Russia Outlook Best practice during and after crisis

The Russian business outlook 2010-14

Best practice during and after the crisis Position paper

by Dr. Daniel Thorniley

President, DT-Global Business Consulting

[email protected]

April 2010, updated December 2010

The Russian Business Outlook 2010‐14

© DT‐Global Business Consulting, December 2010 2

Contents

Executive summary 3

Introduction 3

Business trends 3

Some key aspects 3

Best practice in the crisis and after the crisis 5

Three case studies ‐ helping distributors increase market share 6

Is Russia a BRIC? 8

Explaining Russia (again!) to the Western Boardroom 8

25 good things about the economy and business in Russia 11

Three scenarios 12

The outlook for capital markets 13

Risks to monitor 15

6 things President Medvedev should do 16

Tables

Credit growth in Russia 2007‐10 4

Comparative GDP and consumption per capita ‐‐‐ China, India and Russia 9

Top‐line sales levels in Russia, China and India for western companies 2007‐10 10

Russian economic outlook 2009‐13 13

© DT‐Global Business Consulting GmbH, 2010 Address: Keinergasse 8/2/33, 1030 Vienna, Austria E Mail: danielthorniley@dt‐gbc.com Mobile phone: +43 676 534 6852 Office phone: + 43 1 913 54 14 This material is provided for information purposes only. It is not a recommendation or advice for any investment or commercial activity whatsoever. DT‐Global Business Consulting GmbH accepts no liability for any commercial losses incurred by any party acting on information in these materials.



Executive summary

In 2010 the economy and business will be better than in 2009 Russia will be one of the big bounce back economies in GDP (but back‐ended) The first months of 2010 are showing mixed or sober economic and business results Companies will have to adopt a new paradigm for business – not so easy anymore The oil price will decide how well Russia recovers – fingers crossed for China (!) Russia is still a BRIC –but a European BRIC Executives have to spend more time selling Russia to headquarters (but it is worth the effort) Human capital is still strong but more executives worry about the trends Corruption needs to be fought – change will take time even with the right policies The capital markets will pick up again but slowly Modernisation is the President’s buzz word. He means well, but again, change will take many years

Introduction

If you do business in Russia, you will lose all your money because your Russian business partner will steal it from you because he or she is a thief. And you will die when you visit Moscow because the Russian mafia will murder you in your hotel bedroom.

Crudely put, this is the general view of the western media about doing business and investing in Russia. And it is in very large part wrong and rubbish. Business success in Russia is the best‐kept business secret in the world – which is good because some competitors do not know about the market. But it is also bad because your CEO may not know about it. Unfortunately, this gross misperception colours the opinion of senior executives in the West and among boardroom members, who often know little about emerging markets and even less about Russia. Local and regional executives have to spend a lot of time educating their global colleagues at headquarters. The Russian market is a long way from being a paradise and we do not intend to whitewash it but there are many positive things about the market and business environment. More rubbish is written and spoken about Russia than any other country on the planet earth and we will try to rectify that in this balanced paper. Russia is a big, fat, normal, difficult emerging market. In many ways it is no worse than other emerging markets and in several ways it was the best performing emerging market pre‐crisis. Russia still retains much potential for the next 5‐10 years.

Business trends

Some key aspects

Sales levels in Russia These were very good pre‐crisis at a range of 15‐35% top‐line growth. It is unlikely that we will return to those levels for some time as this was driven in Russia and globally by an unsustainable leverage model. The Russian banks are a relative weak link in the economy and the slow growth of bank credit will prevent an even stronger bounce back.



Bank credits

Credits to companies and consumers are not flowing properly and there appears to be no quick fix for this. The Russian government did many correct things in the autumn of 2008: recapitalised the banks, provided guarantees and provided liquidity. This is what other major economies did. The World Bank called the Russian government’s response “world class”. It was standard and typical and prevented the implosion of the economy and society. But as elsewhere in the world one critical aspect did not work: banks are still not lending money properly anywhere in the world except in China (credit grew at 30%+ in 2009). Credit is relatively better in India, Turkey and Brazil. This explains their relative better performance; it also explains Turkey’s potential for a 2010 bounce back.

Profits Russia was and will remain one of the best profit markets in the world. This is because companies can charge high prices since consumers appreciate and understand quality. Profits rose for many companies in 2009 even on falling sales because they implemented price rises at the start of the year and also carried out extensive cost cuts. Russia is by far a better profit market than China.

Competition trends Competition has risen in Russia during the crisis and will remain strong in the coming years. This is a global trend. Western companies are fighting more fiercely against their western counterparts as everyone looks for new niches. Newcomers from western Europe, often smaller players, are looking around in the CEE and CIS markets for new opportunities left behind by the “big boys”. One Italian manufacturing company that supplies equipment to many industrial sectors reports that German and Scandinavian companies are starting to look at the Russian market, offering machinery at low prices to enter and gain market share. Many companies in Russia and the CEE region are increasingly referring to Chinese competition in many sectors, not just in apparel and shoes. One major US machinery company supplying the construction sector reports that the biggest competitive threat it faces in Russia and the Middle East stems from Chinese companies. The Chinese are also taking a more active role in portfolio investment in the CEE region and may eventually turn their sights on Russia.

Complexity of business Executives doing business in Russia and globally face a new and more complex business future. To summarise: The years 2003‐2008 were ones of managing growth, growth, growth. Parts of 2008 and all of 2009 were managing cuts, cuts, cuts. But managing a business in Russia in 2010‐14 will require nothing so black and white. Executives will have to look at productivity, operational efficiencies, corporate structures, the timing of new hiring, communicating strategy with headquarters, reviewing plans for developing certain Russian regions, examining pricing structure and implementing strategies of affordable innovation.



Some of these issues existed pre‐crisis but now more will come to the fore in an increasingly mixed and complicated fashion.

Looking to the pick‐up in 2010‐11, most executives anticipate that (as after 1998) the consumer goods sector will pick up before industrials and infrastructure.

Best practice in the crisis and after the crisis

How should companies behave in a crisis?

keep management informed;

continue with launches, innovation, profit from the moment;

don’t cut premium products;

recruit the best;

don’t cut salaries;

don’t increase prices drastically (with devaluation);

build a strong sales force, don’t farm it out;

have local manufacturing – this lessens the impact of currency devaluation (depending on the type of imports, this often wipes out importers);

recruit managers from emerging markets, not from US or EU;

keep managers in place as long as possible. (Comments from Managing Director of US food company)

Other related best practice Try to be as generous and as long‐term as possible with distributors and suppliers. This is not always possible as global and regional CFOs impose certain strictures. Give as much autonomy in business to your local operations. They are the ones who know how to manage crises; they know how the game is played in their own country. Don’t throw away or alienate talent – you will need these people during the crisis and the after‐crisis pick‐up of business. Never waste a crisis is a famous phrase but it is an unusual company which goes against the flow. The regional manager of one US industrial company based in Moscow said last year, “Every company does the same thing. We manage cash and cut costs and we say we will use the crisis but we don’t”. Publicly‐quoted companies are under the fierce pressure of quarterly reporting and tend therefore not to behave counter‐intuitively. For example, it was expected globally that the number of M&As would rise during the crisis as companies took the opportunity to buy out collapsed competitors or invest in supply‐chain and distribution, etc. But not that much has actually taken place: more talk than action. Market share: many executives have realised that market share is a critical KPI. Over the last 12 months more managers have come to put more focus on this indicator. This author has argued that in the crisis, it’s not the top‐line that matters, it’s not bottom line that matters, but it is what market share you have retained or captured during the crisis.

When you fine‐tune the above for the Russian market in 2007‐2011 the managerial challenges look like this:2007‐08 ‐ Sales and distribution growth End 2008 ‐ Safeguard market position, safeguard liquidity Start 2009 ‐ Cost reductions, market share expansion 2010‐11 ‐ Consolidation, preparing for growth pick‐up and 3‐5 year plan for steady growth



How will your customers judge you after the crisis? Will your customers and distributors, partners, suppliers, wholesalers and retailers say your company behaved well, as well as possible in the crisis? Will they say you tried to help partners through the tough times? Will customers complain that your company reduced the quality of products, cut down on inputs and ingredients while raising prices; did your company gouge consumers on prices? Or did you offer good payment terms and support to distributors when you could?

During the crisis we noticed distinctly different behaviours of western and Russian companies. Russian companies generally responded to the crisis with deeper and quicker cost cuts than their western counterparts. This is not to say there is any right or wrong approach here and in the long term the Russian approach may prove to be a correct one or at least appropriate for their business models. But on the surface it looks like western companies adopted a more long‐term approach because:

They were in stronger financial positions than their Russian peers and could call on funds from western headquarters if needed;

They were more confident about the crisis as local managers sometimes take a bleaker view of the market outlook –this occurs in other emerging markets as well;

Western companies had stronger brands to rely on;

As the crisis partially stabilised in February‐March 2009, western companies adopted even more of a wait‐and‐see attitude and held back on making deeper cuts.

Three case studies ‐ helping distributors increase market share

1) One major food company reports that its sales and market shares have out‐performed competitors in

Russia and Ukraine because they took the decision to extend credit terms when other companies were more reluctant to do this. The company noted that they had market leadership in several categories going into the crisis. As the regional executive reported, “We were strong market leaders in several product lines, and so we decided to extend terms to our distributors. During the crisis we saw our market share rise noticeably. We were saying to distributors that they can have 28‐40 days instead of 12‐14 days and we talked with them about a payment schedule if there were delays”. This company notes that their products were flowing in Ukraine in the depths of the crisis when their competitors’ stocks were simply not moving. In Russia they combined this strategy with strong marketing, and sales performed well and they took more market share in several categories.

There is a bit of circularity here of course in that it helps to have the market leadership in the first place so that when the crisis comes you are in the driver’s seat and can push the terms you want. This in turn puts more pressure on the number 2‐3‐4 players in the market place.

The key finding here is clearly: Never throw away market leadership for price increases.

Several market leaders across business sectors have pointed out that once you have market leadership, in a crisis you can exert hard pressure on smaller, local competitors and some of the local ones may go bust or go into a spiral of spending too little on marketing and lose more market share.

2) A US IT company states that in Russia (and the CEE region as a whole) they have tried to work very

closely with their several hundred distributors in the region. The regional manager says that, “We explain to partners what is going on, we communicated how badly things were going for us but that we wanted to stick with them and support them as long as possible. We selected several of the more viable distributors and we gave them credits and loans to tide them over the crisis. This didn’t amount to hundreds of millions of dollars but it was enough to ensure security for some of them and to help them steady their business. This in turned helped us”.

Watch how you manage cost cuts. Don’t over‐react and don’t cut too deeply. In summary: Don’t cut costs so deeply that you alienate customers; Don’t cut costs so deeply that you alienate distributors and partners; Don’t cut costs so deeply that you alienate staff and talent.



3) One French food company tells a revealing story of working with distributors in 1998 and in 2009. During the severe crisis of 1998 this company worked closely with their quite‐new Russian distributors and found that generally the Russian suppliers were excellent partners who did their very best to repay credits when possible. The CIS manager who remained in his post said this last year “We built strong relations with our distributors 11 years ago when we didn’t really know them. We built mutual trust in those very hard times. Last year in 2009 we were still working with the majority of these partners. As we came into the crisis (which was less intense than 1998) we were much more confident of our position. We knew these people, we knew what they could manage and we knew we could help each other. We had known these people for more than 12 years, whereas in 1998 we were all new to each other. This is real relationship building”.

Any company can behave well when sales are growing at 18‐35%, but the real test of a company comes not when the sun is shining but when it’s pouring with rain.

More executives realise that keeping and/or gaining market share is a critical goal during and after crises. The big debate then revolves around volume or price. During the crisis in the CIS and CEE region as currencies devalued, global headquarters often pressured local managers to raise prices sharply and quickly in order to protect profits. This is an understandable knee‐jerk response from headquarters but usually local managers wanted to achieve more of a balance in volume and price. Imposing stiff price rises on a fragile local consumer could potentially damage medium‐and long‐term business. Neither position – volume or price—is entirely correct, and it is incumbent on each company to find the right balance. Price rises were made in Russia by many companies at the start of 2009 when they thought that the rouble would depreciate more sharply than it did; some expected it to fall to 50 roubles to the US dollar. That was not an insane scenario at the time. Thankfully this did not occur and indeed the rouble started to stabilise and recover from about March 2009. Many companies raised prices by 20‐30% at the turn of the year 2008‐09 and did not see a sharp tail‐off in volume. The price rises were generally well absorbed by consumers.

Russia has the potential to be both a premium and an affordable market Going into the crisis Russia was one of the best premium‐price markets in the world: maybe number one but certainly in the top three. Some major FMCG companies have said their prices in Russia are the highest in Europe…after Monaco. But now all companies are or should be looking at innovation downwards or affordable innovation. Consumers are under pressure, some will change their spending habits and many will want products at a cheaper price while offering moderate quality. Russian consumers will be among the most likely in the world to revert back (in part) to premium products when their income levels allow and when they regain confidence towards the second half of 2010. This means that companies will still be able to retain a good portion of the premium strategy which helps generate good profits and cover the high cost of doing business in Russia. But more companies operating in Russia realise that, as in other markets, they cannot rely solely or even in large part on the premium game any more. One of the world’s largest consumer products companies has said, “We can’t go back to the good old days, we have to be more affordable and we have to get to know our Russian customers better”. The strategy globally and in Russia will therefore be two‐fold: premium‐priced products where western companies are in their comfort zone, but then developing more affordable products for the rising middle class and the lower‐lower middle class. This will probably entail reviewing the strategy for developing business in the Russian regions. Several major players of course already have different brands and several price points but even market leaders in this area argue that they should do more. More than most other countries, Russia seems to offer good potentials in both ends of these market segments and this should give grounds for some optimism for managers over the next five years. However, the affordable market segment is not sitting there waiting to be picked up. Companies will have to adapt their sales and market strategies and their whole approach to the customer.



Is Russia a BRIC?

Yes, Russia is a BRIC; it’s just that it’s a European BRIC. This is not meant to be factitious or glib. The statement actually underlines that Russia may not match growth in China and India (Chindia) in the coming years because it is a more mature market and more transitioned than the two big Asian markets. True, Russia lags behind them not just because of market maturity but also because transparency is lacking and corruption frightens away investment. But corruption exists in China and India, and high levels of it at that. Russia is a big, fast‐growth European market with relatively high levels of per capita consumption. Of course there are more “capitas” in Chindia but Russia, even with weak demographics, is a very big market in Europe. As one FMCG executive said at the end of last year: "Russia with 135 million people would be more interesting than, say, Austria with 8 million”.

Why did Russia fall in GDP terms more than Chindia and Brazil? There were at least three reasons:

1) The global financial markets see Russia as irrevocably linked to the oil price. When the oil price started to collapse at the end of 2008, investors pulled out, confidence collapsed. Energy output and exports are critical to Russia but it is often forgotten that when the economy was purring along in 2005‐07/08, the energy sector was growing at only 1‐2% while overall GDP was rising by 5‐8%. Other sectors were taking off: consumer products, retail, food, packaging, mining, metals and parts of telephony.

2) The Russian banking sector was weaker and more exposed than its counterparts in other BRIC

countries. In particular Russian corporates had borrowed extensively abroad. When the markets and the rouble collapsed, they were caught short. The Russian banking system did and does not act as a properly functioning intermediary system. The government is still trying to resolve this by limiting Russian companies’ access to foreign borrowing (as other countries are trying to limit FX exposure, e.g. Hungary).

3) The perception of Russia is usually entirely negative in the West, in western media, western

boardrooms and the financial markets. When a crisis hits, the markets turn nasty against Russia with a little more venom compared with other nations.

Explaining Russia (again!) to the Western Boardroom

Senior management globally is sceptical about doing business and investing in Russia. This has always been a challenge for local and regional management. The best way to persuade CEOs and decision‐makers about the market is to physically bring them to Moscow: show them the megalopolis, the teeming streets, the modern retail, the traffic (!) and your skilled local staff. They will soon be persuaded that the market has some appeal. Be careful though that they don’t presume that all of Russia is like Moscow. If that happens, your annual budget will be trebled. To compensate for this, take them to outlying towns and villages where people live in wooden dachas. Russia is not Tverskaya ulitsa. Unfortunately the process of persuading management can take years. It requires patience and stamina from local managers. The crisis of 2008‐09 has hit Russia harder than the other BRIC economies and Chindia looks difficult to beat. So maybe we should not try. Russia needs to be seen simply as a big, fast‐growth European market. Call it a BRIC or not, this is moot. Russia remains very important for corporate strategy. Over the last 12 months country and regional managers have been under even more intense pressure to explain the market to their superiors. One US industrial company held its global strategy meeting in the Mid‐west of the USA last November. The CEE regional executive commented, “We had 60 minutes to discuss Russia. We spent 58 minutes defending the market and two minutes discussing future plans. The decision was made to postpone developments”. Another US industrial manufacturer working across all sectors noted that, “We



believe we need to put moderate investments in place now in early 2010 in order to be prepared for the pick‐up in 2011. But we can’t get headquarters to agree to this. They keep telling us to hold on and wait”. Given that it was a challenge to convince headquarters about Russia when sales were growing for everyone at 25%, it is no surprise that this has returned as a key operational issue for managers in many sectors. Russia looks worse compared with the other BRIC markets in terms of GDP and sales growth now. But Russian GDP per capita (ppp levels) is twice as high as in China and four times as high as in India. Comparative consumer spending figures per capita are even starker. There is no doubt that China and India are growing faster than Russia – exponentially in 2009 and still steadily so in 2010. But Russia remains a European‐type market and China and India are definitely Asian markets. They require two (or three) strategies. The message to Global HQs is “hold your nerves. We believe that in 10 to 15 years’ time Russia will be the biggest market in Europe for our products”. Many executives in consumer goods believe that Russia will be the first driver of profit growth in BRIC and the top growth market after the US in 2012‐15. Most regional managers argue correctly that Russia has to be the premier growth market for Europe in the medium‐term future once the global economy stabilises and picks up. Comparative GDP and consumption per capita ‐‐‐ China, India and Russia

2009 2010 2011

China

Private consumption per head (US$) 1,350 1,500 1,720

GDP per head (US$) 6,720 7,250 7,980

India

Private consumption per head (US$) 560 675 725

GDP per head (US$) 3,110 3,285 3,490

Russia

Private consumption per head (US$) 4,500 5,125 5,670

GDP per head (US$) 14,950 15,290 16,210

Source: DT‐Global Business Consulting

It is not a zero‐sum game. Western companies should and will invest and do business in the other BRIC markets and other key emerging ones such as Turkey, South Africa, Mexico, Saudi Arabia, Nigeria, Indonesia, Vietnam, Pakistan, etc. The following tables provide comparative sales data by sector for China, India and Russia. They show clearly that Russia was outperforming Chindia pre‐crisis. Sales levels started to get hurt in Russia in the last 3‐4 months of 2008 but the annual performance still held up quite well. However, in 2009 China and India pulled away from Russia and will still be doing better this year. By 2011‐12 Russia will be catching up again, especially in the consumer goods and health sectors. But the point remains that Russian sales per capita are hugely higher than those in Chindia.



Top‐line sales levels in Russia, China and India for western companies 2007‐10

2007, in % Russia China India

FMCG 25 18 20

Food 20 16 18

Pharma/health 30 18 17

Industrial 33 19 16

IT 36 23 20

Financials 28 20 13

Professional Services 35 22 11


FMCG 7‐14 15 13

Food 12‐16 15 12

Pharma/health 8‐17 14 13

Industrial 7‐13 17 13

IT 10‐13 15 11

Financials 12‐14 16 9

Professional services 17 17 8

These numbers for 2008 started to deteriorate in Russia quite sharply in the final four months of the year so providing an annual average is trickier than usual for this year.


FMCG ‐3 to +5 12 8

Food 3‐6 13 9


Industrial ‐20 7‐12 4‐9

IT ‐20 7‐12 3‐6

Financials ‐35 3‐6 2‐5

Professional services ‐7 to +2 5‐8 3‐5


FMCG 4‐12 12 9

Food 6‐15 14 11


Industrial 5‐12 12 9

IT 5‐8 13 8

Financials 3‐12 8 8

Professional services 0‐8 10 7

It is always good to have ammunition in corporate debates to talk up the good points about Russia. Following are 25 good points.



25 good things about the economy and business in Russia

1) If your company has a European strategy, then it must have Russia playing a noticeable role. Russia

will be one of the fast‐growth and big‐volume markets in 1‐2 years.

2) GDP per capita in Russia is 4‐5‐6 times that of China and India.

3) Western sales per capita are infinitely higher than in “Chindia”.

4) Procter & Gamble’s annual sales pre‐crisis in Russia were approx. $2.4bn, the same as in China. China has ten times the population. This shows China is an Asian market and Russia is a European one (other major consumer product companies tell a similar story) .

5) Russia was one of the best premium‐price markets in the world and will be so again – perhaps the

best. Consumers understand quality. When they have disposable income, they will spend it on quality.

6) Those consumers who have traded down may then trade back up in Russia more than in other markets. Executives think that Russia will be one of the best markets for uptrading to commence.

7) Russia is not just a good sales market with top‐line sales better than Chindia. In the pre‐crisis period

consumer product companies, pharmaceutical, industrial and IT ones were growing at 16‐40% in Russia whereas in Chindia sales growth was “only” 12‐20%.

8) It is also a very good profit market. Even in 2009 consumer goods and industrial companies were

reporting good profits. China is not a good profit market in contrast. Very few western companies boast about their strong profits in China.

9) The fiscal stimulus was large and will continue to have a positive impact on growth in 2010.

10) Interest rates have fallen and will continue to fall to help growth in the economy. This confirms that

the banking sector is adequately liquid.

11) The current account ended in positive territory with a $25bn surplus down from $100bn in 2008. This still represented a surplus of 3.3% of GDP (at the turn of the year 2008‐09 it looked like this would be a deficit 2%). The outlook for the coming 3‐5 years is for a current‐account surplus of 4‐6% per annum.

The following points relate to the Russian consumer and why he/she may survive a bit better than others:

12) Savings levels are reasonably good.

13) Personal debt levels are very low (only 20% have consumer credit and only 4% are really exposed).

14) Exposure to the stock market’s volatility is tiny with less than one million Russians holding shares.

15) Mortgage debt is also small.

16) Personal exposure to FX debt is very small especially compared with other CEE markets where the

middle class financed mortgages in Euros and Swiss francs. This did happen in Russia but on a smaller scale.

Other issues

17) The oil price may stay at $75‐83 per barrel throughout 2010‐12 (central scenario). At these prices Russia will survive the crisis quite well and GDP growth in 2010 will be one of the fastest “recoverers” in CEEMEA with GDP at about 4.0%+.



18) The falling rouble in 2009 helped Russian competitiveness; the stronger rouble is now working against this. The currency is now stable and looks good for the future. It is likely to strengthen in the next 6‐9 months by 2‐4%. There is more risk for upside than downside.

19) The grey economy is sizeable (15‐20% of GDP or more?) and this will cushion consumers (as it did in

Hungary for 2‐3 years of austerity in 2005‐07).

20) Government purchases of services and products could provide a stimulus to Russian corporates, but such spending plans were downsized in a January 2010 announcement. Still, the government is spending.

21) A lower tax burden on some sectors of the economy will help. This has already happened in the energy

sector but the government argues there will be limits.

22) FX reserves have popped back up to $440bn in February 2010 and remain the third highest in the world after China and Japan.

23) The Reserve Funds hold the equivalent of $50bn in roubles – this is part of federal budget assets

accumulated from energy income. The maximum size of these Funds is 10% of GDP and they are used to cover the budget deficit. The funds are invested in low‐yield foreign government bonds. The National Welfare Fund holds almost another $100bn in roubles. This means Russia has these funds plus $440bn in FX reserves.

24) With FX and local currency reserves the Russian state can cover the full exposure of the Russian

banking sector (not that it would want to do so!).

25) The quality of human resources and talent in Russia was and remains very strong. More than 85% of companies operating in Russia still rate their Russian staff as among the best in the world for skills and hard work. However, the quality of human resources is deteriorating at the margins and those margins are becoming bigger.

Three scenarios

Russia and the world Russia is tightly connected to the global economy. In 1998 Russia suffered a Russian crisis largely in isolation; the world was waiting for it when it recovered. This time Russia is in the midst of a profound global crisis and is deeply affected by 1) growth in China and 2) related to that, the global oil price, and related to those two points 3) risk perception among global investors. Our estimates below for the Russian economy and business outlook are therefore predicated on the following:

1) The global economy will recover macro‐economically in an extended U‐shape. The global macro‐economic recovery which started in August 2009 will require until summer 2010 to underpin a proper (and still fragile) global pick‐up.

2) This will come about because China will pull Asia out of the crisis and the US and the rest of the world

with it. The Eurozone and the CEE region are likely to be among the slower “recoverers” (with the notable exceptions of Russia, Turkey and Poland).

3) Because of the above trends, the global oil price will average $72‐84 per barrel over the next 15‐18

months.

4) Thus the Russian economy will report GDP recovery of 4.2% in 2010 with steady annual average GDP growth of 4.2‐5.5% in 2011‐13.



This is our central scenario and we give this a likelihood of 70%. There is an upside that the global recovery takes hold and gets stronger quickly in summer 2010. China grows well at 10% and overcomes any inflation or asset bubbles. Because of this the oil price rises to an average of $85‐93 per barrel at the turn of the year 2010‐11. Confidence rises and western FDI and portfolio investment starts to pour back into Russia. GDP pops up at the end of 2010 to 5% and rises to 6.5% in 2011 and 7.5% in 2012 despite an over‐strengthening rouble which rises to 25.5 to the US dollar by spring 2011. We give this scenario a 10% chance. The converse is a double‐dip recovery or a very extended U with global recovery postponed until mid‐2011. China stutters with GDP growth in 2010 of 8%, falling to 6.5% in 2011. US and Eurozone growth falters as a result. Russian GDP starts to slow at the end of 2010 and finishes this year at 3.3% as confidence falters. Western investment pulls out, the Russian Trading System (RTS) stock market falls back to 850 points and the rouble weakens against the dollar to 34 by spring 2011 and to 36‐37 by mid‐2011. We give this scenario a 15% likelihood. Russian economic outlook 2009‐13 (annual % change unless stated)

2009 2010 2011 2012 2013

GDP ‐7.9 4.2 4.8 5.1 5.0

Disposable income 1.0 3.5 3.8 4.1 4.2

Fixed investment ‐18.0 5.0 8.5 7.9 8.0

Consumer inflation (year‐end) 8.8 8.0 6.9 6.6 5.8

Budget balance ‐6.9 ‐3.8 ‐2.5 ‐0.8 0.0

Current account (% of GDP) 3.3 5.3 6.4 7.2 6.5

Rouble/US dollar (year‐end) 30.2 31.3 30.2 29.5 29.0

Rouble/Euro (year‐end) 43.5 40.8 39.4 38.5 38.2

Source: DT‐Global Business Consulting

The outlook for capital markets

The Russian banking sector did not and still does not function as a proper intermediary for Russian financing. Before the crisis at the end of 2008 the rate of M2 money supply to GDP stood at 26% compared with levels of 90% in the Eurozone and a remarkable 150% in China. Domestic capital markets are too small, although the recent pick‐up in the rouble bond market is encouraging. There is only a small pool of domestic capital and the pension industry is rudimentary. IPOs virtually disappeared off the screen in 2009 as they did globally, but they are coming back. During 2006‐07 some $37bn was raised in 42 international share issues. Two‐thirds of Russian stocks have underperformed the markets since their issue. But in mitigation these prices are now rising and the issues were probably sold at the very high‐end of the market when much exuberance existed. As more issuances come to market, it will be more of a buyers’ market. Not much has gone on to date because companies did not want to issue at low prices. There was a mis‐match between the buy and sell prices! This year and next, Russian companies will need some $55bn of equity financing, of which at least $11bn will be required to repair balance sheets. Russian companies are going to IPOs in order to:

1) reduce debt; 2) finance growth; 3) add to their reputation (less so than in past); 4) list their assets in order to get an objective assessment of what they are worth: a benchmark with reality.



A lot of Russian debt is short‐term and foreign‐held. Current falling Russian interest rates at 8.25% will go some way to ease the Russian corporate debt burden. Many issuers see an opportunity to strengthen their balance sheets by taking on more equity and reducing their debt. The major issuers will come from the energy and mining sectors with possible consumer products, retailers and pharmaceutical companies coming to market. The first companies to go to market this year were Rusal and probably a $200mn IPO by the seafood firm Russkoye Morye scheduled for spring 2010. The major pharmaceutical player Protek plans to raise $400mn this May‐June and wants to use the funds to develop its brand and pharmacy chain. Rusal’s well‐publicised IPO has put Hong Kong in the limelight and Singapore is actively wooing Russian investors. Germany is also another albeit less favoured option. It seems that for the coming 1‐2 years at least, London will remain the preferred location for Russian IPOs. The RTS has remained sort of stuck in a range of 1,300‐1,500 points in October 2009 to April 2010. Whether it bounces out of this range will largely depend on global trends. Foreign direct investment (FDI) rose to some $55bn in 2008 but dropped to $22bn last year, a fall of some 60%. This was quite typical of the CEE region where FDI fell on average by 50% and global FDI also shrank by up to 38‐42%. The pick‐up will depend on corporate confidence in the global recovery and perceptions of Russia. This may not be rosy in the short term and we therefore expect FDI to rise by only 15‐40% this year to about $25‐35bn in 2010. Prior to the crisis there was talk of Russia becoming a major European financial centre but rouble volatility and current government policies suggest this will be long postponed.

How clever are Russians?

A huge majority of western executives operating in Russia rate their local staff as among the best in the world. They are usually extremely well‐educated, hard working, diligent, adaptable and have responded well to the crisis. The foundation of the Russian talent pool has been the Soviet educational system which gave students a very strong basis in the hard disciplines: maths, chemistry, physics, engineering etc. Learning was disciplined and often through rigorous learning by rote. After 1950 this strong educational basis was exported to the CEE region as a whole. The talent pool in Russia (and CEE) is generally deeper than in other countries. The top 1‐3% of staff everywhere in the world are great. But in Russia the depth of talent goes beyond the top 3% to 10‐20‐45%. Whatever skills employees lack, they usually respond well to in‐house training programmes because they are bright, knowledgeable and willing to learn. These are the good points but a debate on education is now taking place: to what extent and how quickly is the Russian educational system deteriorating and what impact is it having on the pool of talent from which western and Russian companies can recruit? There are mixed views about the degree of erosion. Some executives say that falling standards are becoming more pervasive and there is a clear and sharp distinction between those candidates coming onto the job market in 2010 compared with those who were looking for employment and leaving schools and universities in 2007. Other executives disagree. One managing director of a western FMCG company said recently: “We still find excellent staff and those we interview are very good. Even for marketing positions we find very good people. That said, at the margins, quality is falling a bit”. Not enough investment has gone into education in the last 18 years and quality was maintained thanks to the services of poorly‐paid women teachers who helped stop an educational collapse. But the teaching profession is less attractive now than in Soviet times and teachers are retiring or leaving to take much better paid jobs in the corporate world. Even a receptionist’s job in a western company pays significantly more than an average teacher’s salary. The debate is not whether standards are falling but by how much. Russia needs to invest more in its educational system before this slow rot turns into a cancer.



Risks to monitor

1) The oil price and global growth. The biggest economic and commercial variable is the oil price.

Russia is now inextricably linked to the global economy: global growth, financial markets risk perception, China’s GDP and the oil price are the key drivers which impact the Russian economy and business on the ground. Put bluntly:

If China grows at 9‐10% then Russia will grow at 4‐5%, the oil price will stay at over $75 per barrel, the rouble will fluctuate stronger than 34 to the currency basket and business will recover steadily.

2) Corruption. This is becoming more endemic in the economic system. Over the last seven years

corruption and malpractice between companies had greatly improved and we saw a manifest and steady improvement. Reports that corruption in Russia is similar to that in Sierra Leone are frankly nonsense. But the bad news is that corruption since 2004 has risen steadily in the federal government and municipalities. The government has recently taken concrete steps in the fight against corruption and some positive results have appeared in some regions. But too many Russian officials feel they have a right of entitlement. Finance Minister Kudrin has been reluctant to spend on infrastructure for fear that too much of state investment would disappear in local mafias.

3) Protectionism. This seems to be a manageable threat. Russia, like several other countries, has

introduced certain higher tariffs but this does not reflect the general trend. Recently, however, legislation in the pharmaceutical and retail trade sectors and excise duties on beer raised eyebrows. This led commentators to ask whether this was a tide of protectionism. It seems not and looks rather more like specific legislation aimed at certain sectors in a time of economic crisis (2009) when inflation was rising and the state’s budget deficit was becoming critical (both these factors now seem to be improving).

4) Political stability. This too seems manageable. Commentators may not like all they see in Russia and

the country’s PR skills need to improve to combat an extremely negative picture abroad. But there is a sense of stability. Most western companies and investors are still off the radar screen of the Kremlin. Yukos is still an exception. Most of the major problems appear in the energy sector and these tend to get wide, negative coverage in the West. Recently some long‐standing conflicts in the telecom sector appear to have been resolved.

5) One significant concern would be if the government or friends of the government decided they

wanted to influence or take controlling stakes in the largely free market segments of the economy. Investors recognise which sectors (the so‐called “commanding heights”) the government still wants to control. But if it transpired that the state sought greater involvement in consumer goods, pharmaceuticals, manufacturing products, etc., this would send a very negative message to outside investors. The good news is that this seems to be a limited risk. Those in government seeking to influence the debate to lessen government interference can point to the fact that when the state has been involved in the energy sector, overall results have been inferior to sectors that are left alone by the government. This is a powerful argument.

6) Modernisation, innovation. These are buzz words in current policy and it seems that the problems are

well understood. Russia has some way to go. INSEAD’s global innovation ranking put Russia 64th out of 132 countries, between Kazakhstan and Oman. Russia’s R&D budget in 2009 was $6bn whereas China alloted $137bn; Russia spends 0.75% of its GDP on scientific R&D while Japan and Sweden allocate more than 3%. The demand for innovation in most developed and the better emerging markets comes from the real economy, the manufacturing sector. Business and society have needs and they create methods and resources to meet them. The Russian authorities may be looking at Singapore and South Korea as “authoritarian” models but the legal and commercial environment in those two countries is different and superior to that of Russia.



However, it is questionable whether the government is going about things the right way. What is needed is a system which encourages real entrepreneurship. A transparent and helpful legal system which encourages SMEs and risk taking, one which ensures the authorities nudge the process in the right direction without taking control, is what is needed. Some limited state intervention to smooth over the bumps is required but not a system of “authoritarian modernisation”. The government should seek to co‐opt western partners to get the best benefits from them; this requires more openness. One regional director of a major global IT company said in February, “We want to invest in R&D joint ventures in Russia, but it is not easy. Our headquarters are very cautious and the Russian government should give us a helping hand and ensure intellectual property protection 100% and simply create a more welcoming attitude. I need arguments to push this through”.

Unfortunately it appears that the government is looking at some centrally‐controlled model. Vladimir Surkov, first deputy chief of staff in the Kremlin talks of “consolidated power being the instrument of modernisation” and “authoritarian modernisation”.

The creation of Rusnano, the state‐owned technology giant, was an earlier attempt to jump‐start innovation. But results have been very mediocre or worse. The recent idea of an Innovation City looks flawed. Targets for planned results from innovations created in the City remind one of state planning. The real Silicon Valley was not created by State Committees in Washington DC; rather, it is inhabited by a lot of Indian immigrants with their hundreds of start‐ups. Innovation City has too much the feel of the Soviet Akademgorodok in Novosibirsk. The US IT company Hewlett‐Packard was famously started by two guys working together in a garage.

Sharp‐minded members of the Russian government appreciate that modernisation and innovation will take years, if not decades to achieve.

Frankly, there are no panaceas on this subject but it looks like the government is putting a lot of emphasis on a blind‐alley.

7) Demographics. This is clearly a potential and actual Achilles’ heel for the country. The 1990s severely

impacted birth and mortality rates and this has had follow‐on effects: the population fell from 146mn in 1999 to 141mn at the end of 2009. Over the last 2‐3 years the government has taken social measures to boost the birth rate and economic growth did help lower the mortality rate. The best that can be said is that the very worst may have passed: the mortality rate for men has risen in recent years to 62 years compared with 57 years in the past. Still, this is a remarkably poor figure. Poor demographic prospects will remain for several years with (very) slow progress.

Six things President Medvedev should do

1) Fight corruption constantly. Arrest corrupt ministers on live TV but more importantly raise the salaries

of judges, police officers, customs officials, etc. Inculcate a system of reporting corruption to efficient hot‐lines where complaints are handled quickly; hot‐line telephone numbers should appear on prime‐time TV news programmes. If these measures are undertaken, corruption will be defeated…but only in about 10‐15 years. The trouble with corruption is that it becomes a part of the fabric of society and peoples’ psychology. It takes a long time to change attitudes.

2) Cut defence spending by 80% and reallocate resources to the real economy. Every rouble spent on

defence is a rouble wasted. Russia shares several geopolitical goals with China: both countries want fast GDP growth as this assists in buying off the middle class by providing them with private housing, consumer goods and a higher standard of living, thereby diminishing political opposition; both countries also aim for internal political stability. China in recent years has become more at ease with itself and concludes that internal stability is aided by external stability. China has thus intensified its ‘good neighbour” policy and this has borne fruit in recent years. Russia on the other hand still bears a grudge because of how it feels it was treated in the 1990s when it perceived the West, the USA and the IMF as taking advantage of the country’s weakness. As the government’s confidence grew with a



rising oil price, then President Putin used his elbows in foreign affairs. However, more often than not this has not benefited Russia’s long‐term interests.

3) Massively raise spending on health. The system is dysfunctional. Out‐of‐pocket spending still accounts

for 65‐70% of health spending.

4) Massively raise spending on education to stop the rot which is beginning to affect the system and standards. This must be done sooner rather than later.

5) Find a balance between state spending on infrastructure and social welfare spending. The government

is taking some plausible and sensible steps. Debates are on‐going as to whether to favour social spending over infrastructure and at what level to invest in infrastructure. The needs in infrastructure are massive and the state is determined to minimise wasteful expenditure in this sector. As with many issues (corruption, improving the education and heath sectors, modernisation), even if the right amounts of money reach the right targets, improvements in infrastructure will take 3‐5‐7‐12 years to fully materialise.

6) Promote a more extensive and coordinated PR campaign for Russia. The government did a good job on

macroeconomic and currency management in the last 15 months but Russian PR remains abysmal. The Investment Agency of little Macedonia has conducted a brilliant and concerted PR campaign for the last 3‐4 years in the international press and on TV to promote the benefits of business in that country. Russia could follow this example and these tens of millions of dollars would be well‐spent. During the recent crash of the Dubai financial market, Dubai bombarded CNN TV with a non‐stop series of advertisements on just how good a location this state is. This was more of an emergency PR response. But Russia undertakes neither emergency PR campaigns nor long‐term ones designed to shift the terms of thinking about Russia and the Russian people. There are many good things about Russia and Russians, but too few people know this.

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