A Decade of U.S.– Russian Business: A Long Road Traveled

by Judith Robinson and
Business Information Service for the Newly Independent States (BISNIS)

Geoff Cleasby
U.S. Commercial Service – Moscow

Austria’s Chancellor Metternich remarked at the dawn of the 19th century that Russia is never as strong as she appears, and Russia is never as weak as she appears. The comment has stood up over time and is useful to keep in mind when looking back over Russia’s first decade as a democracy and a market economy.

One decade ago, Russia embarked on the transition to a market-oriented economy that also would transform the nation’s political, social and cultural identity; the changes in public ethics and in business, professional and personal relationships were no less radical than the economic changes. In 2002, after ten eventful years of reform, Russia is a rapidly changing, fast-paced economy offering opportunity and challenge in equal measure. The country is in its third consecutive year of solid economic growth, and there is cause for optimism over its future direction — both economic and political. The reform agenda of the Putin Administration is steadily transforming the economic landscape, and the reformers are gaining in strength and confidence with each success.

Pre-Crisis Russia

The watershed in Russia’s decade of change was the financial crisis of August 1998, a pivotal event. Prior to the crisis, the country managed to enact much of the legal framework underpinning a market economy, but with little real effect. Crony capitalism went virtually unchecked, as many of the Soviet era managers remained in place, continuing to run their operations as personal fiefdoms.

In the deceptive euphoria that ran right up to the crash, Western and Russian businessmen alike appeared to fall victim to unrealistic expectations. To many Westerners, the transition from a centrally planned economy to a free market was of less interest than the new commercial opportunities that it opened: the immense natural resources, the highly educated and inexpensive workforce and, in some fields, the advanced technology. The rush to the “Wild East” carried with it an assumption that once Russia opened its markets, an injection of capital and management expertise would deliver huge returns. Russian managers, inexperienced in valuing their enterprises objectively, and in operating within a competitive environment, were often driven by unrealistic expectations of overnight wealth.

The financial crisis of August 1998, while costly to Russia’s reputation, was by no means an economic meltdown. Life for the vast majority of ordinary Russians was little changed — they were poor before the crisis, and a little poorer afterwards. Russia was selling minerals and oil and gas on Western markets, which remained strong, and this lion’s share of its exports continued to bring in revenue. In fact, the rise in world oil prices supported much of Russia’s recovery from 1999 to 2001.

The dramatic devaluation of the Russian currency in 1998 provided breathing space for the Russian manufacturing enterprises, which form such a large part of the economy. At five rubles to the dollar, many Russian products could not compete with foreign imports in price or quality. At 25 rubles to the dollar, they could effectively compete on price at least. Import substitution with domestic production was especially noticeable in food products. Prior to the devaluation, 80 percent of food products were imported. The crisis was sobering. Many enterprises that had taken
dollar-denominated loans went out of business, and those that survived became financially very conservative. Both Russian firms and their Western partners have developed more reasonable expectations of how a market economy can work in Russia.

Post Crisis Russia

Although the road to a full-fledged, smoothly operating Russian market economy is half traveled, and still carries significant risk, the past two years have seen both accelerated economic growth and an increasing number of business successes: enterprises like Russia’s home-bred oil/gas giant Lukoil; the cell phone and food processing entrants to New York’s ADR market — Vimpelcom and WimBillDann; international cooperative efforts like the young airline Transaero and the stunning new shopping center on Manezh Square. Western tourists in Moscow can drop in at the Russian Bistro for “pirozhki” and “kvass,” or McDonalds for a Big Mac in the same city block. The Western-style hotels and glittering stores lining Moscow’s Tver Street and St. Petersburg’s Nevsky Prospect are highly visible witnesses to Russia’s new economic, political and social relationships, a business culture and business practices, and all the advances towards a stable and permanent framework for domestic and international commercial interchange.

Still, Foreign Direct Investment (FDI) in Russia remains low — a mere $32 billion, flowing mainly into Moscow and St. Petersburg and their environs and into the oil and gas industry, as the countryside meanwhile loses population, regional opportunities remain largely untapped, and numerous remote manufacturing centers sink into decay. America, the largest investor, has invested $7 billion, an amount roughly equivalent to U.S. investment in Costa Rica. Russia is perhaps the best example of the huge premium that international capital markets place on such intangible assets as the rule of law, respect for the sanctity of contracts, assurance of property rights, transparent financial reporting and good corporate governance. Few examples better illustrate the penalty that markets exact when corruption, abuse of power and excessive bureaucracy are allowed to distort the economic landscape.

That these inhibitors to investment are common to most developing countries including Russia is sometimes forgotten. Indeed it is difficult to imagine Russia, America’s Cold-War adversary for so many years, as a developing nation. But Russia’s economic evolution like its history simply differs in nature from that of developing countries in Africa, Latin America and the Near and Far East. Russia’s task is one of reconstruction and refurbishment, rather than development, and Russia now seems prepared to tackle its problems. The results, of late, have been dramatic.

Recent evidence whispers of corporate Russia’s awakening to reality as the new generation managers and officials take their places in the boardrooms. With the growth in business sophistication firms now understand that financial markets reward responsible corporate behavior. Some large Russian firms have been testing the theory that by adopting International Accounting Standards or GAAP, implementing good governance codes and paying dividends, they can increase shareholder value. The overall results may indicate that enlightened self-interest is the surest guarantor of continued reform.

The Economic Landscape

Key economic indicators tracking Russia’s development course provide a two-year picture of strong turnaround. The Gross Domestic Product, in free-fall during each year after independence, registered a tiny positive for just one year, 1997, then plummeted anew in the 1998 crisis year (-4.9 percent). But 1999 and 2000 registered 5.4 percent and an amazing 8.3 percent, a recovery mainly due to substitution of Russian domestic products for imported products, especially food, and higher world prices for oil, which constitutes over half the Russian exports. Barter, once estimated to account for 70-80 percent of transactions in Russia, is rapidly disappearing as liquidity returns to the system.

Russia’s Economy Minister, German Gref attributed the estimated 5 percent GDP growth rate in 2001 to two promising new factors of economic growth: Growth in consumer purchasing power accelerated following a drop of 30 percent in personal income after 1998, and there was an investment surge by the Russian industries, which spent on new or upgraded machinery and equipment, especially in machine building/metallurgy and food processing. This was already reflected in increased outputs of 7.2 percent and 8.4 percent respectively for the two sectors. The inflation rate has steadily declined from 840 percent in 1993 to 38.5 percent, 20.2 percent and 18.6 percent in 1999, 2000 and 2001 respectively.

In 2001, a number of indicators presaged an upswing in the still-lagging foreign investment that might have been expected to support Russia’s development. In 2001, Fitch, Standard and Poors, and Moody all upgraded their investment ratings for Russia to B+, B+ (sovereign long term)/B (short term) and Ba3 respectively. International financial institutions began to make credit available for sub-sovereign loans. The U.S. Export-Import Bank increased its cover in Russia, always a pointer for future U.S. investment. There are indications that Russian capital — having fled the country at the rate of an estimated $1.5 billion yearly — may be returning home. U.S. firms with long term presence in Russia announced expansion plans: Ford announced a second new plant; General Motors has entered into a major joint venture with auto giant AvtoVas; Exxon recently announced the largest foreign investment in Russia to date in its Sakhalin Island oil project — a possible $40 billion over the life of the project. And Pizza Hut and Kentucky Fried Chicken are back in Moscow.

In 2001, the Russian stock market increased in value by 98 percent, one of the world’s best performers, albeit with very modest market capitalization — perhaps a stimulus to foreign portfolio investment, low since 1998.

Meanwhile, much of Russia’s infrastructure is in decay, its manufacturing facilities deteriorating, obsolete, and non-competitive on the world market. Restructuring, rehabilitation and replacement will be costly, an estimated $2.5 trillion in the next quarter century. The electrical power system alone will need $50-70 billion to renovate its power stations, and projected life extensions measures are only stopgaps for upgrades in essential new technology and equipment.

The Political Landscape:

Democratic institutions are young and fragile in Russia. Nevertheless, assertions that, because Russians lacked a history of democracy, they were culturally or psychologically unready for it, proved to be unfounded. The electoral process appeared to work well by the standards of developing countries, and in March 2000, Russia saw the first democratic hand-over of power in its 1,000-year history. Russian law now includes a Civil Code setting out the most basic rights of citizens in a democratic society: equal rights to property, to be free from public interference in private matters, and to legal recourse when rights were violated. A host of commercial laws support operation of a free marketplace, although key amendments to existing laws and new legislation are needed to improve the business environment. Admittedly, the democratic process is far from perfect and a subject of much internal debate, including the role of unbiased electronic media.

President Putin’s administration is firmly focused on establishing orderly governance, reassertion of authority over the far-flung regions, institutional restructuring and progress in economic reform. President Putin, in his two years in office, has overseen measures for the rule of law and judicial reform. His administration has achieved outstanding fiscal results: a budget surplus, debt management with external debt refinancing, and early repayments of IMF loans. He has attacked corruption, and has apparently managed to rein in the oligarchs of finance and industry. He has strengthened the voice of federal government outside Moscow through the appointment of seven personal representatives in Russia’s new federal administrative districts, while limiting the excesses of some regional governments. Critics cite central control and stability at the possible expense of personal freedoms.

There remain protectionist elements in both the executive and legislative branches that call for limits on foreign share holdings and property ownership, or increased tax burdens on foreign businesses.

The small and medium-sized enterprises (SMEs), having spent the last decade in the shadows, are just emerging as a political, as well as economic, force in Russia. Blocked by the collapse of the command economy from careers in state-owned enterprises, many of Russia’s graduates turned to small entrepreneurial endeavors. In an unsupportive, often obstructive business environment, the most successful deliberately avoided the attention of government authorities, which accounts for the sharp upswing in sole proprietorships — up 600,000 since 1999. Still, the number of SMEs fell to 842,000 last year, from 2000’s mere 891,000 — about 5-6 small enterprises per 1,000 people in Russia compared to an average 50-60 in developed countries. This growth failure is blamed on the business costs such as multiple, unevenly applied regulatory requirements, expensive and frequent inspections ranging from tax to fire, and access to capital and credit. The large, former state-owned industries account for an estimated 80 percent of GDP. Big is still regarded as beautiful by many Russians, and the perception of the SMEs as the dynamic engines of job and wealth creation have yet to take hold. Nevertheless, President Putin’s new and unprecedented focus on SME development, the new laws on licensing, registration, and taxes, most notably lowered corporate and personal income taxes, should help improve the health and growth of the SMEs, and keep them ever more visible and politically active in the reform process while opening new trade and investment opportunities for U.S. companies in the year ahead.

The Social Landscape

A decade of relatively free travel outside Russia, of unrestricted access to outside information via television, movies and news media, has helped average Russians formulate their ideas about the direction they wish to see their country take. Moreover, over the last decade a younger generation has begun to take over the reins of power. Currently aged about 26 to 40, this new generation was educated during perestroika, when the excellent Soviet education system was still intact, but less dominated by dogma. In their college years, many of this generation embraced all things Western, realizing that they had no future, or a vested interest in the communist past. Upon graduating, many pursued training or postgraduate study opportunities in the U.S. and Western Europe. Returning home, they are moving up the corporate ladder in successful Russian companies into middle and upper management positions. The more entrepreneurial among them are a driving force behind the rapidly emerging small and mid-sized enterprise sector, which is in turn a factor that should contribute to the rise of a Russian middle class.

Soviet-era education delivered excellent education free to its citizens, reaching literacy rates higher than in the U.S. It endowed Russia with valuable human capital, especially in the form of scientists, engineers and technicians. That educational investment has fallen over the last decade. Teachers, including highly educated professionals, earn 50-60 percent of the average national wage, and the teaching profession is not attracting young graduates. Education standards are dropping as the best teachers seek work in the private sector. Innovations are planned, for instance education delivered by Internet in order to address particularly acute inadequacies in Russian’s vast regions.

Finally, Russia’s birth rate is one of the lowest in the world, about half the replacement rate, and is due mainly to poverty and lack of confidence in the near future. Life expectancy also has fallen since the Soviet era — to age 60 for men. This foreshadows a decrease in the 145-million population by as much as a third at the present rate over the next 50 years. One negative implication among many is the immense financial burden that an aging population will place on the dwindling number of young taxpayers.

Key Reforms

The reform process is very much a work in progress, with debate centered on how much and how fast. Changes in property ownership, taxation, and contracting, all business cornerstones, have required not just decisive action, but significant conceptual reorientations. The Russian government has addressed its super-challenges most effectively since the 1998 collapse.

Rule of Law and Judicial Reform
Russia has well drafted laws in such key areas as business organizations, taxation, property, banking, labor, and land ownership. The “dictatorship of the Law” — correcting imperfect laws and their even more imperfect enforcement — is a priority of the Putin administration. At the federal level, Russia’s commercial courts and arbitration tribunals are demonstrating independence, transparency and impartial judgments. At the regional and local level, it cannot be assumed yet that some courts will deliver judgments of similar quality, free of financial or political persuasion.

A decade of Russian practice in the art of contracting and contract management is leading towards a modicum of respect for contract sanctity — also a rewrite of history; the Soviet era was riddled with disrespect for impossible, complex laws, and its managers routinely forced to rely on informal relationships. The Soviet breakup also shattered the institutions, structures and conditions of repeat business enabling this system to work, leaving private transactions involving business with strangers that could be governed only by written, objectively interpreted rules of the game — commercial law. Starting with a new Constitution and Civil Code, an entire legal framework adapted to a market economy took shape and went into use. Reasonable judicial support came with the emergence of the commercial “arbitrage” courts in the mid 1990s, training of judges to staff them, and increased recourse to international and then Russian arbitration tribunals. Post judgment enforcement is still problematic. Knowledgeable business people strongly recommend pre-contract due diligence, acquaintance between prospective business partners, and thorough understanding of the business terms.

Tax Reform
The star of the past two years is the new Tax Code, comparable to those of advanced market economies and bringing some relief from exorbitant taxes, which threw government’s need for revenue out of balance with business’s need to grow. Adopted in stages, the Code simplifies and reduces both federal and regional taxes. Highlights are a drop in personal income taxes to a flat 13 percent and corporate income tax to 24 percent. One result has been a sharp upswing in voluntary tax payments to the budget — they are now about 16 percent of the GDP.

Natural Monopolies Reform
The natural monopolies, electrical power generation/distribution (Unified Energy Systems — UES), gas extraction/distribution (Gazprom), and rail transportation (Railway Ministry), account for about 13 percent of Russian GDP, but play a huge role in the economy: domestic prices for energy and transportation are set artificially low, distorting the economic landscape. Restructuring plans for UES and the Railways Industry call for government-retained control, but competition will be created by opening access to their unified infrastructure networks by independent rail operators and electricity generators in return for an access fee. Minority shares of UES and Gazprom are to be privatized. Recently, the heads of both the Railways Ministry and Gazprom were replaced.

Banking and Accounting Reform
Glaring weaknesses remain in a half-developed banking system, although a new government Banking Plan of December 5, 2001, calls for gradual overhaul. A shift in corporate accounting procedures to meet International Accounting Standards (IAS) and to the U.S. GAAP has received a push from a renewed Accounting Reform Program. This program is to change the Russian accounting standards from the old bookkeeping emphasis on data provision to a central government to financial reporting for shareholders. Creation of a cadre of accounting professionals through the new Russian Institute of Professional Accountants and the appearance of companies with IAS on Western stock exchange listings are incentives.

Bureaucracy Reform
As a part of efforts to reduce the burden of red tape and bureaucratic barriers to entrepreneurship, a new licensing law, in effect February 2002, reduces the types of business activities requiring licenses from about 500 to 100, while tax reforms impose limitations on hitherto onerous, seemingly capricious tax inspections of businesses. Draft laws going before the Duma this year are expected to simplify business registration procedures, and Russia’s desire for membership in the World Trade Organizations is driving efforts to resolve the non-transparent, complex and procedure-bound practice of certifying nearly every item entering Russia for quality and safety. Much remains to be done: harmonization of Russian standards with those prevailing internationally has not happened; permits and licenses still present unwelcome, expensive and unexpected surprises; and arcane Customs practices and procedures present barriers to free flows of goods and services across the Russian border.

Property
The difficulty of establishing clear property rights, following the privatization process, was the cause of innumerable disputes throughout the 1990s. A system of property law and regulations has since developed from the basis laid out in the Civil Code, which defined the right of ownership itself. The year 2002 opens on a system of well-drafted property-related laws, including those on mortgage, leasing, insurance, franchising, bankruptcy — and the sensitive issues of intellectual property rights (IPR) protection and land ownership.

Intellectual Property Rights: For 70 years, intangibles like technology, designs, literature texts and methods were considered everyone’s property. In 2002, Russian business people have a stake in software they have developed, films and music they have created and published, their own trade secrets, and their own trademarks, and in enforcement of the right to intellectual property. Despite Russia’s well drafted IPR laws and membership in international IPR conventions, the creation of Rospatent in Moscow to manage its own patent and trademark activity and that of other CIS countries through the Eurasian Patent Convention, the country is plagued by an estimated annual $2 billion plus in losses from IPR abuses that defy enforcement. In November 2001, new draft laws aimed at IPR protection, and amendments to the Trademark Law, Criminal Code, Criminal Procedure Code, and Law on Consumers Rights Protection, awaited expected passage. Criminal penalties — imprisonment, fines, and other measures — are to be imposed for unauthorized use of trademarks, counterfeiting pharmaceuticals, and other violations.

Land
Ownership of land is a sensitive issue although it is provided for in the Constitution and Civil Code. In 2002, a Land Code allowed ownership of urban non-agricultural land and land underlying commercial facilities. Ownership of small plots and dachas had been legalized in preceding years. The new laws affect urban land only, which while the most valuable, accounts for an estimated 2 percent of Russian land. Agricultural land remains State property and can only be leased.

Implications For U.S. Russia Business

The outlook for U.S. and Western business with and in Russia looks more favorable, although still risky. A recent Economist Intelligence Unit survey of 75 multinationals operating in Russia revealed a generally positive view of the country’s current business environment. Over 80 percent of the companies reported profits in 2000, and over 60 percent were operating at pre-crisis 1998 levels; about half expected sales growth of 10 – 25 percent in 2001. 70 percent hired new employees and expect to continue hiring. All companies rated political risk as not worsening, and 85 percent believed it improved. Familiar complaints included lack of corporate transparency and crime and corruption, although most companies rated the latter two as manageable.

The Russian market for a wide range of very big-ticket items is unique and huge. No economy in the world has suffered the sheer degree of radical and sudden change in direction, save Russia itself. The disruption and economic decline throughout the 1990s denied enterprises the resources to replace aging capital equipment, and most remain seriously uncompetitive and ultimately unviable. Some survivors of the chaos are gaining strength through good management and strong market positions. Economic reform is forcing major industrial restructuring of others — particularly the natural monopolies — so that they can become viable in a market economy and identifiable income streams. The pent-up demand for a wide range of capital equipment is enormous, but restricted by still low disposable income; however sustained economic and spending power growth is likely to generate big business.

Best prospects in Russia for U.S. exporters include; the oil and gas industry, telecommunications, mining and construction equipment, automotive equipment, aircraft, and agricultural and food processing equipment. With President Putin’s newly announced emphasis on health and fitness, the medical sector is likely to emerge into the market spotlight. In all, and given reform and moderate growth, Russia has the potential to become a major market for U.S. industrial equipment and engineering services, which are vitally needed to upgrade its industry and agriculture. In the near term, industries such as aluminum, steel, transportation equipment, food processing and forestry products seem to have sufficient cash flow and organization to be potential prospects for trade or investment. In the longer term, there should be great demand in such sectors as electric power and agricultural equipment for U.S. products and services. Should incomes continue to rise, demand for a whole range of consumer products can be expected to increase exponentially, although competition from European and domestic sources will be steep.

Once land reform is a fact, Russia will be a major market for agricultural equipment and food processing technology. Meanwhile, there is demand for food products, some for further processing in country, and fruits of trees and the sea — and pet foods. Bulk and intermediate agricultural products with good export potential currently are wheat and soybeans, their products, animal feed corn and planting seeds.

One interesting recent trend has been a growth of the offshore services sector. Much of Russia’s existing large pool of scientific and engineering talent remains underutilized. Foreign companies are opening such enterprises as engineering design bureaus and software development shops in Russia to harness inexpensive human labor. These types of projects are particularly successful, and are embraced by Russian authorities worried by a brain drain of Russia’s best talent overseas.

Indications are that the stability of the past two years may last. That U.S. — Russian relations have entered a
sunnier era is witnessed by Russia’s response to the September 11 terrorist attacks on the United States coupled with a series of high profile events such as the Bush Administration’s first Business Development Mission to Russia led by Commerce Secretary Evans, and the Presidential Summit in Washington and Crawford. With the televised meetings in two countries of their two leaders in amiable conversation, and despite a road yet to be
traveled, the 2002 horizon for U.S. — Russian commercial interchange appears brighter.

Secretary Evans with U.S. Ambassador Alexander Vershbow, U.S. Commercial Service Director General Maria Cino, and Senior Commercial Officer Stephan Wasylko and Moscow staff along with representatives of SABIT and BISNIS.

Photo courtesy of U.S. Commerce Department

Secretary Evans with Sergei Kravchenko, Vice President of Boeing, and U.S. Ambassador Alexander Vershbow (right) at Boeing's Moscow Technology Center.

Photo courtesy of U.S. Commerce Department

Contact Information For Russia

Business Information Service For The Newly Independent States - BISNIS

BISNIS, with its programs of direct information and assistance to U.S. companies, was created in response to a U.S. business community demand for support in negotiating the new and changing commercial conditions in the Russian marketplace. Since then, the BISNIS staff of 12 in Washington and 19 in Russia and the NIS, has developed powerful communications lines to interested U.S. companies and potential Russian business partners, and has a record of assistance that has yielded several billion dollars for our U.S. clients.

Contact:
Tel: (800) USA-TRADE (872-8723) or 202-482-4655
Fax: 202-482-293 E-mail: bisnis@ita.doc.gov
Website: www.bisnis.doc.gov
Mailing Address:
BISNIS, U.S. Department of Commerce USA Trade Center/Stop *R-BISNIS
1401 Constitution Ave. N.W.
Washington D.C. 20230

U.S. Commerical Service In Russia

The Department of Commerce’s Commercial Service (CS), with offices in Moscow, St. Petersburg, Vladivostok and Yekaterinburg, is an integral part of the Ambassador’s country team. The staff in of the Commercial Service in Russia represent U.S. business interests in Russia, maintain close working relations with U.S. and Russian public and private sector clients and support the Mission’s economic reform, market development and regional agendas. CS provides U.S. firms with a full range of business facilitation, trade development and advocacy support in Russia. A full list of overseas offices is available at www.usatrade.gov.

Moscow
23/38 Bolshaya Molchanovka ul. Entrance 2, Moscow 121069, Russia
Tel: 7-095-737-5030; Fax: 7-095-737-5033
E-mail: Moscow.Office.Box@mail.doc.gov
Website: www.BuyUSA.com and www.USATrade.gov

St. Petersburg:
Nevsky Prospekt 25, St. Petersburg 191186, Russia
Tel: 7-812-326-3560; Fax: 7-812-326-3561
E-mail: StPetersburg.Office.Box@ mail.doc.gov

Vladivostok:
32 Pushkinskaya ul., Vladivostok 69001, Russia
Tel: 7-509-851-1212; Fax: 7-509-851-1211
Local tel: 7-4232-30-0070 E-mail: csvlad@online.ru

Yekaterinburg:
15 Ulitsa Gogolya, Yekaterinburg 626400, Russia
Tel: 7-3432-564-736 or 7-3432-564-691; Fax: 7-3432-564-515
Email: FCS.Yekat@gin.global-one.ru