Russia gets competitive

By bne IntelliNews March 28, 2011

Ben Aris in Moscow -

"The only business in Russia is politics." Jailed oil magnate Mikhail Khodorkovsky made this famous remark in the 1990s and it used to be true. Things didn't work out so well for Khodorkovsky, nor his company Yukos, as mixing politics with business is dangerous. But that didn't stop most of Russia's richest men from making fortunes by finagling the state out of its more precious assets.

Russia's "economy" was pretty basic back then and had more to do with trading on the price distortions left over from the Soviet-era than producing anything. As a result, the Kremlin had a hard time defending itself against the US administration, which refused to grant Russia "market economy" status, the lack of which comes with punitive trade tariffs.

A decade later and everything has changed. Ten years of 6%-plus economic growth and no one denies Russia has a market any more. Proper home-grown businesses have appeared in nearly every sector; strategic investors are buying out leading Russian companies in multi-billion-dollar deals. The state has successfully re-engineered a few sectors so that competition, not state orders, drives them forward. And companies are going head-to-head in the marketplace to win over customers. The ukaz (decree) has given way to the reklama (advert) as the weapon of choice in Russian business. Real competition has finally arrived. "Russia's economy has entered a golden phase where strategic investors have arrived and are willing to pay top dollar to break into the most attractive markets," says Roland Nash, CIO of Verno Capital. "This was all those entrepreneurs were dreaming about when they set up their companies in the 1990s."

Banking on Russia

The change is particularly noticeable in the banking sector, which was one of the first to be reformed.

The financial crisis has catalysed the change and the gold rush that began in 2004 with GE Capital's purchase of Russian mortgage specialist Delta Bank has reversed as the global banks that had rushed into Russia to grab a piece of the fast growing retail part of the business have found the competition too fierce post-crisis and are now leaving. "Between 2005 and 2007, lots of foreign banks entered Russia, but despite the competition the sector was still growing very fast, so there was plenty to go round," says Svetlana Kovalskaya, bank analyst with Renaissance Capital. "But after the crisis that growth slowed and competition - especially from the state-owned banks - is more serious. Both Sberbank and VTB have become a lot more aggressive, particularly in the small and medium-sized enterprise and retail banking sectors."

State-owned retail behemoth Sberbank used to be an ultra-conservative lender requiring guarantees and a ream of documents before it would loan money to a person. More recently, it has moved over to a score-based system for approving credits. And VTB went from a standing start in 2004 when it had no retail business at all to become the second biggest retail bank in Russia today. The result is that the foreign banks which didn't have a well thought-out strategy have bailed. The latest example was the UK's Barclays Bank, which announced in February it is looking for a buyer for its retail operations (see


More subtly, the margin squeeze has also affected established banks. Ed Kaufman, CEO of Alfa Bank, tells bne: "In recent years, margins have been continually squeezed in our investment bank business; where we used to make several percent spreads on deals, now we count them in basis points. A standalone investment bank business is not really viable any more; we do it more as a support for our corporate banking business."

And competition will only get tougher as the long-awaited consolidation in the sector gets underway: the number of institutions in Russia fell to 952 as of March 1, down from well over 2,500 in the 1990s. In one of the biggest acquisitions so far, Sberbank purchased leading investment bank Troika Dialog in the middle of March, and Moody's Investors Service says more deals are in the works. "The conditions are in place for [banking] M&A activity to gain momentum in Russia," Eugene Tarzimanov, a senior bank analyst at Moody's, writes in the report. "Banks have the means to finance deals, evidenced by a high share of liquid assets and increased access to debt financing. Many banks also have excess capital, which they are looking to utilise. Lower M&A valuations following the crisis, combined with accelerating credit growth also stimulate M&A demand."

Customer is king

Big deals aren't limited to the banking sector: since the start of the year, there have been several mega-deals in the food/beverage and retail sectors too.

Indeed, the volume of M&A deals in Russia soared last year. A recent survey by CMS, a law firm in Moscow, says the total volume was up to $56bn in 2010 against a mere $18bn worth of deals in 2009 - and that was just the deals that were publicly declared. "The top-10 list shows that the bulk of deals were Russian-Russian, which means that foreigners are partly missing out on the M&A party," says Liam Halligan, chief economist with Prosperity Capital Management. "The conclusion is that those foreigners who have done strategic investments have generally found it not so difficult to invest in Russia and they have very few regrets."

PepsiCo made headlines in January by paying $3.8bn to buy leading dairy producer Wimm-Bill-Dann - and this was on top of the $3bn the US company has already invested in its own Russian operations. PepsiCo is now the biggest food producer in Russia.

This deal followed on from Russian supermarket powerhouse X5's deal to buy smaller rival Kopeika in December for $1.65bn as the supermarket business starts to consolidate.

Supermarkets have become big business. Market leader Magnit, a Russian regional supermarket chain, turned in yet more record sales in February: revenues were up a whopping 54% year on year to $827m, supported by the company's relentless expansion. Magnit opened 51 new stores in February alone.

Russia's formal retail market has become extremely attractive; it had turnover of over $45bn in just the January-February period, of which the leading supermarkets still only account for 15% of the total. But these players are already so big it's becoming increasingly difficult for new players to enter the market and those without a significant presence to gain a foothold. The competition is so tough that the world's biggest chain, Wal-Mart, announced it was finally giving up on an attempt to break into the Russian market and closed its Moscow office in January. Wal-Mart has been floating around the edge of the Russian market for almost a decade, but a week after the X5-Kopeika deal it pulled the plug. "With Kopeika gone, there are no serious acquisition targets available," says Dr Daniel Thorniley, president of the consultancy DT-Global Business Consulting in a survey of fast moving consumer good companies in February, who advised Wal-Mart. "It has become too expensive to launch a new operation from scratch, so Wal-Mart left for China and India where the market is still wide open."

Thorniley says that all the companies in retail, not just grocery stores, have been forced to reassess their strategies. The crisis depressed margins and sales volumes, so now managers are now concentrating on increasing revenues rather than just pushing the most profitable products; prices are set to come down across the board as competition for the shoppers' ruble increases.

Driving competition

Perhaps the most remarkable change has been the Kremlin's success in remaking the country's automotive sector.

With control of a massive $500bn cash pile, it is pretty easy for the state to make the banking sector profitable while it tinkers with the laws to make the sector more efficient (a work in progress). And reforming the retail sector is apolitical - all you need to do is free up prices and ensure there is access to capital for the sector to grow. But getting industrial sectors like cars off the ground is not easy at all, as industrial policy makes a big difference to the health of the sector.

Over the last decade, the Kremlin has signed a series of investment deals that grandfathered in tax breaks and duty discounts, which has brought in nearly all of the world's big carmakers to Russia. Several automotive clusters have sprung up - the biggest in St Petersburg and Kaluga - to the point where the country's roads are getting clogged with traffic; the Lada is becoming an increasingly rare sight on Moscow's thoroughfares.

In February, the Kremlin moved the game forward by signing a second round of investment deals with six of these producers. More tax breaks were on offer for any company willing to increase production to 300,000 units by 2020 as the Kremlin races to make the sector more able to compete head-to-head with imports before it joins the World Trade Organisation (WTO), which will force Russia to lower import duties. The signing of the deals in February (which will be finalised in June) means Russia will almost certainly become the biggest car market in Europe by 2015, if not before (see story). "We didn't expect such a strong response from the producers, so now we are sure that Russia will be the number one car producer in Europe in the next years," Alexander Rakhmanov, director of the automotive and agricultural machinery department at Russia's Ministry of Industry and Trade, tells bne.

The Kremlin's effort to promote investment in the car sector has been an unqualified success and transformed the sector out of all recognition (to the chagrin of anyone who actually has to drive in Moscow). One of the side effects has been that the shares of the listed car companies have soared (see the chapter "Reforms work" in bne's Russia Outlook 2011 here).

The crisis, of course, hit Europe's car market hard and sales collapsed in Russia as they did elsewhere. However, it has also been one of the first sectors to recover.

State support for the car sector - the so-called "cash for clunkers" scheme - is due to end on April 1, but competition is already hotting up. Several leading makers have already announced plans to launch new models this spring. Daimler hopes to begin production of its hugely successful Sprinter van and Hyundai is about to launch the Solaris saloon to widespread enthusiasm amongst Russian dealers. The market would have grown on its own, but the imminent WTO accession is a goad that has focused everyone on the need to pick up the pace.

The automotive sector is emerging as a node for driving Russia's modernisation and diversification - the central themes of Dmitry Medvedev's presidency. The new heightened production levels means the sector will reach critical mass - experts put the magic number at a total production of 4m units a year against the 1.2m cars made in 2010 - that will pull in other business and services to serve the needs of the car-clusters. "For every one job that we create in the automotive industry, we create another 16 jobs in ancillary sectors," says Rakhmanov. "And the Russian market is still far from reaching saturation, but the market is already a developed one with some features of an emerging market."

It may look a little like the Kremlin held a gun to carmakers' heads and forced them to raise production, but it didn't really have a choice. Domestic car production has to be ready to meet the competition that WTO membership will bring, but Rakhmanov says with passenger cars, Russia is already there. "With cars we are ready to compete and WTO access will not have a big impact," says Rakhmanov. "There is a seven-year transition period and that is more than enough time to finish the ongoing reforms. In buses and trucks the situation is different, but we are looking at various measures to prepare those sectors for accession."

And the rest

The success of the car sector has provided a blueprint for how other sectors will be reformed. That is the point of all the national champions the Kremlin has created in planes, rail, shipping, metals and so on - the hope is to get all these sectors to critical mass so the "multiplier effect" starts working (one job in cars makes 16 jobs in ancillary sectors).

The aviation sector was remade several years ago and reorganised into the United Aviation Corporation (UAC), which will supply the first batch of commercial SuperJet planes this April. A very similar investment programme to the car plan was launched for pharmaceuticals in December, which will force international producers to increase their Russian production, as bne reported in February.

At the same time, there'll be heavy spending on infrastructure to support these businesses. The state has been spending on the order of $35bn a year on restructuring the railway network and heavy investment in the roads started this year. Indeed, much of infrastructure spending has been framed by Russia's hosting of the 2018 World Cup - Prime Minister Vladimir Putin promised to spend $10bn on facilities, but if you add in all the airports, hotels, roads, power stations, high-speed rail links also planned, then the spending is closer to $60bn.

All these deals will also result in closer cooperation between Russian and international companies, which bring the crucial know-how and management skills. One of the features of the new investment agreements is that many of the international companies have been driven into joint ventures or alliances with Russia producers. France's Renault has teamed up with Avtovaz; Germany's Daimler is in partnership with Russian truck maker Kamaz; and Fiat joined forces with Russian saloon-maker Solliers. These partnerships will help the sector adopt modern "just-in-time" delivery and efficient production, ending the Soviet-era "next month if you're lucky" supply system that still dominates much of today's industrial production.

In a different version of the same thing, the Kremlin has changed its mind about excluding foreigners from so-called "strategic sectors." The share swap between UK oil company BP and state-owned Rosneft in January created a joint venture to develop deposits in the Arctic in a win-win deal: Rosneft has the oil and BP has the know-how to get at it. In these sectors, the plan seems to be to give multinationals a minority stake in the major Russian companies as well as give up some access to Russia's treasures in exchange for the know-how this cooperation brings.

All these changes come not a moment to soon. Several government officials interviewed by bne in recent months have said that reforms must be made now or Russia will lose its competitive edge as wages rise, driven up by oil prices. The booklet "Attaining the Future: Strategy 2012" published by the Institute of Contemporary Development on policy for the next decade sums up the thinking: modernisation is the only way forward, otherwise Russia will face slow decline. "The catastrophe may not hit for some time, but we have reached the time when a decision must be made and are approaching the point of no return."

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