Russian Renaissance
As Russia undergoes some dramatic changes in an effort to modernise its economy, Heather Connon considers its economic turnaround and is struck by the transformation that has been taking place
In a Moscow winter, when the weather conditions make walking impractical, the clogged streets mean that it can take as long as 45 minutes in a car to complete a journey that would take just 15 minutes on foot. That encapsulates two of the key themes about modern Russia: the poor state of the country's infrastructure and the rising wealth of its residents.
The cars that gum up its streets are not just the decrepit Ladas of old, but gleaming modern cars; instead of queues outside empty shops, Western designer boutiques gleam invitingly on Tverskaya Street - the third most expensive place in the world to open a shop, according to a recent survey - and luxury flats are now rapidly replacing the ugly, uniform Soviet apartment blocks that used to house the majority of Muscovites.
Natural Wealth
Russia is booming: last year, the economy grew by 8.1 per cent and this growth still shows no signs of slowing down. It is a dramatic turnaround from a decade ago, when the country defaulted on its debt repayment and suffered a financial crisis. Foreign direct investment had last year reached more than US$54bn, because investors were attracted by the potential of a fast-growing economy, a growing middle class and, of course, the huge reserves of oil, in addition to the country's other sought-after commodities.
This natural wealth is the key reason for the country's recent transformation. Russia's assets are vast: it holds the world's largest natural gas reserves, the second-largest coal reserves, and the eighth-largest oil reserves, and it is using that wealth to generate external trade - Russia is the world's largest exporter of natural gas and the second-largest oil exporter. But oil is not its only valuable asset. Russia also has some 40 per cent of the world's nickel reserves, plus huge gold reserves - its largest gold-mining company Polyus is the world's fourth-largest gold company by reserves.
Commodities like these are what the world wants. The oil price soared from little over $10 a barrel a decade ago to over $140 in the summer of 2008, while gold has also been enjoying spectacular increases. That is helping Russia generate large surpluses; in the first quarter of this year alone, it generated 549bn roubles (£12bn) but it has been spending heavily too: already this year, the country has spent almost 1.4bn roubles - and it is under pressure to spend more of its resources windfall on further improving the lot of the Russian population.
Building a Future
Russia's government accepts the need to modernise the economy. Indeed, Dmitry Medvedev, the president of Russia, said before his election in May 2008: "Russia in the next four years should focus on four 'Is' - institutions, infrastructure, innovations and investments."
William Sutcliffe, the fund manager responsible for Russia in Baillie Gifford's Emerging Markets Team, believes Russia is poised for a "significant investment boom" as it spends to reconstruct and repair the crumbling infrastructure of the communist era. According to estimates, spending of US$560bn on roads, $80bn on railways, $33bn on ports and $70bn on energy grids is needed through to 2030 in order for this to happen. These sums are desperately needed as it is not just in the capital Moscow
that infrastructure is affecting trade. The number of airports is in decline, power infrastructure is inadequate (a new power station is currently being built at Polyus Gold's proposed Natalka mine as part of the project) and despite privatisation of housing in 1991, the stock is inadequate. In 2005, more than 42 per cent of Russian families lived in homes without sewerage or hot water, meaning many considered taking out mortgages just to make their homes conform to modern standards.
The huge oil wealth that Russia is generating means that it can afford the infrastructure spending. It has already built up a $160bn stabilisation fund, which has been split into the Reserve Fund and the National Welfare Fund - however, much of this is being invested outside the country in order to avoid fuelling the level of inflation in Russia.
Striking a Balance
Inflation is the main blot on Russia's otherwise rosy horizon. In the middle of 2008, inflation stood at 15.1 per cent; almost double that of China and India. That is partly because of the rising food prices that are affecting countries all across the world, but it is also due to the rapid expansion of the economy. Wages have been growing rapidly (real earnings rose by 16.2 per cent in 2007) while unemployment has fallen in each of the last five years to just 6.1 per cent last year. Domestic investment, too, has boomed over recent years.
The World Bank is concerned that these signs suggest the economy might overheat and warns that controlling inflation, while keeping up the pace of reform, is Russia's key challenge. It will be a tough balancing act to achieve. "It is difficult to pursue counter-cyclical policies when there is so much money moving around the economy," says Sutcliffe.
Russia would undoubtedly be left vulnerable to any potential slowdown in the commodity boom. However, unless the oil price plunges to levels of a decade ago (which is unlikely) the government's rather punitive tax regime paradoxically offers some protection. Oil companies have to pay an 80 per cent marginal tax rate when the oil price reaches over $27 a barrel, which means there is not much of an incentive to invest in oil reserves. However, Dmitry Medvedev has indicated there will be reforms to this regime.
The well-publicised dispute between the Russian oil company TNK and BP and, perhaps, the recent military activity in Georgia, illustrate another potential risk in doing business with Russia: political. Certainly, Lord Robertson, TNK-BP's deputy chairman, has complained about what he perceives as an attempt to wrest control of the joint venture from BP, commenting: "They are... tarnishing Russia's reputation among international investors. Anyone who cares... about the future of Russia, its economy and the rule of law should be concerned." Although TNK-BP remains a dispute between two sets of private shareholders for now, some Western commentators see it as just another example of the risks that foreign companies incur by doing business in Russia, drawing comparisons with the events in 2006 and 2007 that led BP and Shell to relinquish control over attractive projects such as Sakhalin-2 and Kovykta to state-owned Gazprom. But while the tactics used may have been somewhat clumsy, many people in Russia regarded these transactions as the country simply trying to regain control over assets it feels that it gave away too cheaply in the aftermath of the Russian crisis. What the BP boss does not add is that oil companies like his have already made substantial profits from Russian oil, nor is there much sign yet that it is deterring any inward investment, given that foreign direct investment has increased four-fold since 2003.
Land of Opportunity
There are, in any case, plenty of opportunities for investment in fast-growing domestic industries. Retailers, banks and other domestic-related businesses are all enjoying something of a boom as Russians start to enjoy their new-found wealth. Indeed, Russia is now expected to become Europe's largest consumer market this year.
There are many companies to choose from. Two decades ago, Russians used to carry a string bag called an avoska, or 'just in case' bag, just in case they saw something for sale in the customarily empty shops. Today, their new-found wealth is sending retail sales and banking services soaring. X5, supermarket and leading retailer in Russia, saw its sales grow by almost 50 per cent in the first half of last year, no doubt as a result of wealthier Russians now spending more in modern supermarkets than in traditional markets. State-controlled Sberbank, the country's largest savings bank, is also benefiting from a gradual move away from the cash (or even barter) economy that used to predominate and into credit cards, mortgages and personal loans. Last year, its profits grew by about 30 per cent.
The Russian story may be based on the international currency of oil, but it's clear that the domestic growth story, while it remains fuelled by oil and commodities, is just as exciting, and is definitely one to watch over the coming years.
Heather Connon is investment editor of The Observer and a regular contributor to Trust.
Baillie Gifford's exposure to Russia
Baillie Gifford has holdings in a variety of Russian companies. Total Russian listed holdings in our global trusts are as follows (as at 31 August 2008): |
| Scottish Mortgage Investment Trust PLC |
5.9% |
| The Monks Investment Trust PLC |
2.1% |
| The Scottish American Investment Company P.L.C. |
1.7% |
| Edinburgh Worldwide Investment Trust plc |
6.5% |
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