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Financial Times: Bright prospects eclipse concerns

By Neil Buckley

Published: October 10 2006 11:17 | Last updated: October 10 2006 11:17

Everywhere a visitor to Russia’s bigger cities turns, the signs of economic regeneration are palpable. Cars clog the streets; construction sites abound; dreary Soviet-era shops are being swept away by international-standard stores; hotels, cafes and restaurants are multiplying.

The trickle-down of wealth still has a long way to go. Drive out of the cities, and the highways soon dwindle to potholed single carriageways. While official poverty figures are down, life in smaller towns and villages remains harsh.

But eight years of solid economic growth, turbocharged by high energy prices, has spawned an urban middle class and turned Russia into a leading investment destination – no longer just for oil and gas companies but now for everyone from cat food producers to luxury carmakers. Foreign investment in the first half jumped 42 per cent to a record $23.4bn; the Moscow stock market is up more than 35 per cent this year. Many corporate investors say returns in Russia far outstrip what they can earn in competing destinations such as China.

Yet if Russia has become one of the more attractive of the so-called “Bric” emerging markets – Brazil, Russia, India and China – it remains the most contradictory: so much opportunity, so many people prepared to bet large sums on its future, and yet so much capacity for unpredictable and sometimes exasperating behaviour.

The threat last month by the natural resources ministry to withdraw a key environmental permit from the Shell-led Sakhalin-2 oil and gas project – the biggest single foreign investment – again raised questions over property rights, sending shivers through investors.

A few days earlier, the shooting of Andrei Kozlov, the deputy central bank chairman who campaigned against bank crime, briefly stirred memories of Russia’s “wild east” transition to capitalism in the 1990s, though that killing is likely to be an isolated incident.

Meanwhile, Bill Browder, whose Hermitage Capital fund is the biggest portfolio investor in Russia – and one of the country’s most vigorous promoters – has found himself denied a visa without explanation for the past 11 months. His campaign to improve corporate governance apparently upset too many people.

These days, however, it takes a lot to deter investors. The macroeconomic picture is, as one Moscow bank economist likes to say, “fabulous”.

Gold and foreign exchange reserves are close to $260bn, the world’s biggest outside Asia, on top of a stabilisation fund, containing windfall oil taxation revenues, of $70bn. That is even after Russia used $23.7bn from the fund to prepay remaining debt to the Paris Club of creditor nations this summer. The rouble, whose devaluation only eight years ago together with Russia’s default on $40bn of domestic debt sparked a deep crisis, became a fully convertible currency on July 1.

Economic growth has averaged more than 6.6 per cent annually since 1999, and is heading for a similar performance this year. Real wages continue to grow well above inflation – the national average grew 14.2 per cent year-on-year in August to just over $400 a month.

“Today, in my view, the reliable growth trend, a healthy macroeconomic situation, and the level of profit that investment in Russia can bring to both direct and portfolio investors, all point unambiguously to the fact that Russia is an attractive investment destination,” German Gref, economy minister, told the FT.

Leading investors agree. Stephen Jennings, chief executive of Renaissance Capital, a Moscow investment bank, who has been in the Russian capital since the early 1990s, says foreign investment is entering a new stage.

“I think there are going to be a lot more transactions and a more diverse engagement,” he says. “People who sat back and sat back are at the stage where they have to do something, now.”

Much of today’s healthy situation is due to record prices for Russia’s main exports of oil and gas. But financial analysts say president Vladimir Putin’s administration deserves credit for its fiscal prudence.

In additon, while he faces criticism in the west for curbing democracy, they add that Mr Putin has created stability that has allowed the economy to benefit from the energy dividend.

The sunny economic picture has some clouds. The influx of petro-dollars is stoking inflation, with the annual inflation target of 8.5 per cent again in doubt. It is also leading to a strengthening rouble, fuelled by rouble convertibility, which is hampering manufacturing competitiveness.

Russia’s reliance on energy and raw material exports also makes the country especially vulnerable to any correction in commodity prices.

There are other concerns. The Yukos case – the jailing of Mikhail Khodorkovsky, and the bankrupting of the oil company he created by issuing $28bn of back tax claims – have faded in investors’ memories. But at the same time the liberal and investor-friendly measures that typified Mr Putin’s first presidential term, such as much-praised tax reforms, have largely petered out in his second term.

Despite pledges from the president himself, little is being done to tackle corruption and red tape – foreign investors’ biggest concerns, and a big factor in Russia’s underdeveloped small and medium-sized business sector.

“Overall, the Yukos situation didn’t help Russia, but it wasn’t the main barrier to the increase of foreign investment,” says Alexander Ivlev, a partner at Ernst & Young and coordinator of the Foreign Investment Advisory Council, which fosters dialogue between business and government. “The main problem was poorly implemented reform. Reform has slowed down.”

Instead, Mr Putin’s second term has been characterised by increasing state intervention – dating from the Yukos affair.

Most notable are moves to create state-controlled national “champions” in some sectors, including the takeover of strategic assets by state companies.

After Rosneft, the state-controlled oil company, took over the main production arm of the stricken Yukos in late 2004, Gazprom, the natural gas monopoly, last year bought Roman Abramovich’s Sibneft oil company.

Gazprom has made it clear that it would like to buy out the oligarchs who control the Russian half of TNK-BP, the oil joint venture with the UK-based oil major, when a “lock-in” agreement expires next year; Rosneft is pursuing other Yukos assets.

The moves have gone beyond oil and gas. Rosoboronexport, a state arms agency, last December seized control of Avtovaz, maker of Lada cars, and this summer bought 40 per cent of VSMPO-Avisma, a previously privately owned titanium giant.

In addition, aerospace and nuclear power engineering are being reorganised into state-dominated groups.

In some cases this may be necessary consolidation – as happened in the US and European aerospace industry.

Creating national champions has also been an effective strategy in some Asian states.

But analysts warn that in a country where the performance gap between private and state ownership is much greater than in many developed markets, the strategy has risks.

Without the increasing state intrusion, according to a report by the Russian Union of Industrialists and Entrepreneurs, the main business lobby, economic growth might have been much higher in the past three years.

“The role of the state unfortunately is manifesting itself not just in setting more transparent and precise rules of the game, but in the state increasing its direct stake in the economy,” says Alexander Shokhin, the union’s president.

Mr Jennings of Renaissance Capital proposes a model for making sense of Russia. He views the country through the prism of two competing trends.

On the one hand is a government with highly centralising instincts – manifested not just in economic interventionism but its also in a continuing drive to dominate the media and political process – and an oversized and inefficient bureaucracy.

On the other is the “economic freight train” created by the spread of private ownership and development of a managerial class, the reforms of the 1990s and early Putin period, and the influx of oil revenues.

Eventually, Mr Jennings forecasts, the two trends will collide – and the latter will prevail.

He says: ”As the middle class becomes more prosperous, confident, more broadly based, the political pressure to create proper institutions and better governance will really become intense.”

Copyright The Financial Times Limited 2006

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