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Knights of the Vine RUSSIA


Business

Paradigm Shift for doing business in Russia
By James Logan

Nescafe Rossiya

The Russian financial crisis of 1998 was a watershed moment that marked a shift to domestic production in Russia. Prior to that and during Russias early post-Soviet period, imports completely dominated the market and there was no economic incentive for domestic production of consumer goods. Charter flights from Turkey were filled to the brim with Russian chelnoki: market traders who bought cheap in Istanbul to sell in open markets in Russia. More than a few fortunes were made from these flights.

When the major bank default came in August 1998, this time the flights out of Russia were filled with departing Western executives. The ruble crashed and suddenly only local goods were available and import prices skyrocketed. Prior to August 1998, a bottle of flat, warm Russian beer cost 6 rubles and an imported Heineken cost 8 rubles. After the crisis, the Russian beer was about 8 rubles and the Heineken 28 rubles. Finally domestic producers had a chance. During the eight years since, Russian producers have made investments in local production and in the past few years, foreign manufacturers have come back into the market and are now here in force. Even the investment bankers who fled in 1998 are coming back to compete with those who stuck it out such as Renaissance Capital and Troika-Dialog.

In the Soviet period, particularly the Brezhnev years, Russia was nothing less than a big prison with inferior products and services far from Western standards. After the breakup of the USSR, shuttle traders were quick to try and serve the needs of the starved ex-inmates of that prison with any and all modern products that had been absent from the economy. Everything from kitchen appliances to computers and foodstuffs were snatched off the shelves and out of the kiosks.

With newly relaxed rules for importing, the name of the game back then was to bring in anything to Russia to fill the vacuum and become an overnight millionaire. There is a story of a pair of Russian businessmen who visited a Finnish chocolate distributor with a suitcase of dollars to buy for the Russian market. They asked the distributor to arrange the transport of the chocolate bars to Russia, but were told that the Finnish distributor was not in the logistics business. The Russians returned several hours later with a new truck that they had purchased with a second cash-filled suitcase. This was the frenetic free-for-all for imports that characterized the Yeltsin years.

Times have changed in the past 15 years and the name of the game has changed from import to local manufacturing, driven by market factors, logistics infrastructure improvements, and customs systemization.

In the early 90s there were few if any consumer products being manufactured in Russia. What was locally manufactured was based upon archaic technology and products were of questionable quality as compared with Western counterparts. One of the staples of communism was that the government manufactured the products it wanted (and when and where it wanted) and since all products were in short supply without competition, this quasi-monopoly meant that the quality and choice of products was not a factor. A winemaker from Anapa commented in 1995, If anyone should be so lucky to get my wines, how could they complain. Another Russian commented that her mother waxed nostalgic for Soviet times: I remember coming home from work at my laboratory at 18:30 and standing in line at the market for an hour just to find out if they had milk, and if they did, it meant another hour of waiting. But the milk might be sold out when my turn came.

Ford Cars get a spray

Today, in almost all sectors of the economy, there are few examples of product monopolies and all product sectors have, many competitors, both local and foreign. Markets have matured and now the name of the game is to offer better products of good quality at the right price, supported by marketing.

And although import infrastructure has improved dramatically, logistics difficulties associated with importing goods, high customs duties and VAT payable upon import, makes local manufacturing look more and more attractive despite the fact that labor costs in Russia are higher than Asian countries or in China. Companies are also finding that their competitors are manufacturing locally and the importer is at a competitive disadvantage. It is true that a lot of companies are investing in production in China. However, this is frequently a complex process requiring quite a bit of local partnering which may cast a cloud of uncertainty over assembly investments. Scores of companies opt for contract-manufacturing which reduces risk in terms of investment but often Western companies are at the mercy of their outsourced factories. There is also a strong counterfeiting culture at Chinese factories. A factory might have a contract for a well known brand such as Levis (for example) and at night when they are no longer working for their client Levis, they could continue producing jeans in the factory and make an unauthorized product which is of the same quality and identical in every respect including the labeling. This type of problem is so rampant that even experts within many Western companies are absolutely incapable of distinguishing the difference between real and counterfeit product. This is one of the major risks of manufacturing on an outsourced basis. Out-sourced manufacturing has not really developed in Russia as it has in China. The story here is more about companies setting up their own private plants which some would argue is easier in terms of the business culture and partnering issues in Russia as opposed to China.

A survey last spring of foreign corporate investors for the Foreign Investment Advisory Council (FIAC) suggested Russia was becoming more competitive with the other big emerging markets; China, India and Brazil. Some 40% of investors said their sales in Russia increased more than 30% in 2005; nearly a third said profits rose more than 30 per cent. More than 90% of investors planned to expand both operations and investments in Russia within the next three years.

Many corporate investors say returns in Russia far outstrip what they can earn in competing destinations, such as China, according to The Financial Times.

Finland has traditionally been the front door for foreign goods coming into Russia. During the Soviet era, Finland was as important to the USSR as a trading partner as the USSR was to Finland. Communism has given way to capitalism, but Finland still is one of the most important import hubs to Russia. Latvia, now an EU country, has also become a key doorway to Russia. Many companies use Latvia as a staging area, warehousing goods at Russias doorstep, ready to enter the market in a matter of hours.

According to GDP trade figures, Russia is currently Finlands most important trading partner. Jon Hellevig, a Finnish consultant who specializes in assisting Finnish and European companies doing business in Russia, is the founder/managing partner of the Avenir Group which offers mini-incubator start-up services in law, outsourced accounting and recruitment for foreign investing companies. Yes, its true, we, as gatekeepers for Western businesses doing business in Russia, have witnessed a dramatic shift in our clients investment plans. Back then [the 1990s] it was all about setting up rep offices and branches to arrange the import of goods. Now, 70% of our new clients want to purchase local players in a given sector, or purchase land to set up local manufacturing. These days are exciting in terms of foreign investment into Russia and there seems to be no limit to its potential. According to Passport Magazines research, this is supported by statistics which indicate that foreign direct investment increased 32% in 2005 and more than 40% in 2006.

Foreign investors still find it important to have a local partner to give it a foothold according to Meridian Capital, a Moscow M&A firm.

M&A specializes in assisting foreign companies enter into business in Russia, and is a member of Global M&A, a worldwide network of mid-market M&A boutiques. A great example was a presentation at a Global M&A conference in Venice by floor tile manufacturer Marazzi. The crowd was stunned by the returns that Marazzi achieved from its export business by first buying a Russian manufacturer and then greenfielding a plant at their domestic partners location. A Meridian Capital report from last year on pharmaceutical manufacturing identified fifteen foreign pharmaceutical companies that had expressed an interest in Russian production. The problem is that very few Russian pharma producers could be upgraded to Good Manufacturing Practices (GMP), so market entry means some form of greenfield.

One of the most highly publicized sectors is automobiles. BMW, Ford, Renault, Hummer, Hyundai, Kia and Ssang Yong and Chevrolet already assemble locally. Other majors such as Nissan (in conjunction with Suzuki), Toyota and Mitsubishi are either about to open local assembly operations or are in the planning process. According to a recent study by one of the large accounting firms, the Russian foreign car market is now #4 in Europe for foreign cars and will exceed the Italian and British markets within the next four years. In addition, although these companies assemble locally from imported parts, all have agreements with the government that requires a steady increase in the percentage of locally produced parts used in assembly. There are significant tax penalties for those that do not achieve their promised domestic content ratios on schedule.

Ford now assembling cars in Russia

The developments in the automobile sector have been mirrored in other sectors of the economy as well. Kohler, the well-known bath fixture manufacturer, has announced plans to build a Russian plant. Italian Candy Corporation has been manufacturing washing machines locally for several years. A major Japanese television player recently inaugurated its Russian assembly line. Cosmetics firm Avon changed the rules of the cosmetics game by reducing its margins and streamlining its logistics with its shiny new plant not far from Moscow. Under competitive pressure, Oriflame soon followed suit. IKEA, not only one of Russias largest retailers but Moscows biggest retail landlord, pledged to increase its sourcing of products domestically, and has done so.

The game has changed so dramatically that compared to the import-only model of 9 years ago (before the crisis), not only is there a large manufacturing base in place in most industries, Russia production capacity is actually being used to supply other markets for many multinationals. Weve come a long way baby! It has been a fast and furious 9 years to say the least. This point is corroborated by the rise in GDP which has increased consistently between 5 and 8% every year since 2000.

Despite the apparent anti-Russian campaign in the West that portrays the country as reverting to the Soviet Union and President Putin as the new Stalin, nothing could be further from the truth. The tidal wave of bad press that Russia suffers abroad has not prevented Western board rooms from overflowing with Russian investment directives. Just listen to Eric Kraus, the articulate author of Truth and Beauty ( and Russian Finance), There is a fundamental difference between journalists and fund managers: journalists do not lose their jobs for being wrong. Any fund manager who followed the advice of the Financial Times and The Economist and shorted Russian assets at the beginning of the decade has doubtlessly found another means of earning a living perhaps owning a bagel shop in Hampstead. Of course, the journalists who warned them of the coming collapse of Russia are still exercising their chosen professions







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