Features : Growing Pains


Both Russian and foreign-owned businesses are finding the countrys rapid economic growth is a double-edged sword.

On October 28 Volkswagen CEO Bernd Pischetsrieder and Russias economy minister German Gref laid a foundation stone together, as the carmaker broke ground on its assembly plant in Kaluga, 100 miles southwest of Moscow. The new factory, scheduled for completion next year, will eventually produce 115,000 cars a year and create 3,500 jobs.

As the factorys foundation stone was edged into place, details of a very different kind of foreign investment in Russia were emerging with luxury US-based fashion brand Ralph Laurens announcement that it would be opening two new retail stores in Moscow early in 2007.

Even recently Russia was a destination only for the brave investor. Now, though, there is no doubt that it has become an attractive place to do business. The country is benefiting not only from a rising tide of foreign investment but also from the general increase in commodities prices. Economically, the results have been spectacular. The current account, capital account and budget are all in surplus. Foreign reserves, which now stand at more than a quarter of a trillion dollars, are the fourth largest in the world, after those of the United States, China and Japan. In August 2006ahead of schedulethe government even managed to pay off Russias $22.3 billion Soviet-era debt to the Paris Club of sovereign lenders.

There is, however, another side to Russias remarkable growth equation. No less spectacular than the countrys economic growth has been the appreciation of the ruble. Spurred by the vitality of the economy and surging commodities prices, by the end of 2005 the ruble had regained both the exchange value and the purchasing power it had prior to its collapse in 1998. From January through September 2006 it appreciated a further 8.1% against a dollar/euro currency basket. And while rocketing commodities prices are providing an export boomthe fuel sector alone accounts for 65% of the countrys exportsthey are also generating inflation, which has been running at almost 10% a year. Confronting such powerful forces, Russias central bank has to tread a fine line between containing inflation and prompting further currency appreciation.

Natalia Orlova, chief economist at Alfa Bank, says the central bank will probably aim to hold the exchange rate steady at between 26.5 and 27 rubles to the dollar. Whether the bank can do this and not add fuel to inflations fire remains to be seen. Part of the problem is that so many crucial factors are out of its control. Another is that its heavy reliance on commodities means Russias economy is in danger of becoming a one-trick pony. Outside oil, gas, gold and minerals, there arent many industries to support the boom, says Laura Brank, managing partner of Chadbourne & Parkes Moscow legal office. The government is squandering energy revenues, she comments, rather than plowing them back into small-business development, infrastructure, education or pensions.

If oil prices collapse, the consequences for Russia could be dire, analysts warn. Each $1-per-barrel decline in the price of oil costs us $3 billion annually, explains Orlova. If oil falls to $35, it could wipe out Russias trade surpluscurrently projected at $100 billion for 2007. While no one is expecting such a drastic price decline, the fact remains that Russia needs to diversify its income sources.

The growth in foreign direct investment (FDI) in the auto industry is a sign that the country is doing just that. Increasingly, foreign manufacturers, such as Renault, BMW, Chevrolet and Toyota, are setting up facilities that assemble finished vehicles from imported ready-made components. By the end of 2006 over 200,000 foreign-brand cars will be assembled annually in Russia, reports Elena Loss, managing partner of RSM Top-Audit in Moscow.

Underlying demand has encouraged FDI, creating a ready market, but foreign companies are also looking for long-term stabilitysomething that the growing power of the ruble is helping create. The ruble strength encourages direct investment, because direct investors want to be insulated from currency fluctuations, says Kim Iskyan, managing director and co-head of research at MDM Bank. It makes sense to have domestic operations in an attractive market.

The numbers are impressive. Over the first six months of 2006, FDI jumped by almost 43% versus the same period for 2005. The central bank expects net FDI inflow to reach $30 billion for the full-year 2006, although other estimates predict a more modest range of $15 billion to $20 billion. Huge though they are, the FDI figures are still a far cry from Chinas, notes Nikolay Kaschev, head of treasury research at state-owned bank VTB. Chinaenjoys approximately $6 billion worth of FDI inflow per month, he points out.

The scenario is not entirely rosy for FDI, either. Labor cost pressures are making it more expensive for foreigners to operate in Russia if they must foot the wage bill in their own currencies. For those that sell products within Russia, the costs are offset by local sales. As a result, Brank judges it a wash for FDI at this stage. She is also encouraged to see companies signing more supply contracts for up to a year, priced in rubles. A few years back, she says, no one would commit to long-term installments in rubles; instead, dollar amounts would be converted on the day of payment. For longer risks, she reports, parties put hedges in placeand are increasingly likely to use the euro.

Portfolio Investment

Although ruble appreciation has an overall positive impact on foreign direct investment, says Loss, the exchange rate of the Russian ruble has a more direct and much greater effect on foreign investments in Russian securities. As a rule, short-term foreign placements respond readily to currency rate dynamics. Debt securities have been the most popular ruble play. The debt market grew by 80% in 2005 and by a further 52% in nine months of 2006, reaching outstanding nominal worth of $27 billion, says Kaschev.

The abolition on July 1 of some of the currency controls established to combat inflation will further boost growth in the securities market. Previously, foreign investors who wanted to buy Russian regional, municipal and treasury bonds were obliged to earmark funds in special ruble accounts; equity purchasers also had to first deposit money in separate accounts. The OECD welcomed the move toward convertibility but added, however, that other measures are still needed, such as adequate reporting on transactions and more robust, prudential oversight of institutions.

Investors still have to be extremely choosy with Russian securities, though, as the impact of currency appreciation varies wildly from company to company. Changes in the bottom line depend on whether revenues are in rubles or foreign currencies and whether costs are tallied in rubles, dollars or euros. Those costs include capital, so firms that are borrowing in dollars can also benefit from the mismatch. Companies with both revenues and costs in rubles are in an ambiguous situation, says Roland Nash, head of research and chief strategist at Renaissance Capital.

Some sectors must compete with imports, too, which becomes more difficult as the ruble climbs. Fortunately for them, the euro has been rising, too. Products from euroland account for more than 50% of Russias imports, and they are becoming more expensive, giving Russian products an advantage on the domestic market, says Peter Westin, chief economist at MDM.

While giant companies juggle their currency positions, consumers feel better about the money in their pockets. In the past, they would immediately convert their rubles to dollars, and Russians often joked that the dollar was their true currency. But pity the expats, who are paid in dollars. For them, Moscow has become one of the most expensive cities on earth to live.

Vanessa Drucke