Russia International Investment

1.2. FDI in Russia

In 2007, Russia recorded highest levels of international investment inflows and outflows, what allowed it to become one of the key players on the foreign direct investment (FDI) arena. According to the official information presented by Central Bank, FDI inflows in Russia made up USD 52.5 billion whereas Russian firms invested USD 45.6 billion abroad. This lead to the substantial increase in penetration of FDI in the economy in terms of shares of FDI in GDP and total investment and allowed Russia's FDI become comparable to some other emerging market economies. Investment inflows come from a relatively few partner countries and its sectoral coverage is mostly limited by the primary sector. Russia's rich natural resources and large and booming domestic market will continue to offer attractive opportunities to foreign investors. Russia's outward investment is also expected to grow substantially, motivated by the efforts of Russian state-controlled and private enterprises to internationalise their activities and control their value chains.

1.2.1. Recent developments of FDI in Russia

Since 2000, the economic situation in Russia and its international investment status have improved considerably. Inward foreign direct investment has been growing since 2003 and Russia became a net FDI recipient in 2004. In 2006, FDI inflows more than doubled what allowed Russia to reach its highest FDI net position (USD 9.2 billion). Although inward FDI remained dynamic in 2007 (+62%), an even more rapid growth of FDI outflows reduced Russia's FDI net position to USD 6.8 billion. Due to the high levels of inward and outward investment in 2006 and 2007, Russia confirmed its leading position in the international investment landscape.

Russia's international investment is characterized by a number of specific features. First, the domination of 'other investment' both in total outflows and inflows (51% and 68% respectively in 2007) shows that Russian private and state-controlled firms adhere to external financing, partly because of the underdeveloped domestic financial markets and because strengthening of the national currency has made external financing attractive. Second, in comparison to many other countries, portfolio investment (6.3% of total inflows in 2007) remains under-represented in Russia's international investment.

In 2007, FDI in mining and quarrying has tripled in comparison with the previous year which reinforced the dominance of the primary sector in Russia's FDI. The manufacturing sector remained the second largest recipient and represented almost 18% of total FDI inflows in 2007. Although FDI in financial services and communications has also increased in last years, traditional services such as trade and repair continue to predominate. In terms of the allocation of FDI within Russia, investments are distinctly concentrated in certain regions: Moscow city remains the main destination for foreign investment in Russia (38% of the total in 2006), followed by Sakhalin (15%) and the Moscow region (less than 10%).

Flows of FDI in Russia come from a certain number of partners: in 2007, the share of the two largest investors made up more than 68% of inward and about 65% of outward FDI stocks. The significant position of Benelux countries is not extraordinary and is caused by the activities of special purpose entities and holding firms established by multinational enterprises in these countries to finance and manage their international investment. Some other major investing partners act as a source of round tripping flows, i.e. investment by Russian firms often seeking to evade domestic regulatory restrictions.

Since opening of its economy at the beginning of the 1990s, Russia has been an active outward investor. As a newcomer in the international investment landscape and a catching up middle-size economy, Russia's position as a net outward investor has been considered odd. Although liberalization of capital control could be partly the reason, outward investment by Russian firms in the 1990s was caused to a great extent by the instability of the domestic situation and their attempt to avoid high taxes, administrative limitations and the risk of loosing property, as well as by the opportunities of acquiring strategic assets available through privatisation in former Soviet republics.

In recent years, the motivations of Russian firms have evolved substantially. The increasing financial capacity of large Russian firms has allowed them to internationalize their activities and control their value chains. Since 2004, foreign assets of the top 25 Russian firms have more than doubled and reached USD 58.4 billion in 2006. About 65% of this investment has been made by only four firms: two oil/gas companies (Lukoil and Gazprom) and two companies specialized in metal/mining (Severstal and Rusal). In 2007, Russian large private companies continued to be strongly involved in outward investment.

Only two countries of the Commonwealth of Independent States (CIS), Ukraine and Belarus, are in top 10 destinations of Russia's FDI outflows, representing together less than 6% of the total outward FDI in the 2007. But these official figures certainly underestimate Russia's real investment in the CIS region as many transactions there are not recorded in the balance of payments because investments are conducted via offshore firms or by Russian companies already presented in CIS countries.

1.2.2. Russia's FDI flows in international comparison

Despite its relatively recent entry into the international investment scene, Russia has occupied an important position, ranking among the top 25 FDI recipients worldwide since 2006. In relative terms (FDI per head and as a share of domestic investment) Russia outperformed China in 2006. Nevertheless the degree of FDI penetration, measured by the ratio of FDI inward stock to GDP, remained still lower in 2006 in Russia (9.5) than in Brazil (20.1) and especially China (25.7). According to 2007 data, Russia's international investment inflows remained to be higher than the investments received by Brazil and India but still much below the level of China.

As already mentioned, Russia's outward investing has occurred earlier than in other countries. It became the third largest outward investor among emerging economies in 2003 already (after Hong Kong-China and Singapore), notwithstanding the fact that capital control system was still applied at that time in Russia. Even though Russia had no until recent time official government support of outward investment, for example as China's "Go Global" programme, its FDI outward flows remain sizeable in absolute terms and as the share of GDP. Russia's ratio of outward to inward FDI stock (80%) is very high in comparison with the three other countries, especially China (12%).

1.2.3. Russia's potential to attract foreign investment

Russia's attractiveness for FDI has benefited from reasonable macroeconomic policies which lead to a surplus in the state budget, diminishing unemployment, growing income per capita, external debt repayments and a substantial increase in foreign exchange reserves. The growth in Russia's international investment flows is expected to continue in the medium term, supported in particular by an ambitious infrastructure upgrade program.

In spite of significant growth in FDI inflows, Russia's capacity for attracting further investment is far from being fully utilized. Until recently, Russia's domestic investment was poor and the share of public and private investment in GDP (18.9% of GDP on average in 2000-2005) was considerably lower than in most developed and emerging economies. This was in obvious contradiction with the government's declared goal of economic diversification and the need to modernize out-of-date and worn-out infrastructure. Fixed investment started to increase in 2006 (by 13.5%) and its increase proceeded to speed up in 2007 (21%). The Russian government has launched an ambitious investment program for infrastructure development, financed mostly through the lately established Investment Fund and Development Bank. Despite these new incentives mainly rely on governmental financing, participation of private, including foreign, investment is also considered to be necessary not only from a financing viewpoint but also to assure the technological success of projects.

From the standpoint of recent developments, the forecasts of Russia's outward investment (USD 25 billion annually between 2007 and 2011, which is about 10% of GDP) can be considered more than modest. But the dominating sectors will likely stay the same, i.e. the energy sector, metallurgy and manufacturing. The key players will continue to be both largest state-controlled enterprises (Gazprom and Rosneft) and private companies, such as Severstal, Norilsk Nickel and Evraz. Although the CIS region will remain an important destination for investment, the Russian companies will probably increase their activity in other regions, including Africa.

But there are certain factors that may threaten Russia's rapid economic growth and investment. The basic external threat would be a considerable decline in energy prices with inevitably negative consequences for economy and especially on public financing capacities. Russia's investment program could also endure the exasperating domestic economic bottlenecks, in particular shortages of skilled labor, which have already been affecting projects of both domestic and foreign investors. However, the most significant obstructions to further development of investment in Russia are of a policy nature, notably greater state interference in the economy and the uncertainty coming from the delay of necessary administrative and regulatory reforms.

The majority of foreign investors consider that Russia's rich natural resource and large and dynamic domestic market offer sizeable opportunities for lucrative returns on investment. For instance, the Russian Federation is placed fourth (after China, India and the United States) among the most attractive locations for FDI for 2007-2008 in the UNCTAD survey on FDI. Russia is expected to attract substantial amounts of FDI (more than 2% of the world total) between 2007 and 2011, with annual FDI inflows higher than those in Brazil and India but still much lower than in China. If these estimates turn out to be precise, Russia should considerably improve its international position, taking the 13th line among the world's largest FDI recipients in the next five years.

1.2.4. Legal framework

a) Legal regulation

At the present moment, norms of several branches and institutions of law are regulating foreign investment in Russian Federation: investment activity legislation, foreign investment legislation, civil law, tax law, and recently passed law on strategic sectors.

Legal regulation of foreign investment on the territory of Russian Federation is realized by Federal law "About foreign investment in Russian Federation" (with revisions and additions from 8 December 2003) (hereafter Foreign investment law; Law), other federal laws and standard acts of Russian Federation, and international agreements of Russian Federation (p.1 a.3 of Law).

As it is mentioned in p.1 a.3 of Foreign investment law, this law regulates provision of state guarantees for foreign investors conducting their activities on the territory of Russian Federation. Legislator stresses that the law does not apply to relations, connected with investment of foreign capital in insurance organizations, banks and other lending agencies that are regulated by the banking legislation of Russian Federation.

The Law also does not apply to investment of foreign capital into non-commercial organizations for achieving certain socially useful goals including educational, philanthropic, scientific or religious that are regulated by the Russian Federation legislation of non-commercial organizations. And, first of all, by the Federal law from 12 January 1996 #7-FL "About non-commercial organizations" (with revisions from 26 November 1998, 8 July 1999, 21 March 2002, 23 December 2003).

Other legal relationships with foreign investors and foreign investment are regulated by the norms of number legislative acts. So, for example, in accordance with article 20 of Foreign investment law legal entities that are commercial organizations with foreign investment are subject to state registration in course of Federal law "About state registration of legal entities".

Special attention should be drawn on Federal law from 25 February 1999 #39-FL "About investment activity in Russian Federation in form of capital investment" (with revisions from 2 January 2002, 22 August 2004) (hereafter Law on investment activity). Law on investment activity defines legal and economic basis of investment activity carried out in form of capital investment on the territory of Russian Federation, and also sets guarantees of equal protection of rights, interests and property of investment activity subjects regardless of property type.

As indicated in article 5 of mentioned law, relationships arising from investment activity conducted in form of capital investment by foreign investors on the territory of Russian Federation are regulated by international agreements of Russian Federation, civil code of Russian Federation, present Federal law, other federal laws and standard acts of Russian Federation.

The system of international investment agreements includes: Seul convention on establishing Multilateral agency on investment guarantees (Seul, 11 October 1985), Convention on settlement of investment disputes between states and natural persons and legal entities of other countries (Washington, 18 March 1965), number of bilateral agreements (Agreement on encouragement and mutual protection of investment, Agreement on double taxation avoidance, Agreement on investment assistance).

Worth mentioning that in the hierarchy of standard acts international agreements are placed on the first position. This is due to the application of the international legal principle pacta sunt servanda – every agreement in force is mandatory for each member and must be fulfilled thoroughly (article 26 of Vienna convention on rights of international agreements). Member can not refer to regulations of own domestic law for acquittal of non-compliance with the agreement (article 27 of Vienna convention).

This means that, if regulations of international agreement of Russian Federation differ from those of domestic law, then the regulations of international agreement are applied.

b) Legal regime of foreign investors activity

In view of existing international practice foreign investors usually enjoy one of the following legal regimes: Most-Favoured-Nation (MFN) and national treatment.

For decades MFN is considered as one of the most important legal instruments for normal development of international trade and economic ties. States that are interested in equal rights and mutually beneficial economic cooperation strive for building it on the ground of reciprocity.

The Most-Favoured-Nation principle means that one contracting state provides other contracting state (its legal and physical persons) in one or another field of relationships with the same favourable treatment as it provides or will provide to any third state, its legal and physical persons.

MFN is a contractual regime and determination of its scope is the business of contracting parties. Parties can extend influence of the treatment to the field of economic relationships, can confine its influence to trade related issues, can negotiate to application of the treatment only to certain fields of regulations and economic relationships (e.g. customs duties).

As set in p.1 a.4 of Foreign investment law legal treatment of foreign investors activity and utilization of received earnings can not be less favourable than legal treatment of activity and received earnings provided to Russian investors, with exceptions set in Federal laws.

Consequently, existing legislation by default sets national treatment. Other (priority) rules of treatment determination are set by bilateral international agreements.

Under national treatment of foreign investment national and foreign entrepreneurs act on the market, with certain exceptions, as equal in rights, which does not infringe upon interests of foreign investors. Therefore, under national treatment rights of foreigners on the territory of host country are determined by local (national) laws, not by the laws of capital's origin country. For all that treatment of foreign investment can not be less favourable than that provided to national legal entities (national capital).

Principle of national treatment might imply some exceptions. Limitations on foreign investors activity are placed in order to set state control over development of certain industries in an effort to maintain competitiveness of national legal entities. In various countries range of these industries is different, however, generally, these are extractive and military industries, as well as certain services (banking and insurance business). Some of these industries are totally closed for foreign investment, some of them require special permission for access.

c) Law on strategic sectors

Recent economic developments in Russia have been tightly connected with strengthening of state control which has considerable implications for foreign investors. The recently adopted law on strategic sectors determines the sectors in which control by foreign investors will be subject to governmental approval. Instead of former case-by-case authorizations, the law aims at improving transparency and predictability for foreign investors. But the law has a larger sectoral coverage and longer timeframe for notification of decisions compared to OECD recommended best practice.

In his annual message in April 2005, President Putin asked the government to prepare a law elucidating the conditions of foreign participation in strategic sectors. The draft was submitted to the Duma in July 2007 but withdrawn by the government after the first reading. The Russian government appointed in September 2007 prepared a new draft which was adopted by the Duma and then by the Federal Council in March 2008. The law was signed by President on 5 May 2008.

In comparison with the initial 2007 draft, the final version of the federal law on "Procedures of Making Foreign Investment in Business Entities of Strategic Importance to National Defence and Security of the State" has a broader sectoral coverage (42 sectors against 39 initially) and contains more confining conditions for foreign activity in the subsoil exploration and exploitation. The final version also determines required documents and information to be presented by applicants and the role of government agencies involved in the approval process.

The 2008 law declares that its terms do not apply retroactively. Nevertheless foreign investors should present information to the appropriate governmental body if they acquired 5% or more shares in strategic companies before the new federal law came into force. Such information should be submitted in 180 days after the date of adoption of the law.

The 42 sectors listed by the new law can be classified into the following broader categories:

Hydro-meteorological and geophysical activities.

Activities using pathogens of infection diseases.

Activities connected with nuclear and radioactive materials and their waste, including research, equipment design, construction and operation of nuclear installations, extraction and processing uranium and radioactive substances.

Activities related to coding and cryptographic equipment and electronic devices for the secret reception of information.

Design, manufacturing, maintenance, sales and use of weapons systems and arms, ammunition, explosives and military equipment and technology.

Space-related technologies and activities.

Design, testing, manufacture and maintenance of aviation equipment and technology, including dual-purpose aviation equipment and technology; aviation safety activities.

TV and radio broadcasting covering the territory inhabited by half or more of the overall population of the Russian Federation.

Production, services and trade in areas covered by the federal law on natural monopolies (excluding electrical power and municipal heating distribution and postal services).

Activities carried out by business units included in the register provided for in the federal law "On protection of competition" and holding a dominant position in the territory of the Russian Federation in communication services (excluding Internet providers).

Manufacturing and sale of metals and alloys used for manufacturing of arms and military technology (if the target company has a predominant position in these activities).

Geological surveys of subsoil and/or prospecting for and extraction of minerals in subsoil plots of federal importance.

Exploitation of water biological resources (fisheries).

Printing services provided by business units printing 200 or more millions lists a month; editing and publishing activities if they concern 1 million or more copies).

Foreign control over Russian firms conducting business in one of these areas is subject to prior approval. Foreign control is defined as 50% of voting shares and giving capability to foreign companies to nominate half or more members of the managing body of the new business unit. If companies' activities are related to geological survey of subsoil and/or prospection and

extraction of minerals in subsoil plots of federal importance, foreign control descends to 10% and more of total shares. If the planned deal involves a foreign state-owned company, international organizations and companies under their control, the threshold for the prior governmental authorization is 25% of the shares in companies operating in strategic sectors and 5% of the equity in companies involved in geological survey of subsoil and/or prospection and extraction of minerals in subsoil plots of federal importance. Russian companies in which the state controls more than 50% of the capital are not applicable to the new law, that is why they are not required to obtain the prior approval, with exception of situation when the foreign investor is a foreign state or international organization or if the transaction refers to subsoil plots of federal importance.

The process of authorization includes several subsequent steps:

The submission of the petition by foreign investors to the "authorized body": the application should contain information regarding foreign investors' core activities during the two years preceding the submission, a business plan of the new strategic entity and information concerning shares structure. The agency has 14 days to register and verify the petition. After the registration, the body should inform applicant in 3 days if it considers that the deal does not lead to the control of strategic companies. If not, the body has 30 days to notify and pass the petition to the Government Commission for Control over Foreign Investment (hereafter the Commission) and the Federal Security Service Agency.

The Federal Security Service Agency has 20 days to consider if the given transaction poses a threat to the country's defence and Security.

The Commission, headed by the Prime Minister, has 3 months for approval. In special cases, this timeframe can be extended by additional 3 months.

A deal is not approved until the authorized agency has confered its explicit agreement.

The approval process thus takes at least four months and could last up to seven months. The law states that the decisions and actions or the absence of action by the relevant governmental bodies can be appealed in the courts. A decision of the Commission not to approve the transaction could be subject to redress in the High Arbitrazh Court of the Russian Federation. The law pays attention to the issue of confidentiality of information presented for the purpose of the inquiry and states that possible damages due to the unauthorized disclosure of such information should be sanctioned in accordance with the procedures specified by the legislation of the Russian Federation.

In defining the conditions of foreign investors' involvement in the so called strategic sectors, the new law seeks to replace former case-by-case approvals and improve policy transparency and predictability. Another positive moment is that the law will not be employed retroactively. Nevertheless, several terms of the new law raise concerns. Most of the criticism is around the broad sectoral coverage of the law going beyond the usual areas of security interest. In particular, natural monopolies are within the "strategic sectors", which means that government exercises control over large parts of Russian economy. The economic sound of restrictions on foreign participation in geological subsoil prospection and extraction of minerals in subsoil plots of federal importance is also doubtful as such limitations risk further worsen the situation in oil and gas extraction which already face difficulties in exploitation and meeting the growing domestic and international demand. The four to seven month delay for notifications of governmental decisions could be quite costly for the applicants in the modern constantly changing environment.

As it was mentioned, transactions between foreign private enterprises and Russian majority state-owned companies are out of competence of the new law on strategic sectors. This accentuates the particular position of "strategic" corporations in which the state contemplates to keep its majority ownership and which are considered as the core of its economic strategy.

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