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9 January 2013

Russian infrastructure development to match growth

Oleg Pankratov, Head of Infrastructure Capital and Project Finance, VTB Capital

Russia’s growing economy has not always been matched by the state of its infrastructure. With new regulation and initiatives, including a host of new public-private partnerships, that is beginning to change

Across the globe, national governments are facing the challenge of deteriorating infrastructure in conjunction with rising state budget deficits. This issue encourages them to seek assistance in the form of direct financial investment and expertise fr om the private sector. In accordance with recent estimates by the Organisation for Economic Cooperation and Development (OECD), the level of investment in infrastructure needed to meet growing demand should equal 3.5 percent of world gross domestic product – or approximately $70trn – in the period until 2030. It is also estimated that up to $25trn of this amount would have to be financed from extra-budget sources.

Similar to other BRIC countries, Russia’s key challenge in the infrastructure sector stems not so much from a rising budget deficit (as seen in many developed countries), but from underinvestment in the sector over the last several decades (especially during the fall of the Soviet Union). With the lack of adequate investment, Russia’s infrastructure is barely capable of supporting its rapid, albeit volatile, economic growth since the early 2000s. It is estimated that Russia has been losing around one to two percent in annual GDP growth due to the existing infrastructure being unable to cope with its economy’s growing needs.

The task of revamping the entire infrastructure sector in the largest country in the world is a very challenging and expensive task for the Russian government, and is likely to take decades to complete.

Russia’s key challenge in the infrastructure sector stems not so much from a rising budget deficit, but from underinvestment

Any major strategic initiative requires careful planning and efficient execution. All pieces of the puzzle will have to fall in the right places: political, legal, regulatory, macro-economic, financial, and social. Since the early 2000s, the Russian government, both at federal and regional levels, has put substantial effort into developing a legal framework to facilitate and attract private capital to large-scale infrastructure projects. To some extent, the vast experience of developed countries has been adapted to the Russian reality.

However, significant adjustments had to be made in these systems to make them work in Russia.

A major milestone was achieved when the Federal Concession Law was enacted in Russia in 2005. It became a catalyst for developing similar policy at regional and municipal levels. One of the best examples is the Public-Private Partnership (PPP) Law of St Petersburg that was adopted in 2007. Since its implementation five years ago (a rather compressed time scale by developing market standards), several major infrastructure projects have been successfully procured under the PPP/concession laws, including Pulkovo Airport reconstruction project, the Western High-Speed Diameter toll road in St Petersburg, the first section of the Moscow-St Petersburg toll road, the Moscow-Minsk bypass, and the Yanino waste processing plant. A number of additional projects are currently in the pipeline, notably in the road sector, aimed at being completed over the next three years.

Issues to address

Despite these spectacular developments and improvements recently, Russian legislation still lacks some flexibility that would enable it to become a highly accommodating legal environment for infrastructure financiers. Each new project reveals a plethora of issues that need to be addressed in improving existing legislation, and market participants hope that the Russian lawmakers can keep up with the demand. Such issues include inconsistency between international and Russian law, matters of security for project lenders (although this is gradually improving), currency control issues, and a lack of basis for fixed sum construction contracts under Russian law. These issues and others need to be thoroughly assessed by Russian lawmakers to take the steps towards aligning the Russian legal framework with the realities of international cooperation in the 21st century.

A key to the long-term health of infrastructure development in Russia is attracting foreign investment. In developed countries, a major driving force behind private investment in infrastructure is pension funds. The size of the pension fund market in Russia is too small to provide sufficient and similar support to large-scale infrastructure initiatives. Besides, certain existing regulations make it difficult for Russian pension funds to accept exposure outside of the Russian sovereign or quasi-sovereign bracket. Some work is being done by the Russian government to address these regulatory lim itations. But apart from this, Russia is also hoping that the international investment community can provide a sustainable, long-term source of direct investment in exchange for a considerable share in the country’s booming infrastructure sector.

In assessing investment risks, especially by long-term infrastructure investors, particular attention is paid to political risks. The sour history of the 1998 sovereign default in Russia is bound to make potential investors wary. On the other hand, during the more recent crisis of 2008-9, the drastic economic and financial situation was handled by the Russian government in a much wiser way, and was to a large extent underpinned by huge currency reserves accumulated over the years leading up to the crisis. A lot has been done recently and continues to be done by the Russian government in order to make the country more transparent for foreign businesses and to reduce red tape. There is a high degree of continuity in strategic approaches on major political and economic aspects, taken on by the new government since the recent presidential elections. It is hoped that with the continuing process of gradual improvements, Russia will be seen by foreign investors as a more politically friendly environment in the long run.

Another traditional worry of international investors in Russia is high inflation and the stability of the rouble versus major currencies. Much improvement has been seen in this area over the past couple of years. The Russian CPI (consumer price index) has subsided from exceedingly high levels of 14-16 percent per annum in 2008-9 to a much more reasonable level of six to seven percent in 2012 (estimated). A longer-term inflation target set by the Russian government is around five percent. The rouble’s exchange rate to the US dollar has demonstrated an average level of approximately 30-30.5 over the past two years, although there was a substantial degree of volatility in early 2012 driven largely by knock-on effects from the eurozone crisis. Russia’s hard currency reserves have been kept at high and stable levels within the $450-500bn range over recent years, which should provide a very comfortable cushion capable of absorbing potential future shocks.

A moderate risk

The cost of risk in Russia as assessed by the markets compares rather well with its peers. Good indicators of the markets’ perception of long-term risk are five-year credit default swap spreads; the cost of ensuring that Russian government five-year bonds have traded in a range of 1.3-2.7 percent per annum over the past 12 months, reflecting the underlying volatility in the global financial markets. This is still substantially cheaper than that of Italy, Spain, Portugal and Ireland, which have also been subject to a high degree of volatility. Russia’s risk is perceived to be similar to that of Turkey (very solid strong developing market with a booming infrastructure sector), but inferior to that of China, largely due to the latter’s high currency reserves and more diversified economy. All in all, when comparing investment opportunities based on underlying sovereign default risks, Russia can be perceived as a ‘moderate risk’ and should be suitable for a variety of international investors.

We at VTB Capital have no doubt that Russia has all the necessary components to succeed with its ambitious long-term infrastructure overhaul plans. There are strong political and economic drivers in place necessitating and facilitating the right changes already happening in the country. This is already confirmed by the early success of major international projects undertaken in the transportation and municipal sectors and structured in line with the best international practices and standards. A number of national funds have been set up by the Russian government (e.g. the Far East Development Fund) targeted at injecting money into revitalising specific geographic regions and industries of the country. Their combined firepower should provide the basis for supporting new infrastructure projects and making them attractive for private investors.

The next few years will be decisive for Russia. The Russian government must accelerate its ongoing efforts aimed at creating an investor-friendly legal and business environment in the country. The lessons learned and experience gained in implementing the recent major PPP projects must be capitalised upon and replicated across the country. A proper infrastructure investment market has to emerge and mature, potentially with specialised infrastructure companies and holdings doing initial public offerings on the world’s leading stock exchanges in the foreseeable future. It is not an easy decision for foreign investors to make a long-term commitment to Russia, but the history of the past 20 years demonstrates that it’s those who stay there the longest who stand to win the most.

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