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18 October 2011
Russian way is a new highway
by Oleg Pankratov, VTB Capital

18.10.2011

Euromoney Transportation Finance Review (UK)

It is not a secret to anyone who has ever been to or lived in Russia that the overall condition of the country’s infrastructure (transportation, municipal, social, etc) is far from perfect. Decades of chronic underinvestment (especially in the 1980–90s) combined with Russia’s vast territorial span and harsh climate, have resulted in the crumbling road system, capacity constrained and out-dated airports and highly inefficient municipal utilities. The rapid and largely oil driven growth in the Russian economy in the last decade, severely reversed by financial crisis in 2008–09 but resuming afterwards, has necessitated active steps by the Russian Government aimed at the fundamental overhaul of the country’s infrastructure to bring it in line with the best international standards. It is estimated that Russia has been losing around 1–2 percentage points in annual GDP growth due to the existing infrastructure not being able to cope with the rising economy’s needs. The task of revamping the entire infrastructure sector in the largest country in the world (by area) is anything but straightforward or affordable, and is likely to take many years to complete.

A lot has been said about prospects of growth in the Russian infrastructure sector over the last few years. The opinions have varied dramatically, from exceedingly skeptical to highly optimistic. The market’s attitude to Russian risk has been highly volatile, particularly during the recent financial crisis that left deep scars on Russia’s economy and overall investment climate. Having said that, one has to hand it to Russia’s Government which has not given up on the idea of making a complete overhaul of the country’s outdated infrastructure its key strategic priority. Therefore, once the ‘perfect storm’ in the Russian financial system and economy subsided, the environment has once again become conducive for implementing the far-reaching infrastructure development programme. Save for the extraneous shocks and often higher volatility inherent in emerging markets, are there fundamental reasons to believe that Russia will struggle to make good on its long-term plans?

In our view, a short answer is ‘no’. There is no uniquely Russian factor that would make that country fundamentally incapable of being successful at what it does, especially if it firmly sets its mind to it. It suffices to mention the great success story of the Russian space exploration programme that started in the late 1950s and continues up to now. Post-Soviet achievements include building a market economy essentially from scratch (albeit, one that’s still very far from being perfect and efficient) and various steps aimed at making the country more open to foreign investors. Among the countries of the former Soviet Union, apart from the Baltic states, Russia can boast the highest GDP per capita (over US$13,000) which to a large extent is due to the relatively high commodities prices in the 2000s. A longterm infrastructure regeneration programme can be the next big success story for Russia. 

Any major far-reaching initiative requires careful planning and favourable pre-conditions. All pieces of the jigsaw have to fall in the right places: political, legal, macro economical, financial. Since the early 2000s, the Russian Government has been busy building a legal framework that would facilitate attracting private capital to large-scale infrastructure projects. To some extent, the vast experience of developed countries has been used, however a simple copy and paste hardly ever worked due to the peculiarities of Russian law and regulations. A major milestone was achieved when the Federal Concession Law (FCL) was adopted in Russia in 2005. It became a catalyst for developing similar legislations at regional and municipal levels, as well as expanding it into industries that were not originally covered by the FCL. One of the best examples is the Public-Private Partnership (PPP) Law of St Petersburg that came to life in 2007.

Five years down the line and several large infrastructure projects have been successfully procured under some of these newly established legal frameworks, including the Pulkovo Airport reconstruction project, the first section of Moscow – St Petersburg toll road, the Moscow – Minsk bypass and the Yanino waste processing plant and of course Western High-Speed Diameter where the Northern Capital Highway (NCH) consortium led by VTB Capital has recently been named the preferred bidder in the tender for the right to construct the central part of the road. A number of further projects are currently in the pipeline, aimed at completing in the next one to two years.VTB Capital has taken an active part in the financing and realisation of the majority of these projects. Some of them, such as Pulkovo, have already won high appraisal and a number of international awards as the best infrastructure project in Russia.

It would be naive to think that the improvements introduced in the Russian legislation over the recent years have solved all major legal issues. We are still on a steep learning curve. Every new project reveals a plethora of problems that are yet to be addressed in the next upgrades of the existing legislation, and the market participants are hoping that the Russian law-makers can keep up with the demand. Various conceptual issues consistently arise in projects in which direct foreign investment is involved, including inconsistency between international and Russian law, matters of security for project lenders, currency control issues, lack of basis for fixed sum construction contracts under Russian civil code etc etc. All these need to be thoroughly assessed by the Russian law-makers, and steps taken towards bringing the overall Russian legal framework more in line with the realities of international co-operation in the 21st century.

A key to the long-term infrastructure development programme in Russia is attracting large volumes of foreign investment. In developed countries, a major driving force behind private investment in infrastructure assets is pension funds. The long-term nature of their liabilities requires looking for stable long-term returns, and good quality infrastructure assets provide a perfect match to their needs. The size of the pension funds market in Russia is too small to provide sufficient support to a large-scale infrastructure initiative. Plus certain existing regulations make it difficult for Russian pension funds to accept exposure outside of the Russian sovereign or quasi-sovereign bracket. Therefore, Russia is looking with hope towards the international investment community in search of a sustainable source of direct investment in exchange for a considerable share in the country’s infrastructure sector.

So, what are the pros and cons that an international infrastructure investor should weigh up whilst pondering over forthcoming opportunities in Russia? A key factor that always comes top of the agenda is political risk. It is hard to deny that there exists some level of anxiety amongst potential foreign investors dating as far back as the 1998 default. This is hardly helped by the fact that Russia scores miserably on the World Bank’s Ease of Doing Business Index (123 out of 183 in 2011, a 3-step slide in comparison with 2010). However, one has to appreciate the efforts that have been made by the Russian Government over the last years in order to make the country more transparent for foreign businesses and reduce the ‘red tape’. It is hoped that, subject to continuing political stability in the country, we will see qualitative changes in the entire system in the long run, and Russia will rise amongst the ranks of its peers.

The macroeconomic aspect is also critical in assessing investors’ appetite to Russia. If one has to characterise the Russian markets in one word, the chances are that the word would be ‘volatile’. And it is true that the Russian markets are volatile. During the last financial crisis, the Russian RTS stock exchange index dropped by close to 80% from its peak to its lowest point in the space of seven months. Subsequently, over the next 12 months it recovered and grew by an astonishing 190%, although it has never reached its pre-crisis peak. Having said that, most of the world markets, including developed and developing, also demonstrated unprecedented levels of volatility in the doomsday period of 2008–09. Can one perfectly hedge against such volatility? The answer is ‘no’, but certain protection is offered by investing in ‘defensive’ sectors, such as core infrastructure, which are GDP driven and show little cyclicality. Over longer investment horizons, which is the case for infrastructure projects, the market volatility tends to average out, resulting in attractive overall returns. For example, a strong solid investment made into Russia in the mid 90s and held firmly until now could have delivered superior returns despite going through two major crises on its way.

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