#19 - JRL 7229
June 19, 2003
Russia Still Too Green for U.S. Money
By Caroline McGregor
When it comes to luring direct investment from the locomotive of the global economy, Russia has a PR problem.
While much of the world has been mired in an economic downturn, Russia has posted four consecutive years of stellar growth, and the administration of President Vladimir Putin has laid the groundwork to keep the ball rolling with progressive changes to the tax, customs, land and legal codes. By most accounts from American executives on the ground here, the country has become a normal place to do business.
But back in the United States, the number of companies bullish on Russia are fewer and farther between. For many, the great bear simply remains too foreign.
As a result, the total stock of U.S. investment here is only about $6 billion by U.S. Embassy calculations -- roughly comparable to the amount sunk into Costa Rica, whose economy is about 40 times smaller.
"It's a question of perception," says John McCaslin, a U.S. Commerce Department official on staff at the embassy in Moscow.
"We hear from U.S. companies here that when they go back to their boards and compete for their companies' resources against China, Malaysia or South America, it still seems to be a hard sell for a lot of companies," he said.
In the minds of many boardrooms across corporate America, Russia remains the rough and tumble, no holds barred, sometimes corrupt, often opaque economy it was a decade ago.
The perception that organized crime is omnipresent and property rights are flexible is mistaken, says James Balaschak, head of Deloitte & Touche's management consulting practice and a decade-long veteran of Russia's business scene.
As a result, he says, "U.S. companies are missing opportunities being snapped up by Western European and Asian counterparts, who are moving more aggressively, and strategically, to invest and produce in Russia."
Some companies didn't hesitate and are here doing a brisk business. Those that account for the bulk of U.S. investment in Russia are household names, clustered around three of the market's most alluring features: natural resources, skilled labor and growing consumerism.
ExxonMobil has invested $1.4 billion of a planned $12 billion at Sakhalin Island in the Far East, and aerospace giant Boeing says it has put in some $1.3 billion so far, which means, if the embassy's $6 billion number is right, these two companies alone account for 40 percent of total U.S. investment to date.
According to the American Chamber of Commerce in Moscow, however, the U.S. Embassy calculations are off.
"Six billion is too low," says AmCham president Andrew Somers, who estimates that the figure is closer to $10 billion.
Peter Pettibone, managing partner of the law firm Hogan & Hartson in Moscow and a member of the U.S.-Russia Business Council board of directors, agreed, saying if the real figure isn't already $10 billion it will be shortly.
Doing the Math
A quick run through the math seems to support that consensus.
Connecticut-based United Technologies Corp. has invested $400 million in two dozen joint ventures making everything from Carrier air conditioners and Pratt & Whitney motors to Otis elevators, the first of which was installed in St. Petersburg's Winter Palace in 1893.
U.S. firms have invested some $2.5 billion in the northwest, where the Leningrad and Novgorod regional administrations are seen as particularly investor friendly. Chicago-based Wrigley's and Boston's Gillette each have $50 million production facilities in the Leningrad region. Cigarette maker Philip Morris, now called Altria, recently announced it would spend $240 million upgrading its massive Izhora plant outside St. Petersburg, its largest facility outside the United States.
Mars, another consumer goods giant, recently opened a $25 million pet food plant in Novosibirsk, bringing its total outlays in Russia to half a billion dollars, while Procter & Gamble, headquartered in Cincinnati, has put $150 million into a soap factory outside Tula and Frito-Lay opened a $60 million potato chip plant in Kashira, southeast of Moscow, last fall.
And you get another $500 million with the launches last fall of new production lines by Ford, outside St. Petersburg, and General Motors, in Tolyatti in central Russia.
Pepsi, meanwhile, has been here since the 1960s, when then-CEO David Kendall brokered a deal to swap bottling plants and soda pop concentrate for the rights to sell Stolichnaya vodka in the United States. Pepsi says it has poured some $1 billion into Russia; rival Coca-Cola is not far behind with $750 million.
And that's before you scratch the lower-tier firms.
The Numbers Game
Misleading numbers could also be to blame for the lukewarm U.S. presence here, as there is much more investment than is actually reported. A small saw-making business can sell and install, say, $100,000 worth of factory components to a furniture-making joint-venture partner and be delivered and done in under two months, all under the radar of reporting statistics.
Any statistical additions, though, would likely be balanced out by subtractions for companies identified with the United States, like McDonald's and Philip Morris, which are not included in U.S. investment figures because their operations here are run out of non-U.S. headquarters.
McDonald's is run through the company's Canadian affiliate, while the parent company for the Marlboro man -- along with the Golden arches, about as American as it gets -- is not Philip Morris U.S.A., but Philip Morris International, based in Lausanne, Switzerland. Similarly, many U.S. companies use offshore investment vehicles to structure their investment here.
When George Soros, an American citizen, purchased his 25 percent plus one share in telecoms holding Svyazinvest in 1997 for $1.8 billion, a stake he still owns, it was through a Cypriot entity and thus not picked up in U.S. investment figures.
Under currency regulations that make it easier to take profits out of the country if they are structured as repayment on a loan, rather than dividends paid on an equity stake, many firms set themselves up as a parent organization in the United States loaning money to a Russian-based subsidiary.
Waiting on Wal-Mart
Beyond oil and gas and engineering and consumer goods, U.S. companies have found Russia somewhat less compelling.
Some sectors, like aluminum, are notoriously hard to break into, because oligarchs have a choke hold on that part of the economy, says James Mandel, a lawyer at Salans. Oil firms have trouble competing for projects on domestic oil majors' home turf unless it's a place where they are incapable of extracting themselves -- like offshore at Sakhalin.
Other sectors simply have been neglected.
Of the top 10 U.S. companies on the Financial Times' rankings of the world's top 500 firms, only Wal-Mart has no presence in Russia, despite a dizzying domestic retail boom that started for real early last year and shows no signs of slowing.
The world's largest retailer has reportedly been sniffing around, sending exploratory teams here in recent months, but when reached by telephone in Arkansas last week, a company spokeswoman demurred, saying only that the company is "always looking for growth opportunities in markets where customers want to see us."
Not to worry, says AmCham's Somers -- Wal-Mart is coming: "Based on what I know and the discussions I've had, they'll be here, probably next year. They're so big, they feel like they can take their time and let the market mature."
Others caution that Germany's Metro and Sweden's IKEA, for example, have big head starts and the market is quickly moving toward saturation point, at least in Moscow.
The surge in the fast-moving consumer goods sector has pretty much run its course, Balaschak says. In the future, the development will be concentrated in heavier industries, like power production and related industries, as the monopolies that control them are unbundled.
Also, with the breakup of Russia's rail and power grid monopolies, General Electric is hoping for a piece of the action. The No. 2 conglomerate in the world after Microsoft is at an advanced stage of negotiating to build locomotives for the Railways Ministry at a $75 million plant outside St. Petersburg.
And as Unified Energy Systems is privatized, the new leaner, meaner electricity providers will be looking to update their power generation machinery.
GE could not be reached for comment, but Somers says: "Discussions are going on, and GE could well play a role."
WTO Opens the Door
As World Trade Organization accession negotiations push sectors like telecoms and financial services toward liberalization, officials at the U.S. Embassy see opportunities for companies to create more of a footprint here.
"American companies dominate these sectors around the world, but we don't really have much of a presence here," says McCaslin of the embassy's foreign commercial service.
U.S. investment banks like Goldman Sachs and Merrill Lynch left Russia when the financial bubble burst in 1998 and they may be tempted back when the banking sector regains a critical mass, but until then they are content to handle energy deals out of London.
Part of the hesitation, many argue, is that Russia's image problem is well earned and still applicable. If Russia gets a bad rap in boardrooms, the argument goes, it's because there's a history of U.S. investors getting burned.
Sawyer Research Products, the No. 1 U.S. crystal quartz producer, lost the $8.2 million it invested in a plant in the Vladimir region in July 2001 when Sawyer's partner took over the company with the backing of the local administration and the courts, which ruled the price it paid for its lease was too low.
And back before Yukos was toasted as the darling of the investment community for its good corporate governance, it fought a number of high-profile battles with Kenneth Dart, a U.S. minority shareholder who accused the oil major of diluting his stake in Yukos subsidiaries, leaving him with an empty shell. The two eventually reached an undisclosed settlement, though a similar tussle with oil major TNK was mired in the court system in 1999 and 2000.
The legal playing field may be getting more level for foreign companies, but it's not there yet, Pettibone says. "Some decisions may have a paternalistic, protective aspect, but I think we'll see that judges will become more professional with reforms, more training and decent salaries."
Finding a Partner
When it comes to structure, a number of people, looking back on cautionary tales like the Sawyer and Dart experiences, advise companies to go it alone, without a partner, known as "going greenfield."
This school of thought argues that it's simpler to have two rather than three negotiating parties: your company and the local government administration of the district where you plan to launch.
The other school argues in favor of investing through a joint venture with a Russian partner who can run interference with the bureaucracy on your behalf.
Which one is best is in many ways dependent on the U.S. investors' corporate culture.
Ford Motors went greenfield with its plant outside St. Petersburg, while General Motors, its competitor across town in Detroit, opted to enter the market here in conjunction with No. 1 automaker AvtoVAZ and with the support of the European Bank for Reconstruction and Development.
Both think they went the right way, says Somers, and both probably made a choice that was right for them.
GM Russia executive Heidi McCormack spoke highly of her company's joint venture experience. "Like all working relationships, there are challenges, just like in a marriage," she says.
Bringing the GM-AvtoVAZ Tolyatti factory to life took more than two years of negotiations and approvals, and the groundwork was laid even before the 1998 crisis.
"That the deal survived is pretty outstanding," McCormack said. But despite the companies' differences, there's a fundamental agreement on principles, she says: "Both of us want the same thing out of the partnership."
UTC and Boeing, meanwhile, have tapped Russia's skilled labor force.
"We have found terrific Russian partners," UTC senior vice president Ruth Harkin said by telephone from Washington. "There's a technical excellence here that in some cases surpasses our own."
"Working with [our partners] has been good for us and good for our business," says Thomas Pickering, a former U.S. ambassador to Russia and now Boeing's senior vice president for international relations. "There's a strong sense of mutual win."
The classic joint venture model involves the American partner bringing to the table technological know-how or its globally recognized brand name, while the Russian partner brings the ability to drive through the implementation of plans to build a production facility.
It pays to be especially scrupulous in selecting a Russian partner, lawyers like Pettibone and Mandel point out, because greasing the wheels often means a few well-placed bribes. Publicly held companies are bound by U.S. securities legislation, through which they can be held liable for a partner's disreputable behavior under the Foreign Corrupt Practices Act, which forbids companies from paying bribes to obtain contracts.
Some payments are OK -- for example, it is acceptable to give a gift in order to expedite the routine tasks officials are supposed to do. But giving gifts to win preferential treatment from bureaucrats is not.
Privately held companies, like Mars or agro-giant Cargill, which is planning a sunflower oil plant in Krasnodar, enjoy greater flexibility, since they aren't under the gun on quarterly financial reporting.
Nor do European rivals face such stringent scrutiny.
If U.S. reporting requirements are tough, Russian bureaucratic busywork is considered exponentially more burdensome. What U.S. companies need, but don't always have, is an awareness of all the ways officialdom can interfere.
"Form over substance is important -- sort of the opposite of the way it is in the United States," Pettibone says, explaining that he has seen firms get in trouble for something so seemingly innocuous as filing documents on the wrong color paper. "Even if you are an upright citizen and have the best of intentions, you can get in a lot of trouble if you don't require strictly with the required forms, and that bothers a lot of people."
U.S. Ambassador Alexander Vershbow has said the difference between the two countries' bureaucracies amounts to "a quantum leap." A recent Russian government study, for example, found that of 5,000 state bureaucratic functions, 4,750 must be preserved in the course of administrative reforms. That mentality is hard for U.S. firms to understand, Vershbow argues, because American businessmen are used to operating entirely independently from the state.
ExxonMobil's experience is a good illustration.
As its Sakhalin-1 project moves from exploration to development, Exxon says it has filed 37,000 pages of documentation to get the necessary approvals from over 50 agencies at the federal, regional and local levels involved in the regulatory process.
"The project ... will require thousands of approvals, concurrences, licenses and permits before we can begin operations," David Simerka, Moscow general manager for Exxon in the CIS, said by e-mail.
Russia is a bureaucratic heaven, as Pettibone puts it, and large companies are at a distinct advantage because they can better afford to pad their staffs with employees whose express purpose is to ensure that the firm is complying with the state's myriad document demands.
In short, size counts.
'There's No Textbook'
A large company can afford to operate at a loss for a year or two while it establishes itself on the market, while the smaller entrepreneurial-type firms that rushed in the early days of capitalism had less staying power. In the mid-1990s, an estimated 700 U.S. firms dotted the Russian business landscape.
Many pulled out before the crisis, or were swept away by it, and there are fewer adventurers these days.
Those that managed to put down roots, however, and weather the devaluation, are now seeing the returns. "They didn't lose the advantage of their trade names," Somers says, and now most have long since passed their 1997 financial-high watermarks.
Boeing's Pickering said firms need to have "multibillions in revenues" if they want to make a go of the Russian market.
But David Jones, head of Delta Capital, which manages the U.S. government financed U.S.-Russia Investment Fund, argues that size is not a decisive factor.
"Anybody can lose money in Russia. The question is more whether you've done your homework and put the right people on the ground," Jones says.
"Part of being successful here is in absorbing the battle scars, establishing contacts and developing a sense for the rules of the game," says Mandel of Salans. "There's no textbook."
A number of these companies are outperforming their sister companies elsewhere in the world.
"Whereas a Russian general manager used to fly off to conferences to learn about how to do business in an emerging economy, now the conferences are being held here or it's the Russian general manager giving the lecture," Somers says.
In addition, legal risk is diminishing as the judicial system is reformed, moving it in the right direction. Political risk is seen as very low right now. Commercial risk, too, is quite low as the country enjoys budget-boosting high commodity prices.
The consensus seems to be that the rewards of being on the Russian market outweigh the risks.
Buoyed by GM's positive experience, McCormack says the balance tilts strongly toward rewards. "It's certainly not a 50-50 proposition."
The more skeptical, like Harvard economist Marshall Goldman whose most recent book is "The Piratization of Russia," see Russia perched in the middle, with any promise the market holds balanced out by the peril. "You have to work with someone who knows the ropes," Goldman cautions. "Nothing can be taken at face value."
Although remarkably immune from the global downturn, Russia has been a victim too. As companies turn inward to ride out the storm, they don't invest as much abroad.
"If companies are hesitant to take any risk at all, the mentality is, why take it in Russia?" says Jones of DeltaCapital.
Balaschak, at Deloitte, says U.S. companies have been internally focused on their bottom lines due to the economic turndown, but as the outlook brightens, they'll once again turn outward, and toward Russia.
"At very senior levels, American executives are saying we think we should be in the market, we're going to come to the market. We want to know how to come in smart," Somers says.
Chip maker Intel is an example of such deliberate, long-term strategic thinking. It announced last month that its venture capital arm would put $10 million into RuNet holdings, a smaller, yet significant investment.
"We're here to get our feet wet, get some experience and figure out how to invest effectively," says Steve Chase, president of Intel for Russia.
Chase says he's heard other American businessmen say they like what they see here, they just don't know whom to talk to. There's no development agency able to attract investment, like national bureaus set up to encourage tourism.
On the positive side, the quality of local-hire managers, which was always considered a weak link, Jones said, has markedly improved.
At the U.S. Embassy, Mary Warlick, head of the economics section, was encouraged by the recent appointment of Yury Isayev, the 30-year-old former president of Impexbank, as deputy economic development and trade minister for investment policy. "He's dynamic and certainly understands the need to streamline the process."
GM's McCormack says there's a big disparity of appetite and impressions between Russian-based managers and those back at headquarters. "[Changing that] has more to do with getting them over here to see Russia for themselves than anything else."
"There should be a lot more U.S. direct investment and that's something we're trying to encourage in a challenging environment," says McCaslin at the U.S. Embassy.
"It's wise to be cautious," says Boeing's Pickering. "But it's not wise not to come."