The Russians are booming

C&I Issue 14, 2008

Business is booming in Russia. Since the collapse of the Soviet Union in 1991, increasing consumer power and high oil prices mean industries like chemicals and pharmaceuticals as well as more established sectors like nuclear energy are all growing rapidly. Russia seems an obvious choice for investment by companies wanting exposure in a fast growing economy. However, inconsistently applied legislation coupled with a culture of corruption and bribery are thwarting investments in Russia and leaving the country lagging the three other largest emerging economies. Most recently, there have been reports that employees of BP-TNK, BP’s Russian venture, are being subjected to ‘orchestrated and choreographed’ attempts to oust them from the country and the company.

Climbing up the attractiveness ladder
Russia is a growth area for industry. The country has made notable progress in attracting investor interest over the past two years – Russia scored this year’s sharpest climb up the attractiveness ladder (up from 5% in 2006 to a 21% rating), according to Ernst & Young’s European attractiveness survey. The ranking reflects a country’s perceived attractiveness by foreign investors and the reality of foreign direct investment, based on E&Y’s European Investment Monitor.

‘Russia offers a promising macroeconomic outlook on the basis of accelerating growth, sustainable twin (fiscal and current account) surplus positions, accumulation of massive international financial assets, and a vast supply of hydrocarbon resources,’ says Kevin Swift, chief economist and managing director of the American Chemistry Council (ACC). Moreover, the economy is in an excellent position to maintain a robust pace of expansion: Investor confidence is increasing and oil prices are high, says Swift. In the first quarter of 2008, natural gas prices averaged $2.10/m British Thermal Units (BTUs) in Russia, compared with $10.15/m BTUs in Germany, $10.75 in Belgium and $10.95 in the UK, according to Swift.

As a result, business is booming. Take chemicals, for example. Russia’s chemical industry output has grown 25.3% between 2002 and 2007 (Figure 1). It grew 5.7% in 2007 and the value of Russia’s chemical industry shipments (equivalent to turnover) was $63.0 bn, according to ACC data. ‘Russia’s demand for chemistry was so strong that the nation is now a net importer of chemistry,’ says Swift.

This alone creates multitude opportunities for Western companies in several related industries, such as agriculture and consumer products (Figure 1).

No Russian chemicals company is a global leader in any segment. ‘Given that they generally only serve the domestic market, none are of sufficient scale to appear on the lists of global players,’ says Constantine Biller, chemical industry analyst at Clearwater Corporate Finance. But, he says, ‘I’m sure this will change over time as they develop an interest in overseas expansion.’

However, Russian companies do operate some important R&D facilities, although many are still linked with state-run scientific institutes, says Biller. For example, Norilsk Nickel MMC, the mining to chemicals group, has significant R&D capabilities. Overseas chemicals groups such as Dow and DuPont also have R&D facilities in Russia, adds Biller.

Pharmaceutical opportunities
The deteriorating health of the nation since the fall of the Soviet Union means that healthcare is another opportunity for Western companies. Healthcare has moved up the political agenda and is transitioning from the former Soviet centralised system to an insurance-based one, according to IMS Health. The current healthcare system, which is ranked 130 by the World Health Organisation, is fragmented, complex and inefficient. But government funding of RUB58bn ($2.1bn) has been allocated to address some of its shortfalls, representing the first significant injection of extra funding for the sector, according to IMS Health. Government funds are projected to reach RUB1450bn (62bn) by 2010.

Areas that should benefit from increased funding include, for example, increased immunisation programmes and improved hepatitis C treatment. ‘A deal between GSK and the government in September 2006 to supply antiretroviral drugs at discounted prices represented the first direct purchase of HIV/AIDS medicines in Russia and could set the trend for other such deals,’ according to IMS Health.

Meanwhile, total pharmaceutical sales (excluding those dispersed under the insurance system) grew 21.3% to RUB128.7bn, and retail pharmacy sales grew 19.9% to RUB97.7bn in 2006, compared with a 9.3% increase in 2005, according to IMS Health figures. Sanofi-aventis has been the largest player in the commercial market for the past five years but its position is being challenged by Novartis. AstraZeneca, Roche and Bayer are among those that recorded strong sales in 2006. And other foreign manufacturers, such as Wyeth, are positioning themselves to penetrate the expected expansion of the non-prescription (OTC) drug market, according to IMS Health.

In addition, an increasing number of pharmaceutical companies and contract research organisations, attracted by low costs and fast recruitment, are conducting clinical trials in Russia, the market for which is expanding at average pace of 20% year on year, according to consulting firm PMR. Monika Stefanczyk, co-author of the PMR report ‘Clinical trials in Russia 2008’, says some companies are also counting on the simplification of legal regulations affecting clinical trials and the implementation of international standards.

Downside to investment
Despite the boom in the country, however, there are several downsides to investing in Russian-based projects.

The track record of, for example, many of the chemical companies investing in Russia has not been great, says Biller. There have been very few acquisitions and very few western companies in Russia.

One problem is legislation – or rather the lack of universal/uniform implementation of legislation. While there are regulations covering monopolies, corporate law, employment, tax, and accounting, there doesn’t seem to be common adoption of regulations, explains Biller. With no timetables and the application of regulations varying from case to case, companies feel they are constantly jumping through hoops and get very frustrated. ‘Arguably, that’s why Russia could be left behind,’ he says.

Moreover, much of the time companies are expected to provide backhanded payments to smooth the path of business, says one unnamed analyst.

The result is that Russia is lagging behind other BRIC countries – Brazil, India, and China – in terms of investment. There are dozens or hundreds more investments from western companies in China – followed by India and Brazil – than in Russia, says Biller.

Indeed, China has just knocked Western Europe from E&Y’s top spot for the country perceived to be the most attractive for foreign direct investment. China, which started the process a lot earlier than Russia, has over time changed its policies regarding foreign ownership and adopted western practices, explains Biller.

Chemical companies that have had some success working in Russia include Unilever, Bayer and Solvay – all heavyweights with the critical mass and scale that enable them to stick it out. Oil and gas companies – some of the largest firms in world – have had most success, but have also had their fingers burnt.

Meanwhile, many companies are keen to invest in Russia but are waiting for a smoother, more certain business climate where legislation is implemented uniformly. Biller says it will take time but suggests that change will come when Russians, eager to spend their cash outside of the country, experience investing outside Russia. ‘They will find out the way it’s done,’ he says.

Many of the industries and projects set up in Russia are tainted with allegations of corruption.
• Russian oil and gas companies are notoriously opaque. The state-run gas monopoly, Gazprom, for example, has a reputation for being corrupt and secretive and has been at the centre of several international disputes over gas supply (C&I, 2007, 10, 5). Shell, Mitsui and Mitsubishi all halved their stake in the Sakhalin-2 natural gas project, ceding control to Gazprom – a move widely seen as a cave-in to Russian government pressure (C&I 2007, 15, 5).

• Some analysts expect Rosatom, the state company that runs the Russian nuclear complex, to go the same way.

• And there are reports that Russia’s former president, Vladimir Putin,  has ambitions to exert control over Rosnanotech, the multi-billion pound state nanotechnology enterprise created last year.

• According to IMS Health, healthcare reform in Russia will be undermined by endemic corruption and bribery. Funding for the country’s medical insurance programme has already failed to meet costs and its management has been called into question. Claims of misappropriation of funds and bribery from pharmaceutical distributors to gain business through the programme are under investigation.

Become an SCI Member to receive benefits and discounts

Join SCI