Russia

Russia presents many promising investment opportunities with the potential for dynamic growth in sales and profits. However, investors face several significant challenges, including a complex regulatory and legal system that requires professional help to navigate, widespread corruption, a lack of respect for the rule of law, and immature banking and financial markets. In addition, state-owned entities have a major presence in many economic sectors, and hence may be potential competitors of new investors.

Russia’s economy is still developing, not diversified, and is largely focused on natural resource extraction. GDP sharply contracted in the last two months of 2008. Although it posted a 7.3 percent growth rate for the first nine months of 2008, the final figure for 2008 is expected to be 6.8 to 7.0 percent, as compared to 8.1 percent in 2007. The numbers for 2009 are expected to be even lower, ranging from 0 percent growth to 2.5 percent. Fixed capital investment saw an increase of 13.1 percent January-September, which was lower than the 21.3 percent increase during the same period in 2007. Most of the capital investment in the first nine months of 2008 went to energy, manufacturing, real estate, and transportation.

According to the Central Bank of Russia, foreign direct investment (FDI) inflows exceeded $50 billion in the first 9 months of 2008, as compared to $38 billion during the same period in 2007. End of year estimates place FDI at $55 billion. At 4% of GDP, this level of FDI inflow is on par with other emerging markets. The United Kingdom and the Netherlands continued to be the top source countries for investment inflows during the year, reflecting these two countries’ heavy investments in Russia’s energy sector.

Capital account liberalization, which took effect on July 1, 2006, helped increase net inflows to Russia in 2006 ($40 billion) and 2007 ($82 billion). The general economic slowdown stemming from the financial crisis and shocks to investor confidence, however, have produced a marked shift for 2008, increasing capital outflow and putting additional pressure on the ruble. As of October 1, 2008 (latest available data at this writing), capital outflows were equal to capital inflows. BNP Paribas has estimated that investors withdrew about $140 billion from August – October 2008. According to the Central Bank of Russia, net private capital outflow reached $50 billion in October 2008 alone.

A sense that the Russian investment climate had generally strengthened in recent years has been undermined by recent Russian government actions, such as the apparently politically-motivated investigations into businesses (e.g., the TNK-BP oil and gas joint venture and the Mechel coal company) and the military conflict with Georgia. The global economic downturn also exposed Russia’s weaknesses. Many structural improvements remain necessary, such as: judicial reform to establish an independent and effective judicial system; banking reform to improve the capacity of the financial sector; accounting reform to promote greater transparency and integration with the international business community; a legal and regulatory framework for preventing insider trading; and improvements in corporate governance.
Reducing government bureaucracy and corruption has long been high on the agenda of businesses large and small, Russian and foreign, operating in Russia. While President Medvedev has committed his government to fighting corruption, his only progress to date has been the enactment of new anti-corruption legislation.

Openness to Foreign Investment
The global economic slump during the latter part of 2008 dampened foreign investor enthusiasm, which had been stoked byRussia’s economic growth and rising incomes in recent years. The Russian Federal State Statistics Service estimates that since 2000, the economy has demonstrated real growth of 72%, where real disposable incomes have grown 209% in the same period. Recent real income growth deceleration, however, combined with citizens’ fears about the future of the Russian economy, raise concerns about future growth, particularly is the retail and consumer sectors. While many U.S. firms reported that their return on investments in Russia was among the highest in their international operations, the global financial crisis and recent Russian government actions may retard their Russian investment plans.

The Russian government has repeatedly emphasized foreign investment’s critical role in Russia’s economic development, but has been reluctant to allow unfettered access in practice. The 1991 Investment Code guarantees foreign investors rights equal to those of Russian investors (although some industries have limits on foreign ownership – see below). The 1999 Law on Foreign Investment also affirms this principle of national treatment.

In practice, the Government of Russia (GOR) tends to favor joint ventures with local entities, especially state-owned entities, or direct cash injections, particularly in Russia’s “strategic sectors.” This has been most obvious in the energy sector, in which the GOR continues to tighten its grip and typically limits foreign companies to minority stakes (often 20 to 25 percent) in larger projects. In the area of consumer products, however, international companies have been able to set up and expand their operations with relatively few restrictions.

At the federal level, Russia is establishing special economic zones, high-technology parks, and special tourist regions to encourage foreign investment. At the regional level, many local governments have developed laws and programs to attract FDI, which include techno-parks near universities and export zones near ports and borders. Although federal tax reform aimed to create a level playing field for all investors and limit the scope of incentives regions can offer, large foreign investors continue to receive incentives from local authorities in practice. In addition, many local administrations view foreign investors as sources of cash for support of municipal services, which can range from topping up teachers’ salaries or provision of carpentry and plumbing services to maintenance of a municipal park or supply of heat to a village from a processing plant’s boiler.

While FDI inflows had picked up substantially since 2004, the slow pace of structural reforms and the ever increasing role of the state in some sectors of the economy continue to restrain foreign investment. In response to the global financial crisis, the GOR is preparing to support various sectors of the economy in return for control of assets and revenue flow, and the role of government and quasi-government entities could become even more opaque. The lack of clarity in Russian tax law and administration, inconsistent government regulation and enforcement, unreliability of the legal system, underinvestment in infrastructure, difficulty in conducting due diligence, and high levels of corruption can dissuade investors.

Rule of law, corporate governance, transparency, and respect for property rights, including intellectual property rights, although improved over the years, remain key concerns for foreign investors. As a result, while there is increased interest, many U.S. companies remain cautious about investing in Russia. Concerns about possible liabilities associated with existing operations (especially environmental cleanup) and inadequate bankruptcy procedures are also factors.

In recognition of widespread corporate governance problems, the Federal Service for Financial Markets has had a corporate governance code in place since 2002 and has endorsed an OECD White Paper on ways to improve practices in Russia. Some large Russian companies have developed their own policies, although implementation is not always robust. International business associations such as the American Chamber of Commerce in Russia, the Association of European Businesses in Russia, and the International Business Leaders Forum, as well as Russian business associations such as OPORA, the Russian Managers Association, the National Council on Corporate Governance, and the Russian Directors’ Institute stress corporate governance as an important priority for their members and for Russian businesses overall.

Roughly three-quarters of the Russian economy has been privatized, although the GOR continues to hold significant blocks of shares in many privatized enterprises. The privatization of remaining state holdings is scheduled to continue, but could be delayed as a result of the current economic slowdown. Furthermore, the GOR may ultimately acquire/re-acquire additional shareholdings in Russian companies if GOR-financed loans, collateralized by shares, are not repaid.

Often foreign investors participating in Russian privatization sales are confined to limited positions and face problems with minority shareholder rights and corporate governance. Moreover, the treatment of foreign investment in new privatizations is likely to remain inconsistent. Potential foreign investors are advised to work directly and closely with appropriate local, regional, and federal ministries and agencies that exercise ownership and other authority over companies whose shares they may want to acquire.

The GOR approved a new “Strategic Sectors” law in May 2008. The law restricts new foreign investment in 42 sectors deemed “strategic.” Investors wishing to exceed set ownership limits must seek approval from a special commission, chaired by the prime minister. There are concerns that the approval process may prove to be non-transparent and burdensome. Concurrent amendments to legislation governing subsoil resources restrict foreign investment to a 10 percent threshold in entities controlling large oil and gas deposits, which are defined as “strategic.” Potential investors in such entities must seek the approval of the special commission.

The government has reasserted control over the oil and gas sector in recent years. Foreign investors who want to do business in the Russian oil and gas sector should keep in mind the key roles played by the state companies Rosneft (oil) and Gazprom (gas).

Particularly in oil and gas investments,Russian officials at both the federal and local levels frequently raise environmental concerns as considerations in the approval process for investments. In some instances, it is difficult to say whether such concerns are genuine.

Foreign Direct Investment Statistics
Table 1 shows flows of foreign investment by country for the first nine months of 2008, compared to the same period in 2007. Total foreign investment declined by 13.8% in the first nine months of 2008, compared to the same period in 2007. According to Russian statistical practice, total foreign investment numbers include direct investment (FDI), portfolio investment, and “other” investment (largely trade credits). Cyprus consistently figures high as an investor because most investment coming from Cyprus is actually returning Russian capital. (Note: The data in the Tables below is from the Russian State Statistical Service and may differ from data maintained by the Central Bank of Russia and the U.S. Department of Commerce.)
Table 1: Top Ten Investors – By Year (in USD million)

Country	Jan-Sept. 2008		Jan-Sept. 2007
	Total	FDI	Total	FDI
Cyprus	15,304	4,320	11,881	2,560
UK	12,550	870	20,729	299
Netherlands	8,911	4,942	17,270	12,638
Germany	6,528	1,847	3,447	530
Luxembourg	6,267	N/A	8,123	N/A
France	5,079	671	4,405	248
Virgin Islands (UK)	2,643	1,595	1,383	352
Switzerland	2,337	207	4,487	102
USA	2,098	216	1,989	207
Ireland	999	N/A	4,412	N/A
All Others	13,076	4,533	9,810	2,708
Total	75,792	19,201	87,936	19,644

The numbers in Table 2 represent an accumulated stock of total foreign investment, which include FDI, portfolio, and “other” investment.

Table 2: Top Investors – Accumulated Basis (in USD million)

Country	Jan.-Sept. 2008		Jan.-Sept. 2007
	Total	FDI	Total	FDI
Cyprus	54,528	38,561	39,122	27,362
Netherlands	45,152	38,773	35,977	32,230
Luxembourg	34,210	1,221	30,282	735
UK	31,356	4,460	24,178	3,192
Germany	14,881	5,512	11,455	3,830
France	8,515	1,950	7,407	1,307
USA	8,503	3,161	8,041	3,643
Ireland	8,017	465	6,404	589
Virginia Islands (UK)	7,470	5,111	4,109	2,383
Switzerland	3,790	1,636	6,200	1,521
All Others	34,857	17,033	24,621	11,009
Total	251,279	117,883	197,796	87,801

Source: Federal Service for State Statistics (FSSS)
Table 3 shows foreign investment by region over the first nine months of 2008, compared to the same period in 2007. Moscow continues to attract the largest volume of investments, mainly due to the concentration of companies’ headquarters and the largest concentration of consumers with high purchasing power.

Table 3 – Foreign Investment – Top Regions (in USD million)

	Jan-Sep 2008			Jan-Sep 2007
	Amount	%	Rank	Amount	%	Rank
Moscow (city)	28,339	37.4%	1	54,582	62.1%	1
Moscow Region	5,157	6.8%	2	3,252	3.7%	5
St. Petersburg	4,806	6.3%	3	4,614	5.2%	3
Sakhalin	3,609	4.8%	4	3,414	3.9%	4
Krasnoyarsk	3,159	4.2	5	9,818	11.2%	2
Vologda Region	2,918	3.9%	6	115	0.1%	33
Chelyabinsk Region	2,836	3.7%	7	668	0.8%	10
Belgorod Region	2,376	3.1%	8	524	0.6%	13
Samara Region	2,051	2.7%	9	1,441	1.6%	6
Lipetsk Region	1,770	2.3%	10	123	0.1%	32
Others	18,772	24.8%		9,386	10.7%
Total	75,792	100.0%		87,936	100%

Source: Federal Service for State Statistics (FSSS) (Note: Includes direct, portfolio, and other investment.)
Table 4 shows investment by sector over the first nine months of 2008, compared to the same period in 2007. Total investment in such sectors as trade, extraction of fuel, and transport and communications fell by over 50%, while other real estate, production and distribution of power, gas and water, finance, food, and construction became higher investment growth sectors in 9M08, compared to the same period in 2007.
Table 4: Foreign Investment: Top Sectors (in USD million)

	Jan-Sep 2008		Jan-Sep 2007
	%	Amount	%	Amount
Trade	23.6%	17,917	42.3%	37,207
Metallurgy	15.2%	11,519	12.8%	11,212
Real Estate and Related Services	14.2%	10,767	4.8%	4,236
Extraction of Fuel	8.3%	6,328	16.0%	14,077
Production and distribution of power, gas and water	4.5%	3,383	0.3%	236
Finance	4.3%	3,249	2.4%	2,152
Food Industry	3.8%	2,858	2.1%	1,854
Production of coke and oil products	3.4%	2,559	3.8%	3,320
Construction	3.3%	2,499	1.2%	1,094
Transport and Communications	3.0%	2,237	3.2%	2,842
All Others	16.5%	12,476	7.8%	6,823
Total	100.0%	75,792	100.0%	87,936