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The Russian Bear Awakens


April 1, 2004
By Pulp & Paper Canada

Topics
PJ Lavelle

It is hard to ignore Russia for long. More than a decade after communism’s collapse, two opinions generally emerge about the country’s economic potential: the nation will become a regional power once again, but it will take years, if not a generat…

It is hard to ignore Russia for long. More than a decade after communism’s collapse, two opinions generally emerge about the country’s economic potential: the nation will become a regional power once again, but it will take years, if not a generation, to repair the many problems that it has amassed; or, conversely, the time is now ripe for the Russian Bear to show its economic prowess.

There are good reasons for such conflicting views. Russia is a country that defies easy definition, as it were, because its borders touch both the East and the West. It’s a nation of heartfelt emotion, ruled as much by its history and sense of place in the world as by anything political, economic or technological.

To be sure, Russia is currently experiencing powerful economic growth. The US Central Intelligence Agency’s World Fact Book reports that since 1998, “the economy subsequently has rebounded, growing by an average of more than 6% annually in 1999-2002 on the back of higher oil prices and the 60% depreciation of the ruble in 1998. These GDP numbers, along with a renewed government effort to advance lagging structural reforms, have raised business and investor confidence over Russia’s prospects in its second decade of transition.”

Investors have lately been flooding in to Russia at a rate not seen since its economic collapse in 1998. Russia is encountering a boom period. The nation’s largest companies are approaching world-class standards of management. In pulp and paper, one of the companies, Ilim Pulp Enterprises, reported sales of almost $1 billion in 2002, making the top-100 list of PriceWaterhouseCoopers’ Global Forest and Paper Industry Survey (2003), nailing down 67th place. Ilim, founded in 1992, is the world’s 11th largest pulp company.

Equally important, in October 2003, Moody’s, a credit-rating agency, raised its rating of Russia to investment grade. That’s long way from the dark days of Black Monday (August 17, 1998), when the Russian economy crashed. (See sidebar, Dark Days in August.)

No doubt, a recovery is taking place, showing hopeful signs that Russia will become a viable and strong economy. In 2002, its estimated GDP was $1.4 trillion (U.S.). Canada’s GDP is around $934.1 billion (U.S.), although our nation is almost five times smaller in population (30 million to Russia’s 144 million people.) President Vladimir Putin aims to double the nation’s GDP within 10 years.

THE RUSSIAN WAY

Blessed with geographical size and a diverse landscape, Russia is awash in such resources as oil, natural gas, metals and timber. For example, it holds one-quarter of the world’s fibre resources, or about 75 billion cubic metres. It is also estimated that Russia contains one-fifth of the world’s old-growth trees. No more than 15% is earmarked for domestic consumption; a considerable amount is shipped as logs to China (see PPC, April 2003).

Indeed, Russia desires to do business with the West, but not at any cost. “The Russian business community is very open to developing ties with the West — though under conditions that are beneficial to themselves and Russia,” says Peter Lavelle, an independent Moscow-based analyst and author of the weekly online newsletter, Untimely Thoughts. “There is no interest in allowing foreigners to control any important sector of the economy. However, participation in the development in the national economy — and making a profit-is welcomed.”

Even so, among average Russians, things ought to proceed in a manner befitting Russia and its people. “Russians are inward-looking and unimpressed with those who declare that Russia follow a Western model of economic and democratic development,” Lavelle points out. “Putin has returned to Russians some of the pride that the Soviet Union provided. Putin, in many ways, is the average Russian on the street.”

Business in Russia is undergoing final transition to a market economy, which opens the way to many business opportunities. Lavelle offers some key advice: “Do your homework and due diligence. Partnerships and friendships are everything in Russian business.”

To be sure, Canadian companies are building some trading ties with their Russian counterparts. For example, in January, GL&V’s Process Group secured a $4.5-million contract to supply a complete sedimentation system that will end up in a sewage-treatment plant in St. Petersburg.

“It’s not an easy process, but there’s plenty of potential to do business in Russia,” says Richard Verreault, executive vice-president and chief operating officer of GL&V, a supplier with global reach, based in Trois-Rivires, QC.

THE BATTLE FOR CONTROL

Even so, worries remain. For one, Russia has a long history of repression, and anti-democratic behaviour. When Putin’s administration arrested Mikhail Khodorkovsky, a billionaire businessman, oil baron and Russia’s richest man, it showed how weak the hold of democracy is in Russia, and how powerful are the spectres of the past. (see sidebar, The Khodorkovsky Affair.)

Many would-be foreign investors are waiting to see how the Khodorkovsky Affair plays out. Although, it must be said that in Russia proper it is popular to bash the oligarchs, the handful of wealthy businessmen who control he majority of Russia’s economy. The idea that a handful of people can control so much wealth irks average Russians, and tends to go against the thinking of Russians, notably those old enough to remember life under communism.

In a sense, it’s the classic battle between the state and private interests, Lavelle notes. “Putin believes it is in the state’s right to determine how Russia goes about strengthening and diversifying Russia’s economy, not a group of oligarchs interested in making or spending huge sums of money on themselves.”

In a country where 30% of the population is undergoing crushing poverty, Putin’s undemocratic-like measures, including the suppression of freedom of speech and monitoring political opposition, weak as it is, has widespread support among the electorate. His popularity is such that he did not really campaign — as campaigning is done in Canada and the U.S. — in the presidential election, where he was returned for another four-year mandate.

Under Putin’s leadership, the country has to continue to work out some of its deep structural problems. “Russia’s infrastructure remains poor, skills are often weak, the population is ageing, and there is a huge amount of domestic capital for investment,” says Matthew Lynn of Bloomberg News, a business publication. “These are all factors that are going to restrain the country’s progress.”

To be sure, the pulp and paper sector is working with old and, in most cases, outdated machines. “Because of the antiquated processes, the quality of the pulp it produces is not as high as global standards,” says Bill Mahoney, senior vice-president, pulp and paper group for GL&V. Mahoney, who spent two weeks in Russia in 2003 touring many of its pulp operations, says, “Russia needs to modernize its pulp mills to bring them up to world-class standards.” (It is looking to join the 146-member WTO in 2006.)

Many of the mills are unproductive, using too many bleaching stages and megawatts of energy to produce a tonne of pulp. To its advantage, the costs for labour, fibre and energy are extremely low, at least when compared to Western standards.

It has taken more than a decade for the mills to come close to the production rates they held before communism’s collapse. It is noteworthy that 1988 was among the Russian pulp and paper’s highest production years. By 1990, when privatization took hold, production fell dramatically; and, in 1994, production plummeted to record lows. “During the transition to privatization, the industry lost a lot of expertise,” Mahoney says. “Many people, driven by hunger, left the industry in search of other jobs.”

POOR PLANNING

What took place in the 1990s is a direct consequence of the way the government of former president Boris Yeltsin went about privatizing its major industrial sectors, including forestry. Almost overnight, after the collapse of the old communist regi
me in December 1991, government-controlled industries became privately owned. Unlike China, Russia decided to liberalize and reform almost overnight. The rapid changes in ownership left employees confused and dispirited. “They didn’t know who their bosses really were,” Mahoney says. “It was not an orderly transformation, but, rather, a chaotic one.”

Today, the mills are running at between 75% and 80% of peak 1988 production rates, a remarkable feat given their inefficiencies. Nevertheless, the industry still needs to become more modern, and for that to happen, the country requires foreign investment. Before foreign capital will flood into Russia, however, the country has to overhaul its financial infrastructure, including banking, tax collection, corporate audits and accounting practices. A number of foreign countries are helping in this effort, including Canada, the U.S., Britain and France. The process will take a few years to complete.

Equally important, the legal system has to be enforced. In the early ’90s, a number of foreign companies lost money in legal disputes with their Russian partners, and had little real recourse before the courts. “If you don’t believe that you can go to court to file a claim against someone who has injured you, then there is no point in investing in Russia,” Mahoney says. “You have to have a credible and transparent system that supports the law.”

Which brings up the ownership disputes, which are often messy, personal and emotional. The disputes result from the lack of a plain and legal paper trail, which clearly document when a company was sold, and to whom.

The continuing ownership fights, including those taking place in the pulp and paper industry, are slowing foreign investment in Russia. For example, Ilim Pulp Enterprises and Continental Management have been involved in a particularly nasty ownership dispute for about two years. “The fight is being waged over some of the largest mills in the country,” Mahoney points out. “That, in turn, is affecting the entire pulp and paper industry.” (see sidebar, Pulp and Paper Wars.)

The struggle for de-facto control of the mills typifies some of the fallout of Russia’s all-too-quick transformation from state-owned and controlled businesses to privatization and free enterprise. Still, as Lavelle puts it: “Russia is not that much different from other emerging markets — risks do exist, but entering these markets with open eyes and understanding the experience of others can make a world of difference.”

No doubt, you need a strong stomach to invest in Russia, and must be a risk-taker at heart. That explains the sentiment of most people from the West, who say you ought to take a wait-and-see approach for another two or three years. Even so, Russia is among the four nations that analysts say will achieve super economic growth in the decades to come.

For example, economists at Goldman Sachs estimate that, within 40 years, the emerging economies of Brazil, Russia, India and China (BRICs) will overtake the G-6 (the U.S., Japan, Britain, Germany, France and Italy). Currently, the BRICs’ total gross domestic product now amount to less than 15% of what the G-6 produces.

Of course, estimates are just that — educated guesses. There are too many factors — political, economic, technological, to name a few, to truly predict the future. Still, as Mahoney of GL&V put it, regarding the growth of the developing BRIC economies: “China is No. 1, and Russia is No. 2, at least in the short term. In the future, if Russia gets its act together, it might share the No. 1 spot.”

Perry J. Greenbaum, a freelance business and technology writer, divides his time between Montreal and a rural community near Concord, New Hampshire. He can be reached at pjgreenbaum@metrocast.net.

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DARK DAYS IN AUGUST

On August 17, 1998, the Russian economy collapsed. The day has been called Black Monday. On that day more than five years ago, the stock market’s RTS index tumbled from 571 to 38.

The dramatic drop resulted in the collapse of the ruble, its currency. In six weeks, the ruble lost three-fourths of its value. Bank accounts were frozen, and people could not draw money from their accounts.

“Russia was effectively shut of the capital markets,” writes Matthew Lynn, a columnist for Bloomberg News. “Bonds could not be issued, deals could not be done.”

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THE KHODORKOVSKY AFFAIR

When President Vladimir Putin ordered the arrest of Mikhail Khodorkovsky, a billionaire businessman, oil baron and Russia’s richest man, it sent shock waves of concern throughout Russia and western nations, many of which were already investing greatly in Russia.

The effects were immediate. Russia’s main stock exchange, the RTS stock index, plummeted more than 10%. Shares in Yukos, Khodorkovsky’s oil conglomerate dropped 16% in value, or $2.3 billion in capitalization. One trader called the session, “Our Black Monday.” (Khodorkovsky has since stepped down as chief executive; and Simon Kukes now heads Yukos.) The market has recovered since then.

The arrest was straight out of a Hollywood action movie. On October 25, 2003, secret police wearing black ski masks stormed the oil magnate’s jet during a refueling stop in Siberia. The agents rushed aboard, shouting to passengers to drop their weapons, and took Khodorkovsky into custody. He was immediately hauled back to Moscow and charged with seven criminal counts, including embezzlement, tax evasion, forgery and fraud.

Khodorkovsky, 40, whose personal wealth was reportedly between $8 and $10 billion (U.S.), has called the allegations “absurd.”

After the arrest, President Putin said: “Everyone must be equal in the eyes of the law – a modest clerk, a civil servant and a big businessman, no matter how many billions of dollars he has in his private or corporate accounts.”

It is unclear whether the charges were based on legal merits or whether they were politically motivated. Khodorkovsky has openly defied the Kremlin by financing two opposition parties, Yabloko and the Union of Right Forces. Such a move has angered the Putin administration.

In December 2003, a Moscow court ruled that Khodorkovsky must remain in prison until March 25, to allow prosecutors time to prepare their case.

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PULP AND PAPER WARS

The Russian publication, Vedomosti, recently reported that negotiations have failed to end a corporate war between Ilim Pulp Enterprises and Continental Management. Continental Management, controlled by aluminium tycoon Oleg Deripaska and St. Petersburg banker Vladimir Kogan, has been trying for almost two years to gain control of pulp and paper mills in Bratsk, Ust-Ilimsk, and Kotlas from Ilim Pulp. While both companies claim legal right to the enterprises, Ilim Pulp has maintained physical control and generally fared better in the courts than Continental Management.

The companies have apparently discussed four possible resolutions to the conflict: 1) Ilim Pulp retains control of the plants and Continental Management receives $100 million (U.S.) to end its legal challenges; 2) Continental Management sells all of its timber assets to Ilim Pulp for $300 million (U.S.); 3) the two sides merge their assets to create a new company in which each holds a 50% stake, with Continental Management receiving $150 million (U.S.) from Ilim Pulp; and 4) Continental Management buys all of Ilim Pulp’s business for $450 million (U.S.).

The battle between Ilim Pulp and Continental Management has brought negative publicity to the industry, and possibly scared off strategic investors. Analysts point out that Ilim Pulp is unlikely to give up its business. After the presidential elections of March 14, 2004, which he won by a landslide, Putin will wade in and resolve such ownership disputes, analysts say. “Putin is a stabilizing force in Russia,” Mahoney of GL&V says. “These disputes have to be resolved in order for investment to take place.”