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. -------------- 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 MOSCOW 00002206 002 OF 005 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. -------------- 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) -------------- The Minister's Conundrum MOSCOW 00002206 004 OF 005 -------------- ¶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 MOSCOW 00002206 005 OF 005 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. -------------- 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