Thus, consumers preferred to opt for new inexpensive foreign cars rather than for used cars. The decline of the used foreign car market share is very likely to continue in the future. Production of new foreign cars in Russia will grow at a fast pace. At the same time, car mortgage interest rates are expected to decline. These factors will certainly put additional pressure on the used car segment.

Table 8.1 Structure of the passenger car market in Russia Market segment

Market share 2002, %

2003, %

2004, %

2005, %

New Russian cars

63.1

59.9

55.4

49.8

Imported used foreign cars

29.2

24.4

18

17.6

Imported new foreign cars

69

12.3

19.2

23.8

New foreign cars (produced in Russia)

0.7

3.4

7.5

8.7

Source: ASM Holding

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In 2005, the average price of a ‘conventional’ car rose to $12,500, compared to $11,100 in 2004 and $5,300 in 2000. It is worth noting that there was a significant difference between the price growth for Russian and foreign cars. According to statistics, prices for Russian cars were growing faster than the annual inflation rate or at around 12–15 per cent per year. During the last five years, Russian producers increased prices by 70–75 per cent. At the same time, the price of foreign cars increased by less than four per cent, which made them extremely competitive with Russian vehicles. Russian producers maintain that the growth in prices was due to increases in the cost of energy, raw materials, car components, and labour. It is not clear whether prices for Russian cars will continue to grow in the near future. However, industry experts suggest that Russian producers should keep price growth below the domestic rate of inflation. Otherwise, they are unlikely to be able to sustain tough competition with their foreign rivals. The Russian consumer’s needs and preferences have also changed during the last two years. Despite the fact that most consumers remain price sensitive, demand is shifting towards high quality and comfortable cars, with a distinctive, contemporary design. As personal disposable income continues to grow, consumers are ready and willing to pay more for a better product. Unfortunately, Russian manufacturers are unable to offer a product of the same quality and design as those of Western companies. Their most important advantage – their low price – will diminish in importance as national prosperity continues to grow. Thus, it is no surprise that foreign car sales rose during the period 2004– 2005, and will remain strong in the near future.

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The majority of new foreign cars were sold in the price range of $10,000–$15,000. However, the highest sales growth was in the range of $15,000–$20,000. Korean and Japanese producers were clear leaders in both ranges, except for the American companies Ford and Chevrolet (GM). Among the most successful sellers were UzDaewoo, Hyundai, Mitsubishi, Nissan, Mazda, Kia and Toyota. Experts agree that Korean and Japanese car companies were able to offer the widest selection of fully equipped car models with affordable prices, satisfactory quality, and relatively modern design. Additionally, they benefited from the growth of the Euro against US dollar and Japanese yen, which made European cars more expensive and less competitive in these two price ranges. In 2004, Skoda’s sales went down by 20 per cent, Seat’s by 50 per cent, and Jaguar’s by 30 per cent. In 2005, Opel’s sales were down by 18 per cent and Saab’s by almost 60 per cent. The demand for the $30,000– $45,000 range declined somewhat, although it grew for the range of $45,000–$60,000. Mercedes, BMW, Audi and Lexus were leaders in the luxury sub-segment. Their sales increased by double digit numbers. In the SUV sub-segment, Land Rover was able to increase sales by 48 per cent at the beginning of 2005, compared to the same period in 2004. Toyota and its Land Cruiser was a clear leader in its class segment. Almost all Russian cars are sold in the range under $10,000, except for some modifications of Lada-110 and new UAZ Patriot models. This range still remains the largest in the market. High import tariffs helped Russian producers maintain a price advantage and to keep leading the market segment. However, several foreign car models are already present in this range. New imports from China and

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India are likely to complicate competition in this mass-market price range even further. In the medium term, Russian producers will maintain their dominance in this market segment. However, we believe that their share of the market will decline as more foreign models begin competing with them.

Domestic production Russia ranks as the fifth largest automobile producer in Europe and twelfth in the world. Production output reached about 1,270,000 units in 2004, 9.9 per cent up from the year before. This growth was mainly due to strong consumer demand and increased tariffs on the import of foreign cars. Additionally, the strong growth in 2004 was also driven by the very rapid expansion of foreign cars produced in Russia. Production of locally produced foreign vehicles doubled in 2004 to more than 120,000 cars, and reached 150,000 in 2005. During January to November 2005, Russian automotive production fell by 4.3 per cent to 1,221,197 units.1 Production of passenger cars decreased by 5.5 per cent to 963,959 units, truck production reached 189,938 (a 1.5 per cent increase from 2004), and bus production fell by 1.7 per cent to 69,290 units. Production output was chiefly affected by the unfavourable economic situation at the beginning of 2005 (including the strengthening of the rouble against other currencies), as well as an increase in competition from foreign imported cars. We think that the domestic production of foreign cars will be the major source of industry growth, as Russian producers are unlikely to significantly increase the output of Russian cars due to a lack of demand. Russian producers continue to suffer from issues such as low quality, weak distribution

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systems and the absence of new modern models. This situation is unlikely to change soon, at least in the medium term. Therefore, various forms of partnerships between Russian and foreign producers seem to be a prospective solution for securing the future of the Russian domestic automotive industry.

Domestic producers The domestic automotive sector is dominated by the three large original equipment manufacturers (OEMs): Volgski Automobile Plant (AvtoVAZ), Gorky Automobile Plant (GAZ) and Ural Automobile Plant (UAZ). KaMAZ dominates the heavy truck sector while Pavlov Autobus Plant (PAZ) is the leading manufacturer of buses. Domestic OEMs are highly vertically integrated and currently do not import major components, as it would make their final production costs unaffordable for most consumers. AvtoVAZ, Russia’s largest car manufacturer, accounted for almost 50 per cent of domestic cars, leaving its two main competitors, GAZ and UAZ, far behind. Its joint venture with General Motors, which started production of the Chevrolet-Niva in September 2002, helped AvtoVAZ to strengthen its leading position among traditional domestic producers. During 2005, each of the three Russian major car-makers announced remarkable changes related to the future development of their companies. We will describe the details of these changes below while highlighting the profiles of VAZ, GAZ and UAZ.

AvtoVAZ In 2004, Volgski Automobile Plant (AvtoVAZ) produced 717,985 cars. Its sales revenue was reported at RUR160.5 billion, with a net profit of RUR4.57 billion; 64 per cent of shares

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of the company belong to its own affiliated structures. Most AvtoVAZ vehicles are produced under a popular and virtually omnipresent Lada brand name. The history of AvtoVAZ dates back some 30 years to when it was developed with Fiat. Lada cars are quite inferior both in terms of quality and design. The company does not utilize existing tariff barriers as an opportunity to work on improving its automobiles and bringing them up to world standards. As a result, Lada continues to lose its position in the local market and suffers from a poor reputation. We believe that AvtoVAZ’s market share will continue to diminish, especially once import tariffs are lifted in compliance with WTO requirements. Major Lada problems – poor quality, safety and overall design – are likely to remain, discouraging consumers from purchasing VAZ vehicles. Industry analysts forecast that VAZ’s market share may go down to 32–33 per cent by 2010. In the past year, AvtoVAZ introduced two new models – Lada-Kalina and Priora. The company has already started production of the Kalina and plans to make 30,000 Kalinas in 2006. Mass production of the Priora will also start in 2006. VAZ hopes to base its future development on the prospective success of these two cars. It plans to add two or three new models closer to 2010. However, the most surprising news came at the end of October 2005, when AvtoVAZ’s CEO, Vladimir Kadannikov, who ran the company for the last 17 years, suddenly resigned. As a result, control over VAZ was taken over by the state. Consequently, the key management positions were taken by managers from the state-owned company Rosoboronexport, whose major business is the export of Russian military products. We are somewhat skeptical about the current changes in owner-

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ship and management at AvtoVAZ and about the future competitive position of the company. It is unlikely, considering the company’s new situation, that VAZ will strengthen its partnership with foreign manufacturers. The possible scenario is that VAZ’s owners will continue to lobby for increased tariffs on foreign exports and will also try to get more government subsidies and preferences. In our opinion, the company will not benefit from state control and management in the long term.

GAZ GAZ is Russia’s second largest automotive producer, producing large passenger cars, light and medium trucks, and minibuses. The factory is controlled by the RusPromAvto automotive holding, owned by Oleg Deripaska’s Basic Element financial group. GAZ is very successful (around 53 per cent of domestic output) in the light commercial vehicle (LCV) sector, which it dominates with the Gazelle brand. The automobile has a load capacity of 1.35 tonnes and nine cubic metres of cargo space. Lack of competition and low costs have made it a best seller with Russian enterprises and entrepreneurs. Overall, the company was able to increase its production by more than seven per cent during the period 2003–2004, reaching around 215,000 units in 2004. That included 65,686 passenger cars, 31,522 minibuses, and 117,043 light trucks. However, between 2003 and 2005 the company continued to suffer from the poor sales of its flagship business class automobile, the Volga, characterized by poor quality and an out-ofdate Soviet era design. In 2005, GAZ produced 56,000 Volgas – a seven per cent drop from 2004. Finally, at the end of December 2005, RusPromAvto announced that it plans to wind down

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production of its famed Volga. The major reason for this decision, obviously, was that the Volga failed to sustain tough competition against foreign cars. The production will be pared down gradually over the next five years. The Volga’s share stands at 4.5 per cent of the Russian market. We believe that its market share will now be shared between AvtoVAZ and foreign producers (most likely Korean and Chinese manufacturers). We also believe that from now on, GAZ will focus on its LCV business. At the same time, the owners of GAZ may also consider jointly producing a foreign car at the factory.

UAZ While UAZ is by far the smallest of the Big Three, it is the most Westernoriented company. Severstal, a metallurgical giant, owns a controlling stake in UAZ. Despite the company’s strong production growth of approximately 16 per cent in 2003, its market position remains vulnerable, as most of its products have not benefited from investments in design enhancements. In 2004, UAZ production was down to 66,700 units (31,136 cars, 17,037 buses and 18,528 trucks) from almost 77,000 units a year before. That translates into a production decline of more than 14 per cent. UAZ remains mainly a manufacturer of LCVs and minivans. However, its production of sport utility vehicles may provide the impetus the company needs to become a stronger competitor. Its UAZ-Hunter SUV car proved to be a rather successful project. Last year, the company also introduced a brand new, updated SUV model, UAZ-Hunter, which costs approximately $11,000, and demand for it seems to be relatively high. In December 2004, Severstal signed a $480 million deal with South Korean SUV maker Ssangyong Motor to assemble its Rexton model at UAZ.

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Severstal-Avto will cover all the set-up costs, while Ssangyong will provide technical assistance to the project. The UAZ-produced Rexton may cost between $25,000–$30,000, in comparison to $40,000–$50,000 for similar imported models. The company plans to make up to 55,000 of the Korean SUVs per year. New strategic investors, experienced management, imported Swiss and German equipment, relatively good corporate structure, as well as the new partnership with Ssangyong make UAZ a potentially successful company on the domestic market. After GAZ’s main shareholder decision to cease production of the Volga earlier in 2005, in December SeverstalAvto announced that production of Oka – another famous Russian brand – will cease in 2006. Until recently, Oka, a domestic leader in the A-class segment with 4.8 per cent share of the whole car market, was produced at the ZMZ plant in Naberezhny Chelny, owned by Severstal. In 2005, ZMZ produced more than 31,000 Okas, compared to 41,000 in 2004. According to Severstal-Avto, the decision to cancel production of the Oka was influenced by the fact that Russia will adopt the ‘Euro-2’ ecological standard from the beginning of summer 2006. The Oka and its engine do not satisfy the requirements of this standard. We believe that Oka consumers may switch to the new AvtoVAZ LadaKalina model and foreign-produced cars like the Korean Daewoo Matiz and the Chinese Chery.

Major FDI projects Western car manufacturers are interested in producing cars in Russia due to a large, unsatisfied demand, the availability of an inexpensive labour force, a vast resource base and the geographical location of the country.

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There are two major tendencies in the way in which foreign producers enter the Russian car market – construction of their own production facilities, or forming joint ventures and partnerships with Russian manufacturers. However, it is very unlikely that the world auto giants will purchase any domestically manufactured cars, due to their notorious reputation for poor quality and outdated production standards. Russian automobile producers have so far not been able to take advantage of existing protecting import tariffs, or to bring the quality level of their products up to Western standards. We believe that world auto leaders would prefer to move into the Russian market by means of constructing their own assembly plants, and over time gradually expand the number and the complexity of tasks performed in their production facilities. This has already been done by the Ford Motor Company, GM, Kia, BMW, Hyundai and Renault, all of which have opened plants in Russia. Among other foreign companies considering moving to Russia in the short to medium term are Volkswagen, Daimler-Chrysler, Nissan, Toyota and Mitsubishi. World automobile giants will be the major driving force of the automotive sector expansion as more and more foreign companies decide to open their production facilities in Russia. The major benefit for the Russian automotive industry is that foreign automobile manufacturers bring in the knowledge, technology, skills and investment necessary to produce high quality cars in Russia. Foreign producers also benefit from producing inside Russia because it allows them to reduce the total cost of their cars by a minimum of 15 per cent. So far, despite a dynamic growth in demand for foreign cars, FDIs into the Russian automotive industry remain very modest. We believe that the Russian government has to take an

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important role in the development of cooperation with the major foreign car producers to encourage FDI inflows into the industry.

GM–AvtoVAZ General Motors’ joint venture with AvtoVAZ is the largest project of its kind. GM, AvtoVAZ and the European Bank of Reconstruction and Development (EBRD) signed a general agreement setting up a joint venture in June 2001. Under the deal, AvtoVAZ provides the facilities, equipment and expertise, while GM mainly contributes cash and some equipment. GM and AvtoVAZ each receive a 41.5 per cent stake worth $99.1 million each, while the EBRD owns the remaining 17 per cent of stock, worth $40 million. The bank provides an additional $90 million in loans. The joint venture started production of the Chevrolet-Niva AWD vehicle in September 2002. In 2003–2004, Chevrolet-Niva became the fifth most popular car, with total sales of 54,910 units, and its market share doubled to 4.2 per cent. Hence, in 2004 the venture introduced a new car – the Chevy-Viva. Its production was 240 units in 2004.

Ford Motor Company The Ford Motor Company opened a $150 million assembly plant in Vsevolozhsk near St Petersburg in July 2002, and started the production of Ford Focus cars. The company reduced the original price it charged in Russia for its European-produced Ford Focus by almost 21 per cent, creating a strong competitive advantage by offering its consumers an attractive price/quality combination. As a result, demand for the Ford Focus model produced in Russia (which retails for $11,400 and is available on credit) exceeds supply to such a degree that

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consumers have to wait up to three or four months before getting their cars, having made a down payment or paid full price for them. Ford Focus is the sixth most popular car in Russia. In 2004, its market share was 2.3 per cent, with sales of almost 30,000 units. Last year, Ford introduced a new modification of this car – the Focus II. Ford has a significant competitive advantage in the Russian market. Not only does it produce one of the most desirable American sedans, with a modern design and affordable price, but it has also developed a special consumer financing scheme with a 4.9 per cent interest rate (half that of one of its foreign rivals).

Avtotor Avtotor invested approximately $100 million in assembly factories for BMW and Kia automobiles in Russia. The company is constantly expanding the range and complexity of the tasks it performs. In 2004, it signed an agreement with GM to produce the Hummer, popular among rich Russians, as well as two Chevrolet models – the Tahoe and the Trail Blazer. Production reached an output of 14,648 cars (2,450 BMWs, 11,350 KIAs, 122 Hummers and 720 Chevys) in 2004. Avtotor may serve as a good example for the future of the Russian automotive industry, where foreign luxury and economy brands being produced in Russia will play a major role.

TagAZ The TagAZ plant was established in 1999 and funded by Korean carmaker Hyundai. The plant’s production capacity is 120,000 units. Hyundai started to produce its Accent at TagAZ in 2001. In 2004, production of another Korean model, the Sonata, also began at the plant. The Hyundai Accent is among the 10 most

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popular cars in Russia. In 2004, more than 20,000 Accents were sold (1.6 per cent of the market share). Hyundai invested around $200 million in the development of the TagAZ project.

Avtoframos French auto-maker Renault SA opened an assembly plant in Moscow at the beginning of 2005 for production of its low-cost Logan model, investing $250 million in the project. This is, in fact, the biggest automotive FDI project so far in Russia. The plant’s production capacity is 60,000 cars per year and Renault plans to reach full capacity in 2006. Production may then be expanded to 120,000 cars if the market demand for the Logan is high. The Logan’s starting price will be between $8,999 and $12,099 (€7,000 and €9,400). We believe that Renault’s investment project has the potential for success and the Logan will take its place among Russian market leaders. The cost of the Logan is relatively competitive, at the same level as that of Hyundai and UzDaewoo cars. Furthermore, Russian consumers traditionally rank European brand names and design higher than their Korean counterparts.

Prospective FDIs Strong market growth, consumer demand for foreign cars, and growth in household income are making several foreign car-makers consider building production facilities in Russia. At the beginning of 2005, South Korea’s KIA Motors Corp launched an assembly line producing its Spectra model at the Russian IzhAvto factory. Kia even agreed to outsource welding and painting to some local companies, and also to cut imports of components by at least 30 per cent in value terms in three stages over about five years.

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IzhAvto plans to make 8,000 Spectras this year, 25,000 next year and reach full capacity of 40,000 in 2008. IzhAvto will be the fourth Russian plant to engage in full-scale production of foreign cars. Last year, Toyota made a decision to build a plant near St Petersburg. Russian President Vladimir Putin personally welcomed the move by Japan’s largest car-maker and, speaking on behalf of the government, promised to give wide support for this FDI project. Mitsubishi Motor Corp announced in 2005 that it is looking for ways to build a production plant in Russia, after its sales increased to 55,000 units, compared to 37,000 units sold in 2004. Nissan Motor is also in the process of selecting its production site. Nissan, which sold over 9,000 cars last year, is currently considering GAZ, UAZ, or a ZMZ factory, as its potential partner for building its production line in Russia. Suzuki Motor may build an automobile plant in Tatarstan. Two Chinese car-makers plan to begin production of two Chery models at a joint venture plant in Novosibirsk, another model in a joint venture in Biysk, as well as the Great Wall SUV vehicle in Irkutzk. Finally, at the end of 2005, after lengthy talks with the Russian government, Volkswagen confirmed its intention to invest €330 million to build an automotive plant in Russia. It will be a full-cycle production plant with the capacity of 80,000–150,000 cars a year. Last year, DaimlerChrysler was negotiating with the Russian government over the conditions of a potential plan to construct a Mercedes assembly plant in Russia. However, the company decided to freeze its plans because current customs taxes do not allow luxury cars to be built at competitive rates. The US-German car giant will continue to look at the possi-

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bilities of establishing production in Russia in the future. It might be that DaimlerChrysler was not able to get preferences from the Russian government, as Toyota and VW did.

Conclusion During 2003–2005, Russian domestic car producers continued to lose their market share, mainly due to increasing competition from foreign carmakers. After Russia joins the WTO, import tariffs will be reduced, placing additional pressure on Russian cars. As consumers’ disposable income grows, people’s preferences will shift towards better quality and better designed foreign cars. In the near future, market growth will be driven by increasing sales in the new imported foreign car and domestically produced foreign car market segments. The used foreign car segment is likely to decrease over time. Domestic producers’ leadership in the low-price segment (under $10K) will remain. However, Korean and Chinese carmakers will certainly increase competition in this segment. Further development of car loans will be another important trend. Bank loan interest rates are expected to go down in the medium term. This will allow consumers to more actively use these options to finance a new car. It is estimated that around 40 per cent of total car sales will be made using car loans. While the development of auto loans is likely to boost sales in all segments of the car market, we expect the major impact to take place in the foreign inexpensive mid-sized car segment with price tags from $15,000– $20,000. Korean and Japanese producers will obviously be leaders in this segment. GAZ will begin to wind down production of the famous Russian sedan Volga, starting in 2006. At the same

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time, ZMZ will stop production of the Oka. These two cars accounted for 5.3 per cent of the whole market in 2005. We believe that this stake will most likely be shared between AvtoVAZ, Korean and probably Chinese manufacturers. In 2005, the Russian government practically eliminated customs duties on the import of auto components to encourage development of domestic production by foreign manufacturers. We believe that this was an important decision that will help to attract more FDI in the Russian car industry. A number of famous foreign car-makers have already expressed their plans to start production in Russia, including such companies as Toyota, Nissan, Mitsubishi, Volkswagen and others.

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However, some system risks – political, legal and technical – still exist in the Russian market. The absence of quality components producers in Russia is another important problem. These risks make some foreign producers cautious about making investments in the Russian automotive industry. Nevertheless, we see the greatest potential for growth in the automotive sector coming from the Russia-based production of foreign manufacturers.

Notes 1. According to an ASM Holding analytical report.

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9. Key trends in the Russian brewing industry Andrei Kouzmin and Maxim Andronov, Deloitte

Market overview Today, the Russian beer market is the fifth largest in the world (after China, the United States, Germany and Brazil) consuming about 857 million decilitres and worth over $7 billion. It is the second largest market, after Germany, in Europe. Western analysts forecast that Russia and China together will account for over 50 per cent of the world’s beer sales in the next five years. After a real boom in the Russian beer market, with an annual average growth of 16 per cent between 1998 and 2003, it is now eventually reaching maturity. In 2004, the Russian beer market growth slowed down to 12.5 per cent growth, and in 2005 it grew by only three per cent in volume terms. That is, in fact, the slowest growth level for the past seven years. There are two reasons behind this slow-down. The major one is that the market is reaching a peak in consumption, especially in Moscow, St Petersburg and the other big cities. Beer demand has grown steadily over the last 10 years. In comparison to the year 2000, when consumption was at 37 litres per head, demand grew to 57 litres per person in 2005. Thus, the consumption level is approaching that of other European countries where people drink, on average, 60–70 litres

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per head (Germany and the Czech Republic consume over 100 litres per person). The market was also hurt by limitations on beer advertising. At the end of 2004, the State Duma approved several amendments to the ‘Federal Law On Advertising’, putting restrictions on TV adverts for beer between 7am and 10pm. New laws also prohibited the use of people and animals in beer advertisements. Some argue that these legislative changes increased companies’ marketing expenses by 30 per cent because they had to pay premium prices for TV adverts shown after 10pm and redirect their marketing budgets to more expensive advertising channels. There are clear geographical trends. Moscow and St Petersburg have a per capita consumption of twice the average of other regions; however, less than one-tenth of the population lives in these two cities. This suggests that further market growth could be stimulated by the expansion of the major players into the under-served regions, which have strong potential. The leading brewers are planning further expansion into the Russian regions, including Siberia and the Urals. Moreover, the relocation of production allows them significant monetary savings. According to some reports, if companies start brewing the beer that they sell in Siberia

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locally, they will be able to save up to 10 per cent on logistics and transportation. Young Russian consumers aged 18–35 have shown a clear preference for beer over vodka and other spirits, and this preference continues to strengthen and gain momentum. Brand awareness, once considered a capitalist manifestation and a scourge to be avoided, is likely to take hold as these educated consumers become increasingly dependent on brands to ensure consistent and world-class quality. However, industry analysts have noticed that consumers are still eager to explore new brands, and, in general, brand loyalty remains low. Compared to Moscow and St Petersburg, disposable income and brand loyalty is much lower in the regions, except for in a few bigger cities with a population of over a million. Therefore, price is the leading, and some would argue the only, factor in the regions.

Competition The Russian beer market underwent a fundamental change between 2003 and 2005. The beer market is now

dominated by the Western companies: Baltic Beverages Holding, SUN Interbrew, Heineken, Efes and SABMiller. Together they claim more than 80 per cent of the whole market. The share of Russian beer companies went down significantly and there are only two big Russian players left – Ochakovo and Krasny Vostok – and they continue to lose market share to their Western competitors. Table 9.1 demonstrates the changes in market share of the major players between 2003 and 2005. Baltic Beverages Holdings (BBH), owned jointly by Carlsberg (Denmark) and Scottish&Newcastle (UK), is the clear market leader with a 37.7 per cent share. BBH owns 18 beer factories including Baltika, Yarpivo, Vena, Pikra, and others. These factories are located in Russia, Kazakhstan, and Ukraine. Production output is over 200 million decilitres and, in 2004, BBH’s sales were $1.7 billion. Four of BBH’s brands are among the top 10 Russian beer brands – Baltika (1st place), Arsenalnoe (3rd place), Yarpivo (4th place), and Nevskoe (7th place). SUN Interbrew, controlled by global leader InBev (Belgium), has nine beer factories in Russia and three

Table 9.1 Major players market share Producer

Share 2003 (%)

Share 2004 (%)

Share 2005 (%)

Baltic Beverages Holdings (BBH)

33.4

34.5

37.7

SUN Interbrew

13.5

16.5

16.7

Heineken

4.6

8.2

14.3

SABMiller

2.0

7.0

7.8

Efes Brewery

3.3

6.7

7

Ochakovo

5.5

5

4.2

Krasny Vostok

4.9

4.2

2.9

Others

21.5

17.6

9.1

Imports

1.0

0.3

0.3

Source: UFG, Goskomstat, Annual reports, companies data

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in Ukraine. The company is in second position on the market, with an estimated 16.7 per cent share. In 2004, SUN Interbrew sold 20.5 hectolitres of beer with a total revenue of over $690 million. SUN Interbrew’s brands include Stella Artois, Beck’s, Staropramen, Brahma, Klinskoe (2nd market place), Sibirskaya Korona (8th place), Tolstyak (9th place), and others. Heineken entered the Russian beer market in 2002 with the purchase of ‘Bravo’ for $400 million, which had a one per cent market share. After completing acquisitions of seven Russian factories in 2004 and in 2005, Heineken went up from seventh position to third. At the end of 2005, its market share was approximately 14.3 per cent. Analysts estimate that Heineken spent in the region of $1.2 billion to secure the third place market position, just behind its major competitor, SUN Interbrew. Last year, Heineken tried to buy Ochakovo, but the company refused to sell. If the deal had been successful, Heineken would have overtaken SUN Interbrew for second place in the market. We expect that the Dutch company will continue in its attempts to acquire other market players in the future. Efes Beverages International, owned by Turkish holding structure Anadolu Group, has three factories in Russia – ‘Moscow-Efes’ beer plant (45 million decilitres), ‘Amstar’ plant (12 million decilitres) in Ufa, and ‘Efes’ beer factory (10 million decilitres) in Rostovna-Donu. EBI’s turnover was $398.5 million in 2004, which is 51 per cent up from 2003. In Russia, the company produces the following brands – Efes, Warsteiner, ‘Stary Melnik’ and ‘Sokol’. Efes controls a seven per cent share of the Russian beer market. SABMiller is the fourth largest beer producer in Russia. SABMiller’s Russian affiliate – ‘Transmark’ – owns one beer factory in Kaluga, which the company built in the late 1990s. SABMiller focuses on the premium beer segment in Russia. Its position is

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especially strong in the Moscow beer market, where people prefer to purchase premium beer brands. The company produces about 40 hectolitres of beer per year under the famous brands – Miller Genuine Draft, Holsten, Pilsner Urquell, as well as Redd’s, Kozel, and Russian brands ‘Zolotaya Bochka’ and ‘Tri Bogaterya’. Ochakovo – the biggest Russian independent brewer – controls one sixth of the Russian beer market. In 2004, its sales were RUR7.12 million, with a net profit of RUR264 million. Ochakovo continues to lose its market share as it faces tough competition from the major foreign producers. Company sales fell by 9.8 per cent, and its net profit decreased by 2.6 times in 2005. Ochakovo’s market share fell to 4.2 per cent in 2005, compared to a five per cent share in 2004, and 5.5 per cent in 2003. Krasny Vostok is the largest independent Russian player. It owns four beer factories, with total production capacity of 120 million decilitres per year. In 2004, the company sold 57 million decilitres of beer, worth RUR6.35 billion, compared to RUR5.8 billion of revenue in 2003. Its EBITDA in 2004 was $56.7 million. However, Krasny Vostok is experiencing the same problems as Ochakovo and continues to lose its market share to foreign rivals. Its market share went down to 2.9 per cent in 2005, compared to 4.2 per cent in 2004 and 4.9 per cent in 2003. Furthermore, Krasny Vostok has a poor portfolio of beer brands (Krasny Vostok, Solodov and Cheshsky Standard), which are mostly focused on the low-price market segment. Thus, the company’s margins are likely to be significantly lower than those of the foreign brewers. Despite the fact that Krasny Vostok sales were up by 9.4 per cent (in volume terms) in 2004, in value terms its revenues grew by only three per cent compared to the market’s average value growth of 11.5 per cent.

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Foreign brewers have made substantial investments in the Russian market to capture the market share, not only with locally produced international brands, but also by investing in the creation of Russian brands. Other international brewers, without local operations, have licensed the local production of their international brands (see Table 9.2). As with all consumer goods, branding, once irrelevant in the Russian market, has become critical. The value of branding can differ between regions and between consumer groups.

The race is on amongst the leading brewers to develop and promote a strong national brand and achieve national coverage. The successful introduction of new brands is partially explained by the fact that Russian consumers tend to be more loyal to new brands than to old brands that have been changed. Baltika (BBH Brand) remains an exception and is probably the only Russian brand with the highest consumer, and relatively stable, market share of 15 per cent. The top 10 Russian brands are illustrated in Table 9.3.

Table 9.2 Brewers and their brands International brewer

International and local brands

Baltic Beverages Holdings

Yarpivo, Cheliabinskoe, Zolotoy Ural, Kupecheskoe, Ubileynoe, Siberian Legend, Baltika, Don, Arsenalnoe, Carlsberg, Parnas, etc.

SUN Interbrew

Tolstyak, Klinskoe, Siberian Crownz, Stella Artois, Volzhanin, Bavaria, Pit, Tri Medvedya, Doctor Diesel, Gosser (Licensed, super premium brand)

SABMiller

Zolotaya Bochka, Staropramen (Licensed), Holsten (Licensed), Miller (Licensed), Tri Bogatirya

Efes Beverages Group

Stary Melnik, Efes (Licensed)

Heineken

Bochkarov, Lowenbrau (Licensed), Bear Beer (Licensed), Okhota, Exportnoye, Amstel

Source: Renaissance Capital, Business Communication Agency

Table 9.3 Key brands’ share of total market, 2005 (%) Key brands

Owner

2004

2005

Baltika

BBH

9.3

15.1

Arsenalnoye

BBH

5.2

4.6

Klinskoye

SUN Interbrew

4.7

6.1

Ochakovskoe

Ochakovo

5.8

3

Tolstyak

SUN Interbrew

3.6

2.7

Yarpivo

BBH

3.1

3.7

Stary Melnik

Efes

3.1

3.2

Nevskoe

BBH

2.8

3.0

Okhota

Heineken

2.7

2.6

Sibirskaya Korona

SUN Interbrew

2.4

2.8

Source: Goskomstat, companies’ data

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Competition for consumers is becoming fierce against the background of slowing beer market growth. Brewing companies are attempting to protect their positions with the assistance of new brands, primarily in the premium segment. For the companies, profits lie in the perceived extra value of brand names. As the dominant brands establish their positions, the focus of competition is shifting. While some international brewers have introduced domestically produced international brands, others have sought to further increase the brand awareness of a number of their selected local brands. Fueled by growing income, premium and licensed segments showed the strongest growth compared to other beer segments. As we can see from Table 9.4, in 2001 these two segments accounted for 11 per cent and one per cent respectively. At the end of 2005, their share stood at 18.5 per cent and 7.2 per cent respectively. In Moscow, premium and licensed brand sales went up to almost 60 per cent. The licensed beer segment is the most attractive one as it is subject to much faster growth than the other segments and promises higher

margins for producers. The biggest players in the licensed segment are Miller (12.4 per cent, SABMiller), Holsten (10 per cent, SABMiller), Tuborg (10 per cent, BBH), and Efes (8 per cent, Efes). Experts agree that the premium and licensed segments will continue to grow in the future. First, the personal incomes of Russians are increasing and more people can now afford to buy more expensive beer brands. Second, Western brands appeal to Russians as they are considered to be of a higher quality than domestic beer. Third, Russian consumers do not show any preference to one particular brand. They like to try new products, especially if it is a Western brand with a proven market reputation.

Market consolidation The main trend in the Russian beer market during 2004–2005 was industry consolidation. A number of M&A deals resulted in an increase of the joint market share of foreign players of 11.1 per cent. By year-end 2005, foreign brewers controlled 84.3 per cent of the market. The majority of

Table 9.4 Beer market segmentation, 2001–2005 (%) Segment share of total beer market

2005 2004 2002 2001

Import

Krombacher, Heineken, Guinness, Corona, Foster’s

0.3

0.3

1

1

Licensed

Miller, Lowenbrau, Holsten, Staropramen, Efes, Stella Artois, {Tuborg, Carlsberg} – BBH

7.2

5.3

2

1

Premium

Zolotaya Bochka, Stary Melnik, Solodov, Bochkarev, {Baltika 0, Baltika 2, Baltika 5, Baltika 7, Baltika 8 Parnas, Nevskoe} – BBH

18.5 17.5

16

11

Mainstream Sibirskaya Korona, Klinskoye, Tolstyak, Stepan Razin,Volzhanin, Pit, 30.6 28.3 Okhota, {Baltika 3, 4, 9, Sibirskaya Legenda, Don, Yarpivo, Arsenalnoye, Medovoye, ZolotoyUral, Kupecheskoye}

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59

Economy

21

28

Ochakovo, Krasny Vostok, {Voronezhskoye, Chelyabinskoye, Uralskiy Master}

21.4 21.8

Source: Goskomstat, companies’ data

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acquisitions were made by the two market leaders – Heineken (now in third position) and SUN Interbrew (second position). Industry players had long been expecting consolidation and it started actively in 2004, continuing through 2005. In August 2004, Heineken announced its ambitious plan to acquire at least 10 per cent of the market share. Consequently, the company made three acquisitions – the Bashkirian factory ‘Shikhan’, ‘Volga’ in Nizhny Novgorod and ‘Sokol’ in Novosibirsk. These deals together were estimated at around $200 million. At the end of 2004, Heineken’s share reached 8.3 per cent. The Dutch company continued acquisitions in 2005 and spent approximately $800 million on four factories – ‘Patra’ (Ekaterinburg), ‘Stepan Razin’ (St Petersburg), ‘Baikal’ beer factory (Irkutzk), and ‘Ivan Taranov’s’ beer factory. These acquisitions increased Heineken’s market share to 14.3 per cent. InBev spent $560 million on the purchase of shares of minority shareholders in SUN Interbrew. Additionally, in response to Heineken’s acquisitions, InBev purchased the ‘Tinkoff’ beer company, which had previously had a one per cent market share, for $201 million. The deal helped the company to retain its second market position with a 16.7 per cent share. The former owner of the ‘Tinkoff’ beer company, Oleg Tinkov, is now focusing on his beer-restaurant business. Baltic Beverages Holding (BBH) announced the consolidation of previously purchased Vena, Pikra and Yarpivo into one company – Baltika. Although due to the legal case brought against BBH by minority shareholders of Yarpivo and Pikra, the consolidation was postponed until 2007. Other Western players – Efes and SABMiller – were also looking for potential acquisition targets in 2005.

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However, the market position of Efes is not as strong as some of the others, and the company is unlikely to spend significant resources on acquisitions. In fact, it may eventually become a target itself. Industry experts expect consolidation to continue in 2006. The major targets are the only two independent big Russian players – Ochakovo and Krasny Vostok. However, after a number of acquisitions in the industry, these companies now seem to be overvalued. Consequently, Western companies are unlikely to acquire either of these two companies while their price remains at the current high level. Subsequently, Ochakovo and Krasny Vostok might be of interest to American Anheuser-Busch and Coors/Molson, which are not yet represented on the Russian market. As the Russian beer market reaches maturity and the major acquisitions have already taken place, a further possible scenario could be the reselling of parts of Russian businesses from one big player to another. Notably, during the summer of 2005, there were rumours of negotiations over the purchase of Efes by InBev. Although those particular negotiations did not come to fruition, we believe that such talks between the bigger players on Russian beer market may continue in the future. We also believe that there could be acquisition of regional smaller players, as the majors expand further into regions where potential for market growth is much higher than in Moscow and St Petersburg.

Distribution channels A notable fact is that all major brewers today use the same equipment, technologies, and produce products of similar quality. Therefore, the efficiency of the distribution system is becoming one of the most important

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sources of competitive advantage for major brewers in Russia. Until 2001–2002, brewers did not participate in sales; this function was generally performed by distributors. SUN Interbrew was the first company to introduce an innovative sales and distribution system, whereby its trade agents started to go from one retailer to another, promoting beer products directly. Today, there are two major product promotion schemes. One whereby a brewer’s trade agents collect orders from retailers and then pass them to distributors, and the second – first adopted by SABMiller – where a trade agent approaches the retailer with a variety of product samples and negotiates a potential contract with the clients. Distributors are then left to resolve the financial and logistical questions. At present, SABMiller has more than 150 direct trade agents circulating in Moscow. The company was also the first to put its own refrigerators into retail shops, a move particularly welcomed by retailers as the refrigerators were free of charge. The company was also able to develop solid relations with its distributors and retailers by giving them a good portion of its margin. Both moves provided SABMiller with a significant competitive advantage for the company’s distribution and sales system. Following this direct sales model, recently SUN Interbrew tried to engage in direct sales of its products in the Moscow region, leaving its distributors with the logistical arrangements. However, the company faced a serious problem. Its three major distributors (accounting for 75 per cent of SUN Interbrew sales in Moscow) did not like the idea and moved to the company’s major competitor – BBH. SUN Interbrew will have to find new partners for its distribution model. In fact, this may cost the company the loss of

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its position in the key Moscow beer market. In 2005, two other major beer producers undertook a similar effort to restructure their distribution system. BBH initiated plans to centralize its sales system, establishing a single structure, which will offer a full portfolio of products to its distributors. Experts agree that this initiative will help BBH to reduce distribution costs as well as to strengthen its sales system. As part of this restructuring, BBH has already reduced the number of its exclusive distributors from six to four in St Petersburg. Heineken also initiated the restructuring of its distribution system in St Petersburg. The company retained only one distributor for its Stepan Razin brand (from 10 distributors a year earlier). Now Heineken has four major distributors in St Petersburg, which will sell the whole portfolio of the company’s brands.

Production Russia is the sixth largest producer of beer in the world. There were over 300 breweries in the country, which produced 7.3 billion litres of beer in 2003. However, there are two issues related to production – maintaining efficiency and ingredients supply. Over the past five years, excise duties have risen faster than inflation. Hence, transportation costs have also increased significantly. These two trends have led to significant pressure for an increase in beer prices. Many producers physically limited their output in the beginning of 2005. Surprisingly, Russian beer production was up 5–7 per cent in the second part of this year, compared to 3.7 per cent growth in the first two quarters. Industry experts consider this to be the result of effective marketing campaigns run by major market players, as well as the

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introduction of a number of new brands and restructuring of the distribution system. Until recently, the main ingredients used for the production of beer, malt and barley, were not available in large amounts domestically and were imported. In order to cut costs and secure deliveries, larger brewers have now started to invest in the development of internal malt reserves and production. Yarpivo company (owned by the market leader, BBH), plans to open its own malt factory. The factory will produce 60,000 tonnes per year and provide 50 per cent of the company’s demand for malt. Kursk, Belgorod and Voronezh-based suppliers will deliver raw materials for the Yarpivo factory. Krasny Vostok, Ochakovo, Tulsky beer factory, and others have already opened their own malt factories.

Conclusion Although market growth is slowing, making industry watchers nervous, the simple fact is that the Russian beer market remains extremely attractive. The main reason for beer companies to invest in Russia has not changed: Russia can still offer growth. There is additional growth in the regions, in

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shifting customers up to higher margin beer products, in diversifying packaging, and, finally, there is growth as beer continues to replace other beverages among consumers in their consumption patterns. The main difference now for companies is that they must properly identify where the best opportunities are, whereas in the past, growth was so rapid it was not very important which space was occupied in the market. Unlike some other consumer goods industries, there will always be room for small niche players, but this space will continually decrease and the niche must be better defined than simply by geography. The trend toward consolidation is likely to remain in the near future. With the challenges of branding, market segmentation and distribution high on CEO agendas, winners and losers are beginning to emerge. The potential targets will be the two Russian independent brewers – Ochakovo and Krasny Vostok, and the prospective buyers – the top four foreign producers. Efes may also be acquired by one of these four. The Russian beer market will be mainly dominated by the top three companies – BBH, SUN Interbrew and Heineken, which already control nearly 70 per cent of the market.

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Author biographies Danila Bochkarev provides consultancy and research services in the area of Russian politics, Russian foreign and energy policy, European and international security issues and is generally interested in energy security and foreign policy/security issues. Prior to joining East-West Institute Global Security Program, Danila spent some time with European Parliament in Brussels and worked as a visiting research fellow at the Institute for European Studies, Université Catholique de Louvain (Belgium). In 2001, he was a trainee at the Foundation for Strategic Studies (FRS) in Paris. He holds an MA degree in Politics/ Political Economy (University College London) and a DEA (MA) degree in History from University of Paris 1 (Sorbonne), a Candidate of Science degree in politics and a BA in International Relations (University of Nizhniy Novgorod in Russia). Danila Bochkarev has several academic distinctions, including being a Royal Dutch Shell and French Government (BGF) scholar, and received funding from the US Information Agency and European Commission. He is a native Russian speaker and fluent both in English and French. KPMG is the global network of professional services firms of KPMG International. Its member firms provide audit, tax, and advisory services on an industry-focused basis. With nearly 100,000 people worldwide, KPMG member firms provide professional services from offices in 715 cities in 148 countries. KPMG in Russia has offices in Moscow, St Petersburg, Nizhny Novgorod and Ekaterinburg, with staff in excess of 700. KPMG in

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The largest databases and news agencies of the world distribute RBC’s information: Bloomberg L.P., Bridge, LEXIS-NEXIS and Factiva (Dow Jones & Reuters). RBC has advanced customizing technologies. Through customization the Company creates personal financial environments for its clients. RBC’s marketplaces have been reliably operated at a peak capacity of 80,000 visitors. RBC is one of the largest software companies in Russia. The company is the only official representative of VeriSign, Network Solutions and AltaVista in Russia and the CIS. RBC participates in the Intel e-Business Solution Provider Program and IBM’s Partnerworld for Software Program. Vyacheslav Masenkov is the General Director of RIA RosBusinessConsulting. He joined the RBC team at the beginning of 2000 as the director of the Consulting Department. Earlier he was the chief of analytical departments at a number of large banks and investment companies. Vyacheslav Masenkov took part in the creation of the first mutual fund in Russia. Dr Masenkov is a member of the Expert Council of PRIOR (Russian eDevelopment Partnership, www.russiagateway.ru). At RBC he is responsible for R&D, financial and market analytics. Stanislav V Mirin is a Senior Analyst of RBC. Dr Mirin has broad experience in analyzing hi-tech markets, project management and preparing analytical reports based on market research. His main professional activity is connected with surveys of telecommunications markets, which he has studied since 2001. Marat Terterov is a political scientist and a Ph.D. graduate from St Antony’s College, University of Oxford, as well as the editor/author of over a dozen major books addressing the business

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and foreign investment environment in countries of the former Soviet Union and the Middle East. He is currently an expert on Russian and CIS relations with the Persian Gulf at the Gulf Research Centre in Dubai, United Arab Emirates. During the last 7–8 years, Dr Terterov has been researching the political systems and economic reform programmes of a number of countries of the former Soviet Union and the Middle East as a USAID consultant, an independent book author, as well as Ph.D. scholar. The focus of his Doctoral dissertation was addressing the way in which the state continued to control privatized enterprises in Egypt, the first recorded study to address the topic in such detail. Further to this, he recently coauthored a major USAID policy study evaluating the impact of over a decade of privatization in Egypt on that country’s public policy framework for Carana Corporation, which advised the Egyptian government on economic reform during 1999–2002. However, the thrust of Dr Terterov’s recent work has been to research and edit a series of books on business and foreign investment in Georgia, Russia, Ukraine, Kazakhstan and other regions of the former Soviet Union all now published by GMB Publishing. Prior to his work with Carana and GMB, Dr Terterov was also a consultant to the British government’s export promotion agency and has advised British companies on the foreign investment climate in Uzbekistan, Kazakhstan and Kyrgyzstan (1998–2000). He has also advised the Egyptian Ministry of Foreign Affairs about the political ramifications of economic reform in the former Soviet Union (1998–99). He is a frequent speaker on the former Soviet Union at the Centre for International Briefing, Farnham Castle, Surrey, England, often briefing officials from the British Ministry

GMB Publishing

Russia

of Defence on the political and economic environment in Central Asia. He is also the author of a number of academic articles on the Middle East and the former Soviet Union, which have mostly focused on issues such as Islamist political militancy in Egypt, political reform in Turkey, and democratization and state building in Central Asia. He is the holder of

GMB Publishing

Chevening Scholarship (British Foreign Office) and received his tertiary education at the Universities of Oxford, Irvine (California) and New South Wales (Australia). Marat Terterov is an Australian citizen residing in Oxford, England, though he was born in Odessa, Ukraine in 1968 – then part of the Soviet Union.

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