COMMENT: Business in Russia - slowdown but still steady growth

By bne IntelliNews September 26, 2008

Sarah Carey of Squire, Sanders & Dempsey -

There has been much discussion since the short battle of August between Russia and Georgia as to whether Russia, because of forced or voluntary isolation or because of intemperate sanctions imposed by the US and a few of its "willing" followers, will suffer a serious blow to its economy. In fact, Russia's stock market has fallen more than 49% since May. On August 8, after Russian troops moved into Georgia, the Moscow Interbank Currency Exchange (Micex) index hit its lowest level since October 2006; since then, it has declined further. Capital flight since the start of the conflict is estimated to be $20bn. Some Western bureaucrats are saying that Russia has sanctioned itself. A new phrase, "self-sanctioning," has been coined.

Although the dust from the Russian-Georgian conflict hasn't settled, a closer look at the Russian economy suggests it will continue to experience healthy growth, albeit with some deceleration. Both officials and private sources predict between 7-7.5% growth for 2008, down from 8.1% in 2007, but still a better performance than in most developed countries. The slowdown, although clearly impacted by the political situation, is also influenced by the global credit crunch, which has hit certain industries, such as real estate and construction, harder than others. The drying up of liquidity (or increased cost of borrowing) will create a shortfall that domestic sources of funding cannot fully redress. For companies with significant borrowings, this will lead to a sell-off of assets - creating a buyer's market.

For now, planned Russian IPOs are being put on hold. The numbers of such offerings, which in 2007 reached 22 worth $20bn, will be dramatically reduced. Further, portfolio investors, who are sensitive to political developments and perceptions of risk (Russian risk has increased because of its warlike behaviour), will not return in droves until their perceptions change. This change could happen as the result of the internationalization of peacekeeping in Georgia or the realization that the US and EU talk big, but have limited or no capability to impose sanctions that actually have an impact. More likely, the passage of time and the continued expansion of the Russian economy (compared to others) will lead to the return of capital.

FDI flows

Unlike capital markets, foreign direct investment (FDI) in Russia continues to grow, although there has been some slowdown, attributable largely to the global economic slowdown. Western manufacturers and other strategic investors are continuing to invest and expand in growth sectors, particularly those involving consumer products. To date, there has been no diminution of consumer spending. Retail Week, in its August 29 edition, commented that, "Russian consumers' voracious appetites for Western products will continue, despite the coolest political climate since the Cold War." Russian consumers can afford to spend because most own their own homes and have low monthly budgets (basic utilities are cheap, healthcare is largely free of charge and education is subsidized) and minimal debt. In bankers' parlance, the Russian consumer is underleveraged. Many Western producers of consumer products claim that Russia is their most rapidly growing market and that they cannot expand as quickly as they would like.

For example, the growth of Russia's automotive sector has beaten all forecasts. In the past five years, auto sales in Russia have tripled. In 2007, sales of new cars grew 36% by volume and 57% by value. More than 2.7m passenger vehicles were sold, with Ford's Focus leading the way. Many market analysts predict that by 2012 Russia's car market will be the third-largest in the world, behind only that of the US and China. Global automakers such as Ford, GM, Toyota and Nissan have been the biggest contributors to this phenomenal growth. Foreign brands accounted for 64% of the vehicles sold in 2007 and hold almost 50% of the total market. The world's major automakers are expanding their facilities and building new plants. The next stage for Russia's automotive market, analysts predict, is the emergence of a powerful components industry for foreign brands. Today, most foreign manufacturers in Russia still import the bulk of their parts.

Another sector attracting investment is large infrastructure projects, for which the government has committed more than $1 trillion in spending over the next 10 to 15 years to modernize the railroads, construct roads and bridges, improve airports and other transportation facilities, and prepare for the 2012 Olympics in Sochi. Agriculture is also a booming sector. Major investors, Russian and foreign, are acquiring agricultural land (land banking) and developing farms, dairies, food processing facilities and the like. Companies combining land with processing and logistics are showing growth rates of 20-30%. Russia is predicted to become one of the major global suppliers of food. One commentator (Richard Ferguson of Nomura) describes agriculture as "Russia's New Strategic Industry."

There are many other sectoral examples of growth from airplanes to telecommunications. Russia remains an attractive target for FDI - not just in commodities but beyond. And, should the government's focus on high tech succeed, another new horizon will be emerge. Although Russia is experiencing a slowdown driven by the credit crunch, its growth rate, like that of the other BRIC countries (Brazil, India and China), is higher than in most of the developed world.

US-based investors may sit back and wait for the political storm to pass, but Europe-based investors aren't likely to do so. And beyond Europe and the US, a large pool of investors is aggressively pursuing the Russian market, whether from China, India, South Korea or the Middle East. Dire threats of expulsion from the G8 or reprimands from the US and Europe ring hollow with these investors.

Sarah C. Carey is a partner at Squire, Sanders & Dempsey

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COMMENT: Business in Russia - slowdown but still steady growth

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