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Investment Climate Statement - Russia

2012 Investment Climate Statement
Bureau of Economic and Business Affairs
June 2012

Openness to, and Restrictions Upon, Foreign Investment

The Russian market presents many promising investment opportunities. Capitalizing on those opportunities, however, requires that firms navigate a complicated and fluid set of challenges ranging from corruption to a weak judiciary to excessive red tape. Russia recognizes foreign investment's critical role in the country's economic development and has encouraged foreign investment by removing administrative barriers and establishing special economic zones, high-technology parks, and investment promotion funds. At the same time, despite the Russian government's stated goals of combating corruption and improving the investment climate, independent organizations continue to rank Russia as one of the most difficult major economies in which to do business.

Russia was one of the countries most adversely affected by the 2008-2009 financial crisis, with 2009 GDP dropping by 7.9%. Russia's economy grew 4.0% in 2010 and further picked up in 2011, with annual growth predicted to reach 4.2-4.5%. From 2004-2008, foreign direct investment (FDI) inflows picked up substantially, rising to $75 billion in 2008. In 2009, however, FDI inflows fell by almost half and have remained well below 2008 levels. According to Prime Minister Putin, FDI inflows for the first ten months of 2011 equaled $36 billion, an 11.8% increase from the same period of 2010. The last few years have also seen large amounts of capital leaving the country. Russia experienced a net capital outflow of $133.9 billion in 2008 and $56.9 billion in 2009. In 2010, capital outflow slowed to $33.6 billion, but has accelerated again in 2011, and is expected to reach about $85 billion for the year. These outflows can be attributed to external as well as Russia-specific factors.

President Medvedev and Prime Minister Putin have repeatedly emphasized the importance of improving Russia's business climate and attracting foreign capital, particularly in the high technology sector. The country's solid base of expertise in the scientific and mathematics fields, combined with a sizable market and an economy growing faster than most others in the region, have helped entice a series of U.S. firms to make headline acquisitions and investments in Russia. Roughly a dozen U.S. companies and organizations already have announced their intention to invest in the Skolkovo Innovation Center, Russia's initiative to create a high-tech cluster, modeled on the example of Silicon Valley, in Moscow's outskirts. Nevertheless, the investment climate has been undermined by the slow pace of structural reform and the government's leading role in certain sectors of the economy, notably energy. Additionally, past government actions have contributed to a sense of wariness among some foreign investors about the risks of the Russian market, such as the apparently politically-motivated investigations into businesses. Rule of law, corporate governance, transparency, and respect for property rights are gradually improving but remain key concerns for foreign investors. While Russia took significant steps in 2010 and 2011 to improve the legal framework for intellectual property protection, effective enforcement remains a challenge. Possible liabilities associated with existing operations (especially environmental cleanup) and still-developing bankruptcy procedures are additional factors affecting the investment climate. In short, while there is strong interest in the opportunities Russia presents, many U.S. companies, particularly small and medium-sized enterprises, remain cautious about investing.

While a legal structure exists to support foreign investors, the laws are not always enforced in practice. The 1991 Investment Code and 1999 Law on Foreign Investment guarantee that foreign investors enjoy rights equal to those of Russian investors, although some industries have limits on foreign ownership (discussed below). Unfortunately, corruption plays a sizeable role in the judicial system (see the Dispute Settlement section). Russia has sought to enhance consultation mechanisms with international businesses, including through the Foreign Investment Advisory Council, regarding the impact of the country's legislation and regulations on the business and investment climate. Still, the country's investment dispute resolution mechanisms remain a work in progress, and at present can result in a non-transparent, unpredictable process.

Russian government officials have repeatedly stressed that foreign investment and technology transfer are critical to Russia's economic modernization. At the same time, the government adopted new policies to more effectively control foreign investments in key sectors of the Russian economy. In May 2008, Russia enacted the Strategic Sectors Law – specifying 42 activities that have strategic significance for national defense and state security – and established an approval process for foreign investment in these areas. According to the law, investors wishing to increase or gain ownership above certain thresholds need to seek prior approval from a government commission headed by Russia's Prime Minister. Partly in response to investor criticism, in 2011 Russia amended the law to simplify the approval process and narrow the range of potential investments requiring formal review by the commission. With respect to the extractive industries, previously, government approval was required for foreign ownership above 10% of companies operating subsoil plots of "federal significance." The November reforms raised the threshold to 25%, a move that experts predict will greatly reduce the number of cases considered by the commission. Some foreign investors have raised concerns that the Strategic Sectors Law could be used to restrict foreign investors' access to certain sectors. Since 2008, however, the commission has approved 128 of 136 applications for foreign investment.

Between 2004 and 2010, the share of Russia's private sector in GDP decreased from 70% to 65%, according to the European Bank for Reconstruction and Development. The government also continues to hold significant blocks of shares in many privatized enterprises. In an effort to increase market forces in the economy and raise revenue for the federal budget, in 2009 the government began considering more ambitious privatization of strategic enterprises. In October 2010, the Russian Cabinet approved a major Privatization Plan, which Russia is now in the process of expanding, that paves the way for selling an estimated $60 billion of government stakes in about 1000 companies (out of a total of 6,467 companies with some government ownership). The government will retain controlling stakes, however, in major Russian companies such as Rosneft, Russian Railways, and banking giants Sberbank and VTB. The pace of privatization has been slow, however, and Russian officials have signaled that it is unlikely to accelerate in the near-term.

To date, treatment of foreign investment in new privatizations has been inconsistent. As with the 2011-2013 Privatization Plan, foreign investors participating in Russian privatization sales are often confined to limited positions. As a result, many have faced problems with minority shareholder rights and corporate governance. Potential foreign investors are advised to work directly and closely with appropriate local, regional, and federal ministries and agencies that exercise ownership and other authority over companies whose shares they may want to acquire.

Efficient Capital Markets and Portfolio Investment

The Russian banking system remains relatively small, with RUB 4.9 trillion ($164.7 billion) in aggregate capital as of November 1, 2011. Though Russia has roughly 1000 banks, the sector is dominated by state-owned banks, particularly Sberbank and VTB. The six largest banks in Russia are state-controlled, and the top five held 49.1% of all bank assets in Russia as of November 1, 2011. The successful implementation of the Deposit Insurance System in 2004 has proved a critical psychological boon to the banking sector, evidenced by growth in overall deposits. Despite measured progress, the Russian banking system is not yet efficiently performing its basic role of financial intermediary (i.e., taking deposits and lending to business and individuals). At the beginning of 2011, aggregate assets of the banking sector amounted to just 75% of GDP and aggregate capital was just 10% of GDP. Russia's banking sector is recovering from the economic crisis, with loan growth reaching 15% in 2010 and accelerating to 20% in the 12 months running to November 1, 2011. The share within Russia's banking sector of non-performing and troubled loans, which during the 2008-2009 financial crisis increased substantially, stabilized in 2010 at around 20% and began to slowly decline in the second half of 2011. Russia's two main stock exchanges – the Russian Trading System (RTS) and the Moscow Interbank Currency Exchange (MICEX) – merged on December 19, 2011. The integration of their trading platforms, clearing systems, data centers and other operations should be completed by the end of 2012 and the MICEX-RTS bourse is eyeing an initial public offering (IPO) soon. Russian authorities and shareholders of MICEX and RTS believe the merged entity, MICEX-RTS, will become a global player. However, most large Russian companies choose to list their stock in London and elsewhere abroad in order to obtain higher valuations.

The Law on the Securities Market includes definitions of corporate bonds, mutual funds, options, futures, and forwards. Companies offering public shares are required to disclose specific information during the placement process, as well as on a quarterly basis. In addition, the law defines the responsibilities of financial consultants who assist companies with stock offerings and holds them liable for the accuracy of the data presented to shareholders.

Russian financial authorities are trying to deepen the ruble-denominated domestic debt market to make it more attractive to foreign investors. In December, the Central Bank issued a resolution allowing, effective January 1, 2012, government bonds (aka OFZs) to be traded outside Russian exchanges (over the counter). Currently, foreign investors wanting to trade domestic bonds have to set up local brokerage and custody accounts, a lengthy process that discourages many investors from buying OFZs. Additionally, MICEX intends to sign an agreement with Euroclear Bank, the world's largest settlement system for securities, which will allow foreigners to settle their Russian government bond transactions without the need for a local trading account.

Hostile takeovers are common in Russia among both foreign and local firms. Private companies' defenses to prevent hostile takeovers relate to all potential hostile takeovers, not just foreign ones.

Russia's financial market suffers from a shortage of private domestic institutional investors. For example, the life insurance market is miniscule, comprising only 3% of insurance premium payments. Private pension funds, held back by a public distrust of financial instruments and a lack of tax incentives, make up just 2% of financial assets in Russia, equal to 2% of GDP.

Competition from State-Owned Enterprises

Despite large-scale privatizations, the seven existing state corporations still play a large role in the Russian economy. (Note: State corporations are 100% owned by the Russian government and operate under special legislation. The Russian economy also features thousands of other companies owned in part or whole by the Russian government that operate under different legal arrangements, such as unitary enterprises and joint stock companies.) While private enterprises are technically allowed to compete with state corporations on the same terms and conditions, in practice, the playing field is tilted. State corporation holding structures and management arrangements (e.g., state representatives as board members) make it difficult for private enterprises to compete. Furthermore, specific legal constructions can result in preferential treatment of state corporations. For example, state corporations have no unified legal framework, being set up under different legislation than that which applies to other corporations. Such a case-by-case approach leaves much scope for discretion and lobbying by company insiders.

Corporate governance of state corporations is characterized by the "dual management" model. The Federal Agency for State Property Management (Rosimushchestvo) is authorized by the Russian government to exercise shareholder rights for federally-owned shares in companies and is responsible for the preparation and nomination of candidates at the annual meetings of shareholders. As a general rule, Rosimushchestvo nominates to a company's board of directors representatives of the most relevant government body, based on the sectoral characteristics of the business. The sectoral state body thus participates in managing the company through its representatives. In important companies that straddle the sectoral priorities of the government and its political interests, top government officials were traditionally nominated to the boards of directors. An April 2011 Presidential decree, however, ordered high-level government officials to step down from the boards of directors of state companies. Issues that hamper the efficient operations of state corporations include a lack of transparency, unclear responsibilities of boards of directors, misalignment of managers' incentives and company performance, inadequate control mechanisms on managers' total remuneration or their use of assets transferred by the state to the state corporation, and reduced disclosure requirements.

As discussed above, the Russian government Privatization Plan aims to sell an estimated $60 billion of government stakes in about 1000 companies, and an expansion of the Plan is currently being developed. In February 2011, the government successfully privatized a 10% minority share in VTB Bank. Overall, however, implementation of the Privatization Plan has slowed, in part due to poor market conditions and uncertain government enthusiasm to carry out the plan.

There are two sovereign wealth funds in Russia: the Reserve Fund ($25 billion as of December 2011) and the National Wealth Fund ($88 billion as of December 2011). Management of both funds' assets is executed by the Ministry of Finance in accordance with procedures and terms established by Government of the Russian Federation. The Central Bank of Russia acts as operational manager.

Reserve Fund assets can be used to purchase: foreign currencies (dollars, euro, pounds) that are then kept in the Federal Treasury's accounts with the Central Bank of Russia, which in turn pays interest on those deposits; and financial assets denominated in foreign currencies. The list of eligible financial asset classes is determined by Russian legislation. Ministry of Finance guidelines for Reserve Fund asset allocation are foreign (12 OECD countries) government debt instruments – 95%, international financial institutions' (a closed list of 9) debt instruments – 5%. The National Wealth Fund can be held in foreign currencies (dollars, euro, pounds) in the Federal Treasury's accounts with the Central Bank of Russia, which pays interest according to the bank account agreement. The National Wealth Fund can also be used to purchase financial assets denominated in Russian rubles and eligible foreign currencies. The Reserve Fund and National Wealth Fund are audited by Russia's Chamber of Accounts and the results are reported to the Federal Assembly. In 2009 and 2010, the Russian government tapped into both funds heavily to finance bail-out programs for major banks and industries during the global economic crisis. In 2011, the funds remained untouched, and in early 2012 the GOR plans to use a trillion rubles from the expected 2011 federal budget surplus to replenish the Reserve Fund to RUB1.8 trillion ($58 billion).

Corporate Social Responsibility (CSR)

While there is still little pressure from Russian consumers and shareholders, contact with peers, investors, and customers overseas has led Russian companies to focus more on their CSR reputations, and those of their brands. When seeking to acquire companies in Western countries or raise capital on international financial markets, Russian companies face international competition and scrutiny, including on CSR standards. Consequently, most large Russian companies currently have a CSR policy in place or are developing one. Russian firms' CSR policies often are now published on corporate Web sites and detailed in annual reports. These CSR policies and strategies, however, are still in an early stage relative to those of Western counterparts. The Russian government remains the most powerful stakeholder in the development of certain companies' CSR agendas, resulting in the expectation that these companies support local health, educational and social welfare systems as specified by the government.

The Federal Service for Financial Markets established a corporate governance code in 2002 and has endorsed an OECD White Paper on ways to improve practices in Russia. International business associations such as the American Chamber of Commerce in Russia, the U.S.-Russia Business Council, the Association of European Businesses in Russia, and the International Business Leaders Forum, as well as Russian business associations, stress corporate governance as an important priority for their members and for Russian businesses overall. One association, the Russian Union of Industrialists and Entrepreneurs, developed a Social Charter of Russian Business in 2004 that over 200 Russian companies and organizations have since joined.

Political Violence

Although the use of strong-arm tactics is not unknown in Russian commercial disputes, the Embassy is not aware of cases where foreign investments have been attacked or damaged for purely political reasons. Many have argued that the Russian Government's dismantlement of Yukos, in which American and other foreign investors held significant stakes, was undertaken in retaliation for the independent political activity of the company's head, Mikhail Khodorkovsky. While this case has raised questions about corruption, selective prosecution, and rule of law in Russia, the European Court of Human Rights ruled in September 2011 that the applicants had not offered sufficient evidence to prove that the Russian Government's actions against Yukos were politically motivated. Russia continues to struggle with an ongoing insurgency in Chechnya, Ingushetiya and Dagestan. These republics and neighboring regions in the northern Caucasus have a high risk of violence and kidnapping.

Recent large-scale public protests suggest that the country has become more politically engaged and that civic action may become more commonplace. Following wide-spread allegations of fraud during December 2011 parliamentary elections, tens of thousands of people turned out on the streets of Moscow and across Russia to demand free elections and the resignation of Central Election Committee chairman Vladimir Churov. Such public protests will likely continue in the run-up to March 2012 Presidential elections.


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