Russia report: A “Eurasian Union on the horizon?

Date: 21 Mar 2012

Citywealth

With the impending Russian elections, Citywealth thought it would be interesting to have a look at Russia and Russian behaviour to get a heads up on news and trends. Q & A interview with Ashley Crossley, Chair of the Baker & McKenzie’s Europe and Middle East Wealth Management Practice Group and Joint Head of the Wealth Management Department; Vania Markova, Head of Russia, CIS and Central Eastern Europe, Crossbridge Capital and Geoff Miller, Chairman of Aurora Russia, and AIM listed fund with equity investments in Russia.

Q Russians seem to have amassed many billions in private fortunes. Is this a reality for your average Russian? Is there old money or is it all new? What sort of private wealth size do you see?

Crossley: “$100m +”

Markova: “This is a region that has seen a lot of change in the last twenty years and by its nature is an emerging market. As such, wealth creation has been a more recent phenomenon.”

“The number of Russia’s ultra high net worth individuals has almost doubled in 2010 compared to 2009 and it is at record high. The country currently accounts for 15 of the world’s 100 richest people (more than Brazil, India and China combined) according to Forbes latest annual rich list published in spring 2011 and ranks third in the World with 101 UHNW individuals (115 in China).”

“The number of Russia’s high net worth individuals has grown equally strongly, by 13.6 per cent over the last year, which is over double the growth of Brazil (5.9 per cent) and preceded only by India’s growth (20.8 per cent) as per the Merrill Lynch/Capgemini World Wealth Report 2011.
Miller: “Due to the history of the country, there is no old money – all assets were seized from the wealthy during Soviet times, so all fortunes have been made in the last twenty years. Whilst there are obviously the high profile super-rich class of Russians, the rising numbers of middle class Russians, are the drivers behind the strong growth in consumer spending. They are far more important to most businesses. We have a stake in the leading DIY chain in the Urals, and its like-for-like sales growth in the high teens is driven by the mass-affluent.”

Q. We hear that many Russians are now buying football clubs in Europe. Also that Russians are buying businesses in Britain now – manufacturing (core businesses that mirror their own in Russia) and hotels or restaurants. What other things have you seen Russians start to invest in around the world?

Crossley: “Infrastructure, supermarkets, logistics, real-estate. There is a current trend towards much needed investment in Russian infrastructure and this is increasingly being seen as a viable investment option. Special tax regimes have been, and continue to be, developed in order to further assist this investment. There also appears to be a recent increase in investment in real estate, especially in London. The trend for investment in football clubs in Europe may well be influenced by the potential for high returns and, importantly, the prestige associated with the game. The Premiership in the UK is one of the wealthiest in Europe, raking in a significant sum (running into many millions of pounds) in TV rights alone.”

Miller “The Russians have a long history of top flight European football. More recently the national side has been somewhat erratic, for example the victory over Holland in the quarter finals of Euro 2008 was followed by failing to qualify for the world cup in 2010. However, football remains a very popular game at club level and much investment is going into domestic sides as well as other European clubs. Interest is only likely to increase in the run up to the 2018 world cup in Russia. More generally, given that many Russian companies have relatively strong balance sheets it is hardly surprising that they are seeking to take advantage of opportunities to expand overseas thrown up by global financial turmoil.”

Q. Many say it is hard to find good investments in the UK for Russians because they can make far more money in Russia however our safe legal system and politics mean they want their money in the UK. Is this the case?

Crossley: “Yes, UK investment decisions for most UHNW clients are based on safe harbour concerns rather than returns on investment.”

Miller: “Generally the IRRs available in Russia are better than the UK but it is true that there can be a trade off for greater security of title. It is all dependent on price, and it may be that UK sellers will be more realistic as to what their businesses are worth as a result of the lack of capital available in coming years. In my experience there is little difference in the attitude of Russians to domestic vs overseas acquisitions.”

Q: Russia as part of BRICS continues to be a growth story that people are interested in, but what about the countries surrounding Russia are they benefiting from a wave of money utilizing services and businesses from Russians and if so what sort of businesses?

“There is a customs union in place between Russia, Belarus and Kazakhstan,” Explains Vania Markova at Crossbridge Capital, “which has already removed tariffs and customs controls along internal borders and has provided access to a significant larger internal market. In January 2012, this union is due to expand into a ‘common economic space’ allowing for free movement of goods, services and capital across a single market of 165m people. There are also discussions of a future common currency union and eventually a “Eurasian Union” on the model of the EU.”

“There is also increased cooperation with Western Europe, which Russia shares a common border with. Last month Russia opened the US $10bn Nord Stream pipeline via which it will be supplying up to 27.5bn cubic meters of gas to France, Germany, the UK, the Netherlands and Denmark as of November this year. A second pipeline is expected to double capacity by 2013. Gerhard Schr√∂der, the former German Chancellor, led the Gazprom-led consortium that built the pipeline.”

“Most recently the German utility company RWE announced that they are also in talks with Gazprom on forming a joint venture to build and operate gas-fired power plants in Germany, the UK, and the Benelux countries by the end of 2011.”

“And the newly formed US $10bn SWF Direct Investment Fund has also started announcing first projects whereby Russia will be starting a strategic partnership with a leading European pharmaceuticals group, which is to begin local production in Russia.”

Ashley Crossley, Partner at Baker & McKenzie offers his view. “CIS jurisdictions: Ukraine, Kazakhstan, Azerbaijan continue to develop their markets, led on by the market activity in Russia and the interest generated in established players in these markets. Russia-China and Kazakhstan-China are also examples of how oil and gas deals between BRIC countries are helping each other grow.”

“Russia’s infrastructure is also in a very poor state, therefore the opportunity for capital project investment is good and this will expand as capital projects are used to maintain growth.”

Miller: “There are spin off benefits for neighbouring countries from the growth of the Russian economy, but as the nature of the growth in the Russian economy is different to the nature of the growth in the Chinese economy, so the benefits are different. Whilst China has a significant internal migrant worker population, much of the manual labour in Russia is drawn from neighbouring countries. Aurora Russia owns a stake in a leading, fast growing Russian money transmission business and much of that business is money being remitted back to CIS countries from workers in Russia.”

Q. What are the investment restrictions across the regions for UK citizens going in and for Russian investors coming out?
“There are virtually no restrictions on the free movement of capital; Unlike other BRICs, there are also no foreign currency limitations in Russia,” explains Markova, “There is a regime of managed floating currency exchange rate, whereby the conventional floor and cap values for the rubble are set to the dual currency basket.”

“There is a highly favourable tax regime in Russia which allows for twenty per cent corporate income tax rate, a personal tax rate of thirteen per cent regardless of income size and from 2011 no capital gain tax for long-term direct investments as well.”

“There has been an additional significant effort towards encouraging further foreign direct investments into the country as well. In June this year President Medvedev unveiled a US $10 Direct Investment Fund to co-invest alongside foreign investors. The fund has been joined by some of the leading private equity names in the world.”

“Russia’s FDI target for 2011 is US $60-70 billion.”

Miller: “The UK Government has tightened the requirements for Russian businessmen in recent years and unfortunately that is being reflected, understandably, in increasing requirements from Russia for UK citizens seeking business visas. In the rest of Europe there are less restrictions on Russian businessmen and accordingly less restrictions on other Europeans entering Russia.”

Q. Do you know what the political situations are in the various countries. For instance it has been reported that many wealthy Kazakhstan individuals have departed with assets to the UK following government restrictions and laws suddenly changing. The Georgia conflict was also recently an issue?

Crossley: “We’ve seen a considerable number of wealthy Kazakh clients come to the U.K., just as we’ve seen an increasing trend for Ukraine and other CIS clients. This is a product of both push and pull factors which will often be quite specific to the individual and family. The changes in the U.K. Investor category have certainly led to a considerable increase in activity.”

Q. Can the Ukraine or any other CIS country become serious competition to Russia or are they just too large to compete against?

Crossley: “Competing against Russia is not an option either party will pursue. Growth has come from opportunities between the jurisdictions and an opening up of their wealth management sectors.”

Miller: “The size of the economies relative to the Russian economy are very small. Although there can be difficulties in the relationships between Russia and both the Baltic States and Ukraine, in all cases Russia is an important potential market and cannot be ignored. In addition, the fact that there are close links with Russia can make these countries important gateways into Russia for business from the rest of the world.”

Q. Does Russia have any population issues like food crisis/ employment issues that are simmering?

Crossley: “Russia may suffer in the future due to its shrinking and ageing population, however this is not as significant as the ageing populations in countries such as Italy and Japan. Inflation remains a concern within the country.”

Miller: “Russia’s population has been in decline, and hence demographic issues are focused more on the ageing of the population than other areas. How Russia deals with this issue and with the need for infrastructure renewal will determine its growth trajectory in coming decades.”

Q. Is Russia doing any work with the Middle East as both are big oil producing nations or are they like the Chinese just looking for new oil companies to invest in, in countries like Brazil? Any trends in the oil business?

“In the last few years Russia has been actively engaged in diversifying away from its dependency on natural resources; it has pioneered various efforts to become a more knowledge-based economy and given its highly educated labor force (one of the highest in the world according to the OECD), this is fully achievable,” continues Markova at Crossbridge Capital.

“Only five years ago, the oil and gas sector accounted for over forty per cent of GDP, it now accounts for only seventeen per cent. In line with this effort, the US $10 billion SWF Russia Direct Investment Fund launched by President Medvedev will also not be investing in energy assets, but focus on healthcare, technology and infrastructure.”

“Along similar lines, Russia has also recently founded Skolkovo, a business park outside Moscow, intended to be Russia’s Silicon Valley.”
Crossley: “The current high price of oil has served to support the demand for new infrastructure within Russia, which will be crucial to support the region’s onward growth. Russia continues to focus on exploiting its own natural gas and oil reserves, however the country does retain links with the Middle East and was noticeably against the UN’s attempt to impose further sanctions against Syria, following an embargo ban on the Syria’s oil exports due to the political and civil unrest in the country at present.”

Q. Any information on what else Russians are buying? Art, cars or yachts? Are Russians interested in hedge funds and alternative investments or is it all property and businesses?

Markova: “Each of the clients is unique and it is extremely hard to generalize. We see a rise in real estate and commodities investments, as well as art and generally the alternative asset space, including luxury collectibles, as these are seen to have a low correlation to global markets. We also observe a general tendency away from complexity and towards simpler products.”

Crossley: “Yes, all three. There has also been an increase in securitizing their Art collections.”

Miller “Like any other investors, Russians are interested in a good risk adjusted return. It may be that, in the UK, property acquisition is more visible than alternative investments but Russians will consider anything that can provide the returns they seek, providing the risks can be analysed and understood.”

Q. Corruption is sometimes an issue that appears in the news and even some James Bondesque Cold War style spying. Are these a reality of doing business in Russia or is this a myth now?

Crossley: “Key decisions are made by Russia’s political elite. Russia’s political landscape is now relatively stable after Putin’s presidential announcement, because the decision-makers look set to remain.”

Miller: “The reality of doing business in any emerging market is that the culture will be determined by modern business practices tinged with culture inherited from the past. Coming from a Soviet past, it is no surprise that Russian businesses are probably more aware of the importance of security of their information than Western businesses. It is helpful to our document storage business, OSG, that people realise the value of information and the importance of industry-leading levels of security but I don’t believe that industrial espionage is any more or less sophisticated than the West.”

Is there any financial difficulty as experienced in the UK with the crunch? And how is their currency?

Crossley: “The global financial crisis came slightly late to Russia, but the country still felt the impact of the worldwide recession in a fairly strong way. In particular, the banking industry suffered from currency volatility as well as feeling the effects of becoming increasingly dependent on international capital markets for funding. However, times are improving and the sector appears to be emerging well from the financial troubles. “

Markova: “Russia is blessed with an enviable fiscal health, it has large foreign exchange reserves and a sizeable sovereign wealth fund, however the country is clearly not isolated from the rest of the world economy and, as most recently observed, global markets are increasingly correlated.”

“In 2011 Russia expects zero budget deficit. The country has accumulated the third largest foreign exchange reserves in the world ($531 billion in 2011) preceded only by China in the BRIC space and Japan worldwide. There are increasing recent talks of Russia becoming a potential global creditor to support the troubled Euro zone.”

“Russia has also, since 2008, amassed the second largest sovereign wealth fund in the BRIC space ($142.5 billion), preceded only by China. By comparison the world’s largest fund, in the UAE, which was set up in 1976 stands at $627 billion and Norway’s fund, now at $556 billion, was set up in 1990.”

“In the current turbulent economic environment Russia’s fiscal strength is another important financial cushion for the country.”
Miller: “Being an economy whose exports are mainly priced in dollars, the big issue for Russia is a strengthening of its currency against the dollar squeezing profit margins for exporters. A weakening of the currency tends to be positive for domestic production as it leads to import substitution.”