RUSSIA: INVESTMENT BOOMING AT RECORD LEVELS

C O N F I D E N T I A L SECTION 01 OF 04 MOSCOW 002932

SIPDIS

SIPDIS

STATE FOR EUR/RUS AND EB/TPP/BTA
STATE PASS USTR FOR DONNELLY, ERRION, MOLNAR
NSC FOR MCKIBBEN, KLECHESKI
USDOC FOR 4231/IEP/EUR/JBROUGHER

E.O. 12958: DECL: 03/30/2016
TAGS: EINV ECON RS
SUBJECT: RUSSIA: INVESTMENT BOOMING AT RECORD LEVELS

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
billion.

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

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"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 form 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

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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
infrastructure.


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
liabilities.


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
institutional 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.

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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.

Comment
--------------


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.
BURNS