Bearing with the bear

Harrison Salisbury, the New York Times’ first regular correspondent in Moscow after World War II, once described life in the Kremlin as “shrouded in impenetrable secrecy”. As intrigues and fighting rage in Eastern Ukraine, few Western observers would dispute the continued relevance of his depiction today.

Yet it was with an open heart that Vladimir Putin, and much of the country’s diplomatic establishment, addressed delegates at the fourth Moscow International Security Conference last month. Military agencies from 79 nations got to hear about Russia’s personal view of the world, starting with the responsibility of Western powers for the ongoing crisis in Ukraine and the danger posed by the international organisations they lead.

Whether these arguments managed to move many foreign ministries over to Russia’s side remains unclear, and the exercise was probably largely rhetorical anyway. But there is at least one reason why the country does urgently need to win people over. As it seeks to stimulate an economy battered by an oil price slump, sanctions, and scarce international financing, the government is courting investors of all stripes to support a growing list of mega-projects.

The need is made all the more pressing by the decaying state of much of Russia’s infrastructure. “A lot of it dates back to the Soviet era, and needs replacing. The country’s investment needs are extremely high,” observes Alex Nice, an analyst at UK-based research firm the Economist Intelligence Unit.

This helps explain why, despite a cash crunch at many levels, funding allocated to infrastructure for the five years to 2020 seems to have been partly ring-fenced. Steven Eke, a senior analyst at London-based consultancy Control Risk, says the government sees infrastructure as a creator of economic growth, innovation and jobs at a time when the oil and gas industry is squeezed. Transport and telecoms assets are not directly targeted by sanctions, he notes.

“This whole mantra of infrastructure investment as a generator of growth is the key political leitmotiv in Russia’s Far East, where unemployment tops the national average,” he says. The Russian Direct Investment Fund (RDIF), a sovereign vehicle set up in 2011 to attract foreign investors to the Russian economy, together with partners allocated RUB40 billion (€727 million; $786 million) to the region last year.

THE BIG CHILL

Yet elsewhere, the investment climate has largely worsened over the past year.

With an economy projected to contract by about 4 percent in 2015, the local currency tanked as capital flew out of the country; inflation, at more than 16 percent, is the highest it’s been in a decade.

The central bank has reacted by hiking interest rates, which now stand at 14 percent.
This backdrop has made financing very hard to come by. Sergei Moiseyev, a co-founder and managing partner of Moscow-based buyout firm Unicorn Capital Partners, says lenders now charge interest rates of around 22 percent on rouble debt. Local offices of international banks have cut staff and remain eerily quiet.

But the biggest concerns are political. Economic issues and diplomatic isolation have prompted the government to move towards more statist, autarchic nationalist policies, which Nice says don’t attract international investors. “So far the government’s response to the crisis has not been to consider the sort of reforms that would open up economic opportunities, encourage investments and strengthen the business environment.”

He reckons the Kremlin, focused on shoring up the banking sector, is waiting to see how bad the crisis gets on other fronts. “The leadership’s expectation is that oil prices at some point will rebound and that the economy will recover.”

Equally disruptive, he adds, has been the decision by the European Bank for Reconstruction and Development (EBRD) and other multilateral lenders to halt their activities in the region. Prompted by Western sanctions, the move has left many foreign institutions in the dark. “It’s often appealing for big investors to co-finance projects alongside such organisations: they help hedge some of that geopolitical risk.”

The EBRD and World Bank declined to comment on the Russian market, which a source said is viewed internally as a “very sensitive topic”, for the purpose of this article.

FRIENDS AND FAMILY

These heightened barriers to entry are adding to the market’s perennial pitfalls. A long-time observer of the country says corruption and nepotism remain endemic problems in Russia, as evidenced during the construction phase for last year’s Olympic Games in Sochi as well as of the Russky Bridge, a $1.1 billion project undertaken in the run-up to the 2012 Asia-Pacific Economic Cooperation conference in Vladivostok.

“Many of the key state corporations that lead these mega-projects are owned by people who are close personally and politically to the Russian leadership. There is a massive syphoning of state funds into the pockets of selected individuals,” says the observer.

Finding well-connected partners can help outsiders navigate such problems. But informal networks of power brokers are vulnerable to changing political winds and the fallout from potential sanctions; relying on them exposes investors to other types of risks.

In a context where ownership structures often remain opaque, carrying out adequate due diligence on said partners is of paramount importance. “When companies do it, they find that things are actually much more complicated than they would have expected,” Eke comments.

Such endeavours are not made easier by the lack of coherent national policy for infrastructure investment: investors often find themselves dealing with local realities that differ widely from what the central government initially promised. Neither does the concept of a unified public-private partnership (PPP) framework, advocated by the EBRD before East-West relations turned sour, seem to have taken hold.

ANIMAL SPIRITS

The flipside of this lack of unity, however, is that some regions have done remarkably well out of their relative autonomy by opening themselves to the outside world. Such is the case of Kaluga and Tatarstan, which have become hubs for industries such as automotive and electronics assembly.

“Kaluga has been an unusually attractive region for foreign investors.” says Nice. “You have a regional government that’s really switched on and understands what foreign investors need. They have created economic zones where there’s far less of some of the harassment you get from regulatory authorities in other places.”

Yet in the current climate institutional investors tend to be more prudent than their corporate peers. “Russia should be a huge market for institutional investors. The problem at the moment is that the perception of risk is extraordinarily high,” adds Nice.

Even the most adventurous of them seem to have pushed the pause button. Moiseyev says Unicorn, which a year ago came close to signing limited partners (LPs) from overseas, has since closed its $100 million debut fund with commitments coming exclusively from Russian family offices. “At this point in time there’s just zero possibility of having an international LP,” he says.

For all this, opportunities to invest do exist. Moiseyev goes on to explain that his firm – which targets companies supplying parts and services used in the building of infrastructure – is now able to buy businesses at knock-down prices, due to the dearth of alternative financing sources and the rouble’s weakness. He has no doubt he will vastly exceed his original internal rate of return (IRR) objective of 25 percent.

Infrastructure investors themselves may have to be more patient. But Eke reckons they are happy to see Russia as a long-term play. The World Cup in 2018, which Russia is hosting, and mega-projects like the Moscow-Kazan high-speed line are likely to bring sizeable contracts to the private sector.

Meanwhile the central bank is making “a lot of positive noises” about the security of investments, he says, and the economic downturn is not quite as bad as many expected. In five to 10 years’ time, relations between Russia and the West may well have bottomed out.

“It’s important to see beyond the immediate crisis,” Nice concludes. “Russia, like many emerging market economies, has a weak institutional climate and difficult business environment. But for reasons that are not just to do with economics people have given a lot more attention to these problems.”