For every high-profile failure, Alex Nice says there are several other foreign companies quietly developing their businesses in Russia, often with very high margins

Russia tends to polarise investor sentiment in a manner unlike any other country. The challenges to investment have been well documented, and Russia is undoubtedly a difficult place to invest. No assessment of Russia’s business climate can ignore its weak rule of law, pervasive corruption, or ineffective and obstructive institutions. It is perplexing, however, that these problems are represented as uniquely Russian failings, rather than characteristics typical of an emerging market, which are often accompanied by potentially high profits for those companies willing to take the risk. Whilst it is true that Russia’s institutional environment is unusually weak for a country of its income level, the economy is much more ‘normal’ than the lurid press accounts of corporate raiding and high corruption would suggest. Popular press coverage tends to exaggerate the economic and political risks of the country; success stories receive very little attention. But for every high-profile failure, there are several other foreign companies quietly developing their businesses in Russia, often with very high margins.

There are good reasons why Russia should seek to encourage higher rates of foreign investment into the country. The sources of growth which powered Russia’s rapid economic expansion in the early 2000s have now been exhausted. Dependence on oil exports is growing, even as production is starting to plateau. Russia’s economy is now running at full capacity and much of its capital stock is worn-out or poorly deployed. If Russia wishes to maintain economic growth in the medium term, an investment-led strategy is the only option, both to develop new productive infrastructure and to increase productivity. Given the lack of domestic private capital funds, this investment must largely come from abroad.

This is well-understood by the country’s leadership, which has provided a frank assessment of the country’s economic weaknesses and the need to improve the business environment. At the World Economic Forum in Davos in late January, Prime Minister Medvedev set a target to raise investment from 20 per cent to 25 per cent of GDP. President Putin, meanwhile, has stated that the main economic goal of his Presidency is to raise the country 100 places in The World Bank’s Ease of Doing Business rankings, from 120th to 20th by 2015.

Whether this can be achieved remains an open question. Past experience suggests that reform is possible when the economic rationale is very strong, but these reforms are typically reactive in nature, incomplete in design and tentative in execution. One such example is Russia’s accession to the World Trade Organisation (WTO) in 2012 after many years of negotiations. This will marginally reduce export and import tariffs, thus increasing competition in some sectors, but the overall effect on the openness and productivity of the economy is likely to be marginal. The best hope is that Russia’s WTO accession could act as an anchor or foundation on which further reform could be built. However, the government has already undermined such hopes by its slow implementation of new trade commitments, which has provoked criticism from the EU.

Russia is conventionally viewed as having a two-tier economy, in which light manufacturing, service industries and retail operate in a relatively free market, whilst the strategic industries, such as oil and gas and defence, are dominated by the state. Although these sectors operate in very different ways, opportunities exist for foreign investors in both parts of this dual economy.

For any company producing or retailing consumer goods, Russia is quite simply an indispensable market.  Russia’s retail and service sectors developed ex nihilo in the post-Soviet period, largely by importing foreign practices and expertise. They are therefore amongst the most competitive and productive sectors of the economy. Russia has an expanding middle class which continues to enjoy rising salaries. Income tax and VAT are comparatively low, and few Russians have mortgages or invest in private pensions or healthcare. As a result, disposable incomes are high as a proportion of total income – and Russia has turned into a booming consumerist society eager to adopt any innovative product or service developed abroad. Russia is already the largest market in Europe for children’s goods, milk and dairy products. According to the leading business analyst Ben Aris, every year from now until 2020, Russia will take the lead in another sector until it becomes the biggest consumer market in Europe.

The most obvious source of large scale investment in Russia is likely to be in the extractive industries. While the state has significantly increased its role in this sector, there are nevertheless likely to be significant openings for foreign companies to enter as partners in joint ventures in the coming years. The oil and gas sector is perhaps the area of greatest potential opportunity. The geography of Russia’s oil extraction is shifting from Western Siberia to far more challenging fields in Eastern Siberia and the Arctic. These areas lack necessary infrastructure and are technically far more difficult to develop than existing deposits. Russian companies lack the capital or technical expertise to develop these new fields alone. Foreign companies are thus essential to the next stage in the evolution of Russia’s oil and gas industry. To this end, Russia’s Rosneft, now the largest publically-listed oil company in the world, has already entered exploration agreements with several IOCs including ExxonMobil, BP and Statoil.

The situation in the mining sector has to date been much less encouraging. Given the country’s mineral wealth, it is an indictment of Russia’s regulatory environment that all the major mining assets are based around deposits initially developed in the Soviet period. Much of the country’s subsoil law is not fit for purpose and acts as a serious brake on investment. Why is it, asked Vitaly Nesis, the head of the Russian mining giant Polymetal at an industry conference in 2012, that in the age of three dimensional computer modelling, investors are still required to submit hand-drawn production plans to Russian officials? As a result of the poor regulatory environment, international mining companies have to date tended to avoid Russia, with the notable exception of Canada’s Kinross Gold.

Whilst Russia as a whole has struggled to increase foreign capital, some regions have succeeded in transforming themselves into hubs of foreign investment. Sverdlovsk Oblast boasts ‘Titanium Valley,’ a world-class supplier to the aviation industry, whose clients include Boeing and EADS. Kaluga Oblast has likewise transformed itself into a centre for the foreign car industry through a combination of targeted government incentives and a business-friendly local administration. To overcome any bureaucratic meddling, the governor of the region famously provided his personal mobile phone number to new investors.

Such regional success stories underline the difficulties of generalising about the investment risks for foreign companies in Russia. In the course of advising potential investors, political risk and business intelligence firm GPW has conducted interviews with dozens of managers of foreign companies operating in Russia. These surveys have underlined the diversity of their experience, with the challenges to doing business varying strongly from sector to sector and region to region. In such circumstances, decisions made early on in the investment, particularly with regard to location and local partners, are likely to prove decisive for the future success or failure of the investment project. Whilst the headline ratings for corruption and ease of doing business provide a generalised and unprepossessing picture of the investment climate in Russia, they need not reflect the reality of an individual company on the ground. With a strong management team, the right partner and a good understanding of local conditions, investing in Russia can be a successful enterprise. www.gpwltd.com