The regional trigger for the investment climate

Core Case

Regional governance as an investment theme

Regional differentiation in economic performance in Russia is driven by a variety of fundamental factors. Some of these were highlighted in a recent study by the Russian investment bank Troika Dialog of how the seven federal districts fared during the 2009 recession. Least affected were the Far East (where both output and investment grew) and the South. The study argued that the main causes were, respectively, proximity to fast-growing China and internal north-south migration (now that labour allocated to inhospitable regions under Soviet central planning can opt for the attraction of a warmer climate for quality of life).

To this analysis, we would add the role of economic geography – namely, the effects of the preceding years’ development of transport infrastructure for Russia’s external trade (pipeline and rail links to commodity and container shipping terminals at the Pacific Ocean and Black Sea ports). And on an even more basic level, we note the catch-up potential of relatively poor regions (the Far East District, besides being among the country’s poorest, had a less developed financial infrastructure and thus less to lose from the credit crunch and capital outflows).

Varying regional growth rates stemming from all these factors can be played by financial investors through companies that are oriented to the domestic market and have exposure to the most dynamic regions. In this report, however, we focus on another factor that can accentuate or buck the growth patterns of the individual regions: namely, the business climate resulting from the quality of regional governance.

This effect can make itself felt not only in such obvious ways as the demand growth that stems from an increased rate of creation and expansion of small and medium-sized enterprises (SMEs) causing a multiplier effect through the wages of higher employment and more migrants. It can also be seen in the opportunities that improved regional governance creates for productivity gains in larger and established companies. Not least, it is evident in the attractions for foreign strategic investors (alongside the economic geography factors mentioned above) in choosing where to target acquisitions or locate greenfield projects.

As regards this last point, two governors have been outstandingly successful in attracting FDI into their regions:

Novgorod. As governor of this northwestern region in the 1990s, Mikhail Prusak took a notable share of investment by foreign companies in production facilities aimed at the newly emerging domestic consumer market. The highest-profile investor was Cadbury Schweppes.

Kaluga. Headed by Anatoly Artamonov since 2000, this small region bordering the Moscow oblast to the southwest has become the most popular destination for international vehicle manufacturers seeking exposure to Russian automotive demand by locating assembly plants inside the country. Volkswagen, Volvo, Peugeot Citroen and Mitsubishi are now present on the ground. Apart from this automotive cluster, other major companies that have been attracted to the region include Stora Enso (food packaging cartons), SAB Miller, Samsung, Nestle and the Serbian pharmaceuticals manufacturer Nemopharm. Strategic investors with near-term plans to open production plants in Kaluga include John Deere and Russian steel producer NLMK.

Both these regions owe a good part of their success to being located close to Moscow and St Petersburg. But as several other regions share that advantage, we believe that the governors must have made a difference.

Artamonov’s approach resembles that of Chinese provincial administrations which in the 1990s made every effort to help strategic investors: in a recent interview, he refers specifically to Guangzhou as a model. Probably even more important than waiving all of the regional government’s 13.5 per cent share of profit tax for companies that invest more than Rb3 billion (US$103 million) over three years is his innovative approach of arranging pre-approval by all permitting agencies – with plant construction further facilitated by the creation of business parks hooked up to utilities. Building on his success in competing for inward investment, Artamonov has also competed for human resources (including, he claims, 20 per cent of all skilled immigrants from the Russian diaspora) by providing new housing and other incentives.

The results are impressive. SMEs accounted for 26 per cent of value added in the region in 2008 compared with a national average of 18-20 per cent (the official data series is under revision). Also in 2008, Kaluga posted the fastest industrial production growth – 32 per cent – of any region in the country, while the 2009 slump of 19 per cent was close to the national average decline in manufacturing output of 16 per cent.

Towards improved governance

While Kaluga is the outstanding recent example of how an enlightened regional leader can transform the local business climate, many of Russia’s regions have made no significant progress in this direction. Even allowing for such handicaps as poor location and obsolete industrial structures inherited from Soviet days, the root cause will often be the shortcomings of the regional leadership. The problem is not limited to incompetence and inefficiency but can all too often stem from resistance to change owing to weakness (in the face of opposition to Kaluga-style reforms from bureaucrats and local business groups) and/or inherent corruption (regional leaderships which themselves are mired in graft and criminality).

It is not surprising, therefore, that the Kremlin has focused in recent years on improving the performance of regional governors. The important part of this story is how Moscow decision-makers judge that performance. In a nutshell, it is clear that during the Medvedev presidency the quality of the regional business climate has become a key factor.

Reliability – the main criterion under Putin

The story begins with the decision by President Putin after the Beslan tragedy in October 2004 to abolish direct gubernatorial elections in favour of appointments by the Kremlin (rubber-stamped by regional legislatures to preserve at least the appearance of Russia’s constitutional organization as a federal state). Putin, who is given to plain speaking, left no doubt about his motive – namely, to make governors loyal and accountable to the centre, especially for implementing national policies. He capitalized on the sense of national emergency created by Beslan to take to its logical conclusion his policy of reversing the centrifugal tendencies of the 1990s – seen as undermining Russian statehood – by means of a comprehensive recentralization.

Making governors accountable to the Kremlin did not, however, entail a purge. Of the first 12 governors who asked to be reconfirmed in office (an option open to governors under the new rules), 10 received the requested vote of confidence from Putin and only one was dismissed outright. Moreover, many of the reappointed governors began serving a fourth or even fifth term – some having first assumed office in the early 1990s. In the three years between the introduction of this new system and the end of Putin’s presidency, only 27 governors were replaced (a little under one-third of the total corps).

Important changes under Medvedev

In contrast, Medvedev has already dismissed a quarter of all governors in the less than two years in which he has been president. As with many other aspects of the Medvedev presidency, the aim is to intensify change but to avoid radicalism. In this spirit, Medvedev has made clear that his “modernization” agenda does not include a return to the direct election of governors. At the same time, he has made the Putin system of gubernatorial appointments more transparent and less centralized by requiring the party with a majority in the regional legislature (which, as things stand, means exclusively United Russia) to submit three candidates from whom the president nominates one to be approved by local deputies.

While this is consistent with Medvedev’s incremental liberalization of the political system (a trend examined more fully in our January 2010 note The Putin-Medvedev tandem at mid-term), there is also a more pragmatic and self-interested reason for this change. Subordinating regional governors to the centre has made it more difficult for the Kremlin to spread blame when things go wrong. Some share of responsibility has now been shifted back onto United Russia and, ultimately, the voters who elect regional deputies. (And in an interview with Danish radio on 26 April, Medvedev stated more explicitly than ever before that the existing system of direct elections of city mayors will be maintained – despite widespread lobbying for governors to be given the right to appoint mayors in the same way that the president appoints governors.)

Since this new appointment procedure went live in November 2009, three notable trends have emerged.

1. Bias towards locals

With only two exceptions (Sverdlovsk and Khanty-Mansiysk), all gubernatorial appointments have come from within the elite of the region concerned. In the case of one major industrial region, Chelyabinsk, leaked details of the lobbying leading up to the appointment showed the United Russia leadership unsuccessfully pushing the candidatures of several federal (Moscow-based) officials. Previously, Medvedev had followed Putin’s lead in occasionally appointing a national figure to head a region: the best examples are the December 2008 parachuting of Nikita Belykh, previously leader of the liberal opposition Right Union party, into the post of governor of Kirov, followed in mid-2009 by the transfer of Agriculture Minister Alexey Gordeev to head the Black Earth agricultural region of Voronezh. In line with the procedural change making governors appear to emanate more directly from regional legislatures, such examples are likely to be rare from now onwards.

2. Younger blood

In December 2009, Medvedev explicitly warned regional heads that for many of those who had served several terms, the time had come to make way for younger blood. Accordingly, a good number of old-guard governors from the 1990s now in their sixties or seventies have been retired: Eduard Rossel of Sverdlovsk, Nikolai Maksyuta of Volgograd, Aleksandr Filipenko of Khanty-Mansiysk, Mintimer Shaimiev of Tatarstan and Pyotr Sumin of Chelyabinsk. The average age of the replacements for the above-named is 48.

3. Business background

About a quarter of appointments under this new procedure are businessmen (Table 1 below summarizes their backgrounds). Moreover, all five of these new businessmen-governors were appointed to economically important regions that are resource-rich and/or have a well-developed industrial base that includes companies of national significance (see the Appendix at the end of this report for a list of the major companies located in these and other regions in which pro-business governors have been appointed).

Sources: websites of the respective regional administrations; Russian press reports.

Two additional details should be noted. First, Lev Kuznetsov (Krasnoyarsk), like his predecessor Dmitry Khloponin, has senior management experience at Norilsk Nickel, the mining giant controlled by Vladimir Potanin’s Interros Group. Khloponin, who was promoted in February 2010 to presidential representative in the North Caucasus, is not the only junior Interros partner from the 1990s to have succeeded in regional politics. Dmitry Zelenin, the Governor of Tver (a poor region northwest of Moscow), also made a career at Interros. First elected in 2003 and then reappointed by Putin in 2008, Zelenin has produced one of the better business climates from an unpromising starting point (for more details, see below).

Second, Anatoly Brovko of Volgograd and Vyacheslav Gaizer of Komi are both members of the “presidential reserve”, a list of high achievers from both government and business unveiled in 2009 (and due to be expanded to 1,000 names) to broaden the pool of younger talent on which to draw when making appointments both in the regions and at the centre.

The only other governor to be drawn from this pool so far is 35-year-old Andrei Turchak of Pskov, who headed several engineering companies before entering government.

Appointment criteria: Social stability remains key …

One key criterion has not changed since the Putin period – namely, social stability. This explains the lower proportion of governors dismissed in 2009, when the recession was at its height (see Chart 1 above). It is also reflected in the fact that the only prominent veteran of the 1990s to be reappointed under the new procedure is Aman Tuleev of Kemerovo (Western Siberia). Like Chelyabinsk, Kemerovo has a large number of so-called one-company towns (coal mining is the dominant industry), which have suffered badly during the economic downturn, leaving many local workers unemployed. But unlike Pyotr Sumin, whose grip on the region was threatened by a high propensity for conflict within the local elite, Tuleev has ruled with an iron fist, permitting no dissent within the ranks and thus gaining the reputation of a guarantor of political stability in the region. (Another factor in Tuleev’s reappointment is likely to have been the memory of the political impact of coalminers’ protests in the late Gorbachev period and the run-up to the financial debacle of 1998.)

Two of the largest public protests anywhere in Russia since the start of the economic crisis took place in Vladivostok (Primorsky Krai) in December 2008 and January 2009. The fact that Governor Sergey Darkin managed to contain the unrest must explain his surprising reappointment in late 2009 after a corruption probe earlier in the year had pointed towards his dismissal.

… while the business climate assumes new importance

At the same time, the quality of the regional business climate has become an important factor in gubernatorial appointments. This change is strongly implied by the recent rash of new governors from the business world – as discussed above. Looking beyond piecemeal appointments, there is also evidence of a more systematic focus on business climate issues at the regional level.

This becomes clear from evolving approaches to appraising governors’ performance. The first attempt at a formal appraisal framework was made in the last year of Putin’s presidency (2007). The result was an unwieldy wish-list of 43 criteria – to which another 39 were subsequently added – related to social and economic development indicators ranging from regional GDP, average wages and unemployment levels to less easily quantifiable (and somewhat random) tests such as the number of public library books per 1,000 population and the number of people participating in state-organized cultural and leisure activities. Governors’ reports on to what extent their regions met these criteria were supposed to provide the basis for decisions on whether they would keep their jobs. Widely criticized on fundamental grounds (notably by the Audit Chamber), this appraisal system has not been systematically and transparently implemented. In any case, no such system would dispel suspicions that formal appraisal results can be trumped by subjective and political factors.

Under Medvedev, a different tack has emerged. First – and consistent with the increased weight given to regional legislatures in the process of appointing governors – formal accountability procedures will now be based on annual reports by governors to their own regional parliaments rather than the federal bureaucracy (the enabling legislation for this was enacted in March 2010).

Second – and more significant – the federal government’s latest initiative (March 2010) on the systematic monitoring of regional governance focuses on competition policy and includes a new requirement that each regional administration draw up its own programme for improving competition under a set of uniform headings. This prescribed framework (comprising topics such as administrative barriers, transport and financial infrastructure, anti-competitive behaviour of officialdom and state procurement) spans much of the standard business climate agenda.

That agenda is fully captured in the World Bank’s global “Doing Business” survey, which the Ministry of Economic Development (MER) is about to apply across the country. For the 2010 survey, the city of Moscow served as a proxy for Russia (which must have contributed to Russia’s slipping two places compared with 2009 – to 120th out of 183 countries – since the consensus is that corruption in the capital city is worse than the already poor national average). However, a slimmed-down version of the survey (using four out of the 10 criteria) was also conducted at Russia’s request in a representative selection of nine other cities (Table 2 shows the overall ranking).

* In four areas: starting a business, construction permitting, property registration and cross-border trade.

Source: “Doing Business” database.

In the coming year, the MER plans to extend this survey to 30 regions (perhaps with some changes to the agenda to capture distinctive Russian conditions and problems) before rolling it out throughout the country.

Conclusion

Progress on improving the business climate – which largely boils down to reducing corruption – is an essential condition for the increased investment rates required to raise total factor productivity generating higher potential GDP growth. The whole Russian investment case ultimately hinges on this prospect. From this perspective, unleashing “Doing Business” on Russia’s regions is an excellent initiative. Globally, this annual ranking of countries according to the ease of doing business has inspired a positive spirit of emulation among increasing numbers of countries striving to become champion reformers. Attempting to reproduce this effect at the regional level makes even more sense, given that business climates depend heavily on the actions of local authorities. The incentive for regional governors in Russia should be all the more powerful since the reward is not merely prestige but also job security.

A good example has surfaced at time of writing – namely, the reappointment of Oleg Korolyov as governor of Lipetsk. Against the background of increasing numbers of new and younger appointees with business backgrounds, this decade-long incumbent and career bureaucrat looked a likely candidate for dismissal. Yet under Korolyov, Lipetsk has become a leading business region. Of course, this development has been driven by the presence of Russia’s highest-rated integrated steelmaker (NLMK); but it also reflects the success of the special economic zone close to the steel works, which has attracted a range of domestic and Western manufacturing companies (see our February 2009 note on SEZs).

This case history reinforces the impression that the Medvedev administration is giving particular weight to clear signs of an improving business climate when making gubernatorial appointments. Hence business experience is regarded as a positive qualification but not an essential one. The champion pro-business governor, Artamonov of Kaluga, was chairman of a Soviet state farm before becoming regional head (as, incidentally, was Prusak of Novgorod).

Be that as it may, the coming months will provide ample fresh evidence of this trend: a total of 30 governors will have reached the end of their terms by December 2010. Of particular interest and significance will be the fate of Moscow Mayor Yury Luzhkov, whose fifth consecutive term expires in mid-2011. As usual, this timing coincides with the federal electoral cycle, a fact that has so far deterred any Kremlin inclination to remove him, given the political importance of social stability in Moscow and a well-mobilized pro-government vote. It will be revealing to see whether those traditional priorities will at last be outweighed by a resolve to try to tackle the poor business climate in the country’s richest and most populous region.

How to play an improving business climate

While it is easy to grasp the potential impact of an improved regional business climate on overall investment risks and rewards in Russia, applying this analysis to particular investment decisions is less straightforward. The most obvious relevance is to strategic investors’ choice of location for building new capacity in Russia. The attitudes and track records of regional administrations will always be factored into such decisions; and the trends identified in this report will offer industrial companies a wider geographical range of opportunities to exploit. For example, Tver offers untapped potential of the kind that has already been exploited in Kaluga. (This conclusion does not apply to most companies in the extractive industries, which of necessity operate in regions where available deposits are located and have to deal with regulation and regulators largely dependent on the federal authorities.)

For portfolio investors, restructuring of the electricity and telecoms sectors has eliminated the long list of companies specific to individual regions. With the imminent consolidation of fixed-line operators into Rostelecom and with the markets of regional power generation and distribution companies now covering bundles of regions (“federal districts”), listed plays on variations in regional performance are a thing of the past. But this play can be partly replicated through exposure to the potential for productivity gains in companies located in the better-governed regions. In the Appendix, we flag the 11 regions which, in our view, best capture the positive trends identified in this report; and we also list the investible companies which have important operations in each of those regions.

Appendix

* The governor of the northwestern region of Murmansk, Dmitry Dmitrienko, is not mentioned in the main body of this report; but it is worth noting here that Dmitrienko – who before his appointment in March 2009 was deputy head of the Federal Fisheries Agency and in the 1990s and early 2000s worked in the private sector – is busy cultivating good relations with major enterprises in the region and taking measures to promote SMEs.