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Financial Times: Industry’s vanguard

EXTRACT: “… cases such as the Sakhalin-2 oil and gas project created a damaging precedent. After seeing Royal Dutch Shell strong-armed by Gazprom out of controlling the $22bn project, some investors may baulk at partnering with the state in infrastructure developments.”

By Neil Buckley
Published: November 15 2007 02:00 | Last updated: November 15 2007 02:00

Within a few years, an industrial behemoth is to rise from the banks of the Volga river: the world’s biggest aluminium smelter, capable of churning out 1m tonnes of the metal a year, powered by two nuclear reactors.

The company planning the $7bn (£3.4bn, €4.8bn) project is Russia’s UC Rusal, the world’s top aluminium producer. It owns the world’s two biggest existing smelters, at Bratsk and Krasnoyarsk in Siberia. Built in the 1960s and 1970s, both were monuments to the Soviet Union’s industrial might, taking their electricity from two of the world’s biggest hydroelectric dams. The new Saratov smelter will be one of Russia’s largest industrial projects since those Soviet days.

Russia is once again thinking big – and Rusal’s plans signal that the country’s economic revival is entering a new phase. The steep economic decline of the 1990s, caused by the turbulent shift from communism to capitalism, is over. Gross domestic product will be around $1,200bn this year – six times higher, in nominal dollar terms, than in 1999. In real terms, GDP is finally back to its 1990 level, just before the Soviet collapse.

The recentralisation of political power in the hands of the Kremlin under President Vladimir Putin is also largely complete. So, too, is a consolidation of resources fuelled by record oil prices. After being virtually bankrupt when it defaulted on domestic debt in 1998, Russia has amassed reserves of almost $450bn.

That does not make it a rich country – GDP per head is still only 40 per cent of Portugal’s. But with the economy in its eighth year of near-7 per cent annual growth, both the state and private businesses are thinking in terms barely conceivable a few years ago.

At a government-run investment forum in St Petersburg this summer, Russia set itself the ambition of becoming one of the world’s top five economies by 2020, from ninth last year – a stretch, economists say, but not impossible. At a similar event at the Black Sea resort of Sochi in September, the government unveiled plans to invest $1,000bn over 10 years in rebuilding and expanding a dilapidated social, industrial and transport infrastructure. That would be one of the largest such programmes outside China and – with the government aiming to raise 80 per cent of funding from private, including foreign, investors – a potential bonanza for international construction and engineering groups.

On a deeper level, the two statements indicate that Russia is embarking on another of its periodic attempts since the time of Peter the Great to catch up with the west. “After decades of underinvestment Russia still is far behind any developed economy in infrastructure, whether it’s highways, airports, hospitals or health services,” says Hans-Jörg Rudloff, chairman of Barclays Capital and a longtime Russia hand. “Without efficient infrastructure you cannot be an economic power, nor a geopolitical power.”

The magnitude of the ambition and the difficulties involved may help explain why Mr Putin last month signalled his intention to continue to play a powerful role even if, as Russia’s constitution requires, he steps down as president next year. Parliamentary elections on December 2 and March’s presidential elections mark the gateway into this new phase in Russia’s renewal. So, while civil society groups fear for Russia’s faltering democracy, investors have welcomed as a guarantee of stability Mr Putin’s announcement that he would head the ticket for the pro-Kremlin United Russia party in the parliamentary poll and might become prime minister next year.

Yet there is some question whether the Putinite model of central control and state-directed capitalism is appropriate for a new investment and expansion phase that relies on dynamism and entrepreneurialism. Moreover, is a team dominated by former KGB men the right one to lead such a shift?

“The concern is that this is a bunch of secret policemen who got lucky on the oil price and were able to consolidate power. But these same policeman are about to embark on an economic transition that would challenge the brains of a Nobel prizewinner,” says one Moscow-based banker.

The scale of the infrastructural task alone is daunting. Despite Russia’s vastness, its railway network is half the length of that of the US and freight trains crawl at an average 40km/h. The paved road network is less than one-tenth the size of America’s; barely 5 per cent of roads are considered “good quality” – which in Russia means having at least two lanes and a decent surface.

The government’s trillion-dollar figure for investment in righting those problems may be more symbolic than precise. But more concrete figures being touted indicate the extent of the ambition.

Mr Putin’s state of the nation address this year outlined plans to spend $480bn by 2020 on expanding electrical power. The project has been dubbed Goelro-2 after the Russian acronym for Lenin’s 1920s plan for electrifying the USSR. After building 30 nuclear reactors in the entire Soviet period, Mr Putin added, Russia now plans 26 in 12 years. Russian Railways plans to spend $400bn by 2030 modernising and expanding the network; $30bn will go into airports.

Money is not going only into infrastructure. Russia is putting $5bn into a Russian Nanotechnology Corporation, aimed at kick-starting a high-technology sector. A report this year by the Institute for Regional Policy, an independent Russian think-tank, found that planned industrial and infrastructural investment projects up to 2020 exceeded $400bn, including only those projects costed at above $100m each.

If carried out successfully, such investment could transform Russia, removing bottle-necks such as power shortages that are starting to restrain economic growth. It could reduce the fragmentation of the economy that resulted from Soviet planners building cities across Siberia with poor links between them. Analysing planned investment projects, Nikolai Petrov, a scholar at the Carnegie Moscow Center think-tank, has also calculated that the centre of Russian investment will shift from the country’s European part to beyond the Ural mountains. The result could be a new industrialisation of Siberia and the Russian far east.

The spending plans also aim to reduce Russia’s reliance on natural resource extraction, by developing more refining and processing activities. The construction of new hospitals, schools and housing could meanwhile make Russians at last feel they are sharing in the country’s energy wealth.

But even aside from the question of whether the money will indeed be available, there are huge challenges in managing an investment programme this big. One is ensuring money gets to projects without disappearing into bureaucrats’ and middlemen’s pockets. Russia must also avoid the mistakes of other emerging markets such as Mexico, whose mishandled $15bn programme of privately financed highways in the 1990s became mired in delays and cost overruns and ended up little used. It must build projects according to market disciplines in some of the world’s most inhospitable climates. That means avoiding the mistakes of the Soviet past, when trophy projects could be planned without regard for true economic or environmental costs.

To get the job done, Russia will be mobilising the state-controlled “national champions” Mr Putin has nurtured – such as Gazprom, the gas monopoly; Rosneft, the oil giant; Transneft, the state pipeline operator; and the monopoly Russian Railways. Analysts suggest it can also lean hard on the new class of Kremlin-friendly private oligarchs to play their part. Some who built their groups in the 1990s, such as Oleg Deripaska – who controls Rusal – are keen to prove they can build and create, not just buy Soviet-era assets cheap.

Unlike China, which financed and built $956bn of infrastructure projects in 2004-06 alone, mostly from domestic resources, even oil-rich Russia will not be able to do everything itself. Yet it may face difficulties raising the 80 per cent of its needs it expects to raise from private investors. Tactics used to restore strategic industries to state control could return to haunt it.

Carlo Gallo, Russia analyst at Control Risks, which advises companies on investing in the country, says cases such as the Sakhalin-2 oil and gas project created a damaging precedent. After seeing Royal Dutch Shell strong-armed by Gazprom out of controlling the $22bn project, some investors may baulk at partnering with the state in infrastructure developments. “The question is: is the Russian state a credible partner for these long-term projects?” says Mr Gallo. “Public-private partnerships are based on trust and the government’s record so far has not been brilliant.”

In an apparent response to such concerns, Sergei Ivanov, Russia’s first deputy prime minister, said at the Sochi conference that foreign investors would be offered unspecified “additional guarantees” to invest in infrastructure.

Concerns are also being expressed – even within Russia’s governing apparatus – that the growing attachment to state-controlled “national champions” could hold back the development of a vibrant economy. Investors say the model may be appropriate for reviving some capital-intensive sectors such as aerospace, shipbuilding and nuclear power – in all of which Russia is creating state holding companies. But alarms have sounded over government talk of plans for state holdings in drug manufacturing, road building and even fishing.

“The government is not even trying to understand that private businessmen can do all this. This is the path to zero growth for the Russian economy,” warned Arkady Dvorkovich, an adviser to Mr Putin, at a recent conference.

Critics warn that state ownership, especially in Russia, means less effective management than private ownership. The shift of a significant chunk of oil and gas assets to state control since 2004 has coincided with a sharp fall in output growth. Rumours that the state may absorb yet more energy have prompted some private businessmen to speak publicly of the dangers. They include Vladimir Bogdanov, chief executive of Surgutneftegaz, a Kremlin-friendly oil company, and Vagit Alekperov, head of Lukoil, Russia’s largest crude producer.

In an interview with the Financial Times, Vladimir Potanin, one of Russia’s leading industrialists, says the state’s involvement in any economic sector inevitably distorts competition. “It reduces the space for private business,” he says. “Entrepreneurial qualities become less in demand. So they move instead into areas which the arm of the state has not reached and, accordingly, whole zones are lost to private initiative.”

Chris Weafer, chief strategist at UralSib, a Russian financial group, says Russia’s spending plans provide enormous opportunities for investors – but could bring political troubles in a year or two. The next phase of Russia’s development could make the comparative unity among Russia’s political elite achieved by Mr Putin difficult to sustain.

“The easy ride is over, based on the $750bn of oil and gas revenues Russia earned during the Putin presidency,” he says. “Now they are getting into spending and they are going to have to start real projects with real money. If we are going to have problems, this is when we could see them.”

Additional reporting by Catherine Belton
Copyright The Financial Times Limited 2007

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