Growth Rate — Coping with Difficulties

Владимир Горчаков
20 августа 2012, 00:00

On the whole, investment risks in constituent subjects of the Russian Federation have been reduced. Large-scale government programs remain the fundamental driving force, followed closely by private investors. The main risk for the latter group remains poor governance quality and performance

Photo by Oleg Slepyan
There is an increasing demand for metallurgical products

The investment appeal of Russian regions (currently rated in 16th position) has drawn attention to an obvious fact: overcoming the economic crisis has improved the investment climate in the country. This can be clearly seen in the decreased integral indicator for investment risks in the country as a whole (see Figure 2). Incidentally, the appearance of an overall all-country indicator was an innovation in 2010-2011. In addition, qualitative changes in the investment environment, which had accumulated over the recent years in the regions, prompted us to upgrade our rating methodology (for more detailed information, see “What Composes the Investment Appeal Rating of Russian Regions”). Of course, this led to some changes in regional positions, based on the last rating, but it caused few changes in their mutual relations, and most importantly, the main trends did not change.

From General to Specific

The overall integral risk in Russia could not be reduced without compromising its components and the fall of this indicator in the regions: three-quarters of the constituent subjects of the Russian Federation, including most of the heavyweight regions, followed the overall all-country trend (see Figures 3 and 4). Accordingly, all the components of the integral risk indicator showed a decline.

We can be glad that the most significant risks were notably reduced in Russia: financial risks were reduced by 12%, whereas social risks dropped by 13.5%. This was a consequence of reducing the number of arrears among companies, improving the balance of regional budgets, less unemployment, and fewer overdue wages.

This general optimistic picture was marred by management risk indicators: their value is almost one and a half times higher than the integral investment risk, and higher than all the other types of risk. This means that the poor performance of regional administrations represents something much worse for investors in Russia than all the other difficulties (unfavorable economic situation, social environment, financial difficulties, crime, and environmental conditions).

Although overall management risk has been reduced in the country, there has been an increase in risks associated with governance, which has had an impact on a number of key points of investment activity, including Moscow, Saint Petersburg, Tatarstan, Bashkiria, Sverdlovsk, and many other regions.

Changes, Places, Terms

Removing the “Elders” from government bodies, an event that took place during the second half of Dmitriy Medvedev’s presidency, came too late in many cases: a detailed analysis showed that management risk increased in almost 80% of the regions, where the top persons were replaced (see Figure 5 and Chart 1). This does not mean that the quality of governance suffered under the orders of a new team; in fact, so many problems had accumulated beforehand that the new head and his team just did not have enough time to resolve them.

Moscow is the most vivid example of such a situation. Sergey Sobyanin, who replaced Yuriy Luzhkov as mayor, inherited a region with traditionally high management risk. In Moscow, this component rarely managed to rank higher among the bottom twenties in our previous ratings, and even dropped below the 60th place in the 2009 and 2010 ratings. The fact that governance quality and performance in the capital dropped was due more to inertia, which was inevitable in view of the large mass of statistical data to be analyzed, than to any mistakes made by the new mayor’s team.

First, quality management of regional budgets (one of the main indicators of management risk) was evaluated according to 2010 performance, whereas the main financial document was approved at the end of 2009, that is, when the former mayor had still been in office. The Moscow budget constitutes a subject for a separate and more thorough discussion. In this case, we can recall the expenses related to the economic unit, which were enormous compared to similar standards in other regions (there were years when the capital city accounted for 40–45% of budgetary investment expenses of all the regions of the country), specific targeted expenditures, which were not at all related to the city (such as costs for livestock farms in Central Russia, or for purchases of health centers in distant Bulgaria by the capital city), and indecently generous social obligations compared to general standards in Russia, which were often implemented by sequestering allocated funds and spending them on other items — and the list goes on and on…

Second, sudden changes, even if they are for the better, tend to scare off investors. So, if a new head appears in a region, changes will be inevitable. The point here does not concern destroying established patterns for “resolving problems”, but changing the fundamental rules of the game. The capital city is a shining example of this fact. Suffice it to say that construction — the backbone of Luzhkov’s economy — suffered severe setbacks when the new team arrived on the scene. All unfulfilled investment projects in the construction sector were revised. Some of them were cancelled, others were thoroughly overhauled. This process continues to this very day. Therefore, we can say with confidence that the rating results of management risk in Moscow for the next year (as well as in Saint Petersburg, where a new governor was recently appointed) are likely to undergo quite a radical change.

A similar picture, i.e. the predecessors’ poor governance inherited by the new administration, can be observed in Tatarstan, Bashkiria, Chuvashia, Karelia, Kalmykia, the Novosibirsk, Tyumen, Kaliningrad, Nizhny Novgorod, Orenburg, and Rostov Regions, and a number of other regions. The new administration teams, which arrived in these regions, literally did not have enough time to deal with the old sore spots of the administrative systems. So, our ratings of Medvedev’s appointees will be evaluated, at best, only next year. In the meantime, we can only state that personnel replacements were carried out in places, where the volume of problems exceeded permissible limits.

Potential Anchors

The impact of political risks on regional economy is balanced by a much more stable indicator — their economic potential. We should remember that potential shows the share of each region in the country’s economy, and this share varies not as quickly as management teams. It is unlikely that a region will change its ranking by ten or more positions according to the annual potential indicator (despite the fact that natural disasters may also occur, with devastating consequences for the given area). Nevertheless, changes also take place in regional potentials. Thus, current ratings show that the Samara Region, which has been yielding its position for two years in a row, immediately rose up to fifth place this time. The program — “New cars for old clunkers” — helped the region to attain this position; it created a miracle for the deeply-ingrained regional AvtoVAZ Company, which many people had written off completely during the economic crisis.

Chechnya rose by three positions at once. However, it is obvious that this was due to its initial low position: the republic rose from the 76th to the 72nd place. In addition, according to Ramzan Kadyrov, the financial security of this region was protected by higher forces, before which any kind of rating is powerless (at a recent celebration on the occasion of the Day of Grozny, the Chechen leader invoked Allah as the source of the republic’s funds).

Compared with previous ratings, the potentials for Moscow and Saint Petersburg fell slightly; this was due to the fact that these major megalopolises gradually lost their status as the main investment “movers and shakers” of the country. 

Many regions of the Far East slightly increased their potential; however, this had virtually no impact on their positions in the rating for this parameter. In addition, the potential for long-term migration to the European part of the country cannot be stopped, which is basically due to a continuous decrease in population. In 2010, the regions comprising the Far Eastern Federal District lost more than 20 thousand people.

The State Comes Back Down to Earth

However, we can state that large-scale investments in the Far East and many other regions began to show results under various state programs. We should remember that last year, the amount of funds from state programs injected into numerous regions had little impact on their potential and investment appeal. Federal money, which “fell from the heavens”, and the local economy lived far apart — but, the long-awaited reunion finally took place this year. Thus, for the first time in the history of our rating system, the Krasnodar Region took first place, a “Gold” medal in the general competition for integral risk, and thanks to the “Olympic Games effect”, thus leaving its competitors far behind. At present, the region is in the top ten for management risk (first place), economic risk (second place), and criminal risk (seventh place). Social risks have decreased significantly over the past year (the region rose from the 27th to the 16th place): unemployment and the poverty rate dropped, the percentage of overdue wages also fell at times. The growing financial risk is disturbing (the region immediately sank by seven positions, flying out of the top ten). This was a result of worsening budget parameters: the relation between costs and own income increased, and the debt load nearly tripled. Unfortunately, an ever-increasing flow of money almost always has a deplorable effect on financial discipline.

Raw material industries showed significant dependence on demand on international markets exp_august_096-1.jpg Photo by Oleg Slepyan
Raw material industries showed significant dependence on demand on international markets
Photo by Oleg Slepyan

Nevertheless, the Krasnodar Region remains one of the most powerful magnets for investments in the whole country (see Figure 6). From 2006 to 2010, its share in total investments in the country increased from 3.2 to 5.4%; during the 2009 crisis, when investment projects were being curtailed all over the country, capital investments in the regional economy slowed down ever so slightly, but managed to reach pre-crisis 20% growth per annum.
A second example of the positive impact of federal policy on investment appeal in the regions, as noted above, was recorded in the Far East. Investment risks decreased in most regions of the Far Eastern Federal District in the past year (see Figure 7).

All the components of integral risk, except for environmental risk (growing negative effects on the environment) have dropped in the Primorskiy Region, which is engaged in large-scale construction within the framework of the APEC summit. As a result, the region rose by five places in the current rating for integral risk. There is hope, albeit faint, that state investment operations have reduced the “marginality” of this region in the eyes of outside investors. In the meantime, business is moving along thanks to “neighborhood circles”: Transneft and Gazprom infrastructural projects have been implemented, and the construction draft of a grain terminal at Vostochny Port has been designed. However, there are some examples of genuine “market” investors: in the past year, two major Japanese automobile concerns — the Mazda Motor Corporation and the Toyota Motor Corporation — signed agreements providing for the launch of facilities for a car assembly plant for their own automobiles in Vladivostok. It is possible that the attraction of foreign transnational corporations will influence the region’s position in future ratings.

The investment pool is mostly traditional in the other regions of the Far East: infrastructures and raw materials. In September 2010, the gas pipeline — Sobolev-Petropavlovsk-Kamchatskiy (Kamchatka Region) was commissioned, construction on the gas pipeline — Sakhalin-Khabarovsk-Vladivostok — continues, and the construction of the second phase of the oil pipeline — Eastern Siberia-Pacific Ocean — is also in progress. Vaninskiy Port, designed for coal export, is expanding its facilities. Signal constructions for Eastern Siberia and the Far East were completed in 2011: technical operations were launched on the railway line linking the Trans-Siberian Railway and the Baikal-Amur Mainline with Yakutia.

Certain hopes to diversify the local economy may be linked to the fund, established by the government, and created to develop the Far East and the Baikal Region, but even its operational system has not been defined yet, so the impact will be seen no earlier than in a couple of years.

Architects of Their Own Fortune

Among the factors that determine the business climate in the regions, along with federal money and state programs, an increasingly important role is played by the team of active members of an administration, which is dissatisfied with the operations of Soviet assets.

“The Elders” of active investment policies are the Belgorod and Lipetsk Regions, which began breaking out ahead of the neighboring regions in the first half of the 2000s. Initially, these regions were keeping large steel mills in operation. However, with such great state assistance, the governors were able to attract a large number of medium and large investors, primarily in the agro-industrial complex (AIC). Moreover, for many years now, the Belgorod Region has been famous for its housing program, whereby the region has enjoyed great success among producers and developers of building materials.

As a result, the economy of both regions became more stable during the years of economic growth, and they managed to get through the recent economic crisis less painfully than their neighbors. Traditionally, both regions are included in our rating of constituent subjects with minimal risks; the Lipetsk Region occupied first place for three consecutive years, until this very year, when it was pushed into second position by the Krasnodar Region. Belgorod received the “Bronze” medal this year.
Stories of recent economic success are made by administrations, which are able to involve large foreign “anchor” firms. The most striking example can be seen in the Kaluga Region, where the first phase of the facilities for the German automobile concern, Volkswagen, was completed in 2007. It was followed by other car manufacturers, producers of automobile components, household appliances, building materials, and many others. A pharmaceutical business venture is being actively developed in Obninsk with the support of the administration. While we were preparing this year’s rating, the German Continental AG Company (the second largest tire manufacturer in Europe) began building a plant with a production capacity of 4 million tires per year. In general, the region is going through a complete re-industrialization process.

Some economic branches in Russia have not even noticed recent economic torments of the world exp_august_097-1.jpg Photo by Oleg Sepyan
Some economic branches in Russia have not even noticed recent economic torments of the world
Photo by Oleg Sepyan

As a result, although the Kaluga Region was rated in the low thirties on the list of regions for risk in 2007, it managed to take 12th place in 2010. The region improved its position by four positions, and it is quite likely that this trend will continue in the next rating. In addition, the Kaluga Region represents a rare example of a central region, where its investment potential is rising despite growing depopulation. According to this indicator, it was in 48th place in 2006, but it managed to rise by more than ten positions by 2009. Nowadays, the Kaluga Region stands in 34th place among all the Russian regions with regard to total potential, and in first place among all the regions constituting the “outer ring” of the capital city’s agglomeration. It is typical that the region immediately moved up by six positions for its production potential during the post-crisis upward swing.  

A similar strategy was implemented several years earlier in the Leningrad Region, but two natural factors contributed to this situation: the region’s coastal location and the proximity of a megalopolis. However, as we all know, “beneath a stone no water flows”. As in Kaluga, the region began to prosper when a major foreign automobile concern arrived — a plant of a subsidiary company belonging to the American Ford Motor Company has been operating in Vsevolozhsk since 2002. During the years of economic growth, the region and the neighboring city of Saint Petersburg came to be known as the “Russian Detroit”.

Another example of an active investment policy led to sustained growth of investment appeal in the Ulyanovsk Region. This is a very recent post-crisis example: in one year, the region moved up by six places in our rating for risk, and by two places for potential (the 25th and 51st position respectively). Characteristically, the Ulyanovsk Region combines the features of the pre-crisis investment surge by focusing on the food industry, construction materials, and automobile manufacturing, as well as by pointing out the future paths for other investment waves. In this case, we are talking about industrial enterprises in the high-tech sector: production of aircraft components and machine tool building. In the first case, the construction of corresponding production facilities began this year; in the second case, it will begin next year.

Uniting the City and the Village

The bets on diversifying the economy should be placed by the regions, which previously focused primarily on the development of the agricultural sector. For example, in the Altai Region, industrial production increased by 20% last year after nearly a ten percent drop during the 2009 crisis year. Other macroeconomic indicators followed suit in the region. As a result, the Altai Region moved up by 26 positions for integral risk and 21 positions for economic risk in the new rating. Financial and social risks dropped significantly in the region.

A similar situation was observed in the Rostov Region: the decline in the agricultural sector was smoothed over by the recovery of industrial production and trade and commerce. In addition, the regional authorities (in the neighboring Stavropol Region as well) adopted a more accurate approach to the expenditure of budgetary funds in their own regions.

However, several regions were less fortunate. The drought of 2010 had a much greater impact on the agricultural sector in the Chernozemye Region.

The positions for this indicator in the Tambov and Voronezh Regions, where agricultural production fell by nearly 30%, deteriorated immediately by 11 and 16 positions respectively. A complete collapse of integral risk was avoided thanks to the stability of the other indicators.

How Bright is the Future?

Preliminary data from regional statistics for 2011 show that investment risks will continue to decline in most regions of Russia, and it is highly likely that the overall all-country risk will decrease in the next rating. However, not everything is so clear vis-à-vis administrations. These new administration teams are building up relations with the business community so quickly that we are inclined to believe that management risk will continue to represent the most important factor for investing in Russia.
When looking at the different regions, we can predict that the leading positions for attracting investments will be preserved for the traditional leaders, i.e. the largest agglomerations and the developed regions in the South. Above all, the positions of other constituent subjects of the Russian Federation, which had created their own “success story” before the economic crisis, should be strengthened; they should also prove to the business world, and particularly to distrustful and wary foreign investors that it would be safe and convenient to operate on their respective territories.

We would prefer to be cautious in evaluating the impact of federal mega-projects in the Far East on the regional investment climate. The APEC summit will be held in Primorye next year, and it is highly unlikely that this region will ever see such large investment projects again… in preparation for this important event. The region’s infrastructural backwardness may be smoothed out, but defective institutions and the population exodus will continue. The development of roads and bridges is both expensive and important, but it is also a one-time opportunity, whereas forming an image of a reliable and stable partner for the business world requires constant and persistent efforts.