Betting On A Russian Revival

Investing in the former Soviet Republic is still risky, but many U.S. manufacturers think it's worth the gamble. Here's why.

The list of Western companies making new investments in Russia recently is a veritable who's who of multinational business, not just the oil and gas companies heading in to capitalize on the country's recently gained No. 2 status in the industry. Ford Motor Co., General Motors Corp. (GM), Boeing Co., R.J. Reynolds Tobacco Holdings Inc. and Philip Morris Cos. Inc. are among the U.S. companies that have joined Conoco Inc., ChevronTexaco Corp., Marathon Oil Corp. and Exxon Mobil Corp. in investing in the country. According to Keith Bush, research director of the U.S.-Russia Business Council, Washington, D.C., the IT sector is expected to attract more than US$2 billion in foreign direct investment (FDI) in 2002, and the consumer goods sector has attracted investment from large companies such as Ikea, Heineken NV and Interbrew SA. The companies are being lured for a number of reasons, not the least of which is the high returns on equity investments. Russia may be a country still in transition and with much room for improvement, says Daniel Thorniley, senior vice president with the Economist Group. But for those who dare to do business here, returns on equity investments remain among the highest in the world. "In the mid-'90s, people were making a lot of money in Russia for not doing very much. Now, they are making a lot of money, too, but are working damned hard for it," Thorniley told attendees at the Economist Intelligence Unit's (EIU) third annual investors' conference in Moscow earlier this year. Investors already committed to Russia know what the rewards are. According to the EIU's estimates, the average return for pharmaceutical companies in Russia during the past 12 months reached 50% to 65%. The booming consumer sector also led in terms of earnings with 40% to 60% returns on equity last year. Returns for chemical companies were lower at 35%, while IT companies were at 20% to 28%. "Every company that has a representative office in Russia is thinking now about launching distribution. Those who have distribution want to open a subsidiary, while subsidiaries think about starting their own manufacturing," Thorniley says. Putin, stability are factors Marshall Goldman, a Wellesley College professor of Russian studies and Harvard University's associate director of the Davis Center for Russian and Eurasian Studies, lists three reasons Western firms are placing their bets in the former Soviet Republic. "[These companies] have been incubating deals for a long time -- and the new rash of foreign investments reflects a few facts: First, the Russian economy has for 10 years been going up and down. Many of the foreign firms began negotiations when the economy was down. Clearly, the foreign automakers and some others outside oil and gas who are making investments think it's on the way up now." Second for Goldman is the fact of momentum: "GM's Russian joint venture has begun to attract other parts manufacturers, which begins to set in motion a process which feeds on itself. As Russia's economy begins to grow, the big foreign firms recognize that they simply can't afford to neglect this market." Finally, says Goldman, the crucial fact is that "[President Vladimir] Putin's wand is larger and more sincere than that of [Former President Boris] Yeltsin's," thereby making cautious foreign investors less cautious and more ready to commit real capital in a place that still leaves many worried. "With Putin, there's a feeling that conditions have certainly improved for foreign investors." Bush of the U.S.-Russia Business Council agrees: "Foreign direct investment has been very low for the first 10 years of the existence of the Russian Federation, owing to political instability under Yeltsin, poor corporate governance and a host of other factors making for an unattractive investment environment. After more than two years of political and economic stability under Putin, and with the move towards WTO [World Trade Organization] accession increasingly enforcing rules-based economic management and corporate discipline, we expect FDI into Russia to increase sharply. In addition to many billions of dollars going to the energy sector, substantial foreign capital will be invested . . . in telecoms, agriculture, food-processing and pharmaceuticals." Economic stability is evident in the country's GDP and income growth, as well as its slowing inflation rate. GDP figures have been strong for three years and are projected to be in the 3.5%-4.3% range for 2002. (See "10 Years of Transition," below.) Meanwhile, real disposable income has grown the past two years, and inflation is expected to be around 16%, the second-lowest rate in a decade. Automakers make their moves Automobile manufacturers are attracted to Russia because it is one of the few countries of the world with sales exceeding 1 million units annually. In 2000, just over 1 million new passenger cars and light commercial vehicles were sold in Russia, of which 969,000 were locally produced, and only 48,000 imported. In 2002, Russia's overall car output is expected to grow 2% year-on-year, the Russian Economic Development and Trade Ministry said in a report published in May. The companies themselves offer still other reasons. Henrik Nenzen, president of Ford Russia and CIS (the Common-wealth of Independent States), says that the decision to rejoin the Russian automotive society after a 70-year absence was made "with a vision that this industry and this market will become larger and more powerful than many of European countries. Russia will become a successful automotive industry model. It has all the factors needed for success: highly qualified workforce, good market potential and local resources to make a supply base efficient." The first phase of Ford's proposed business plan calls for an investment of $150 million in a Ford Focus plant in Vsevolozhsk, near Leningrad, with initial output of 25,000 vehicles and potential capacity for 100,000 units annually. David Herman, former head of GM's Russia/CIS operations, says the draw for his firm was the untapped potential of a market where car ownership is well below European and U.S. levels. He also said he sees "no reason why Russian manufacturers should not one day build cars to the same standards as western firms," citing the case of Czech manufacturer Skoda, owned by Volkswagen AG. "If we had said 10 years ago the Czech Republic could build great cars, which they can export, or that Thailand can build cars for Japan, no one would have listened to us."

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10 Years Of Transition Controls On Inflation Are Working
YEAR Annual inflation rate
1992 2,509% Wholesale and retail prices are freed on Jan. 2, 1992
1993 840% Tight fiscal and monetary policy bring down inflation (1993 - 1997).
1994 215% Tight fiscal and monetary policy bring down inflation (1993 - 1997).
1995 131% Tight fiscal and monetary policy bring down inflation (1993 - 1997).
1996 22% Tight fiscal and monetary policy bring down inflation (1993 - 1997).
1997 11% Tight fiscal and monetary policy bring down inflation (1993 - 1997).
1998 84.4% Economic meltdown in August causes inflation to rebound.
1999 36.5%
2000 20.2%
2001 18.6% In August, the newly formed Unified Tariff Agency freezes tariffs on natural monopolies (gas, electric, railways), which had accounted for 38% of inflation during first half of the year.
2002 16% Forecast. As of July inflation stands at nearly 10%, but increases in gas and wholesale electricity tariffs and railway fares are expected to push rate to 16%.
SOURCE: U.S.-Russia Business Council Economic Growth Is Substantial
YEAR GDP annual percent change
1992 -14.5%
1993 -8.7%
1994 -12.7%
1995 -4.2%
1996 -3.5%
1997 0.9%
1998 -4.9%
1999 5.4%
2000 9.0%
2001 5.0%
2002 3.5%-4.3%*
* Forecast SOURCE: U.S.-Russia Business Council Real Disposable Income On The Rise
YEAR RDI annual percent change
1992 -41.0%
1993 14.0%
1994 8.0%
1995 -13.0%
1996 5.0%
1997 2.5%
1998 -13.8%
1999 -15.1%
2000 9.6%
2001 5.9%
2002 N/A
SOURCE: U.S.-Russia Business Council
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