INVISIBLE HAND: Foreign investors in Russia ignore Cold War rhetoric

INVISIBLE HAND: Foreign investors in Russia ignore Cold War rhetoric
French retail chain Auchan has established almost 100 hypermarkets across Russia.
By Liam Halligan in London March 28, 2017

What are grown-up investors to make of relations between Russia and the West? The rhetoric emanating from politicians and media commentators, in the US and UK at least, seems to be drawn from another era.

Mainstream British and American newspapers are full of coverage about the Kremlin’s connections to US President Donald Trump, Secretary of State Rex Tillerson and Trump’s former National Security Advisor Michael Flynn. Some headlines go into full Cold War retro mode, talking of spy swaps and “Soviet agents”.

Russia’s official media has, typically, responded in spades. Against the background of the Ukraine crisis and related sanctions, accusations of “Kremlin meddling” in the US election have been met with more, even harsher, anti-Western rhetoric from Moscow. Such spiralling paranoia makes it seem like we’re through a bizarre re-run of the halcyon days of McCarthyism and Mutually Assured Destruction.

Beyond the garish headlines, though, there are signs of life in the Russian economy and, while they’re not necessarily shouting about it, many Western companies are taking note. After growth stalled badly in 2014 and 2015, as sanctions bit amidst a collapsing oil price, Russian retail sales, industrial production and broader GDP are now firmly in expansion mode.

For all the Cold War chest beating, Russia’s growth uptick has sparked renewed foreign direct investment.

Daimler in February announced it is pumping $260m into a new plant near Moscow to make Mercedes-Benz cars, the first major Russia commitment by a leading Western automaker since sanctions were imposed three years ago. While Daimler already builds trucks in central Russia – in partnership with local manufacturer Kamaz - this is the German thoroughbred’s passenger vehicle debut in Russia, with the first cars due to leave the new factory in 2019.

Since Russia’s downturn, a 50% slide in the ruble has reduced automakers’ local production costs – a benefit felt across the economy, from car production to oil and gas and food processing. Although auto sales in Russia have halved from a peak of almost 3mn in 2012, industry insiders now report rising demand, as prospective buyers start venturing back to the showrooms – a trend not lost on Daimler.

Ikea has latched onto the same idea. Over the last decade and a half, since opening its first Russia-based store in 2000, the Swedish furniture-retailing giant has built more than a dozen Ikea “Mega” shopping centres in Russia, from St Petersburg to Novosibirsk in Siberia. As consumers bounce back, Ikea has announced a $1.6bn investment into more Russian malls over the next five years or so. French DIY-specialist Leroy Merlin has similarly announced $2.2bn plan to double its 50+ Russian stores over the same period.

Having contracted 2.8% in 2015 and around 0.2% last year, the Russian economy will grow by around 2% in 2017, according to the economy ministry. The World Bank, which has a track record of under-estimating Russian growth, has pencilled in a 1.5% expansion this year and 1.7% in 2018.

An expected recovery in consumer demand and investment, then, is set to combine with a stable currency and lower inflation. The official 2017 inflation target is 4%, down from an outcome of 5.4% last year and 12.9% in 2015. In February, year-on-year inflation fell to 4.6%, the first sub-5% reading in Russia’s post-Soviet history.

Falling price pressures have already raised speculation that, while the US Federal Reserve is now clearly increasing interest rates, the Central Bank of Russia is now embarking on a series of cuts. Russia’s main bank rate, having been cut from 10% to 9.75% in late March, could now drop further, if price pressures abate faster than expected. The government hopes that getting inflation and rates down “to levels seen in normal countries” will boost long-term borrowing and investment.

Having demonstrated sustained interest in Russia, the likes of Ikea and Daimler froze new investments in 2014, as the US and European Union imposed sanctions after the annexation of Crimea. Now such companies are once again upping their Russian stakes, despite little sign that sanctions will be lifted anytime soon.

Fabled spending power

Experienced investors are mindful that Russian retail sales, having plunged by 10% in 2015, and 5.2% last year, are set to expand by a relatively healthy 2-2.5% in 2017. But that’s not the full story. Prior to sanctions, consumption was properly booming, reflecting the fabled spending power of the emerging Russian middle class long-targeted by brave multinationals. From 2010 to 2012 inclusive, retail sales grew by an extremely buoyant 5.8% a year. Dollar-terms per capita income expanded, over that same three-year period, from $10,500 to $14,200, with gross fixed investment growth averaging 7.3%.

The victory last October of Donald Trump, who had praised Vladimir Putin during his presidential campaign, suggested to some that the US might ease sanctions against Russia. From Trump’s election, until the end of the year, the main Moscow stock index rallied 20%. The steady rise in the oil price to $56 per barrel in December, from lows below $30 a year earlier, also helped make Russia look more attractive to portfolio investors.

In December, though, the EU extended sanctions by another six months, until July 2017. And just before Trump’s inauguration, President Obama prolonged America’s punitive measures until March 2018, blacklisting more senior Russia officials in response to Moscow’s alleged cyber-attacks during the US election. Oil has also settled close to $50, rather than pushing higher, as US shale providers have raised production, while Opec has found it hard to make recently-announced output quotas stick.

Despite all that, some big companies are starting to bet on Russia again, even if relations with the West remain in deep freeze. FDI into Russia rose to $8.3bn in 2016, up from $5.9bn the year before - a 41% increase. That’s still low compared to the pre-sanctions norm. From $43bn in 2010, annual FDI surged to almost $70bn in 2013, before crashing in the aftermath of the Ukraine conflict. The latest increase, though, despite on-going sanctions and ubiquitous negativity, shows just how determined some Western companies are to increase their presence.

In January, Pfizer launched the production of three drugs in Russia, in a joint venture based in St Petersburg, having long recognised the size and attractiveness of the country’s domestic market. The US pharmaceutical giant is also constructing a plant in the Kaluga region, some 125 miles from Moscow, alongside the Russian state-owned company Rusnano.

Mars, having operated in Russia for more than 25 years, has just launched an online store of handmade chocolates, manufactured in the group’s factory close to Moscow. Clocking up Russia sales of $190m last year, Mars is also expanding its existing local plants for chewing gum and pet food.

Remaining deterrent

And PepsiCo, yet another US giant, remains committed to Russia, its third-biggest market after the US and Mexico. The iconic food and beverage conglomerate acquired a majority stake in Russian dairy and fruit juice maker Wimm-Bill-Dann for $3.8bn in 2010, Russia’s biggest ever non-energy foreign investment. Since the West imposed sanctions, and Russia retaliated by banning most imported cheese, Pepsi has expanded domestic cheese production in Russia. At the turn of the year, the company also announced plans to build a baby food factory in Southern Russia’s Krasnador region, where it already has a diary plant.

Ikea is similarly emphasising Russian production, having opened a $60mn furniture factory near St. Petersburg late last year, while acquiring land for a third Mega mall near the country’s second city. The flat-pack specialist aims to raise its share of Russian-produced goods to 80% over the next few years - and is already exporting Russia-made products to Western Europe and China.

Geopolitical tensions certainly remain a deterrent to overseas portfolio investment. Since Trump took office in early February, and the US-Russia mood music has not only failed to improve but actually got worse, Moscow stock indices have dropped more than 10%. Highly-experienced foreign direct investors, though, are not only hanging in there, but are now starting to take the opportunity to localise production and grab additional market share.

French retailing chain Auchan, having established almost 100 hypermarkets across Russia to see off its compatriot rival Carrefour, is investing anew in Russia, having concluded the economy there has largely adapted to sanctions. Bulgari and Hermes are also investing, fighting over the seemingly limitless Russian appetite for haute couture bling.

Some British companies, aside from the oil majors, are also getting in there when it comes to the Russian market. High-end fashion chain L.K. Bennett launched its first Moscow-based store last August and has plans to open five more over the next two years. Accepting the political challenges of operating in a country that’s been under financial sanctions since 2014, the London-based brand, famous for smart dresses, shoes and handbags, has been unable to resist the allure of Russia’s numerous big-spending female consumers.

Cold War coverage

The idea of a renewed superpower stand-off has been in the air for much of the last quarter of a century - ever since the actual Cold War ended. It has gained momentum since the Russia-Georgia conflict of 2008, of course, before going mainstream after the Ukraine crisis in 2014. Since then, and particularly since Trump secured the Republican nomination, even rather tenuous “links to Russia” have become a stick which Western politicians use to beat domestic political rivals.

Today’s Cold War frictions, though, bear little resemblance to the struggle that dominated the second half of the twentieth century. Most obviously, the ideological stakes are far lower – the contest between capitalism and communism having long been decided, at least as far as the Russians are concerned. The related proxy wars across Asia, Africa and Latin America, which pockmarked the 40 years after the Second World War, are also (with the tragic exception of Syria, perhaps) largely consigned to the past.

Yet this continued and intensifying East-West tension still poses serious dangers, going beyond nuclear weapons. Return to Cold War, a new book by Robert Legvold, a foreign policy expert based at New York’s Columbia University, argues that on-going bitterness between Russia and various Western powers has “crippled efforts to come to grips with the 21st century’s new challenges” – from nuclear arms reduction to anti-terrorism measures and climate change. Political leaders on both sides, says Legvold, need to behave differently if we are to make this new cold war “as short and shallow as possible”.

Foreign investors in Russia, in the meantime, already facing notoriously complex bureaucracy and tax laws, must keep contending with sanctions and ubiquitous “Cold War” media coverage from all sides. Some seem up for it anyway. That’s good news - and not only because lawful wealth creation is always good news.

For the reality is that this stand-off will only cease for good when the Russian and Western business interests who want to co-operate across the old Cold War divide are powerful enough to really assert their will on their domestic political masters. That will require many more joint ventures, much more trade and far greater volumes of cross-border business – not least, in both directions, ever more commercially-driven foreign direct investment.

“We see Russia as a real opportunity,” says Darren Topp, L.K Bennett’s Chief Executive. “At the end of the day we’re not into politics, we’re selling clothes and shoes,” he says “That’s all we do, sell clothes and shoes”.

Liam Halligan is Editor-at-Large at 
bne IntelliNews. Follow him on Twitter @liamhalligan.

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