Strategic Sectors Law Update – Third Commission Meeting of 2012

On November 28, 2012, PM Medvedev chaired a session of the Commission on Foreign Investment, the third time the Commission has met this year.

Changes to Russia’s Business Environment

In his prepared remarks, Medvedev noted Russia’s recent improvement in the World Bank’s Doing Business rankings, which evaluate the ease of doing business with respect to several areas (e.g., trading across borders, construction). Russia was ranked 112th out of 185 countries this year, rising from 118th place last year. As Medvedev himself noted, “[i]t’s modest growth, but growth all the same.”

Medvedev highlighted changes to Russia’s tax system, where Russia displayed particularly significant improvement over the past year, moving up 30 spots on this measure alone. Russia also improved modestly in the area of dealing with construction permits, where it has performed remarkably poorly ever since the rankings started keeping track.

Unfortunately, Russia’s rankings fell in the categories for trading across borders and protecting investors. The fall in trading across borders may be a side-effect of changes to the customs code over the past year, and resulting hiccups related to implementation. The negative trend for protecting investors, however, is more concerning especially because this is one of the highest-profile problem areas with Russia’s business environment, both for domestic and foreign investors. Also worth noting is the lack of change in Russia’s ranking for getting electricity, where it ranks at an abysmal 184/185. Russia’s laughably complicated construction and electricity procedures are especially frustrating in light of the frequent accidents related to violations of safety standards. The poor rankings also illustrate that many of the deficiencies of Russia’s business environment are ‘low-hanging fruit’ that can in principle be fixed with minimal legal and regulatory disruption.

Proposed Strategic Sectors Law (SSL) Amendments

After the meeting, FAS Head Igor Artemyev summarized several proposed amendments to the SSL. Specifically, the amendments include the following changes:

  •  Bacteriological Food Products: in the past, there have been some major foreign investments in Russian manufacturers of dairy products (e.g., Coca-Cola purchase of Nidan, Danone purchase of Unimilk). These deals required approval from the Commission because Art. 6.3 of the SSL included “activities connected with the use of infectious disease pathogens” (i.e., including bacteria cultures used in production of dairy products like yogurt). Foreign investors will no longer be required to obtain the Commission’s approval for companies involved in the use of “Third and Fourth hazard category” bacteria (the least dangerous categories).
  • Offshore Rule Expanded to Regions: the recently adopted federal rule – which was a part of the 2011 amendments to the SSL – excludes from the SSL’s scope any foreign investments made by offshore entities (i.e., non-Russian legal entities) that are controlled by “tax residents of the Russian Federation” (TRM’s analysis of this provision, here).
  • 75 Percent Rule: foreign investors already owning 75+ percent of a strategic enterprise will no longer have to apply for approval from the Commission if they wish to increase their stake up to and including 100 percent.
  • Permit Extension: foreign investors that have already been issued a permit (typically with a 2-year term) to invest in a strategic enterprise, may at the end of the term request that the permit be extended from 2 to 5 years without obtaining approval from the Commission (it appears that the extension is requested from and granted by FAS directly).
  • “Coordinated Actions” Principle Eliminated: as the SSL was drafted by FAS – the regulator responsible for enforcing Russian antimonopoly law – it originally contained various references to the principle of “coordinated actions” (согласованные действии), from Art. 8 of the Law on Competition. Coordinated actions are essentially analogous to collusion – e.g., an agreement between one or more companies to set a price floor for goods that they all sell. The confusion arose from Art. 8.8 of the SSL, which required applications for foreign investments to include details on coordinated actions having “substantial influence on the activity of a strategic enterprise.” Also, Art. 13.6 of the SSL permitted FSB investigators to evaluate “coordinated actions” by a foreign investor and third parties, specifically to see whether they are aimed at establishing control over a strategic enterprise. Including these references to coordinated actions implied that control over a strategic enterprise under the SSL could be obtained by a foreign investor acting in a mutually beneficial way with a third party. Naturally, such a principle could lead to absurd results where a Russia co-investor’s ownership would be imputed to the foreign investor simply because the two act in a collaborative manner in relation to the strategic enterprise.

According to Artemyev, the government expects the new SSL amendments to be introduced into the Duma within the next few weeks, and adopted and signed into law within the next six months.

Deals Reviewed at the Commission Meeting (as of publication)

  • Pacific Andes: at the last meeting in August, the Commission took note of Pacific Andes Int’l Holdings Ltd., a HK/PRC company, which allegedly obtained control over several Russian fishery companies (specifically, those harvesting Pollock). At the August meeting, the Commission instructed unspecified “ministries and governmental agencies” to undertake “certain measures to bring operations of these companies in line with the current law of the Russian Federation.” At the meeting on November 28, the Commission determined that Pacific Andes’ acquisitions were illegal because they were made in noncompliance with the SSL (Pacific Andes did not apply for Commission approval).
  • Telenor-Vimpelcom: the Commission recognized the validity of all deals involving Norwegian telecom Telenor’s acquisition of shares in Russian telecom Vimpelcom. Telenor originally raised its stake in Vimpelcom from 25 percent to 36.6 percent, making it the company’s largest shareholder. It later raised its stake to 39.5 percent through an option with JP Morgan, and then 42.9 percent through an option with Weather Investments. Altimo – the telecom division of Russian conglomerate Alfa Group – complained that Telenor’s exercise of its options violated shareholder agreements, while FAS went to court claiming that the share purchases resulted in Telenor’s acquisition of control over Vimpelcom, and thus should have been approved by the Commission. The Commission and FAS later conditioned retroactive approval of Telenor’s share purchases on there being parity between the Russian and foreign Vimpelcom shareholders. In November 2012, Altimo purchased an additional 5.95 percent of Vimpelcom shares, bringing its total to 47.85 percent, at which point the FAS withdrew its claims against Telenor.
  • Gharysh Sapary: the Commission approved the acquisition of 23 percent of Kosmotras (Космотрас) by a Kazakhstan state-owned company, Gharysh Sapary (Гарыш Сапары), which is working on a joint Russian-Kazakh-Ukrainian project, Dnepr (Днепр).
  • Russian Sea: the Commission approved the acquisition of OAO “Arkhangelsky Tralovy Flot” (ATF) (Архангельский траловый флот) by OOO “Russian Fishing Company” (Русская рыбная компания), which is a subsidiary of Group of Companies “Russian Sea” (ГК “Русское море”). The deal, which came about through a privatization auction, was approved because the shareholders of Russian Fishing Company are Russian citizens.

As always, we end the post with some video from the meeting:

Posted in Business and Economy, Dmitry Medvedev, duma, Economic development, FAS, federal laws, Foreign direct investment, foreign investment, Government of Russia, Law, legal update, legislation, offshore, Russian economy, strategic industries

The Engineer’s Plot

Apologies for my absence from blogging over the past few months. I’ve been traveling and generally busy with work. I promise to provide some update on the strategic sectors law and Russia’s anticorruption efforts soon. In the meantime, here is a classic – the episode ‘The Engineer’s Plot’ from Adam Curtis’ documentary, Pandora’s Box. It’s all about the strange results of the planned economy under the Soviet Union (spoiler alert: Magnitogorsk was modeled after Gary, Indiana).

Video | Posted on by

Strategic Sectors Law Update – Second Commission Meeting of 2012

On July 30, 2012, PM Medvedev chaired a session of the Commission on Foreign Investment. This is the second Commission meeting of 2012, but the first chaired by Medvedev. In his remarks, Medvedev largely rehashed Putin’s presentation at his last Commission meeting, specifically describing the general situation of foreign investment in Russia.

Below is a list of deals that, according to public sources, were considered at the meeting:

  • Astrakhan, Chita, and Tomsk Airports - the Commission approved the acquisition of shares in OOO “Aeroport Tomsk”, OAO “Aeroport Chita”, and OAO “Aeroport Astrakhan by T.S. Trans Siberia Co. Ltd. (Cyprus),which is believed to be affiliated with Roman Trotsenko, founder of Aeon Corporation and former President of state-owned United Shipbuilding Corporation (“USC”). Aeon Corporation’s airport holdings are in turn owned and managed by Novaport. T.S. Trans Siberia won an auction to purchase a majority of the Astrakhan airport held by the Federal Property Management Agency (Rosimuschestvo) late last year (it’s unclear whether similar auctions were held for the other airports).  The interesting thing about T.S. Trans Siberia is that it is not entirely clear who owns it. According to Izvestia, in the Cypriot corporate registry, two owners are listed: Golburn Trading Ltd. and Mittelmeer Nominees Ltd. The actual owner of Golburn is Anatoly Matveenko, about whom little is known aside from his frequent affiliations with companies owned or controlled by Roman Trotsenko or Trotsenko family members. Mittelmeer Nominees – the other 50 percent owner of T.S. Trans Siberia – is reportedly a nominal owner. The real owner is in fact another Cyprus company – Legniton Ltd., which is apparently owned by Saut Mynbaev, the Minister of Oil and Gas of Kazakhstan, and two other Kazakh businessmen. These individuals also allegedly own Meridian Capital, which in turn owns 50 percent of Novaport (the other 50 percent reportedly controlled by Trotsenko). Formally, Novaport has one owner: yet another Cyprus company, M.M. Airport Management Company Ltd. Trotsenko, for his part, abruptly resigned from USC last month, apparently resulting from a dispute with Vladimir Lisin, who replaced Igor Sechin on the USC board. Trotsenko will reportedly move into a new position as advisor to Sechin on the Rosneft board.
  • TNK-BP Purchase of Refueling Complex at Sheremetyevo - the Commission approved LLC TNK-Sheremetyevo – a subsidiary of TNK-BP Holing - acquiring a 74.9% stake in ZAO “Toplivozapravochny Kompleks Sheremetyevo,” a jet fuel storage and refueling operator for $200mln.
  • Telenor Dispute - FAS reported on its attempts to negotiate with the shareholders of Vimpelcom on resolving violations of the Strategic Sectors Law. FAS reportedly agreed to withdraw claims that the Norwegian Telenor illegally increased its stake in Vimpelcom under one condition: a Russian citizen must head Vimpelcom. So far, this offer does not seem to have settled the dispute.
  • Chinese Fishing Scofflaws - the Commission took note of Pacific Andes Int’l Holdings Ltd., a HK/PRC company, which has allegedly obtained control over several Russian fishery companies (specifically, those harvesting Pollock). At the meeting, the Commission instructed unspecified “ministries and governmental agencies” to undertake “certain measures to bring operations of these companies in line with the current law of the Russian Federation.”
  • Iranian Sanctions Evaders - the Commission also reviewed an issue involving Iranian companies that reportedly established control of OAO “Astrakhan Port,” in violation of sanctions imposed on Iran. The Commission stated that documents are being prepared to file a lawsuit in order to hold the transactions void.
  • Helivert-AgustaWestland Deal - for some reason, the Helivert joint venture was mentioned at this Commission meeting, even though it was already approved at the previous meeting.

Comments

First, this being PM Medvedev’s first Commission meeting, the amount of bad news dealt with at the meeting is significant. It’s almost as if they decided to discuss the Helivert deal – which was approved at the last meeting – in order to brighten up the mood. My personal guess is that Putin left all of the unsavory issues for Medvedev to deal with.

Second, it is worth noting that not a single “genuine” foreign direct investment was approved/announced at the meeting – if memory serves, Putin always had at least one deal to hold up as an example of the Strategic Sectors Law facilitating investment into Russia.

Third, the airports deal involving the multitude of Cypriot companies is yet another shady deal involving offshore companies controlled by Russian government officials/oligarchs. The structure of these deals, which often involve the sale of government shares, suggest that privatization is alive and well in Putin’s Russia, and is just as non-transparent as in the Yeltsin era.

As always, we end with some video from the meeting:

Posted in Business and Economy, Dmitry Medvedev, economics, FAS, fish, Foreign direct investment, foreign investment, goskorporatsii, infrastructure, Law, legal update, Medvedev, offshore, oligarchs, russia, Russian economy, state corporations, strategic industries, Vedomosti

Legal Update – New Law on “Foreign Agent” NGOs

On July 21, Pres. Putin signed the much-discussed amendments to the Law on Nongovernmental Organizations (or, Noncommercial Organizations as their called in Russian). Given the back-drop of protests and other opposition activity, the new law generated more interest than usual, both in Russia and abroad. Indeed, both Russian activists and the U.S. State Department criticized the law, and many Russian NGOs have pledged non-compliance with its provisions. The NGO law has been in the works for a long time, with Pres. Putin warning NGOs from receiving foreign funds as early as 2005. At that time, Putin justified his position by stating, “He who pays the piper calls the tune” (Кто платит, тот и заказывает музыку). Coincidentally, this same phrase was invoked by Sen. Konstantin Tsybko and again by Putin, during consideration of the current NGO law (as well as by Putin spokesman Dmitry Peskov during a New Yorker interview last year, regarding state funding of television stations). Vedomosti Opinion editor Maxim Trudolyubov wrote an interesting piece on the “piper principle” that infuses Putin’s thinking.

What is in the NGO Law

Most important, the NGO law is not itself a stand-alone law, but rather a number of amendments to existing legislation. The NGO law is thus organized into four substantive sections, each amending a different, existing Russian law. Below is a summary of the amendments, broken down by the existing laws they amend:

Article 1 – Amendments to the Law “On Public Associations”

  • New Registration Requirements - in order to obtain legal status, a public associations must register with the Russian government. This registration process now includes a requirement that the public association declare its inclusion on the list of NGOs serving as a “foreign agent.” A public association serves as a “foreign agent” if it receives money or other property from foreign sources and engages in political activities (more on this in the “On Noncommercial Organizations” section below). A public association must also inform the federal registration body, in a form and time determined by that body, about the volume of money or property received from foreign sources, the purposes for which this money/property was intended, and the actual uses of the money/property.
  •  Limitation on Activities Prior to Registration - public associations serving as a “foreign agent” and participating in political activities must register prior to engaging in said political activity. Informational materials (i.e., on size/sources/purposes/expenditures of funds) must be provided on a quarterly basis.
  • Money Laundering / Terrorism Hook – the NGO law adds a requirement that the federal agency responsible for monitoring money laundering the financing of terrorism in Russia inform the federal registration body when a public association is in non-compliance with Russian law, either at the federal registration body’s request or on its own initiative.

Article 2 – Amendments to the Law “On Noncommercial Organizations”

  • “Foreign Agent” Provision – the heart of the law. This new provision defines and NGO as “serving as a foreign agent” when it (1) receives money or property from foreign governments, international organizations (e.g., UN, World Bank), foreign organizations, foreign citizens, stateless individuals, or Russian citizens receiving money or property from the aforementioned sources, and (2) engages in political activities (aside from political parties). An NGO is deemed to be engaged in political activities when, regardless of the goals stated in its charter documents, the NGO organizes and participates in political acts, aimed at influencing decision-making by public authorities, intended to change government policy, or intended to shape public opinion with respect to government decision-making or policy. Political activity does NOT include activity in the following fields: science, culture, art, health, social support, defense of motherhood/children, support for the disabled, environmental protection, philanthropy, and volunteerism.
  • Registration Requirement – similar to the public association requirements, NGOs serving as “foreign agents” must register as such.
  • Accounting Provisions – the NGO law subjects NGOs serving as “foreign agents” to mandatory statutory audits. Such NGOs also must submit a variety of documents and information to the government, including: sources, purposes, and actual uses of foreign money/property (quarterly basis); the composition of board/management bodies of the NGO (every 6 months); and an auditor’s report (yearly). The state entity to which these documents are provided may publish this information on its website or provide them to the media.
  • Audit Provisions – the NGO law also provides for planned and unplanned audits of NGOs serving as “foreign agents.” Planned audits may not occur more than once a year.  Unplanned audits, however, can be conducted on the basis of one of several circumstances: (1) expiration of the period within which an NGO is supposed to correct an alleged violation; (2) receipt of information from applications/declarations by citizens or mass media indicating that a “foreign agent” NGO is “extremist”; (3) receipt of information from government agencies that a “foreign agent” NGO is violating Russian law; or (4) an order issued by the head of the state authority responsible for overseeing “foreign agent” NGOs.
  • Suspension of Activity – if a “foreign agent” NGO fails to register with the state authority, it is prohibited from participating in mass/public rallies and from using bank deposits except to pay for day-to-day expenses and taxes.
  • Money Laundering / Terrorism Hook – same as section above
  • Public Warning – NGOs serving as “foreign agents” must include a warning label stating as much on any materials distributed through the mass media (including the internet).
  • Religious Organization Exemption – the NGO law explicitly exempts religious organizations “registered in the established legal framework” from the new “foreign agent” provision
  • State Corporation Exemption - the NGO law explicitly exempts from the “foreign agent” provision: state corporations (государственные корпорации), government companies (государственные компании), and NGOs created by them, and government and municipal institutions (государственные и муниципальные учреждения).
  • Business Groups Exemption – the NGO law explicitly exempts employer associations (объединения рабодателей) and chambers of commerce (торгово-промышленные палаты) from the “foreign agent” provision

Article 3 – Amendments to the Criminal Code of the Russian Federation

  • Illegitimate NGO Creation - a new criminal violation, for creating an NGO that threatens violence to or the health of citizens, carries with it a fine of up to RUR 300k or 4 years imprisonment. Creating an NGO that urges citizens to not perform their civic duties (гражданские обязанности) or other illegal acts carries a fine of RUR 200k or three years imprisonment. Participating in the activities of either of the previous two types of NGOs carries a fine of RUR 120k or 2 years imprisonment.
  • Willful Refusal to Comply with “Foreign Agent” Requirements – willfully refusing to comply with the requirements of the “foreign agent” provisions of the NGO law carry fines of up to RUR 300k or imprisonment or corrective labor (исправительная работа) of up to two years.

Article 4 – Amendments to the Law “On Combating Money Laundering and the Financing of Terrorism”

  • Obligatory Monitoring of Foreign Donations – foreign donations exceeding RUR 200k (around $6k) are now subject to obligatory monitoring.

Analysis

Based on the text of the NGO law, it is difficult to disagree with the law’s critics, who claim that it amounts to a wholesale attack on Russian civil society. The Bellona Foundation – an Environmental NGO based in Norway – wrote a detailed post on how the NGO law would affect organizations like itself, and some useful analysis as well. Other useful English-language analyses can be found here and here

Expansive Coverage

One point that stands out is the broad range of activities to which the NGO law could apply because of the expansive definition of “political activity.” Moreover, the NGO law contains an inherent contradiction in that it applies to NGOs regardless of their stated goals, while creating a categorical exception for a host of organizations of a religious, business, scientific, etc., nature. Thus, it is not clear whether a religious organization, by definition, is not subject to the “foreign agent” provision, or if it could be subject to that provision if it is found to be a religious organization that also happens to engage in political activity. My guess is that the latter applies.

Exceptional Exceptions

The exceptions themselves are fascinating and perhaps reveal something about the mindset of the Russian political elite. Aside from exempting state corporations – wouldn’t knowing the foreign sources of their funding serve the public interest? – the choice of expressly exempting religious organizations and business lobby groups is interesting. First, it is notable that the Russian orthodox church is one of the most trusted institutions in Russian society, and likely receives significant funding from abroad. Second, Russia is still trying to prove to foreign investors that it is a great place to put their money. Thus, the NGO law’s explicit exemption of these groups from the “foreign agent” provision seems like a “divide and conquer” strategy aimed at nudging these groups towards siding with the current regime over the opposition. But, as noted above, the NGO law still likely applies to religious and business groups engaged in “political activities,” making this a Faustian bargain indeed.

U.S. Law Copy?

Unsurprisingly, the negative reaction to the NGO law has generated replies that the law is an “exact copy” of the U.S. Foreign Agents Registration Act (FARA) (this is a good example of Russian “whataboutism“) . The Russian Legal Information Agency (RAPSI) already pointed out some differences between the two laws. Perhaps the most important distinction, however, is to which types of political activity the two laws apply. Whereas the Russian NGO law applies to political activity generally, so long as the NGO receives foreign funding, FARA applies to “political activities for or in the interests of … [a] foreign principal.” In other words, the U.S. government must demonstrate that the person or organization receiving the foreign funding is engaging in political activities on behalf of the source of that foreign funding in order for FARA to apply. One would assume that the Russian government would wholeheartedly accept a similar foreign principal-local agent nexus requirement, given that it believes opposition NGOs are acting on behalf of the State Department and other foreign interests.

“Piper Principle” Policy – Recipe for Failure

Perhaps the most telling fact about the law is the conspiratorial worldview it reflects, in which any foreign funding – even from, e.g., the UN – is equated with nefarious purposes. To be sure, Russia should have – and does already have – laws aimed at preventing improper influence on its government, including from abroad. But there is no evidence that (1) NGOs receiving foreign funding are systematically doing the bidding of foreign masters or (2) that the law could not be narrowly tailored to address only instances where an NGO acts on behalf of a foreign principal. Given the context in which it was adopted, it is more likely that the NGO law is aimed at deligitimizing legitimate critiques of Putin and the power vertical. The easiest way to accomplish this is through bureaucratic harassment and using the “foreign” label, which is actually quite popular with most Russians.

The problem with this strategy is that Russia cannot – to borrow another folk saying – have its cake and eat it too. As Russia’s leaders know, the modernization of its economy requires more interactions abroad, not less – both in terms of trade and investment. By fueling jingoistic attitudes to serve short-term political goals, Russia’s leaders will undermine the country’s long-term development goals.

Posted in Law, legal update, legislation, NGOs, russia, state corporations | 4 Comments

Strategic Sectors Law Update – First Commission Meeting of 2012

Last month, then-PM Vladimir Putin chaired his final meeting of the Commission on Foreign Investment Oversight (at least until 2024 barring any change to the makeup of the Commission). Indeed, the Commission meeting was one of the final significant acts by PM Putin, at least judging by his public calendar. There is a certain degree of historical symmetry to timing of the meeting: then-Pres. Putin signed the Strategic Sectors Law in the last three days of his presidency in May 2008. Perhaps because this was his final meeting – or perhaps due to the lack of applications to discuss – Putin opened the meeting with some general remarks on the application of the law over the past four years:

“As a matter of fact, a new mechanism has been created and tested for attracting foreign investment and granting foreign companies access to operate in strategic sectors of the Russian economy. Since it was formed four years ago, the commission has considered more than 140 applications from foreign companies and investors. An overwhelming majority of those applications has been approved.”

In some ways, Putin’s observations are correct. The SSL did fill a legal/regulatory void that existed prior to its enactment, which meant that ‘strategic’ investments were subjected to informal negotiations and political interference (the Siemens-Power Machines case being the most famous example). On the other hand, Putin’s comments are premised on a belief that the list of strategic industries is as narrow as possible. Surely more foreign companies would invest in Russia’s media and fishing industries if they were not deemed ‘strategic’. Moreover, based on media reports of Commission meetings, we know that many – if not most – of the applications reviewed by the Commission have in fact been submitted by offshore entities controlled by Russian oligarchs (including Putin friends Timchenko et al). Thus, to say that the SSL is a mechanism for attracting foreign investment is a bit of a stretch, and Russia still has a lot of ground to cover in improving its investment climate.

Some other interesting statistics on the Commission’s work over the past four years:

  • 140 applications have been considered by the Commission
  • 132 applications received preliminary approvals, 26 included preliminary obligations
  • 8 applications were denied, and 26 applications were abandoned by the applicants
  • 38% of applications related to the extractive industries sector
  • 21% of applications related to companies with encryption licenses
  • 11% of applications related to natural monopolies
  • 10% of applications related to companies that work with infectious agents
  • 9% of applications related to media companies
  • 6% of applications related to companies active in the defense sector

Applications Reviewed at the Meeting

Below are several of the deals that have been publicly reported so far.

  • Changi Airport Group (CAG) - the Commission approved the Singaporean CAG’s acquisition of 30 percent of the shares of Sochi International Airport (Международный Аэропорт Сочи), Krasnodar International Airport (Международный Аэропорт Краснодар), and Anapa Airport (Аэропорт Анапа) from Oleg Deripaska’s holding company, Basic Element (Базовой Элемент). Interestingly, the approval was subject to several obligations on the part of CAG to maintain the secrecy of certain airport operations and to immediately comply with any orders in the event martial law is declared. Indeed, the Russian Ministry of Defense came out in opposition to CAG’s acquisition of shares in the Sochi and Anapa airports because they are used for defense purposes, in addition to civil aviation.
  • AgustaWestlandthe Commission approved AgustaWestland’s (Italy) acquisition of 50 percent of the shares of Helivert (Хеливерт), a Russian helicopter company. The purpose of the deal is to form a joint venture for the production of AW139 civilian helicopters in Podmoskovye, Russia.
  • Othersthe Commission also reportedly approved Norilsk Nickel’s acquisition of Taymyr Gaz (Таймыргаз) and “a number of deals by TNK-BP”, although the details of these transactions are not available.
More recently, the Russian government announced plans to include internet companies (e.g., Yandex) in the list of ‘strategic’ companies, thereby requiring government approval of acquisitions of shares in those companies by foreigners. Naturally, such a move will not be not only draw the ire of foreign investors but also raise eyebrows considering the role the internet has played in recent opposition protests (not to mention that it is coinciding with a movement among like-minded countries to ‘regulate’ the internet via a UN entity).
As always, we end the post with VVP’s opening remarks to the Commission meeting:

Update: as expected, PM Medvedev will chair the Commission going forward, according to Order No. 888-r issued today. The members of the Commission will be as follows (new members in bold):

  • PM Dmitry Medvedev (Chairman of Commission)
  • First Dep. PM Igor Shuvalov (Dep. Chairman of Commission)
  • Igor Artemyev, Head of FAS (Secretary of Commission)
  • Andrey Belousov, Minister of Economic Development
  • Alexander Bortnikov, Head of FSB
  • Arkady Dvorkovich, Dep. PM
  • Sergey Donskoy, Minister of Natural Resources
  • Sergey Kiriyenko, General Director of Rosatom
  • Alexander Konovalov, Minister of Justice
  • Denis Manturov, Minister of Industry and Trade
  • Nikolai Nikiforov, Minister of Communications
  • Alexander Novak, Minister of Energy (previously on Commission as Dep. Min. of Finance)
  • Vladimir Popovkin, Head of Roskosmos
  • Dmitry Rogozin, Dep. PM
  • Vladimir Selin, Head of Federal Service for Technical and Export Control
  • Anatoly Serdyukov, Minister of Defense
  • Anton Siluanov, Minister of Finance
  • Maxim Sokolov, Minister of Transportation
  • Vladislav Surkov, Dep. PM

I don’t recommend reading too much into this, but it’s worth pointing out that the new members of the Commission are 9 out of the 19 (i.e., not a majority). Also, there are now 19 members of the Commission, versus 18 under PM Putin. This is accounted for by the addition of Maxim Sokolov, Minister of Transportation, to the list. All things considered, the new members belong to the vaguely-defined ‘pro-investment’ crowd, notably Dvorkovich and Siluanov.

Posted in foreign investment, Medvedev, Putin, russia, strategic industries | 2 Comments

Russian Business Environment Update – Part I

Economic Fundamentals

Economic indicators over the past year were mixed, although a consensus view appears to be forming that they were a net negative and, notably, underscored the long-run structural deficiencies in Russia’s economic development model rather than short-term risks. The cementing of this view gained traction in January, when Fitch cut Russia’s outlook from positive to stable. In April, Fitch’s analysis was apparently vindicated by the announcement that Russia was cutting its 2012 GDP growth forecast to 3.4% (compared to 4.3% in 2011).

In March, Financial Times published an in-depth analysis of Russia’s economic situation, finding that the country will likely begin running twin deficits (i.e., budget and current account deficits) within the next few years. The prospect of becoming a twin deficit country would be particularly threatening to Russia, as such deficits are typically financed by attracting capital from abroad (something at which Russia does not excel).

Also in March, the World Bank released its Russian Economic Report, which noted that, despite recovering GDP growth to near-pre-crisis levels, most of Russia’s recent economic strength was due to the recent surge in oil prices. Moreover, Russia’s post-crisis recovery has been weak compared to other economies. The 2011 OECD Economic Survey of the Russian Federation concluded that a primary source of Russia’s weakness remains the wide gap in the business climate in Russia vs. OECD countries. And rather than facing its dependence on fossil fuels and unattractive business climate, observers argue that the Russian leadership is fixated on short-term solutions, such as retooling the tax system to target gas producers rather than oil producers.

The 2012-14 Forecast for Russia by the Bank of Finland Institute for Economies in Transition similarly anticipates weak GDP growth over the next several years (regardless of unusually high oil prices). BOFIT highlighted that, despite the oil price growth from early 2009 -11, Russia still experienced net capital outflows in 2011. In addition, fixed capital investment growth remains tepid even now that capacity utilization is back to pre-crisis levels.

Investment – Russian, Foreign, or None of the Above? 

The surge in domestic capital outflows - i.e., Russians moving money out of Russia – suggests that local investors and business owners are not up to the task of making the investments needed to modernize the Russian economy. The locals’ equivocal stance on keeping their money in-country and the “twin-deficit” specter noted above mean that Russia’s only viable modernization strategy relies heavily on “benevolent” foreign investment. Indeed, while Russian businesses are free to take all “low-hanging fruits” afforded by the Russian economy and then ship profits abroad, the Russian government wants foreign investment only if it promotes its modernization agenda (see, Skolkovo). PM Putin admitted as much the other day when discussing the development of the oil industry on the arctic shelf, saying:

We hope that major global corporations will be our partners in implementing shelf projects. I’d like to say that I have already asked government members to think of ways of making invitations to these projects more effective, and making use of the opportunities of strictly Russian companies. Of course, our domestic companies will have to work on certain terms – they will have to attract the necessary funds and technology rather than simply trading their right to take part in these projects.      

What Putin is referring to are schemes in which a Russian company wins the exploration or drilling rights to a given deposit or field during a competitive bidding process, and then turns around and sells the rights at a mark-up to a foreign company that actually intends to develop the field. It was Putin’s Strategic Sectors Law that severely limited the ability of foreign companies from participating in Russia’s extractive sectors, short of playing a minority role in a joint venture with Gazprom or Rosneft. Ironically, BP – which has the most substantial presence in Russia via its TNK-BP – was unsuccessful in forming such a venture with Rosneft precisely because of its ties to Russia (i.e., TNK owners opposed it).

It’s unclear whether Putin’s change of heart will reassure foreign investors. And unfortunately, similar “business climate” risks in other Russian sectors – which are far less profitable than oil/gas – have an even greater cautionary effect on foreign companies. Statistics on FDI seem to evidence the hesitancy of foreign investors to “commit” to Russia.  Although all forms of foreign investment inflows fell dramatically in 2008-09 due to the crisis, FDI inflows peaked in 2007 (at $27 bln), with no growth between 2007-08, and then plummeted 44% between 2008-09.

The good news is that growth of FDI inflows was positive in 2011 for the first time since 2007. The bad news is that the aggregate total is still only around 2/3 of the 2007 number, and this slow recovery in FDI stands in contrast to a rapid – almost bubble-like – increase in “other foreign investment.” To the extent the “other” category consists of genuine foreign investment (vs. repatriated capital), it is typically in the form of short-term debt issued to large enterprises with the lender poised to withdraw its money at the first sign of trouble. It was the foreign “portfolio” and “other” investors who led the charge out of Russia following the war with Georgia, culminating in panic sales after the Lehman collapse. In other words, this type of foreign investment will almost certainly not stimulate the modernization of the Russian economy, and may in fact have a net negative effect. Most important, Russia’s FDI inflows as a % of GDP are much too low to sustain the sort of extreme makeover that the Kremlin anticipates (see graph below).

Russia – the Ideal Investment Destination?

One counterintuitive yet compelling conclusion is that the problems facing Russia described above would make it the most attractive investment destination among its fellow BRICs. For example, in addition to the weakening growth in China, 2010-11 was the year that everyone figured out that (i) China doesn’t want/plan to make clothes, toys, and other low-cost consumer goods forever, and (ii) Chinese enterprises have been engaging in massive theft of their Western “partners’” trade secrets and intellectual property, with the goal of replicating entire developed industries, but without the political or social shocks that would likely accompany the organic development of such industries (see this excellent BusinessWeek feature on one companies travails). As for India, it is clear that its impressive growth is largely a function of starting from such a low base, and it’s strange to put a country with 42% poverty rate and 75% literacy in the same group as Russia, China, and Brazil.

Most important, the global anticorruption fervor shined a light on corruption in Brazil, China, and India. As people from or having lived/worked in these countries can attest, the officials have always been just as corrupt. The perceptions of what corruption is, however, have grown less tolerant and more strict as incomes have risen. In this regard, the Russian population’s inherent distrust of officials and penchant for conspiracy theories means they are uniquely attuned to any hints of corrupt behavior. As a result, indicators like Transparency International’s Corruption Perceptions Index are flawed and even misleading in cases where a lower “perception” of corruption actually suggests a greater acceptance of corruption (or at least a definition less broad than TI’s). Despite the methodological problems inherent in trying to measure a real phenomenon like corruption based on the subjective perceptions and judgments of local observers, the CPI is relied on very heavily by anticorruption practitioners and businesses when evaluating which country offers the appropriate risk-reward balance to a foreign investor.

The CPI‘s weakness as an indicator of “real existing corruption” does not mean that the corruption risk in Russia is exaggerated, only that it is not helpful as a tool for comparing corruption risks in Russia vs. the other BRICs. Thus, if Russia’s corruption and weak rule of law are roughly on par with the other BRICs, you could see how Russia would be more appealing. Specifically, Russia’s low FDI/GDP ratio and ambitious modernization plans mean that the Russian government will finally have to start following through on its promises to improve the business climate.

Part II will address the unique non-economic risks that Russia must tackle and mitigate in order to attract the domestic and foreign capital investment it needs in order to transform the economy.

Posted in corruption, foreign investment, PM Putin, russia, strategic industries

Jackson-Vanik: Exit, Stage Left

There is a now-infamous study on the subject of “decision fatigue,” which looked at decisions by Israeli judges to grant vs. deny parole. The researchers found a wildly skewed trend in the judge’s decisions, but not by criminal history, ethnicity, gender (even rehabilitation programs had less impact). Rather, the prisoners in front of recently-fed judges were granted parole 70 percent of the time, while those in front of hungry judges were granted parole only 10 percent of the time. Plotted on a graph, the chances of parole sink drastically as the previous meal becomes a distant memory (image taken from study):

The researchers concluded, among other things, that (i) glucose depletion in the brain increases the effort required to make complex, although binary decisions such as whether to release a criminal into the public; and (ii) as the decision-making process grows more difficult, individuals will tend to prefer the “safe” decision of not making any changes (in this case, denying parole, and keeping the prisoner incarcerated).

Decision Fatigue in U.S.-Russian Relations

Although the situation is not identical, it is possible to discern a similar type of “decision fatigue” that plagues U.S.-Russian relations (Bush ‘freedom agenda’ and Obama ‘reset’ notwithstanding). The reason is that Russia (as USSR) was the U.S.’s primary antagonist for nearly 50 years, resulting in a set of reliable behavioral interactions aimed at forestalling sudden change and uncertainty (raising risk of nuclear war). Now, Russia is not our primary antagonist, but the behaviors remain. Consequently, like the Israeli judges, U.S. and Russian policymakers more often than not opt for no change in the U.S.-Russian relationship, which is convenient because we already know what roles to play after 50 years of practice. This is particularly true with Congress, where pushing a rethink of Russia policy is a low reward / high risk gambit. Still, one would hope that Congress would at least spot the low-hanging fruit – moves that benefit the U.S., respond to Russian concerns, and eliminate Cold War legacies that no longer serve any purpose.

Repealing Jackson-Vanik – A High Reward/Low Risk Improvement

Very soon, Congress will have the opportunity to take action on an issue that, for practical purposes, was irrelevant up until now. With Russia’s accession to the WTO scheduled for August, the deadline for repealing the Jackson-Vanik Amendment is closing fast.

The Jackson-Vanik Amendment was added to the U.S. Trade Act of 1974, with an aim of pressuring the USSR on human rights issues, particularly restrictions on the emigration of Jews from the Soviet Union. The effect of Jackson-Vanik is to deny permanent normal trade relations (PNTR) status to communist countries that restrict emigration. The President, however, may waive the application of Jackson-Vanik on a yearly basis, which has been done for Russia without fail since the Soviet collapse. The WTO, however, requires all member countries extend PNTR to one another, and Congress has permanently lifted the application of Jackson-Vanik from a number of former communist states (e.g., Kyrgyzstan, Georgia, Mongolia, Ukraine, Vietnam).

So, in principle, repealing Jackson-Vanik for Russia should be nothing more than a procedural issue: it has no practical application due to the annual waiver, but now must be lifted to comply with WTO regulations. Unfortunately, the ‘decision fatigue’ over Jackson-Vanik is already showing, with some members of Congress treating Jackson-Vanik like an essential element of U.S.-Russian relations. For example, Sen. Orrin Hatch said, “The president would have Congress pass PNTR and ignore Russia’s rampant corruption, theft of U.S. intellectual property, poor human rights record and adversarial foreign policies for a market that amounts to .05 percent of U.S. exports.” Hatch is a smart guy – he knows Russia gets PNTR every year already, and thus that not repealing Jackson-Vanik will not influence Russian behavior. But the autopilot is already on, and Hatch doesn’t see that the issues he cites would be helped by repealing Jackson-Vanik.

Why Repeal Jackson-Vanik Under the Hatch Criteria:

  1. Human Rights/Democracy/Corruption – although related to human rights, Jackson-Vanik dealt with a specific issue – freedom of movement for Soviet Jewry – that died with the Soviet Union. This happened because Russia swapped its economic/political model for ours, albeit with imperfections. Further integrating Russia into the international economic system will undermine corrupt oligarchs/officials who profit from Russia being kept in the dark. Perhaps most persuasive – the leading members of the non-systemic opposition (Navalny, Milov, etc.) are all for lifting Jackson-Vanik.
  2. Foreign Policy – again, if the U.S. would like more leverage over Russian behavior, it would make sense to increase trade and investment in the country. Hatch seems to imply that if we could get U.S. exports to Russia down from .05 percent to .025 percent, Russia would join NATO all of a sudden.
  3. Intellectual Property Rights – if the U.S. does not repeal the Jackson-Vanik amendment by the time Russia accedes to the WTO, we will not be able to use WTO dispute resolution mechanisms (e.g., enforcement of TRIPS Agreement).

Most important, Congress needs to remember that if Jackson-Vanik is not lifted, the U.S. will face all of the negative consequences (WTO-related sanctions, nullification of WTO agreement with Russia, higher barriers to entering Russia), and Russia will still be better off than it was before (i.e., in the WTO). In contrast, repealing a Soviet-era relic that has not been used in decades will be no more of a ‘victory’ for Russia than for the U.S. Instead of being seduced by the old rhetoric and patterns, Congress should weigh the consequences, listen to the protest leaders in Russia, and repeal Jackson-Vanik this session.

Posted in congress, corruption, foreign investment, jackson-vanik, russia, WTO | 12 Comments