Alexander Pakhalov, National Rating Agency
In early February, Russian statisticians summarized the results of 2015, a year that proved to be one of the most difficult in the past 25 years of Russia’s contemporary economic history. According to preliminary estimates by Rosstat (Russian Federal State Statistics Service), Russia's economy shrank 3.7 percent, industrial output fell 3.4 percent, and retail sales dropped 10 percent in 2015. Last year, the key investment activity indicators were on a downward trend, e.g., investment in fixed capital assets declined by 8.4 percent, and foreign direct investment (FDI) was down by 92 percent, a record for contemporary Russia, according to the United Nations Conference on Trade and Development (UNCTAD).
“Leadership tested by challenges”
- Even despite the financial turbulence and falling oil prices, the key economic metrics of Russia’s main regions are on a growth path.
- Not only megapolises and oil producing territories, but also industrially developed regions with an export potential are among the best performing entities.
- The best performing regions, in terms of socio-economic development, backed by investment project implementation and maintained industrial potential, are the Republic of Tatarstan, and the Oblasts of Leningrad and Kaluga.
Despite the nation-wide economic crisis, some Russian regions have managed not only to maintain positive economic growth, but to increase the investment inflow as well. These regions rank high in the 2015 investment attractiveness rating worked out by National Rating Agency (NRA). In NRA’s opinion, regions most attractive for FDI include not only large megapolises (such as Moscow and St Petersburg) or oil producing territories (Tyumen and Sakhalin Oblasts), but also a number of other sub-federal entities, such as the Republics of Tatarstsan and Bashkortostan, Krasnodar Krai, Belgorod, Leningrad, Moscow, Kaliningrad, Kaluga, Lipetsk and Samara Oblasts. All these regions are known for their considerable industrial and export potential, which enables them to be resilient to external shocks. According to Victor Chetverikov, NRA CEO, “those regions’ economic self-sufficiency, coupled with their administrations’ efforts to develop the investment infrastructure, employment opportunities and a more favorable business environment produce real results at a time when Russia's economy is in doldrums”. An important factor underpinning those regions’ economic success is the favorable investment climate, in particular, a comfortable institutional environment for investors.
One example of a region with an economic sustainability maintained in a challenging operating environment is the Republic of Tatarstan, where industrial output and investment in fixed asset capital increased 0.4% and 1.6% respectively in 2015. Tatarstan’s good performance is largely due to its high industrial diversification that allows weaknesses in some sectors be offset by strengths in other parts of the economy. Last year saw a slump in the region’s engineering, car making and light industries, and an increase in oil processing, metals, as well as pulp and paper output.
In addition to a well-balanced industrial structure, Tatarstan has a favorable operating environment; in fact, it is one of the few Russian regions that have implemented the principle of reducing administrative barriers to business. According to a recent study by the Agency for Strategic Initiatives, the time limit for obtaining a construction permit in Tatarstan is 41 days on average, while in some Russian regions the process may take more than 300 days. Tatarstan has a high socio-political sustainability, supported by the regional government’s effective work, and an adequate relationship between government, society and business. With such a relationship in place, it is much easier to enforce investor rights and obtain state support for an investment project.
Tatarstan case should not be treated a something unique, as there are other Russian regions, committed to improving their investment climate. Kaluga and Leningrad Oblasts, that always used to be FDI attractors, are taking additional measures to encourage the investment activity at a time of crisis. Kaluga Oblast is putting effort in infrastructure development, which includes the construction of a new international airport and a special economic zone. Leningrad Oblast has developed and enacted a law introducing a 50-percent property tax benefit for local car makers. In this way the region’s government is trying to support a sector, severely affected by the crisis.
The ruble devaluation hits the imports while opening up new export opportunities
- The declining oil export revenue makes the Russian government take a more ‘responsible’ stance on its investor relations. As a result, Russia has risen to the 51st position in the World Bank's Ease of Doing Business Index.
- The cow cost base, combined with skilled labour availability, make Russia one of the most attractive investment destinations for labour-intensive activities.
- The economic crisis became an additional impetus for the authorities to take meaningful steps to reform the investment climate at both the federal and regional levels. The result was not long in coming, as evidenced by Russia’s rising to the 51st position (from the 92nd position in pre-crisis 2013) in the World Bank's Ease of Doing Business Index. Foreign investor and expert surveys also show that at a time of economic turbulence, Russian authorities are willing to support business, acknowledging its role in promoting sustained economic growth. Owners of both large and mid-sized investment projects may now count on authorities for closer cooperation, assistance in overcoming difficulties and financial support in the form of tax benefits and subsidies.
A better investment climate is not the only attraction for potential investors. International investors begin to realize the benefits of the Russian ruble depreciation. Three years ago, they noted that production costs in Russia were about the same as in Europe (on average) or even higher for a number of products. The sharp currency depreciation has reversed the situation, making the Russian economy competitive in terms of production costs. Currently, labor costs and the expenses relating to the procurement and transport of goods in the Russian regions are several times lower than in Europe, albeit remaining higher than in a number of Asian countries. However, the low cost base, combined with skilled labor availability, make Russia one of the most attractive investment destinations for labor-intensive activities. In addition, “a lower reliance on foreign investment and capital have removed the touch of artificiality about the economy and enabled a number of industries to move to a higher-profile market role. This happened in the context of the slower downward trend of macroeconomic fundamentals that may have indicated that the Russian economy has bottomed out. And this is exactly what can be a new starting point for international investors to provide more investment in Russia”, according to Victor Chetverikov.
The liquidity crunch and sanction pressure are providing a chance for international investors
- The tightening of the Central Bank of Russia (CBR) monetary policy following the ruble depreciation have affected the Russian financial institutions, limiting their access to financing and driving up the cost of their funding;
- The Western sanctions and geopolitical tensions are driving down the price of Russian corporate stocks, making them much cheaper than corporate stocks from other BRICS countries.
- Russia’s investment attractiveness is much dependent on its export potential. Despite the shrinking disposable income and the resultant decrease in domestic demand, Russia is becoming a lucrative location for developing export-oriented activities. Factors, such as the currency devaluation, reducing production costs, free trade area existing under the Customs Union Act, and the advantageous geographic position are major sources of the Russian exporters’ obvious competitive advantages. Unfortunately, the country’s export-oriented companies fail to fully exploit the new opportunities. According to Rosstat, only a few industries (e.g., fertilizer plants and some agro industries) managed to increase their exports, in value terms, in 2015. One factor constraining the exports was the tightening of the central bank’s monetary policy, namely the key rate increase, which translated into sharply raised funding costs, on the one hand, and the tighter loan loss provisioning requirements for commercial banks, on the other hand. These changes in the financial regulatory framework have caused the money supply to shrink, liquidity to dry up and external funds to become hardly accessible to commercial companies. According to National Rating Agency’s analysts, the annual effective interest rate for corporate borrowers at year-end 2015 was 15.88 percent on average, with more than one-half of total bank corporate loans (56.12 percent) due within one year and 15.52 percent payable within one to three years. Medium-term investment loans (for a period of 3-plus years) accounted for less than one-third of total loans (28.31 percent). One may therefore expect that advantages like having access to credit and investments will determine the competitive position of Russian companies. In general, Russian export-oriented enterprises are quite capable of increasing their export volumes and geographic breakdown (largely through entering the Asian markets).
Another reason in favor of investing in Russia is the low cost of Russian corporate stocks, opening up new opportunities for foreign direct investors. The market value of Russian production companies, excluding mining entities and oil produces, has dropped more than 40% since March 2014. In some sectors, large export-oriented companies are seriously undervalued by the P/E ratio. This ratio is 3.90 for Rusal (RUAL), 2.42 for Nizhnekamskneftekhim (NKNC), 3.98 for Irkut (IRKT), 4.23 for Pharmstandard (PHST) and 4.84 for Cherkizovo (GCHE). “The undervaluation of Russian companies and projects, as well as the sharply depreciated ruble are not only investment attractiveness criteria. They may also become a gateway to an enhanced stock market development, in terms of trading volumes, liquidity and issuer diversity”, says Victor Chetverikov.
The crisis will not last forever, and analysts already note the favourable prospects for many sectors of the Russian manufacturing industry. In this situation, international investors have a chance to acquire potentially lucrative assets at an attractive price. One should only keep in mind that an investment in Russia, like in any other market, involves certain risks, including the currency, reginal and institutional risks. A sound and comprehensive risk assessment is a vital part of the investment decision-making process.