Russia’s entry into the WTO is now a done deal. This reality follows from the final agreement reached in Geneva yesterday (10 November) on Russia’s “Accession Protocol”, which summarizes all Russia’s relevant commitments and obligations regarding tariff and non-tariff barriers, legislation and regulation and so forth. The remaining steps leading to formal Russian membership, which will take until July 2012 at the latest, are mere formalities.
During the marathon negotiation on Russian entry into the WTO since the Yeltsin administration first applied to join in 1994, the finishing line that has at last been crossed often appeared close, only to melt away. Those false dawns generated waves of commentary by analysts (myself included) on all aspects and implications of Russia joining the WTO. As a result, many investors may have long since tired of the whole topic. But at least questions about the consequences of WTO membership can now be revisited as “live” rather than hypothetical ones.
The question that obviously matters to investors is whether WTO membership will have any material impact – moreover, within a meaningful timescale – on particular sectors and/or on the market as a whole. Most of the standard lines of analysis suggest no impact. But I do see one way in which Russia’s entry into the WTO could catalyze strong returns for investors in Russian equities as early as 2012. This positive potential stems from the link between Russian imports and FDI. To put this idea into perspective, we should start by reviewing the areas where the potential impact of the WTO looks weak in practice.
‘Textbook’ gains for exporters are marginal…
Much analysis naturally focuses on picking out relative winners and losers among industry sectors as a source of equity portfolio strategy conclusions. But for the most part and for mostly well-known reasons, the conclusions are weak. The main potential sector winners are in export-oriented manufacturing, which have been hampered by protectionism. The only Russian sectors exporting manufactured tradable goods on a sufficient scale to account for a material portion of earnings are metals (mainly steel) and bulk chemicals (fertilizers). But the relief now in prospect from the kind of anti-dumping actions typically initiated mainly in Brussels and Washington – welcome though that relief will be – hardly seems likely to cause a step change in earnings of the likes of Evraz Group, NLMK and Severstal or Phosagro and Acron.
… especially for the wider economy
As Chart 1 shows, the lion’s share of Russia’s exports by value are natural resources, which largely lie outside WTO multilateral trade rules and dispute-resolution processes. The same goes incidentally for most of Russia’s other main export-oriented sectors – such as military equipment (comprising the bulk of “machinery” in Chart 1) and nuclear fuel, which are highly politicized and controlled. One export sector with strong growth potential is grain (accounting for most of the small segment labelled “other” in Chart 1): but here again, the impact of WTO membership will be minimal since governments have striven so long and hard to ring-fence agricultural trade from multilateral level-playing-field disciplines.
Fundamental gains too long term for market relevance…
Despite all these practical reservations, there can be no serious doubts about the long-term economic benefits for Russia of participating fully in the global multilateral trade regime – both through export access and through the boost to productivity from increasing import competition. And the most numerous and immediate beneficiaries of many of the regulatory steps required for WTO entry – such as improved customs administration and IP protection – will be domestic firms rather than foreigners exporting into the Russian market. This positive potential is downplayed in much commentary, perhaps because of natural scepticism (although any such scepticism flies in the face of a mass of studies showing significant correlations between enhanced multilateral trade and GDP growth) or at any rate because this benefit is far too long term to be relevant for most financial investors.
… while the immediate sentiment gain is drowned out by global turmoil
On the safe assumption that the deeper integration into the global economy resulting from WTO membership and contributing to a higher trend rate of growth over a decade or more is irrelevant to today’s Russian equity market, that leaves just the possibility of an immediate sentiment-based boost to the market on the membership news. But this is the kind of sentiment that underpins a bull market – supplying buyers with an additional argument in support of what they already want to do anyway – rather than countering the present headwinds from Europe and the world economy. So this factor would be relevant only if, for the sake of argument, the fresh headlines generated by Russia’s formal accession to the WTO in mid-2012 (following the required ratification by the Russian parliament) were to coincide with revived risk appetite.
The real gains stem from the ‘textbook’ vulnerability to imports…
To complete this survey of standard WTO-related effects, we turn to the potential losers: domestically-oriented sectors that are vulnerable to increased import competition. Here again, the implications for portfolio equity investment seem marginal. Listed Russian companies selling into the domestic market should be less vulnerable than their unlisted peers since, with only a few exceptions, the fact that their shares are actively traded (typically following set-piece IPOs in the case of most companies in these sectors) reflects relative maturity and robustness.
If anything – and this brings us to the most important positive WTO-related result for investors in Russian equities – more of these listed companies will be acquisition targets for foreign strategic investors. In other words, WTO membership will increase the frequency of deals like the acquisition of the dairy and juice producer Wimm-Bill-Dann by PepsiCo and Unilever’s acquisition of Kalina (the leading domestic producer of personal hygiene products) – to take examples only from the past year. Those deals generated handsome windfalls for shareholders in the target companies and had some wider positive sentiment effects on related companies and the market as a whole.
The relevance of WTO membership to this investment theme lies in the growing importance of Russian imports. The chart below shows that by the eve of the 2008 crisis, Russia had become one of the top 10 global importers (counting Hong Kong as part of China).
Although Russia’s share of global imports remains modest in absolute terms, it has been growing relatively fast – and that growth has resumed impressively after the 2009 recession. The importance of the Russian market for global trading partners is perhaps the single biggest reason why the negotiations on Russia's WTO entry terms dragged on for so long: the stakes for all concerned were quite simply higher than for most new entrants - in fact, the highest since the negotiations on China's accession in the late 1990s. The Russian market is particularly important for the EU – ranking alongside China and Switzerland in a closely bunched group of runners-up to the US as the top destination for EU exports (see Chart 3 below).
… stimulating more FDI – and often by acquisition
The strength of Russia’s import demand is broadly based. It stems both from the country’s need to re-equip its industry (since 2005, around half of all imports have been capital goods, with Germany the single largest supplier) and from the under-penetration of many product and service markets relative to per capita incomes – a long-term legacy of the distortions of central planning. The beauty of Russia’s case is that the large size of its economy and the country’s vast geographical scale mean that it is logistically impracticable and commercially sub-optimal for foreign companies focused on the opportunity presented by this demand to exploit that opportunity merely by shipping goods into the country. The best market share prizes have been and will be won by companies that locate production and distribution inside the country. Many foreign direct investors in Russia have focused on brown-field and straight acquisitions (hence the potential returns for portfolio equity investors) not only because of notorious bureaucratic obstacles to green-field projects (which are relatively rare, although there have been notable successes) but mainly because of the wealth of existing capacity that can be productively redirected.
WTO membership as catalyst…
So how will WTO membership enhance this phenomenon of FDI by acquisition? The answer starts with the incremental expansion of the Russian market stemming from the 25 per cent reduction in the average import tariff (from 10 per cent to 7.8 per cent) as a result of WTO accession. The growing scale of this opportunity will increase competition for market share and hence the incentive for foreign companies to take the leap from export sales to a domestic market presence by means of investment or acquisition. Finally, international company boards asked to approve such investments in Russia should find additional comfort from Russia’s becoming a member of the WTO (this might prove an even more important channel for a positive sentiment impact on Russian equities than the direct effect of sentiment among market participants).
… even for automotive FDI
The automotive sector deserves a particular mention as this has been an important FDI recipient (including some equity investments as in Sollers and AvtoVAZ) – based on a sweetener (import duty concessions on assembly kits) that Russia is obliged to phase out by 2019 under the WTO entry terms. In practice, this will most likely encourage these automotive investors to intensify their presence in the Russian market the better to compete with pure importers when the market becomes less protected seven years from now.
Europe and Russia as economic bedfellows
European companies will continue to be the most important source of FDI into Russia. I base this prediction on the fact that Russia’s entry into the WTO opens a pre-agreed way to the negotiation of a Free Trade Agreement between Russia and the EU, from which both sides have much to gain owing to present economic challenges and opportunities stemming from both respective domestic structural weaknesses and Asian-led globalization. The sectors where FDI and, specifically, foreign strategic acquisitions seem most likely include retail, financial services, telecoms, consumer goods, domestic energy (electricity) and manufacturers with the potential to tap into the demand for energy efficiency.
With best regards,
Christopher Granville
Director of Russia & FSU Research
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