The EBRD on Russian Opportunities: Diversifying Investments and Trade Links

By EBRD  Press Office
@ebrd

Delivered by: 

Sir Suma Chakrabarti, EBRD President

Venue: 

U.S. Chamber of Commerce, New York

Why Russia? Why now?

Russia and the US

Many of you may be asking yourself those questions as you sit here listening to this speech. After all, this is not the easiest of times in the relationship between the United States and Russia. The news is often full of the tensions, either real or imagined, between the two countries. There is no doubt that the days when Russia might have seen America or Western Europe as a role model are over. The reset in relations during President Obama's first term in office has borne some fruit but has certainly not eradicated all the difficulties.

The recent history of bilateral relations demonstrates, however, that even when political interaction between Russia and America is troubled, business relations continue to expand. There are still good reasons to engage with and invest in Russia. There are signs that Russia wishes to become more integrated in the global economy, not less.

EBRD in Russia

Russia is often difficult to understand. But my organisation, the European Bank for Reconstruction and Development, has a long track record of navigating the waters of that country, and of successfully guiding companies there. We have invested more than 23 billion Euros in over 700 successful projects in Russia in 21 years.

The European Bank for Reconstruction and Development was set up after the 1989 fall of the Berlin Wall, to help the former communist economies make the transition to open-market economies. 1991 wasn't just the moment that the Bank began operating; it was also the year that the Soviet Union collapsed. Economic change has proved a lengthy process, far longer than was envisaged originally.

Over the past two decades, the United States has been one of the strongest sources of foreign direct investment in the EBRD's countries of operations. Joint investments between US companies and my Bank stand at some 3.5 billion Euros in Russia, proof that Russia and the EBRD have something to offer.

Just ask companies like John Deere. We worked with this company to introduce a new financing option for agricultural, construction and forestry companies interested in acquiring John Deere equipment. This wasn't just good for John Deere but also for economic transition in Russia. The project promoted the expansion of markets for high quality equipment. At the same time, it represented a successful collaboration between an equipment manufacturer and a financial institution, encouraging other manufacturers and banks in the country to introduce similar schemes.

I could mention our investments with GM in Russian car plants, or how we helped Guardian Industries Corporation invest in a new float glass manufacturing plant and a glass coating line in the city of Krasny Sulin in Russia's Rostov region. The aim was to address the many, growing opportunities in the construction market and the production of high quality glass products which can enhance energy efficiency.

We don't just strive to help firms like yours open up or expand your markets in Russia. We also want to contribute to changing and modernising the Russian economy and the way that business is conducted, one project at a time. We don't just bring financing; we bring more than two decades of expertise on the ground which can spell the difference between success and failure.

So, back to those questions: Why Russia, Why now?

Significant opportunities to seize

There remain huge opportunities for American investors in Russia. PricewaterhouseCoopers recently surveyed 38 international companies. They all expressed optimism about the Russian economy and said they had high expectations that their presence there would grow over the next three years. They noted the availability of well-trained English-speaking employees. In fact, a US State Department report on Russia says the educational system produces nearly 100 per cent literacy. An emphasis on science and technology education means that medical, mathematical, scientific and aviation research is acknowledged and respected beyond the country's borders.

It's always worth noting that Russia is the largest market in Eastern Europe with a population of 143 million. Critically, there is still a huge pent-up demand for consumer goods and a middle-class with growing spending power. Some estimates are that the middle class now constitute about a quarter of the population. Real disposable incomes are rising. Consumers are becoming more sophisticated. They want higher quality products that often only western companies can manufacture in Russia. An expansion of domestic demand will carry on producing reasonable growth even if the external environment, the opportunities for export, remains problematic. That demand isn't just from consumers, though, pointing to business opportunities in many sectors. Tax reforms designed to revitalise the economy – including a cut in the headline rate of corporation tax – are also boosting the commercial climate.  

A difficult business environment

The key to success in Russia, though, is not being starry eyed about the prospects there. It's important to have a trusted guide and that's where the EBRD's hard-won expertise is useful. Corruption is a major problem and has a serious impact on the business climate. Russia ranks low on the World Bank Doing Business Survey. Many Russians regard public corruption with acceptance and weary resignation. President Putin has admitted that corruption is one of the bigger threats to his country. He has set a clear target of moving Russia from 112th on the World Bank survey to 50th place by 2015 and 20th by 2018.The regulatory environment is prone to high levels of bureaucracy. To build a warehouse in Russia can require 53 procedures, take 540 days and cost much more than anywhere else in Europe. At one recent EBRD conference, a foreign investor in Russia said he'd only got his warehouse built after a long battle with the local authorities, including a request to spend a million dollars on enhancing the regional electrical supply so that he got the power needed for his operation. Despite all that, he says it's worthwhile and the returns on investment are high. At another level, copyright infringement is common, intellectual property theft is rife.

These aren't the only areas where the nation is in need of reform. The government is pledging to reform but there remains a wide gap between the passing of legislation and its effective implementation.

Dependence on natural resources

As I said earlier, and as history relates, Russia has always been hard to read.

More than 70 years ago, the British Prime Minister Winston Churchill said "I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key. That key is Russian national interest."

In the world that we live in today in 2013, the key remains the same: Russian national interest. But Russia knows that it is overwhelmingly in its interest to diversify its oil and gas economy and attract foreign investment.

If Russia is to be more successful in future, it knows that it must restructure its economy. And American and other foreign investors could take advantage of the opportunities. The EBRD has just produced a detailed report entitled “Diversifying Russia”. It says the economy is still far too dependent on oil, gas and other commodities production. In fact, the share is higher, today, than it was fifteen years ago. Diversification is both urgent and overdue. In 2012, oil and gas accounted for nearly 70 per cent of exports. Oil and gas revenues also contribute around half of the federal budget. Excessive dependence on the natural resource sector is undesirable. Diversification would allow the development of new industrial capabilities. Eventually, that would lead to a platform for future specialisation in Russia. These new areas should initially complement – and in time replace – natural resources as the main driver of Russia’s growth. There is a body of evidence which suggests that, while natural resources can play an important role in giving societies a developmental push, they are rarely associated with strong long-term growth. They are also less likely to create jobs, given the high capital intensity typically observed in natural resource sectors. There are two other issues which we shouldn’t forget. Fluctuations in commodity prices result in macroeconomic volatility; and an abundance of natural resources make it much more difficult to improve the business climate. The abundance encourages corruption and weakens constituencies which support institutional reform. In turn, that undermines growth in non-commodity sectors.

How to foster diversification?

So, how can diversification be fostered? What should Russia do? The EBRD’s Diversifying Russia report is explicit in stating that there is no silver bullet. There are some ideas, though, which are worth pursuing.

Horizontal policies should focus on improving the general business environment in the country. Russia is often depicted as a centrally-run monolith but the extraordinary variation in the business climate across the country’s regions is striking. The diversity suggests that institutional development could be promoted through the transfer of experience and competition between regions. This idea hasn’t been lost on government; considerable effort has gone into strengthening incentives for regions to improve the local business climate. This should continue.

Federal policies must also place greater emphasis on skill formation. More needs to be done to link education with the needs of industry and there must be more vocational training. Generally, access to finance has improved in Russia, but there are still significant financing gaps at the initial stage of the innovation cycle. The government should aim to take minority stakes in privately managed funds, rather than attempting to launch or majority-own investment funds. Companies and organisations must have incentives to innovate. A vicious circle of small numbers of internationally competitive companies, limited pressure to innovate and little need to innovate should be broken.

Russia should pursue some major state-led initiatives, with private sector participation, to make progress. Examples include the use of the highly ambitious Rusnano. It was originally founded to foster the establishment of a high-tech niche in the nanotechnology industry but it was transformed into a national innovation network by its dynamic CEO, Anatoly Chubais. Rusnano now has strong management and significant capital. Its management has declared its intention to eventually privatise the fund. The immediate aim is to bring in external investors and open up its governance. The long-term objective must be for the government to reduce its stake to less than 50 per cent of the fund’s share capital.

Another example of what’s being done is Skolkovo Innovation City – dubbed the Russian Silicon Valley. It is probably the most high-profile and ambitious government project fostering innovation and diversification. An American university, the MIT, has been contracted to build a local campus, attracting investment from some of Russia’s finest research universities. A number of global leaders in high-tech industries have pledged to help build five science clusters. Tax and legal exemptions have been granted, creating an attractive environment for investing companies. Next, efforts should be made to extend these conditions to the rest of the country. Skolkovo should not be an enclave but the norm.

So, there are things that are being done and should be done. Success is not guaranteed, though. Such state-led initiatives will take significant effort and resources, and in order for them to progress, private sector participation is the key. Ultimately, the success of Russia’s diversification effort rests on the ability to harness the country’s tremendous regional diversity, improve the overall business environment and ensure that educational attainment is on a par with advanced economies. If you, and other foreign investors, see that happening, you will then consider investing and committing sufficient capital and skills to break the nation’s dependence on natural resources.       

World Trade Organisation accession

Russia is also pinning some of its hopes on its recent accession to the World Trade Organisation. It's been a long time coming; talks began not long after the break-up of the Soviet Union and the collapse of communism. Almost two decades of effort before agreement was reached. The deal obliges the country to cut import tariffs from an average 9.5 per cent to 7.3 per cent by 2015, giving firms time to invest in improving their competitiveness. Russia hopes that membership will lead to a surge in foreign direct investment which, in turn, will bring about an increase in the efficiency of Russian industry. Russia also believes that exports will gain by around 2 billion dollars a year from the dismantling of barriers to trade. Again, this is not clear cut, though. Much of Russia's inefficient manufacturing may struggle to compete with rivals in the rest of the world. The hoped for foreign investment also depends on the appetite of investors, like you. Given the difficult investment backdrop that I've described, that may not be on the scale that the government in Moscow envisages.

Conclusion

So, how can one sum up this very mixed picture that I've outlined. In essence, it is simple: There are lucrative opportunities out there - the big risks are commensurate with the big rewards. We've worked with many of those who've done it already and we don't often hear regrets. To quote an old Russian proverb, `without pain there is no science’ or as we would say `adversity is a great teacher’. In other words, investment in Russia isn’t easy but companies tell us the benefits are clear in the end.

Why Russia, Why Now? Because it continues to provide the opportunities and rates of return, the profit margins, which are increasingly elusive elsewhere. Why do we want you to do it? Not because we make money out of funding your projects but for a more elevated reason. We were set up to promote economic change in Russia and the rest of the former Soviet Union and Eastern Europe. That was what our founding fathers and mothers wanted when they launched the EBRD in 1991. Every project helps us keep moving down that road. Over time, economic transition underpins the evolution of stronger institutions which are needed to ensure the checks and balances on which all democracies rest. That is a goal which requires patience, the work of decades, but is worth pursuing.