Russia starts to get to grips with infrastructure funding
InvestmentEurope | Gary Litman, 03.04.2013
In an exclusive article for Investment Europe, Gary Litman, Vice President, International Strategic Initiatives, at the US Chamber of Commerce, assesses how Russia is addressing its infrastructure challenges
All 11 times zones of the Russian Federation are alive with economic ambition that primarily manifests itself as hunger for infrastructure development.
Over the last couple years, the markets have registered substantial growth in Russia’s infrastructure build-out. According to Rosstat, infrastructure investment last year was RUB 4 trillion (about $130bn), or 7.3% of GDP, up 26% from 2011.
Morgan Stanley analysts note this was the highest level since the end of the Soviet Union, driven by a surge in Gazprom investment, as it completed two major projects (Nord Stream and Bovanenko).
Since the peak of the crisis, infrastructure has been accounting for one third of Russia’s fixed asset investment, which should have provided a substantial stimulus to the economy. Morgan Stanley forecasts the current level of infrastructure investment (over 7% of GDP) will continue to 2018.
As a stimulus, Russia’s financing of shovel-ready projects may be on a par with the rest of the world but the projects’ potential to substantially modernize the economy is debatable.
Russia, spanning almost half the Northern Hemisphere, has a special, sometimes tragic, relationship with infrastructure investment. In the newly popular Anna Karenina, Tolstoy’s alter ego Levin complains: “…in our unsettled condition of the land, railways, called into being by political and not by economic needs, were premature”.
This nation still sees its own roads as obstacles to overcome, rather than the stitches that hold the market fabric together. At the start of 2012, the total length of the transportation system was 86,000km of common use railways, 38,000 km of industrial use railways, 903,000km of public roads, 101,000km of internal water routes, 485km of underground and 639kkm of air routes.
The share of transport costs in total finished product costs is now at 20-25% percent, which is 2.5-3 times higher than for developed countries.
The Government’s own Transport Development Strategy recognizes the need to spend over $664bn on the development of transport infrastructure up to 2020, in order to move Russia up in the global ranking of competitiveness.
While ministries pile up plans and stats that may inspire awe or skepticism, personal observations speak volumes and give ground for optimism.
At a recent exhibition of architectural projects from across the Russian Federation, it was exciting to see dozens of new and revived Russian publishers of all sorts of architectural and construction magazines vie for the attention of young developers and architects from over 20 regions. None of the publishers was a state-owned behemoth. Clearly they feel their market expanding, both in volume and the sophistication of demand.
The increasingly frequent roadshows by Russia’s18 special economic zones present a very sophisticated understanding of both Russian capacity to absorb investment and its appeal to international investors.
In a January update, the Special Economic Zones management company reported over $12.8bn of committed private investment. It is now working out a detailed plan for presenting each of the zones to potential American partners.
Even US politicians have responded to this new Russian approach. On March 18, the US Department of Commerce and the Russian Ministry of Economic Development agreed to an action plan that will let Russian infrastructure projects benefit from the political cache in a series of presentations of large investment projects across the United States.
In a step toward higher relevance to global investors, Russians offered their own side show at the March 2013 Infrastructure Summit in Berlin. The Russian Direct Investment Fund (RDIF) hosted a meeting of major asset managers, funds, multilateral development banks and institutional investors on global investment challenges in infrastructure.
RDIF's no-nonsense CEO Kirill Dmitriev personally chaired the meeting because Russia hosts this year's G20, and Russian business has taken it upon itself to help global private sector players interact with G20 policy-makers.
In addition to the practitioners of infrastructure investment, the meeting included the largest business federations of US, Turkey, Germany and France, keen to influence the policy messages passed to G20 policy makers as they reshape capital markets and try to rebalance growth between the high debt, crisis stricken mature markets and high-saving, emerging export-driven markets.
In Berlin, Russian players treated as respected equals were keenly interested in grasping the challenges of everyone else around the table, from Australian superannuation funds to European green infrastructure equity firms.
RDIF, around for slightly over a year, has already made possible investments of over $2bn in Russian companies, of which its own stake is $480m. It has struck a deal with the China Investment Corporation for a new investment fund with a billion dollars from each side to underwrite projects to further boost trade between the two neighbors.
RDIF even joined the prestigious Long Term Investment Club run by the venerable French Caisses de Depots. In the latest Ernst & Young attractiveness survey of Russia, Dmitriev promises his fund will continue to share the risks and "elucidate the finer points of investment machinery in Russia".
That machinery is still a work in progress. It consists of a handful of state owned conglomerates and a complex system of budget redistribution. In theory, at current levels of oil revenues and low debt, Russian budget can continue to finance infrastructure investment through State Owned Enterprises (SOEs).
However, other budgetary obligations are likely to squeeze out infrastructure, evident in the public debate between the thrifty Ministry of Finance and ambitious sector ministries. Poor infrastructure and inefficient prior investment are both the reasons for, and the result of the slow pace of economic growth and the disappointing competitiveness of enterprises.
The Russian Direct Investment Fund and similar vehicles are partly a response to the fact that private investment in Russia is flowing into real estate, malls, prestigious international events, terminals -- and little else. It does not help turn the country into an efficient single market where goods and people can actually move at a reasonable cost and spread growth across the nation.
Private domestic savings are not mobilized by the pension system, which is mired in a drawn out process of tinkering. The roughly $500bn under management in private pension funds barely contributes to the economy and struggles to keep up with inflation.
The Ministry of Finance has proposed issuing RUB200-300bn of infrastructure bonds in 2013, which may be bought by Russian pension funds, for example. However, the details remain unclear, including who would be the issuers, how the funded pensions would participate, and the role of any government guarantee.
The bond market is still too shallow and dominated by a few extractive firms to provide a source of long tern funding. Project bonds are an academic subject matter that lack legal foundations.
Russian banks are too skittish to underwrite large constructions risks, with uncertain exit strategies. The answer seems to emerge in the form of political will to allow governors of major regions a lot more discretion creating conditions to attract global capital.
At one time, at the peak of the global asset bubble, Russians tried to convince themselves that public private partnership offered the solution to the dearth of purely private finance. Over 60 regions passed their own PPP laws ranging from detailed legislative frameworks in St Petersburg that benefited from EBRD’s help, to fuzzy declarations of vague preferences.
It turned out the public side was too prone to rent-seeking and the private side was ill-prepared to take the longer view. The way that the federal center directs the flows of funding from resource-rich regions to the less-prosperous ones makes Moscow essential to any large project.
The financing of a public partner is rarely local, or devoid from political calculations. In a recent interview to the Rossiyskaya Gazeta, Deputy Minister for Economic Development Sergey Belyakov noted that conflicting local and regional laws on PPP were one of the major investment risks in Russia.
A partial solution may be offered by a new bill on public private partnerships submitted to the Duma at the end of March. The bill is supposed to define the rights and obligations of both public and private parties, and broaden opportunities for investment financing beyond old-fashioned concessions.
According to Belyakov, the bill will grandfather the existing projects while bringing badly needed consistency to the PPP regime across the entire Russian market.
Analysts expect that investment financing through PPPs and other schemes will grow beyond direct budget allocations. Unless the economy suddenly takes a sharp turn for the worse, user charges in the form of electricity, rail freight, gas and utility tariffs may emerge as more important financing sources for Russian infrastructure.
They will allow state owned enterprises to keep up the pace of investment ingas, transport, power generation, distribution and water. Investment in road infrastructure will depend on the excise taxes, which are also likely to grow moderately.
The anticipated availability of financing and the clear need for major infrastructure improvement are not sufficient to solve the country’s investment challenges. There is growing doubt even among Russian officials about sinking capital into projects such the ambitious Northern Latitudes Passage (NLP) which is expected to provide a 1,500km rail link to a number of booming oil and gas fields above the Arctic Circle.
Its estimated cost of over $40bn is to be financed by the state and state-owned companies plus credits from the Cesca Exportni Banka to the tune of ?800m. While the project may be a way to return money from the center to the oil-producing northern regions via the railroad and associated jobs, its scale is no longer seen as a plus.
The discussion with Russian long term investors is now more focused on the efficiency of investments rather than prestige. As RDIF’s CEO Dmitriev pointed out, it is the return on investments, not their volume, that are the right yardstick.
In fact, as Russia’s legacy from its G20 presidency, there are proposals to create a Russia-based knowledge network on long term investment efficiency assessment. Such a network may eventually save the country billions of dollars in wasted investment.
Talking to Russian officials and private sector leaders suggests political leaders have reached some important conclusions. One is that the economy will not grow unless cities across Russia continue to grow, bring together labour and business, and connect to each other and to the global markets.
Enterprises cannot compete if their transport costs are more than double (20% of the total production cost in manufacturing) any of their competitors in Europeand Asia. The average speed of a Russian freight train is around 10 km/hcompared with 50-60 km/h in China.
The openness of the Russian debate on what projects should progress and how they should be financed to gain competitiveness reflects an earnest search forsolutions, and a sober assessment of challenges.
The money for this vast market will be there when the credibility of the government in the eyes of its own and international investors matches the level of its ambitions. And when that happens, Russia will have everything to remain a top ten economy for decades to come.
Gary Litman is Vice President, International Strategic Initiatives, at the US Chamber of Commerce