Mixed messages for investors as Russia goes 'from horrible to bad'

The risks are enormous, but so are the potential returns. As oil giants get their fingers burnt, Tim Webb and Abigail Townsend see how Western companies can chart a path through corruption and political uncertainty
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The Independent Online

On Monday, delegates gathered in Westminster for the annual jamboree for Russian business. As usual, it was a slightly chaotic affair at the Russian Economic Forum, with a serious amount of networking going on over brandies in one of the bar areas of the conference centre.

On Monday, delegates gathered in Westminster for the annual jamboree for Russian business. As usual, it was a slightly chaotic affair at the Russian Economic Forum, with a serious amount of networking going on over brandies in one of the bar areas of the conference centre.

The tone was remarkably upbeat, in contrast to gloomy reports in the media, which have focused on the $1bn (£530m) back-taxes bill for the oil joint venture TNK-BP. This will be no doubt be high on the agenda when BP chief executive Lord Browne meets President Putin this week. The fate of the biggest victim of retrospective tax bills, the fallen Russian oil giant Yukos, will soon be sealed with the sentencing of former chief executive Mikhail Khodorkovsky.

There is still plenty of appetite for investing in Russia because of the potentially high returns. But Charles Hecker, associate director for Russia at Control Risks Group, the business adviser, says Western companies are confused by these mixed messages about the country.

"Some speakers in business conferences come across as extremely enthusiastic and give the impression that the door is wide open," he says. "But if I was a businessman, I would find it hard to reconcile these different signals."

It is his job to evaluate the risk of a proposed business venture, and that varies from sector to sector in such a big country where the rule of law is uneven and the political landscape constantly changes.

"Western businesses have to be very specific about their situation and ask themselves: 'What does this mean for me?'," he says.

Risk is incredibly hard to quantify, and impossible to eliminate. Some Western firms assume that dealing with a far-flung local authority, rather than the central government in Moscow, is easier as it avoids negotiations with the unpredictable Kremlin. But corruption is often more prevalent in local government. While it may be low level, it is a growing problem, particularly for Western businesses, says Mr Hecker. "Problems happen which we do not hear about. Often, negotiating with the mayor's office in Siberia can be very difficult, for example, and far harder than talking to the Kremlin about an asset of national importance. Corruption and bribery are massive problems, even for Russians."

Peter Hambro, chairman of Peter Hambro Mining, jokes that when he first started out 10 years ago in Russia, in the remote Amur region near the Chinese border, he did not have any money so wasn't in a position to pay bribes. But he says the company took the conscious decision early on not to cut its tax bill using perfectly legal tax- saving schemes, as many other companies (domestic and foreign) have done. The chairman of the gold miner says that, as a result, it has earned the goodwill - and protection from bribery and corruption - of local officials.

"We are the third-biggest taxpayer in the Amur region. Tax dollars are more efficient than bribes to get votes for local officials. Our taxes pay for local hospitals and schools, so they're happy. We have a very collaborative relationship with local officials."

He has another tip for wannabe Russia investors: always work with a local company: "Anyone who thinks you can walk into Russia and be a success without being involved with a Russian partner is deluding himself."

It becomes apparent that everyone has a different way of doing things in Russia. There is no "right way". US metals giant Alcoa specifically decided that it did not want a Russian partner when it bought some rolling mills from Rusal, the aluminum company owned by oligarch Oleg Deripaska, last year.

Barbara Jeremiah, executive vice-president of corporate development at Alcoa, who led the 18-month negotiations with the Russians, says: "We felt it was a complicated enough deal to get done without having a partner as well. We are pleased that the Russian government felt comfortable with Alcoa having 100 per cent ownership of the facilities, without a Russian partner. We will learn as we go forward." She adds that if the Russian government issued a retrospective tax bill on the assets, Rusal would be liable. "We think we have fully addressed any tax issue: any prior liability would be directed to them. But you can never be 100 per cent sure."

Each sector has a different kind of risk. There is a large organised crime element in the tobacco and alcohol industries, says Mr Hecker at Control Risks, while Edward Parker, a senior director at credit-rating agency Fitch, warns that the banking sector is vulnerable - which poses a big risk both to the entire Russian economy and Western investors. "There's not a lot of confidence in the banking sector. There's not a great deal of transparency about the ownership or financial position, and regulation and supervision is fairly weak. There's also a lot of connected lending, where banks lend to companies connected to their owners."

It is very hard to find Western businesses willing to speak openly about their bad experiences in Russia, but they certainly exist along with the success stories. Either the company has packed up and left Russia, and wants to put the whole sorry episode behind it - or, more commonly, it is still operating in Russia and knows it is being ripped off - even by its partner.

This is a hazard that goes with the territory. Sibir Energy, the UK-listed Russian oil company, had its shares suspended for over six months last year after discovering that a partner - Sibneft, controlled by Chelsea Football Club owner Roman Abramovich - had quietly taken most of its stake in the joint venture. But the company is still expected to make a profit from its other Russian assets, despite an unexpected $100m back-tax bill lodged last week. Chief executive Henry Cameron did not return calls. Since trading resumed in December, Sibir's share price has recovered most of its lost ground.

Those who are prepared to invest in Russia usually accept the risks involved, for the potential returns - high-profile casualties such as Yukos apart - can be seriously high. If you had invested $100 in 1996 in Hermitage Capital - the largest foreign investment fund in Russia with $1.65bn invested in the stock market - it would now be worth $1,116. The chief executive of Hermitage, Bill Browder, says: "The main drawback with Russia is that it has a very weak rule of law. We are constantly being stung. But the low valuations reflect this. The Russian stock market prices in catastrophe. If it doesn't happen, we make lots of money."

He says that Russian stock market valuations have still not recovered to the levels seen prior to the Yukos crisis.

In September 2003, just before Mr Khodorkovsky was arrested, the average share price to earnings ratio was 10.7 times for Russian companies. Now it is 6.6 times, which Mr Browder claims makes it the cheapest market in the world.

"Confidence is only returning slowly," he says, adding that the level of risk has fallen over the past 10 years, though that risk has also become more understated.

"Ten years ago, you thought your shares could be removed from the share register overnight. You did not know if you would own them from one day to the next. Now the risk is more subtle, like with tax liabilities."

His overall assessment on investing in Russia is: "There has been a big transition from horrible to bad." But, as some Western companies have found to their cost, some investments are worse than others.


The pros and cons have been weighed up, the politics assessed and the risks judged worth it. But in which sectors should investors put their money?


Oil is the most popular industry for overseas funds that buy into Russian stocks. The attraction is obvious: resources are vast and global demand booming. "High oil prices, it's as simple as that," says Zsolt Papp, chief economist for emerging markets at ABN Amro. "The other pull is that these companies will increase production over the next few years, and there's a feeling most are undervalued. That's why stock investors are hanging on."

Yet despite the trail blazed by BP, direct foreign investment is uncommon because of the uncertain political attitude towards oligarchs. "You always buy political risk when you invest in Russia, but it's even higher if you're investing in energy," notes Mr Papp.

Other natural resources

Another area of risk, political baggage, and potentially massive rewards, is resources such as metals, minerals and timber. But again, political uncertainty means this is an area favoured by funds rather than direct investors.


The telecoms market is burgeoning and international companies are already moving in. Nordic giant TeliaSonera, for example, owns 44 per cent of mobile phone group MegaFon.

Mobiles are popular targets for foreign cash because of Russia's size and lack of infrastructure. "They are laying cables in heavily populated areas but it will take a long time, so investing in mobiles is the more logical choice," says Mr Papp.

But problems exist: TeliaSonera is in dispute with Russian finance group Alfa about who owns another 25.1 per cent stake in MegaFon - a typical row as players vie for control of customers and each other. Vodafone is understood to be keen on Russia but is steering clear until such issues are resolved.

Consumer goods

"Sausages and salami have improved but cheese is still absolutely tasteless," sighs one visitor to Russia. But an offence to one man's palate is nectar to investors.

Russians have always favoured Western brands as home-grown ones lack quality and range. Changing tastes help: Russia's love affair with vodka is waning as younger generations turn to beer. Scottish & Newcastle has bought Hartwell, which owns 50 per cent of BBH, Russia's leading brewer; Diageo has announced a joint venture with Heineken to brew Guinness in St Petersburg; and Gallaher snapped up tobacco giant Liggett-Ducatt in 2000.


The least politically influenced sector, European retailers are flooding in. Russia is a huge consumer market, home to 150 million people, and empty shelves and food queues are history: retail sales surged 12.1 per cent last year.

Shoppers now have British-owned DIY outlets through Kingfisher, French hypermarkets and even high fashion: Harvey Nichols has announced plans to open in Moscow.

Then there's Ikea. The Swedish chain opened two malls in Moscow, and with Russians desperate for all things flatpack, is planning similar outlets in 10 other cities. And last week Dixons became the latest to venture forth, taking out a $1.9bn (£1bn) option to buy rival Eldorado.

Abigail Townsend