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Reference ID Created Released Classification Origin
07MOSCOW2932 2007-06-19 05:58 2011-08-30 01:44 CONFIDENTIAL Embassy Moscow

DE RUEHMO #2932/01 1700558
P 190558Z JUN 07

C O N F I D E N T I A L SECTION 01 OF 04 MOSCOW 002932 
E.O. 12958: DECL: 03/30/2016 
REF: A. MOSCOW 6926 (06) 
     B. MOSCOW 13002 (06) 
     C. MOSCOW 1326 
Classified By: ECON M/C Quanrud for reasons 1.5 (b) and (d). 
1. (C) Summary: This year's annual update on Russia's 
investment trends includes a number of impressive headlines: 
record foreign direct investment (FDI) flows into Russia; 
record domestic investment; record sums raised by Russian 
companies through IPOs; and record outward investment by 
Russian companies.  Investors of all stripes are jumping into 
a Russia boasting numerous advantages: its eighth year of 
strong GDP growth increasingly fueled by an ongoing consumer 
boom; a panoply of enviable macroeconomic indicators; ity; 
outstanding bottom line results for many companies; and the 
promise of more to come.  American investment continues to 
bound ahead, bringing individual companies uncommonly high 
profit margins and helping bridge the "values gap" between 
the U.S. and Russian business communities. 
2. (C) Whilt the trends are indisputably positive, the fact 
remains that both absolute levels of foreign and domestic 
investment as well as investment levels per capita are well 
below potential.  Key perennial roadblocks to investment must 
still be addressed through further reform and liberalization, 
and investment levels must increase to improve efficiency, 
encourage diversification, and maintain growth as competitive 
pressures increase, energy prices soften, and capacity 
constraints worsen.  While this past year has seen renewed 
efforts on the part of the current administration to appeal 
to investors through outreach, initiatives and incentives 
aimed at strengthening the high-tech and manufacturing 
sectors, much work will fall to the next administration to 
secure Russia's medium-term growth outlook.  End summary. 
Record Breaking Investment Levels 
3. (SBU) The past year has witnessed a boom in foreign and 
domestic investment in Russia.  According to the Central Bank 
of Russia, 2006 FDI came in at $28.7 billion, almost twice as 
much as 2005.  The 2006 figures bring FDI to just under 3% of 
GDP.  Significantly, Russia led its BRIC peers for the first 
time in this category, beating China's 2.66% of GDP, Brazil's 
1.39% and India's 1.07%.  FDI is also increasingly directed 
to a broader range of Russia's regions and sectors.  Beyond 
the natural resource sectors, the lion's share of 2006 FDI 
went to metals, the financial sector, transport, real estate 
and services.  Rosstat figures for 1Q07 indicate the boom 
continues this year, as FDI increased 25% year-on-year to 
$9.8 billion.  UNCTAD's 2007 study of FDI inflows over the 
period 2004-06 indicates that Russian inflows increased 
94.6%, compared to China's negative 3.3%, Brazil's negative 
2% and India's 44.4%. 
Russian IPOs Draw Investors 
4. (SBU) Investors also continued to show strong interest in 
Russian IPOs.  Vastly improving on record IPO performance in 
2005 ($4.3 billion raised), last year Russian companies 
launched 23 IPOs and raised almost $18 billion.  In a decided 
shift from the previous drive to list almost exclusively 
abroad, 17 of the 2006 listing were in part or in full on 
Russia's two main exchanges, RTS and MICEX, representing a 
total of 34.8% of listed market share.  The heavy weight IPO 
of 2006 was that of Russian state energy giant Rosneft, which 
raised over $10.4 billion.  Steel giant Severstal came in 
second place with over $1 billion.  Other companies include 
Magnit (retail), Raspadskaya (coal) and OGK-5 (electricity), 
each of which raised more than $300 million on local 
exchanges.  PricewaterhouseCoopers forecasts that some 30-35 
Russian companies will conduct IPOs in 2007, raising $20-25 
U.S. Investment Continues to Grow, 
and Have Positive Impact 
5. (C) U.S. firms continued their strong march on the Russian 
market, with extremely positive results.  According to a 
recent Ernst and Young survey commissioned by the American 
Chamber of Commerce, U.S. firms invested at least $24 billion 
between 2001-05 in Russia, with 50% of companies showing a 
MOSCOW 00002932  002 OF 004 
"better than budget" profit over the same period.  For 2008, 
41% of the companies surveyed expect turnover to increase by 
more than 100% over 2005, while an additional 29% expect it 
to grow by 50-99%.  Average investment by companies entering 
the Russian market between 1989-1993 was $519 million per 
company from 2001-2005, while average investment of companies 
which entered the market between 1999-2006 totaled $55.5 
million per company. 
6. (C) In 2006, some of the larger U.S. company investment 
included: International Paper ($400 million to f
orm a joint 
venture with Ilim Pulp); Guardian Industries ($260 million to 
construct a glass factory); Philip Morris ($600 million to 
expand a high-tech facility); General Motors ($115 million on 
a greenfield manufacturing facility); Dow (up to $20 million 
to establish control over polyurethane systems manufacturer 
Izolan); Cargill (up to $30 million to acquire a vegetable 
oil extraction plant and 25% of a sugar plant); 
ConocoPhillips (which increased its share in Lukoil from 
16.4% to 20%); and Motorola ($2 million to open a brand shop 
in Moscow).  These and many other companies are planning 
additional investments to take advantage of the favorable 
market.  The Ernst and Young survey indicated that those 
companies which entered the market between 1989-1993 and are 
most comfortable here expect investment during the period 
2006-2008 to be roughly $358 million. 
7. (C) A separate AmCham survey confirmed that U.S. companies 
operating in Russia have been making a profound impact on 
their Russian employees and business partners, greatly 
contributing to bridging the "values gap."  The survey 
revealed that Russian employees in American firms here 
increasingly come to expect transparency, fairness and 
accessibility to senior management.  U.S. firms are strongly 
promoting charitable works among their employees in Russia, 
and are demonstrating ways to unlock Russian innovation 
better and faster.  U.S. firms are seen by their employees as 
law-abiding, helping build a culture of accountability, and 
bringing top-line management models to their Russian 
operations.  Russian employees increasingly see law 
compliance, merit-based compensation, strong business ethics 
and social responsibility as necessary conditions of 
integration into the international business community. 
Domestic and Outward Investment Also Up 
8. (SBU) Domestic investment has also reached new heights 
over the past year.  During 2006, RosStat estimates that 
domestic capital investment increased by 13.7% to $163.9 
billion, or 16.7% of GDP.  World Bank figures indicate that 
sectors attracting most of this investment in 2006 were 
transport and communications (26.8%), mineral resource 
extraction (17.3%), manufacturing (16.4%, 4.3% of which was 
metals), and real estate operations (11.5%). 
9. (SBU) The World Bank and RosStat estimate approximately 
20% growth in fixed capital investment over first four months 
of 2007, which suggests that investment growth this year will 
exceed the record 17.4% registered in 2000.  Elevated 
investment, particularly in machinery, equipment, and 
construction materials manufacturing, led to a surge in 1Q07 
industrial production, which RosStat estimated at 8.4%. 
Fitch Ratings indicated in January 2007 that the current 
recovery in domestic investment appears more sustainable than 
in the past, reflecting rising public investment, strong 
private sector balance sheets, easier access to financing 
from capital inflows and bank credit growth, tightening 
capacity utilization, and good growth prospects. 
10. (SBU) Reflecting their very positive cash flows, Russians 
have invested more money abroad as well.  Evraz's acquisition 
of Oregon Steel (the largest outbound transaction of 2006 at 
$2.3 billion), Stratcor, and Highveld Steel and Vandium; the 
RusAl, SUAL, Glencore aluminum merger; Norilsk Nickel's 
purchase of U.S.-based OM Group's nickel business; and 
acquisitions by telecoms, steel, banks and oil companies in 
Africa, Europe, and the former Soviet republics reached $13 
billion last year.  Russia is now the third largest foreign 
investor among developing countries. 
Explaining the Boom 
11. (SBU) Both foreign and domestic investors are drawn to 
MOSCOW 00002932  003 OF 004 
Russia by its continued strong macroeconomic fundamentals and 
the market potential of what is now the world's tenth largest 
economy.  Principal attractions include enviably strong 
average annual GDP growth over the past 8 years of just under 
7%, a federal surplus of 7.5% of GDP last year, low external 
debt (about 5% of GDP), enormous financial reserves, an 
increasingly strong ruble, improved investment ratings, a 
booming domestic market (10.7% increase in consumption in 
2006) backed by rising average salaries and real disposable 
income, comparatively low wages, vast natural resources, and 
significant opportunities for building up badly decayed 
12. (SBU) Increased investor confidence in the Russian 
economy is evidenced not only by raw investment figures.  The 
financial story of 2007 - the pick-up in capital inflows - is 
further proof.  Central Bank Chairman Ignatiyev stated in 
early June that net private capital inflows already reached 
$60 billion in the first five months of 2007, compared to 
$41.7 billion for all of 2006.  While in the past, additional 
capital inflows were due to sharp increases in oil prices, 
2007 inflows largely resulted from an increase in foreign 
borrowing by Russian corporations and foreign participation 
in Russian IPOs. 
13. (SBU) Russia's equity and bond markets were attractive to 
investors in 2006, with the RTS index up for the year 70.8%. 
Sell-offs of emerging market stocks in 2007 as well as the 
huge increase in equity investments on offer in Russia have 
contributed to an almost 10% decline year to date on the RTS 
index.  Russia's EMBI  spread has narrowed over the year to a 
range of 85-100, slightly worse than Mexico's 71-85, but well 
below Brazil's 139-155.  Standard and Poors raised Russia's 
sovereign credit rating from BBB to BBB  for foreign currency 
liabilities and from BBB  to A- for national currency 
14. (SBU) Investor confidence surveys back up the positive 
outlook of domestic business.  A 2007 study by the Russian 
Managers Association revealed that 90% of Russian business 
leaders surveyed believe the financial and economic situation 
of their companies will improve in the near future. 
Could Be Much, Much Better 
15. (SBU) As we noted last year, Russia's impressive strides 
in investment are tempered by the certainty that they could 
be even stronger.  While the 2006 percent of GDP figures put 
Russia ahead of China for the first time, the stock of 
Russia's net FDI is still modest; the EBRD estimates that 
Russia received cumulative net FDI of just $61 per head from 
1989-2005, compared with a Central and Eastern European 
average of $2,714.  The Economist estimates that even by 
2011, stock of inward FDI will barely exceed 12% of GDP. 
16. (C) Factors limiting growth are numerous, and include 
administrative barriers, uneven application of laws and 
regulations, capacity constraints, the slow pace of 
utional change, the impact of real ruble appreciation 
leading to a decelerating pace of economic expansion, and 
corruption, which Fitch analysts point out is the worst of 
any investment-grade country (Transparency International's 
2006 rating put Russia at 121/163).  According to a survey by 
the Economist Intelligence Unit commissioned by RusAl, 
Western investors are most concerned about lack of corporate 
governance, transparency and appropriate business ethics. 
Despite much debate and discussion, Russia is still 
struggling over proposed legislation governing investment in 
so-called "strategic sectors" and corresponding amendments to 
existing subsoil legislation that will eventually give 
investors greater clarity.  And although broad policy 
continuity is likely, political uncertainty over the election 
period is likely  to be a factor affecting short-term 
investment decisions. 
17. (C) Russia will need further structural reform and 
investment to improve efficiency, productivity, and maintain 
growth as competitive pressures increase, energy prices 
soften, and capacity constraints worsen.  At just under 17% 
of GDP, domestic investment levels are still significantly 
behind widely-recognized benchmarks for fast-growing 
transition economies.  Higher investment rates would 
unquestioningly help sustain GDP growth and promote 
additional economic diversification over the medium term. 
MOSCOW 00002932  004 OF 004 
What has been marked about Russia under Putin is the 
government's complacency with solid (i.e. 7% average annual) 
growth rates, while clearly foregoing the opportunity for the 
kind of super growth rates seen in China and India. 
18. (SBU) But things may be changing in that regard. Over the 
past year, the GOR has rolled out a new package of 
legislative and policy initiatives designed to stimulate 
investment in sectors to promote economic diversification and 
reduce reliance on resource extraction.  The measures are 
particularly focused on encouraging the high-tech and 
manufacturing sectors, and include changes in tax rules (more 
favorable amortization write offs and tax breaks for 
innovation activities), increased state funding for science 
and R&D, creation of a state development bank (ref B), the 
creation of special economic zones (ref C) and technoparks, 
public-private venture capital funds, and public-private 
partnerships for development of large infrastructure projects. 
19. (SBU) The Russians are also trying for the first time in 
half a decade to improve their presentation to the foreign 
investment community. The GOR also greatly increased its 
presence at this year's World Economic Forum in Davos (after 
a near no-show performance the previous year), and pulled out 
all the stops to attract thousands of business and government 
representatives to the June 2007 St. Petersburg Economic 
Forum.  At the latter, President Putin highlighted the role 
of foreign investment in Russia, singling out the electricity 
and infrastructure sectors as two in which Russia 
particularly welcomes foreign participation.  Presidential 
hopeful First Deputy Prime Minister Sergey Ivanov said that 
foreign investors would play a key role in the economy's 
development.  Notably, all major administration players met 
with groups of CEOs, including President Putin, First Deputy 
Prime Ministers Sergey Ivanov and Dmitry Medvedev, Economy 
Minister Gref and Finance Minister Kudrin. 
20. (C) The dichotomy we presented in last year's investment 
wrap-up continues (ref A): while the investment climate is 
far from ideal and certainly carries risk (particularly in 
sectors considered strategic), both foreign and domestic 
investors are seemingly inexorably drawn to the Russian 
market by its phenomenal profit margins and significant 
forward potential.  The investment inflows are in many cases, 
as demonstrated by AmCham's values survey, encouraging 
positive shifts to business principles of transparency, rule 
of law, and good corporate governance.  Increased Russian 
investment outflows to places like the U.S. and Europe are 
also spurring positive changes in the way Russian companies 
conduct business at home. 
21. (C) It remains to be seen if the incentives put in place 
to encourage greater foreign and domestic investment in high 
tech and manufacturing sectors (assuming they continue in the 
next administration) will help diversify the economy and 
better insulate it from price fluctuations in the natural 
resource sectors.  Certainly further structural reform, more 
vigorous action against corruption, and clear legislative and 
regulatory rules of the road will be key to attracting the 
huge sums of additional investment still needed to make 
Russia's economic growth sustainable in the medium-term. 


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