Investing in Russia

This chapter was written before the global economic crisis and at the time of submission the full effect of this remains unclear for Russia.

If you are a foreign businessman reading this in a very expensive hotel bedroom in Moscow or St Petersburg it probably means you have come to Russia to work on your existing investment in the country or to look at new opportunities to invest.

I have been living and working in Russia since 1997 and, in that time, have seen enormous changes in the country. Some good, some not so good, but on the good side is the opportunity to invest and the returns that can be made from that investment IF you get the investment right. Sadly, there are plenty of examples of companies who got it wrong here. Some of them are household names.

One important factor to bear in mind is that, from an investment perspective, everything here is relatively new. The current economic regime only began when Russia climbed out from the rubble of the economic crash of 1998 and the increase in oil prices that followed from 9/11. The Russian Tax Code only came into effect from the year 2000 and the whole Tax Code is contained in one volume (and it’s much smaller than most of the Harry Potter novels).

In one of its more inspired moves, Russia adopted a flat tax system (initiated by President Yeltsin though President Putin enacted the legislation after he took office) in the year 2000. The standard tax rates are low with personal income tax at 13% and corporate profit tax at 24% (though the effective rate can be higher). The standard rate of VAT is 18% but there has been much discussion about lowering this, despite the inflationary pressure this may cause. The rates may be attractive but whether the flat tax system does boost economic performance while also providing improved tax revenues has never been satisfactorily proved in Russia due to the distorting effect of oil prices and the massive tax take from that sector.

Sadly, while the tax burden in Russia may be lower than elsewhere in terms of rates of tax, this is more than made up for in terms of burdensome administration. The frequency and detail of filings, tax audits and the difficulty of claiming VAT repayments should not be under-estimated.

One final positive tax point is that Russia now has a fairly comprehensive tax treaty network and withholding taxes are low or none whatsoever in many cases. Basic international tax planning usually involves using Cypriot or Dutch holding companies. The decision as to where the holding company is situated is normally down to the investing company’s policy or where management and control can be more effectively demonstrated.

Going back to the crash of 1998; this wiped out the savings of a lot of what was then the emerging middle class, destroyed faith in the banking system and left Russians with a very short term view. Make the money, get it in cash and get it out of the country is still an attitude that one finds, even after almost 10 years of relative stability. My wife, until very recently, drew out all her salary in cash the moment she got paid (and under Russian Labour Law salaries are paid twice a month) even though she banks with the local office of one of the major international banks.

In business one still finds that making a quick profit is often regarded as more important than building long term shareholder value. Even the Russian banking system shows signs of this. A client (a long established Russian company) was recently looking to take on substantial debt for a major modernisation program with a pay back period of 11 years. No Russian bank was willing to look at a loan over more than a 3-year period.

So what is the current investment climate like in Russia? Even a brief perusal of economic and corporate metrics shows that Russia's investment credentials are robust. It has the third-largest foreign exchange reserves in the world, budget and trade surpluses, a growing middle class and a government stabilization fund projected to hit $255 billion in 2009 and which is earmarked for infrastructure projects. If you have ever driven anywhere outside the main cities you will know how badly infrastructure needs to be improved. For example, it is still impossible to drive on paved roads all the way from Moscow to Vladivostok.

Perhaps more importantly, the Russian Central Bank has sufficient funds to back the entire Russian banking system

According to forecasts provided by Daniel Thorniley of The Economist Intelligence Unit, Russia can look forward to GDP growth of between 5% to 8% per annum until 2012, private consumption growing 10% per annum, a fairly stable exchange rate, unemployment around 6% and a predicted to be declining inflation rate (though this still remains a primary concern in Russia). Add to this the relatively low levels of government and corporate debt (public debt to GDP is forecast to be 1% by the end of 2012 with foreign currency reserves at $550 billion) and profitable companies whose earnings were growing at around 30 percent a year (though that level of growth now looks unlikely to continue, at least in the short term), a financial sector that seems to have relatively little exposure to sub-prime lending and stock valuations that are among the cheapest in the emerging-markets universe, and the investment case for Russia would appear to be complete. Some might claim that, in investment terms, “Russia is just an energy play, there’s nothing else”. This may have been true in the past but now there is evidence of strong growth in many areas. At the moment, to the fore are food and beverages, retail, consumer goods, banking, real estate, construction, mobile telephony, aerospace, mining, metallurgy, automotive, industrial products and IT (adapted from the Economist Intelligence Unit).

What is impossible to judge now is the effect of the liquidity crisis on the Russian economy. A credit squeeze remains the biggest threat to the Russian economy.

But in Russia there is always a “but”. But it would be true to say that many major Russian corporations still struggle to provide the levels of transparency and corporate governance that a western investor in a publicly quoted company might expect to see. A small personal story may serve to illustrate this. A good friend of mine is a translator who specialises in corporate reports. She was engaged by a major company to translate the corporate governance section of their annual report. This was a lengthy essay about how socially and environmentally responsible the company is, fulfilling all its obligations to the State and its citizens etc. When my friend asked to be paid she was made to wait for over three months and was then paid in cash, off the books, no records etc. The irony of this was evidently not apparent to the payer.

It would be impossible to write about investing in Russia without touching on the subject of corruption. In recent surveys Russian citizens have consistently rated corruption as one of the biggest problems affecting Russia today, ahead of poverty, crime and health issues. There is no arguing that the scope of the problem is massive. A survey in late 2007 found that two-thirds of Russians believe corruption cannot be rooted out of the system and 28 percent reported that they had personally been affected by some form of official corruption within the previous year. A 2007 study by the Russian NGO “Against Corruption” estimated that up to one-fourth of all the money Russia spends each year on state orders is stolen. Anyone who has driven in Russia and committed a real or imaginary traffic violation will have found a traffic cop willing to settle the matter unofficially.

Alan Broach