Chapter 7 Outline

Closing Case FDI in Russia

Five years after the launch of economic reforms designed to transform Russia's lumbering state-directed economy into a modern market system, Russia was experiencing unprecedented capital flight. In 1996, some $22.3 billion left the country, most of it illegally. In contrast, a mere $2.2 billion in foreign investment flowed into the country. According to data from the European Bank for Reconstruction and Development, between 1989 and 1996, foreigners invested just $5.3 billion in Russia, compared to foreign investment of about $11.5 billion in another much smaller former Communist state, Hungary.

Russia consistently tops the charts as the riskiest investment destination tracked by the Economist Intelligence Unit. The risks include a complex tax code that is ever-changing and randomly enforced, often at the expense of foreign companies. Weak and untested property and contract safeguards, endless regulations, and a playing field made uneven by trading and tax favors granted by the Russian government to Russian companies are also frequently cited as contributing to the high risks associated with investment in Russia.

Russia's privatization laws have also tended to discriminate against foreign investors. Most privatization schemes in Russia favor incumbent management and/or local companies. For example, a "shares for loans" scheme in 1995 saw a dozen large companies sold for a fraction of their market value to several large Moscow banks. Foreign investors were not given an opportunity to bid on these assets. Similarly, the privatization of several large-scale companies has seen the majority of stock sold to incumbent managers and employees for a fraction of the price the stock could fetch on the open market.

The failure of the Russian government to capitalize on the sale of state-owned assets is self-defeating given that the country desperately needs capital resources to upgrade its crumbling infrastructure, which is suffering

from years of neglect and mismanagement under communism. The Russian oil and gas industry is an example. Russia has the largest oil and gas reserves in the world, but increasingly it is finding it difficult to get these reserves out of the ground and to the international market. Russian oil output plummeted after the collapse of the Soviet Union from 569 million tons in 1988 to 305 million tons in 1996. The problems include leaking pipelines, aging oil wells, a lack of new drilling, and conflict between the various states of the former Soviet Union as to who actually owns much of the oil and gas infrastructure. According to estimates by the World Bank, Russia needs to spend between $40 billion and $50 billion per year just to maintain oil and gas production at its current levels. Boosting production back to the levels achieved in the 1980s could require investments of $80 to $100 billion per year--money that Russia does not have.

In an attempt to reverse this slide, the government of Boris Yeltsin in November 1997 announced that Russia's oil and gas industries were open to foreign investment. Among other things, the decree signed by Yeltsin allowed foreign investors to buy 100 percent of Russian oil companies. Within days, Royal Dutch Shell had teamed up with RAO Gazprom, Russia's giant gas monopoly, to bid for Rosneft, the last big state-owned oil group to be privatized. This was quickly followed by a deal under which British Petroleum announced it would purchase 10 percent of another Russian company, Sidanco, giving it a stake in a huge oil field near the Chinese border. The benefits that flow to Russia from such investments could be substantial. In a report prepared for the Russian parliament, Western oil companies said foreign development of just six identified oil and gas fields could create more than 550,000 jobs and earn about $450 billion over their operating lives.

However, before they are prepared to make further large-scale investments, many Western companies say they need stronger legal and tax guarantees. Their preferred method of operation would be to sign internationally recognizable production sharing agreements, which leave the ownership of natural resources with the state but allow foreign developers a defined share of future revenues. Although the Russian government has tried to enact such legislation, the Communist-dominated parliament has so far resisted any attempt to pass such laws.

http://www.gazprom.ru

Source: C. S. Nicandros, "The Russian Investment Dilemma," Harvard Business Review, May - June 1994, p. 40; T. Carrington, "World Bank President Says Economists Were Too Optimistic on Soviet Block," The

Wall Street Journal, October 14, 1994, p. 13; R. Holman, "Russia to Lift Oil Restrictions," The Wall Street Journal, December 6, 1994, p. 24A; R. Corzine, "The Beginning of Russia's Oil Rush," Financial Times, November 19, 1997, p. 18; and M. Kaminski, "Russia: Foreign Direct Investment," Financial Times, April 9, 1997, p. 6.

Case Discussion Questions

1. What are the benefits to the Russian economy from foreign direct investment in general and in the oil industry in particular?

2. What are the risks that foreign companies must bear when making investments in Russia? What is the source of these risks? How substantial are they?

3. How can foreign companies reduce these risks?