Chris Weafer of Uralsib Capital -
Russia has a very strong financial platform and the national wealth is boosted daily with record high oil and gas tax revenues. The government promises to take a much more active role in helping the country's small- and medium-sized enterprises (SMEs) develop with a mixture of fiscal incentives and a step-up in efforts to deal with corruption and intrusive bureaucracy. The so-called rules of the game for investing in the country's strategic industries are also now much clearer and leave the way open for increased participation by private and foreign investors. What that should mean is that the country is about to enter a new golden-age of investment and re-building, a 21st century version of the "new economic plan."
Whether that promise is actually delivered or not will mainly depend on how effective the new government is in managing the process and, in particular, how it deals with the increasing problem of rising inflation and maintaining a competitive backdrop in the economy. It will also depend on the external environment because, while the country has considerable fiscal resources available domestically, a large portion of the investment and debt required to deliver on the main objective of diversified growth will still need to be sourced from international banks and investors. In reality, this next phase in the Russia story will be much more difficult than the last because the priority is now to start using (rather than accumulating) the nation's resources effectively in order to pursue the goals of diversification and with less reliance on extractive industries. The period of preparation is over and the honeymoon period is starting. Quite rightly that means investors will give the new government the benefit of the doubt, but for a maximum of one year. This time next year, it will be a lot clearer as to whether investors can look forward to a long and successful cohabitation in Russia or whether the obstacles proved too difficult to overcome.
The Medvedev presidency represents the start of phase two of the so-called Putin plan. While phase one can best be described as the preparation period when investment was a matter of betting on a high oil price while waiting for the "rules of the game" to be clarified, this phase marks the start of a new period in the development of the economy. During this next phase, it is expected that there will be a greater range of opportunities available for both strategic and portfolio investors and a lot fewer frustrations.
In effect, we are now moving into the spending phase when the state will more actively use the wealth generated by the nation's abundant natural resources to push for investment and growth in areas of the economy that represent real diversification. As the priority of the Kremlin over the past eight years was wealth accumulation and building state control structures in the strategic industries, the priority for the next eight years should shift to the non-commodity based industries and promoting a more meaningful role for the country's SMEs. In theory, the shift is obvious and straightforward. In practice, it will only take place slowly in a sort of "one-step forward, two-steps sideways" pattern. Dealing with endemic corruption and entrenched bureaucracy and generally developing a more entrepreneurial approach to government will take a very long time. But what we hope is that this new phase in the twenty-year Russia development plan at least brings more investment opportunities and fewer of the frustrations of the past eight years.
The president and those who are going to play key roles in his new team at the top of government have already spelled out many of the priorities for his administration. On a first reading, they represent a radical shift from the actions of the past eight years. To many investors, this leaves open the question of whether the planned changes can be achieved without endangering the fiscal and political stability that has underpinned the Russia growth story of the past eight years. But this is evolution, not revolution. Everything that the new president has talked about can be identified as part of the so-called Putin plan, ie. the 20-year plan to change Russia from the old Soviet inheritance to a more modern country. Putin as president largely achieved the objectives he identified for phase one of that plan, and now we are moving on to phase two. Putin will remain as the guarantor of basic stability while Medvedev's role will be to emphasize the objectives of this next phase. To this extent and in terms of economics, the two compliment each other rather than potentially conflict.
The next phase
So what, in practical terms, can we expect from the new administration and from this new phase in the Putin Plan?
We have had theoretical speeches outlining the long-term objectives of diversification, of creating more sustainable growth drivers in the economy, of delivering more even wealth distribution, and of ridding the economy of such growth retard-ants as corruption and red-tape. The reality is that the bureaucracy is still entrenched in Soviet-era practices, productivity in the economy is falling, and there has been little meaningful investment in new capacity over the past eight years. Even though the country's financial reserves are over $500bn and incremental growth is coming from outside of extractive industries, the basis of the economy and over half of budget revenues are vulnerable to the price of a barrel of oil. It is all very well to say that the economy can withstand a fall in oil price to $50 per barrel (a level close to what it was nearly a year ago) in financial terms, but much of the success or failure of the objectives of this next phase in the development of the economy will depend on investor and consumer confidence, and a great deal will depend on effective management by the government. A falling oil price has tested both in the past. Without any meaningful progress in reducing the dependency on oil revenues, it surely will again. The only way that this risk can be reduced is to increase the pace of diversification, efficiency and productivity across the economy. Until this starts to happen, the "Russia investment story" will remain vulnerable.
But, let's take the optimistic view that the price of oil stays high enough long enough to provide a supportive backdrop. Basically that means an average price for Brent of approximately $65 per barrel over the next three years. Where should we look to invest - both in terms of strategic and portfolio - and which industries are best placed to benefit from a successful roll-out of the Medvedev-phase of the twenty-year Putin Plan?
If you add up the monetary value of all of the spending plans declared by the many industry interest groups, the total quickly climbs into the trillions of dollars. Obviously, even with the current level of financial reserves and revenues, the state does not have unlimited spending power. It also does not have the capacity in terms of administrative resources to push too many projects at once. It will again be a case of prioritizing strategies, as it was during the past eight years. Only this time the priorities will be for spending rather than restructuring.
From an investor's perspective it is best to divide opportunities into six main categories: process industries, refocused industries, defence industries, new economy industries, infrastructure, and the broadening economy.
Process industries: While the main objective of the government's plan for the economy is to create greater overall diversity, the initial focus is expected to be towards achieving a better balance within the extractive industries. Basically to move further up the value chain by processing more of the country's raw materials into products that then create a better export mix. This is already very evident in the oil sector with its more advantageous tax regime for oil that is processed in refineries rather than exported as crude. It is also the reason for the rising tariff on the export of unprocessed timber. Generally we expect to see the government use a mixture of tax and other financial incentives, plus direct spending on infrastructure, such as pipelines, to encourage the building and modernization of refineries, petrochemical processing plants, LNG facilities, smelters, timber processing plants, etc. In the oil, gas, and chemicals sectors alone, the total amount targeted is around $150bn over the next eight years, with between $75bn and $100bn targeted for other processing industries.
Re-Engineered industries: Industries such as the nuclear sector that the state plans to extensively modernize and then develop as either one of the drivers of the economy or as an export earner. Typically these industries will require several years of high levels of investment and restructuring before they significantly raise their contribution to the economy. Apart from the nuclear sector, already identified as a contributor to Russia's own energy needs and a future export earner, other sectors in this category include civil aviation, agriculture and shipping. Spending plans in the nuclear sector alone are planned at over $60bn until 2025, and the agriculture sector is targeted with spending of at least $100bn until 2020.
Defence Industries : The government is planning to raise spending for defence equipment by 30% per annum compounded over the next eight years to 2015. This is mainly to develop new equipment for the export market that is worth about $7bn annually today. The plan is both to increase the value of the business and to use direct state support in the development of the industries to help boost growth in civil technology industries.
New economy industries: These are the industries, such as information technology and nano-technology, which the government sees as capable of developing into major new industries that can contribute sustainable growth to the economy, create new sources of employment, and deliver export earnings. The funding in place to help promote the development of these industries is already about $35bn with allocations having been made from the Stabilization Fund and the proceeds of the Yukos auctions to the Development Bank, the Investment Fund and the Nano-Technology Fund.
Infrastructure: Russia's infrastructure quite obviously needs a major upgrade, and senior ministers have openly acknowledged that investment into other areas of the economy or industry will not be efficient unless infrastructure capacity is increased. The electricity generating and distribution industries are a major part of this, and the preparatory phase of splitting UES into dozens of independent entities is now all but done. It is estimated that spending in this sector will need to total at least $500bn over the next 20 to 25 years. Russia Railways has advanced in its plans to add 20,000 kilometres of new rails, plus rolling stock and other infrastructure. The estimated likely cost is another $400bn-500bn.
Broadening economy: While the state is mainly concerned with overseeing the development of strategic industry sectors, the broader economy is expected to continue growing if the basic conditions of fiscal and political stability remain in place and the confidence of consumers and investors is preserved. This also implies that the new government will be successful in controlling inflation, creating the right liquidity conditions and interest rate environment, and fostering a competitive backdrop. This is no easy task for any emerging economy during the phase of change that Russia is now entering.
Finally, there is the international factor. Yes it is fair to cite Russia as an example of an investment haven because it has a substantial amount of the resources it needs to fund major infrastructure and other development programs available domestically. Of course this assumes an oil price average of over $80 per barrel (Urals) for this year and an average of at least $65 per barrel over the following three years. This required average is likely to rise if the trend in current spending to cover higher pensions and state employee salaries continues. But domestic resources will mainly be focused on strategic industries and on creating a favourable backdrop for investment into other areas of the economy. The money to actually push the targeted growth in these industries will have to come mainly from foreign banks and investors, and the first hurdle will be to refinance a considerable amount of the existing private sector debt. Failure to do this will call a halt to the boom times just as effectively as uncontrolled inflation will. There is no question, the benefit-of-the-doubt will be critically tested several times during the approaching honeymoon period.
Chris Weafer is Chief Strategist at Uralsib Capital LLC
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