RUSSIA: COMMUNICATIONS SECTOR AT A CROSSROADS

C O N F I D E N T I A L SECTION 01 OF 05 MOSCOW 002206

SIPDIS

SIPDIS

DEPARTMENT FOR EB/CIP/MA (GIBBS),EUR/RUS (GUHA),
AND EUR/PRA (NASH)
COMMERCE FOR 4321/ITA/MAC/EUR
BERLIN FOR HAGEN

E.O. 12958: DECL: 05/11/2017
TAGS: ECPS ECON EFIN EINT ETTC PGOV PINR PREL RS
SUBJECT: RUSSIA: COMMUNICATIONS SECTOR AT A CROSSROADS

REF: A. MOSCOW 01904

B. 06 MOSCOW 12191

C. 06 MOSCOW 11387

D. 06 MOSCOW 09942

E. 06 MOSCOW 05355

F. 06 MOSCOW 04091

Classified By: EST Counselor Daniel O'Grady. Reasons: 1.4 (b,d)


1. (C) SUMMARY: The information and communications
technology sector is the most vibrant in the Russian economy,
demonstrating double digit growth year to year since 2000 and
contributing more than five percent to total GDP in 2006.
Despite the prospect of surging expansion of the IT sector
based on outsourcing and product development, the mobile
phone segment has reached saturation of the market,
threatening to slow future growth. The Ministry of
Communications has become part of the problem due to
regulatory constraints and the legal travails of its head
Leonid Reyman. At this juncture, First Deputy Prime Minister
Sergey Ivanov has taken control of the ICT sector and
promises to continue the positive trends, but to crack the
whip on negative aspects. This shifting situation poses a
strategic question for the prospect of cooperation. END
SUMMARY


2. (SBU) The Russian information and communications
technology (ICT) industry contributed $28 billion, or more
than 5 percent, to 2006 GDP, according to figures released by
the Ministry for Information Technologies and Communications
(MinInformSvyazi). The latest economic reports for 2007 show
that the ICT industry continues to grow by more than 20
percent per year, as it has every year since 2000, while the
overall GDP is growing by 6.7 percent. In March, Minister of
Communications Leonid Reyman predicted the ICT market would
reach $40 billion by 2010 and exports of software would total
$10 billion, up from $1.5 billion in 2006. Steve Chase,
president of Intel Russia, said on April 14 that Russia would
have an outsourcing market for software design of $1 billion
by the end of 2007. Russia currently ranks third in
outsourcing behind India and China (albeit having less than
10 percent of the market) and is valued for its strong design
capability and highly-educated workforce. There are 300,000
IT professionals in Russia, and Russia is second to the
United States in producing science and engineering graduates
every year.


3. (SBU) Despite the impressive growth of the ICT sector in
recent years, it reached a crucial stage in its development
in the past year. The mobile telephone industry -- the
largest component of the C in ICT -- moved from the era of
explosive growth that characterized the period from 2000 to
2005, when it grew by over 20 percent per year, to more
gradual expansion in 2006-07 with the growth rate dropping
below 15 percent. The telecommunications industry faces
potential stasis in 2008 and thereafter. While mobile phone
operating companies are looking for new customers and new
markets to increase stagnating revenues, the information
segment (IT) of ICT has continued to climb rapidly from 33
percent of total ICT output in 2005. In 2006 the IT market
grew 17 percent to $13.6 billion and shows signs of becoming
the more dynamic element as a result of increased consumption
by government, the corporate sector and increasingly affluent
households. The IT export market -- primarily software, but
increasingly turning to outsourcing -- reached $1.8 billion
in 2006, according to the MinInformSvyazi.

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3G . . .and beyond!
--------------


4. (SBU) On April 20 the Ministry of Communications awarded
the eagerly-anticipated licenses for the third generation
mobile services. The 3G mobile technology will allow mobile
telephones to become an extension of the Internet. Services
such as e-mail, instant messaging (IM) and video-telephony
will be available. Although 3G is hailed by the Russian
media as signaling the arrival of the Russian ICT industry on
the global market, this step is fraught with painful choices

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and potential pitfalls for the major mobile phone operators.
Minister Reyman said in December: "We were not in a hurry to
issue 3G licenses...because from our point of view there is
not a big demand for some services that 3G can offer."
Losers in the 3G license competition claim the winners only
intend to roll out their service in the largest cities and
will ignore the regions in contravention of the license
requirements. They have asked that a fourth 3G license be
awarded to a regional alliance of mobile operators using the
networks of the companies that obtained the licenses.


5. (SBU) MobileTeleSystems (MTS),the largest mobile phone
operator, has 72 million subscribers in Russia and the CIS,
with 2006 fourth quarter revenue of $1.81 billion. MTS
President Leonid Melamed said on April 23 the company would
spend $1 billion through 2010 in the creation of the 3G
network. According to Melamed, MTS plans to start operations
in the second half of 2007 in Russia's 15 largest cities and
expand to the rest of the country in 2008. However, Melamed
said there was an "uneasy state with frequencies" that must
be approved in some of the local markets to begin operations.
But he predicted that in three years 30 percent of all
companies in the customer base would be using the 3G network.


6. (C) VimpelCom,the second largest mobile phone operator,
declared on April 13, even before it received the 3G license,
that it would spend up to $350 million by the end of 2008 to
create the infrastructure necessary to carry service to all
regions as required by the license. VimpelCom plans to build
up to 2,000 base stations in three years to cross Russia.
VimpelCom's CEO Alexander Izosimov said that 3G would
"contribute to healthy competition in the Russian
telecommunications sector." However, a month earlier the
senior vice president for Central and Eastern European
operations of Telenor (protect),one of VimpelCom's two
controlling shareholders, told us that 3G operations were at
best likely to contribute little to the bottom line. He said
that the enormous initial investment in infrastructure would
offset the expected growth in revenues for the foreseeable
future.


7. (SBU) Going beyond 3G, in the past year
telecommunications provider Comstar initiated wireless
Internet access services (Wi-Fi),starting in central Moscow
and expanding to Metro stations in Moscow and St. Petersburg.
Other companies offer a national broadband wireless access
network (WiMAX) in Voronezh, Lipetsk, Penza, Samara, Tula and
Yaroslavl. By the second half of 2007 WiMAX will be
operating in 32 cities outside Moscow and St. Petersburg.
This development capitalizes on the spread of personal
computers (up 33 percent to 23 million units) and the
increase of Internet users (up 15 percent to 25.1 million
people) in 2006. Although trailing the United States by a
wide margin, Russia is outstripping India and China in the
expansion of the telecommunication society. However, the
unpredictable regulatory environment and growing conflict
among the major players in the mobile phone market cloud
prospects for the future.

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Regulatory Hurdles and Hidden Interests
--------------


8. (SBU) VimpelCom stock has been listed on the New York
Stock Exchange for over 10 years. Corporate rating agencies
rank it as one of the most transparent Russian businesses.
However, VimpelCom has had difficulty obtaining favorable
regulatory decisions. VimpelCom applied 20 times for a
license for radio frequencies in 11 regions in the Russian
Far East, but was denied by the Federal Service for
Supervision of Communications (Rossvyaznadzor),the agency
responsible for assigning radio frequencies. Finally,
VimpelCom filed a complaint with the Federal Anti-Monopoly
Service and won a ruling in 2006 ordering Rossvyaznadzor to
issue the license. Nevertheless, the Ministry and
Rossvyaznadzor now claim that no frequencies are available.


9. (C) Dmitriy Zimin, founder of VimpelCom, told us with a
shrug that this is the reality of doing business in Russia.

MOSCOW 00002206 003 OF 005


He acknowledged the common belief that Minister Reyman has a
concealed stake in MegaFon, the only mobile operator with
licenses in all regions. He strongly voiced his opinion that
this interest dictated decisions favoring MegaFon and
disadvantaging its competitors.


10. (C) On March 19 President Putin ordered Rossvyaznadzor
to be incorporated into the new Federal Agency for Mass
Communications, Telecommunications and Cultural Heritage.
(NOTE: The head of the new agency, Boris Boyarskov, has
written to us that he intends to continue to work with the
USG on IPR issues such as the licensing of optical disk
production plants. END NOTE) The new agency will also
inherit Rossvyaznadzor's oversight of protection of personal
privacy pursuant to the new laws "On Personal Data" and "On
Information, Information Technologies and Information
Protection." (REF D) According to the Presidential decree,
regulations for the new agency will be drafted by early
summer to reassign functions among the various agencies.

--------------
Minister vs.Oligarch vs. Shareholders
--------------


11. (C) Reyman's concealed interest in MegaFon allegedly
arose in the 1990s when he oversaw the privatization of the
local communications sector.(REF E) In May 2006, the Swiss
Arbitration Court identified (but did not name) a Russian
minister as the secret beneficiary of a Bermuda trust, IPOC
Holdings, that owned a controlling interest in MegaFon as a
result of a web of money laundering and fraudulent transfers
that took place in St. Petersburg. The description clearly
applied to Reyman, but he was not a party to the legal
proceedings and was not bound by the decision. He has
repeatedly denied the accusations over the years, claiming he
has no interest in MegaFon. However, his explanations have
been unraveling, and in March, Bermuda initiated steps to
dissolve IPOC for fraudulent concealment of the secret
interest. German prosecutors are currently investigating
transactions from the 1990s in which Reyman may have received
payoffs.


12. (SBU) The charges against Reyman came to light as part
of a struggle for control of MegaFon by Mikhail Fridman, the
billionaire oligarch controlling the Alfa Bank empire.
Fridman claimed to have purchased stock representing 25
percent of MegaFon from LV Finance, to whom IPOC had
previously paid $50 million for an option to purchase the
same stock. In June, 2006, IPOC brought a $150 million RICO
(Racketeer Influenced and Corrupt Organizations) action
against Fridman, Alfa Bank and LV Finance in New York Federal
court based on allegations that the defendants conspired to
seize IPOC's right to the stock. On April 16 Leonid
Rezhetskin, former owner of LV Finance, sued Reyman in the
same court, claiming Reyman threatened his business in order
to force him to sell to IPOC. The legal wrangling is
expected to continue long into the future.


13. (C) While charges swirl around Reyman and Fridman over
MegaFon, the Norwegian communications giant Telenor is locked
in a struggle with Fridman for control of VimpelCom. Fridman
owns approximately 36 percent of VimpelCom while Telenor has
29 percent. According to sources at Telenor, Fridman has
been trying to oust Telenor by circumscribing its minority
rights. They also claim Fridman directed VimpelCom to expand
into Ukraine, where Telenor has the majority interest in the
largest Ukrainian mobile operator, without business
justification and solely in order to dilute Telenor's
interest in VimpelCom. (COMMENT: The competitiveness of the
telecommunications industry is at stake in the conflict among
Reyman, Fridman and Telenor. Fridman threatens to seize
control over two of the three largest mobile companies while
Reyman manipulates the industry despite a glaring conflict of
interest. Ominously for Russia, the ICT industry is the
fastest growing sector in the economy and represents the
breakthrough to future innovation technology. END COMMENT)

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The Minister's Conundrum

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14. (C) Reyman is at once one of the most forward-looking
members of the cabinet and arguably one of the largest
gluttons at the privatization trough. In public disclosure
for cabinet members, he ranks as the third richest minister,
but his acknowledged income is only $44,000 with assets
(primarily his apartments) valued at about $400,000. His
reputed interest in MegaFon may be worth several billion
dollars, but his accusers allege he acquired the interest
through fraudulent conversion of state assets to personal
benefit and the use of laundered money.


15. (C) In contrast to his alleged private behavior, Reyman
is leading his ministry, in cooperation with the Ministry of
Education and Science, in a new national project to provide
licensed software for all Russian schools by the opening of
the coming school year, and he offered a plan for federal
funding of the program. He has championed the freedom of the
Internet from state control over content despite calls in the
State Duma to regulate electronic speech. (NOTE: A case is
wending its way through the judicial system where a chat room
user was charged with defaming President Putin. END NOTE) As
minister, Reyman has promoted development of public-private
partnerships to foster innovative technology. He was one of
the primary sponsors of the Investment Fund for Information
and Communication Technologies and will oversee 1.5 billion
rubles ($60 million) in investment in technology development.
And yet the price for his public service seems to be
tolerance of his shady dealings with one of the major
companies his ministry regulates.

-------------- -
A Very Long Engagement...and Ivanov Takes Over
-------------- -


16. (C) For over a year, Reyman has been trying to engage
the USG in a variety of cooperative efforts. In May 2006, he
visited Commerce Secretary Gutierrez in Washington and
invited him to attend an October roundtable of
telecommunications companies and government officials in
Moscow. Although the Secretary declined, Reyman renewed the
offer in August and coupled it with an invitation to the
Communications Ministers meeting of the Black Sea Economic
Cooperation Organization (REF B). After Reyman met the
Secretary on his recent trip to Moscow, he renewed his

SIPDIS
pursuit on April 24 by proposing the Secretary attend a
business-government roundtable at the Ministry-sponsored
InfoCom gathering this coming October (REF A). At the same
time, the Ministry requested the creation of a government to
government working group on communications, which would meet
semi-annually.


17. (C) Reyman is a savvy member of the St. Petersburg
circle that is close to Putin. As such, he has been a nimble
player of the Kremlin power game, even when confronted by
such powerful adversaries as VimpelCom and Mikhail Fridman.
Reyman will now have to deal with First Deputy Prime Minister
Sergey Ivanov, who was given responsibility for
communications and innovation technology as part of his
elevation in status from Defense Minister. In his first
speech on ICT issues, Ivanov addressed the MinInformSvyazi at
the annual departmental convocation on March 27 about the
value of innovation, but he also criticized "a whole industry
of corrupted officials." He told Reyman and the assembled
bureaucrats that the future of Russia was intimately
connected to the new technology they supervised, but that
"the current situation still leaves a lot to be desired."
While praising the industry's accomplishments, he took a
swipe at its shortcomings by noting that too many components
were imported. He held out hope that Russia would rise from
its current low position to become a major player in the
international ICT market and said "all regions of the Russian
Federation should have the technical infrastructure in place
for land-line connection, mobile communications and access to
the Internet by 2015."


18. (C) Ivanov's influence is already being felt. On April
19, Deputy Information Minister Boris Antonyuk, Federal

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Communications Agency Head Anatoliy Beskorovainy and Deputy
Chief of the General Staff Evgeniy Karpov announced the
future coordination of regulation of civil and military radio
frequencies. Antonyuk said this represented "a one-stop
principle" for regulation whereby one agency will be
responsible for processing applications and obtaining civil
and military clearance. This holds promise that the Kremlin
may finally proceed with the long-delayed privatization of
Svyazinvest, the government-owned communications holding
company that controls the fixed-line telephone services.
This sale would raise up to four billion dollars, but the
Defense Ministry reputedly has stalled the sale over concerns
within the armed forces that their lines of communications
would be compromised.

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Comment: Encourage Progressive Trends
--------------


19. (C) The ICT industry is poised for significant growth if
it can overcome both the natural flattening of demand in the
mobile phone sector and complications related to the
precarious legal position of the Communications Minister.
The former conditions are within the control of the major
industry players based on innovation, competition and the
growth of the IT sector and outsourcing. There is a
significant chance that Reyman's schemes will be exposed in
coming months, and it is even possible that he may be accused
of criminal acts in several jurisdictions. Ivanov evidences
support for Reyman's vision of the telecommunications
industry's future, but he promises a strict standard of
accountability. In these circumstances, the USG should
support the opening of Russia to competition and innovation,
acknowledging the Communications Ministry's overtures by
responding to invitations to greater cooperation, such as the
establishment of industry working groups, the creation of
experts' panels and the exchange of regulatory experience.
However, we should keep an arm's length relation with the
Minister himself, who may not survive the transition after
Putin or even before as Ivanov takes control of ICT.
BURNS