The huge problem of corruption in Russia is nowhere more concentrated or damaging than in the customs administration. The problem is not even limited to crude extortion by customs officials. Still more widespread is the practice of kickbacks to officials for reducing import duty. Radical deregulation would help, but the scope for this is limited because of the importance of customs for public finances.
But now there is a private sector-led breakthrough, which has normalised competition in the affected – mainly retail – sectors and which, crucially, is helping companies exploit the growth opportunities offered by the Russian market. This development not only reduces general corruption-related risks, which is important for many international consumer goods companies focused on Russia’s buoyant consumer markets. It also reduces the cost of capital for domestic companies involved in customs legalisation pacts. The spread of such pacts is a pointer to future IPOs – such as in clothing retail.
Corruption is a core factor in Russian country risk, and the customs administration may be considered the nucleus of this core. It is not merely that customs exemplifies all aspects of corruption (for a broad typology, see our November 2006 note Corruption: A way of life). More important, customs makes perhaps the largest single contribution to the damage caused by corruption to the country’s economy and investment climate.
The activities of corrupt customs officials – and their accomplices in the private sector –combine theft from the public purse and from the shareholders of private companies. Such breadth and wealth of opportunities for graft explain the widespread criminalisation of the Federal Customs Service (FTS). A single instance of this problem was presented with eye-popping candour by the head of the FTS, Andrey Belyaninov, in a speech to the Federation Council (upper house of the federal parliament) in November 2006. He said that he could find no one suitable to head the Bryansk branch of the service because “as is well known, gangsters are in control there”. Belyaninov has continued since then to speak about the uphill battle he faces in tackling deep-rooted corruption throughout the entire FTS.
There are two main reasons for customs consistently being among the worst corruption black spots – something that in the Russian environment may be reckoned an outstandingly negative distinction. Both have to do with the importance of customs for the public finances and the domestic economy.
Customs’ revenue-raising role greatly reduces the scope for applying the one remotely effective antidote to corruption – namely, deregulation. Most opportunities for state extortion from business stem from unnecessary, contradictory and (increasingly these days) invented regulations. The first-term Putin administration took an initial stab at deregulation in 2001, with some resulting benefits – especially for new business registration. And the new Medvedev administration has placed a fresh deregulation drive at the heart of its programme. But reducing official powers is problematic in the case of an agency – the FTS – which in 2008 will raise Rb4 trillion – close to half of all federal revenues (see chart below).
By far the single largest component of these customs revenues are the proceeds of the crude oil export duty which is pegged to the soaring oil price. But a material contribution also comes from imports, whose accelerating growth rate (more than 40 per cent year on year in the first quarter of 2008 after 36 per cent in 2007) is fuelled by ever-buoyant domestic consumer demand. And that demand is now increasingly reinforced by demand for investment goods as Russia’s fixed capital base is renewed.
The practicalities of the import trade account for the second reason for the seriousness of corruption in the customs administration. Customs officials’ physical control over valuable goods offers a powerful lever for extortion (much more effective than their counterparts in, say, the Tax Service, who merely inspect past financial records). At the same time, the relatively high level of duty gives an equally powerful incentive for importers to suborn customs officials. Here again, deregulation is not a realistic option. Put another way, there is no realistic prospect of any Russian government abolishing import duties. Even if the fiscal stakes are lower than in the case of export duties, the main function of import tariffs is, of course, the economic one of protecting domestic producers and employment.
The most widespread form of corruption in the customs system is what are known in Russia as “grey imports”. To be distinguished from “black imports” (which is a Russian designation for contraband), this type of illegal import undergoes standard customs clearance but is falsely identified (for example, as a cheaper product), underreported and/or undervalued in customs declarations. Customs undervaluation allows grey importers to reduce the duty paid. The boost to their profits is ensured by the margin of that reduction in duty exceeding the commission (kickback) payable to the customs officials for colluding in the fraud.
Grey imports – as well as outright contraband – flourished amid the customs chaos of the mid-1990s, when around a quarter of all imported consumer goods were shipped by informal individual traders (the “shuttle” trade). In 1996, grey imports were estimated to be worth almost half of the value of all legal imports. Since then, various simplifications of customs procedures as well as an improved legislative and regulatory environment have helped reduce the volume of grey imports, while business itself is making an important – and growing – contribution to this process (see next section).
But the practice of grey importing has been typical of many consumer goods sectors and has therefore outlasted the decline of the “shuttle” trade in recent years. Accordingly, the scale of the problem remains considerable. Last year, the total value of grey imports was estimated by the Central Bank at $29.3 billion (a calculation based on a comparison between the figures for retail trade and domestic production, on the one hand, and official import figures, on the other). That is the equivalent of around 16 per cent of the value of all goods imported legally into Russia in 2007.
During the present decade, the Russian custom authorities have been focused on bringing customs procedures into line with international practice. The single most important step – stimulated by the need to comply with WTO entry requirements – was the enactment of the new Customs Code in January 2004 replacing its hastily and ill conceived predecessor dating from the early 1990s. Various other legislative and regulatory changes have been introduced before and after the enactment of the new Code in order to increase the level of harmonisation with international – and EU, in particular – practice. These measures include providing for an advance information procedure and the institution of the customs “post-audit”. Both these procedures allow goods to be imported without being subject to controls at the border – which is the point at which most corrupt dealings take place. Such regulatory advances have done something to moderate the corrupt free-for-all typical of the customs service in the 1990s.
At the same time, the customs authorities have actively sought to encourage domestic importers to go legal. To this end, the State Customs Committee (the FTS’s predecessor) at the end of the 1990s drew up “white lists” for so-called “good faith” importers. To get onto such a list, companies had to buy goods directly from the manufacturer – which, crucially for the fight against corruption, cuts out the intermediary. Other key qualifications for inclusion on white lists relate to track record – in the sense of having existed for a stipulated period and of having a clean customs record. Once on the list, importers enjoy a simplified (and more rapid) customs clearance procedure, which means, above all, not being subject to customs control until after the release of the imported goods.
Today, two white lists exist for importers: one for automobile dealers, which provides, in particular, for a simplified procedure of customs value control, and the other for all other types of importing company. But since the spring of 2006 there have been no new additions to these lists. Now the FTS is planning another refinement of its approach to distinguishing between honest and suspect importers. This would divide importers into two categories. The first group would comprise mainly companies that have links to major international partners or already have a large market share as well as smaller companies that have existed for an as yet unspecified period; these companies would enjoy a simplified system of customs control. The second group would be made up of companies that are brand new and thus have no customs records; these would be subject to full customs controls.
The main motivation behind this division is to change the emphasis from preferential treatment for law-abiding players to strict control over a group of companies that are considered to pose a high risk of illegal practices. According to the FTS, around 61,000 firms were engaged in the import of goods into Russia in 2006, the majority of which were fly-by-night outfits (known in Russian as “one-day companies” [firmy-odnodnevki]) – that is, commercial entities that are set up for the purpose of one-off (grey) transactions and vanish without trace two or three months later. While the total number of importers in Russia fell by more than 40 per cent in 2007, an estimated half of the remaining players belonged to this category of sham company.
The legislative changes needed to target the one-day companies have been under discussion for more than a year but have yet to be drafted as amendments to the Customs Code. Similar delays have dogged other proposed anti-customs corruption measures – on which more below.
Meanwhile, leading importing businesses have seized the initiative – with sporadic assistance from the customs authorities themselves – and are now providing the main momentum to eradicate grey imports. Specifically, a critical mass of players in important parts of the retail sector have opted or are opting to go legal – in at least one case in an obviously coordinated fashion.
One of the main drivers of this ongoing push towards self-regulation is the emergence of mature retail companies with solid market shares in their respective sectors. But there are two ways in which customs corruption hampers the ability of these ambitious companies to take full advantage of the huge opportunities for further growth offered by the Russian retail market. First, corruption interferes with fair competition and business planning, since the players who play the corruption game best will gain market share and boost profitability compared to their rivals. Second, this distortion of competition by corruption makes it commercially dangerous to abandon grey schemes. Yet only by going legal and presenting clean financial accounts can companies exploit the falling cost of capital and tap the debt and equity capital markets for the finance necessary to ride the growth wave.
Retail mobile phones are first off the block …
The first market segment to all but do away with the scourge of “grey” imports was retail mobile phones. A series of highly publicised mass confiscations of allegedly illegally-imported handsets that began in August 2005 was the catalyst for this development. Initially, the seizure of so many phones caused a temporary shortage on the Russian market; this, in turn, forced retailers to rapidly rethink their import strategies, which largely meant cutting out intermediaries and ordering directly from the manufacturer.
According to various industry associations, including the Russian consumer electronics and computer trade association (RATEK), the mobile phone industry had become 100 per cent legal by the end of 2006. That success rate notwithstanding, the Ministry of Economic Development and Trade (MERT) pushed through a “zero tariff” on mobile phones in July 2007. Industry experts argue that this move has helped consolidate the legalisation of the retail mobile phone segment; at the same time, they explain a “temporary negative downturn” in the segment’s legalisation – to 90 per cent – as the result of various bureaucratic difficulties in importing bluetooth and other small radius gadgets (see chart below).
Full legalisation is an important precondition for leading foreign manufacturers to make the parallel switch to direct delivery. Out of fear of losing market share (especially now that Russian consumer boom is making a material contribution to the global revenue performance of international companies in many sectors), such companies are reluctant to take such a step until the relevant sector or segment in any country of destination has been substantially cleaned up. Yet without the commitment of the foreign manufacturers, the clean-up process can be compromised by “grey” intermediaries. Leading mobile phone makers Samsung and Alcatel began direct deliveries to Russia last year and were followed by Sony Eriksson and Motorola. Nokia, the world’s largest producer of mobile phones, announced in November 2007 that it intended to make the switch in the first half of 2008.
… while other consumer electronic products make major strides
Like mobile phones, many other consumer electronic goods are an easy prey for grey import schemes, not least on account of the huge demand for such products in Russia as well as the high retail value of each individual unit relative to its size. In the summer of 2007, MERT singled out digital photo and video cameras for the “zero tariff” treatment accorded to mobile phones, while the FTS introduced a tougher customs declaration regime for digital cameras as well as laptops and liquid crystal television sets. Under this new regime, the importers of these products must declare the serial number and date of manufacture of each item; this information allows the products to be tracked after customs clearance and is thus intended to serve as a safeguard against their ending up on the grey market.
But the main thrust to go legal has come from the sector players themselves. In June 2007, on the initiative of RATEK, some of the largest retailers and wholesalers signed a declaration, jointly with several leading foreign manufacturers, to purchase products directly from the manufacturer. Since then, other companies have added their signatures to the declaration. All signatories will benefit from the customs advantages of direct delivery; those who do not sign the declaration will continue to be subject to thorough customs controls.
The involvement of foreign manufacturers – albeit in what is a non-binding document – is a bid to get those companies on board, as it were, ahead of the full legalisation of the sector. While the list of signatories has not been disclosed, it is public knowledge that by no means all leading manufacturers of consumer electronics have opted to be included on it. According to RATEK, by the end of 2008 around 70-80 per cent of all consumer electronics goods on sale in Russia will be direct imports. The remaining 20-30 per cent will continue to be imported through intermediaries and thus remain vulnerable to grey import schemes.
Meanwhile, the digital camera market in Russia was reported to be 90 per cent legal by the end of 2007 – that is, six months after the introduction of both the “stick” (tougher customs declaration scheme) and “carrot” (zero tariffs) – up from just 21 per cent in 2006, according to RATEK. But laptops and liquid crystal television sets continue to lag: the markets for these products were reported to be 48 per cent and 70 per cent legal, respectively, in 2006; the corresponding figures for 2007 – 50 per cent and 70 per cent – indicate there was no improvement whatsoever after the introduction of the tougher customs declaration regime.
In November 2007 M.Video became the first retail consumer electronics chain in Russia to hold an IPO. Technosila plans to follow suit later this year. Without the self-regulatory regime introduced by the industry players themselves, it would likely have taken longer to unleash IPO momentum in the retail consumer electronics sector.
Introducing the criminal responsibility of customs brokers …
Customs brokerage is a thriving business in Russia, worth an estimated $3-4 billion a year. First introduced (by decree) during the final years of the Soviet Union, customs brokerage companies are believed to number around 1,500 today. However, only 400 are included on the FTS’s register of customs brokers, which is a condition, enshrined in the 2004 Customs Code, for providing customs brokerage services on the territory of the Russian Federation. This means that almost three-quarters of all customs brokerage companies are operating illegally in Russia. It is estimated that around 20 per cent of all imports into Russia pass through these companies.
Draft amendments to the Customs Code are aimed at clamping down on the activities of so-called grey customs brokerage companies. Above all, it is proposed that these companies be held more to account for information submitted to the customs authorities: the current practice is for grey customs brokers to submit all necessary documentation to customs under the signature and seal of the client, who then has sole criminal responsibility for any infringements; under the draft amendments, the importer and the broker would share not only administrative but also criminal responsibility.
… clamping down on warehouse raids …
So-called warehouse raids have become increasingly common in post-Soviet Russia. Typically, such raids involve a government agency confiscating imported goods on some pretext or other and then colluding with corrupt officials at the Federal Property Fund to sell the goods at throw-away prices to “friendly firms”; later, the goods are re-sold on the open market at the going price. According to Deputy Prosecutor-General Aleksandr Gutsan, the Federal Property Fund made a total of Rb1.05 trillion (US$42 billion) from the sale of confiscated goods in 2007 alone.
(The most egregious recent example of the confiscation and re-sale of allegedly illegal imports was in March 2006. On that occasion, Interior Ministry agents seized a consignment of Motorola mobile phones worth US$17 million, issuing and subsequently retracting various statements explaining the reason for the seizure. Motorola successfully challenged customs in court; however, it regained possession of phones worth only US$15 million, the other US$2 million worth having doubtless lined the pockets of corrupt officials.)
Several draft amendments to the Customs Code stipulate that the decision to sell confiscated goods be taken only by a court of law rather than, as is the case now, by a prosecutor or Interior Ministry official. They also provide for establishing the criminal responsibility of the person who values the confiscated goods for any infringements or abuses that result from his/her work. The proposed legislative changes failed in the first reading in March 2007 and are not expected to be approved until the end of this year at the earliest.
… and renationalising customs premises
In the meantime, the FTS is seeking to bring all customs posts into state property ownership after the General Prosecutor’s Office discovered in the second half of 2006 that the premises at a number of customs points belong to for-profit companies and that many of these companies are involved in customs clearance. Last year, it was estimated that out of a total of 413 customs control points, more than one-third are the property of commercial affiliates of Russian Railways and the Ministry of Transport, while thirteen are owned by wholly private companies (most of which are located in the Far East). To carry out the renovations and re-equipment necessary to bring all customs points under direct state control would require an estimated $50-70 million.
An equally important and related issue are the so-called temporary storage warehouses – essentially warehouses used to store goods awaiting customs clearance. No precise data exist for the country as a whole, but many of these warehouses remain in the hands of commercial structures; in the northwest of Russia, for example, not a single warehouse belongs to the state. Over the past decade the number of temporary storage warehouses has increased rapidly: in the city of Moscow and the Moscow region alone, there were no fewer than 16 in mid-2007. As an illustration of what it would cost to privatise all these structures, a 3,000 square metre warehouse in the Moscow regions was valued on average at around US$20 million in mid-2007.
Dealing with the intermingling of business interests and customs at the customs posts and temporary storage warehouses dotted around the country is a priority frequently acknowledged at the highest levels in Moscow. These control points and warehouses often amount to illicit mini-businesses in their own right. Yet the cost of state acquisitions of this real estate renationalising is not covered in the federal budget, nor have the authorities explained to date just they how would go about carrying out that process.
Tatyana Kruglova, General Director of the Targo Group customs holding
The problem with the so-called white lists has always been one of subjectivism. In other words, the white list rules are open to arbitrary interpretation and application – for instance, as regards the criteria for inclusion or the exclusion of law-abiding companies on purely formalistic grounds.
Take the example of a leading international brand that has been selling in Russia for many years through intermediaries and then decides to establish a company in Russia in order to strengthen its position on the Russian market and dispense with the services of distributors. Such a company will be interested only in “white” import schemes – its business reputation depends on it. But that company, famous and respected among business circles worldwide, will be regarded as a "one-day company" in Russia. It will not be included on the white list, because it will not have existed for the stipulated period of time, and thus it will be unable to benefit from the preferential treatment of simplified customs procedure.
We do not need “white lists” – and certainly not the subjective distinction of “white”, “whiter” and “whiter still” – to fight grey imports in Russia. Preferential treatment means there can be no universal rules of the game for all companies – and it is precisely universal rules that, in my opinion, are the best stimulus for companies to be law-abiding.
Such rules are provided for by the order on the “Control of the customs value of certain types of goods” (No. 727 dated June 2004). The significance of this order is that it established customs codes of goods considered to pose a risk – fixed customs duties are paid on those goods according to their codes – rather than a division into “white” and “grey” companies. The concrete advantage for companies operating under this regime is that they enjoy a simplified customs procedure – they no longer need compile weighty documentation confirming the value of the imported goods and then wait for all that information to be checked by customs. Order No. 727 is an effective tool for encouraging companies to abide by the law – without forcing companies into “white” or “grey” categories. It should be fine-tuned or revised but not revoked.
Igor Yakovlev, President, Eldorado (the largest retail consumer electronics chain in Russia)
Most important for establishing order in customs is equal conditions at all customs posts. Companies cannot themselves determine the customs value of imported goods; this is a matter exclusively for the customs authorities. (The statistics show that imports are growing, but the figures are not always correct since the customs values themselves are rising.)
Gradually, order is being established in customs – sector by sector. The resulting increase in recorded customs valuation has the effect of exaggerating the rate of import growth indicated by official statistics. Besides electronics, this clean-up process has already taken place in the automobile and alcohol sectors. Now it is under way in the clothing sector. Insofar as the process began in electronics, that sector is today the “whitest” – that is, most legal.
At the end of 2006, all vendors of consumer electronics and household appliances conducted negotiations with the manufacturers about direct deliveries. Today, more than 90 per cent of all suppliers themselves oversee the imports of goods into Russia or have opened manufacturing companies here. We are satisfied that all vendors are now operating under the same market conditions. And I am sure that soon we will have the same situation in Russia as in Europe: retail chains will be involved only in marketing, assortment and logistics within the country. Imports, like in all other countries, will be handled by the manufacturer. This will make life significantly easier for the retail chains and in particular reduce their working capital requirements.
A former high-ranking Russian customs official and ex-consultant to a leading Russian company
At present, the most transparent category of imported goods from the point of view of customs clearance is products, such as alcohol and tobacco, subject to excise stamp requirements.
It is essential that those companies that have existed for a long period time and have proved themselves to be sound importers of a particular type of product be granted simplified customs procedures, including the post-audit. Such companies might include, for example, reputable players in the tobacco industry like BAT and other companies that are of economic significance to the state. Unfortunately, there has been no progress in developing this approach: there are too many interested parties whom the current arrangement suits very well.
As for the consumer electronics sector, I do not believe that it has been legalised to the extent that is frequently claimed. Many leading international manufacturers of consumer electronics are not handling directly the shipments of their products into Russia – in fact, there are only a few isolated examples. Of course, there are the leading retail chains which are notably transparent. However, there is an even larger number of not so well known wholesale companies that widely use the so-called one-day companies to import goods. The situation in the automobile sector is better. Practically all foreign car manufacturers import cars into Russia independently. Mercedes, for example, has assumed direct responsibility for the import of its cars, which it then sells through a network of distributors.
The reader will have noted considerable divergence – and even apparent discrepancies – in the judgements offered by our three trusted sources. This range of views in itself highlights the difficulties of achieving and assessing progress across the board in reducing customs corruption, simply because of the variety of opportunities for graft as well as the stubborn force of the incentives.
However, the results of the Central Bank’s objective method of calculating the extent of grey imports show unmistakable progress – underpinning the claims of players in various parts of the retail trade that imports of key categories of goods have now been successfully legalised. The sceptical note on the clean-up of consumer electronics imports sounded by our trusted source with FTS experience underlines the important point that the legalisation initiative has come from the established retail chains, which, combined, control sufficient market share to give them a common interest in the kind of pacts on direct and legal imports that have now materialised. The participants in these pacts themselves normalise the competition and, above all, marginalise the grey import wholesalers, which – as stated by our sceptical trusted source – continue to exist.
The consumer electronics experience leads to the key conclusion. It turns out that even this most intractable of Russia’s many and deep corruption problems can be effectively addressed by cooperative private-sector initiative. And an important motive for such initiatives has direct relevance for portfolio investors – namely, enabling companies to tap capital markets in order to finance the growth which is there for the taking in the Russian market.
It follows that the progress of this customs clean-up trend from one part of the retail sector to another amounts to a leading indicator of future IPOs. So it is worth noting Igor Yakovlev’s signal that clothing retail is following on the heels of consumer electronics, autos and alcohol. The Relevant Companies section of this note lists some players in clothing retail in Russia.
Against this background, the attempts at top-down improvements to customs regulation are of secondary importance. Here, as so often, the bureaucracy cannot cure its own diseases. At the same time, regulatory efforts – often linked to the WTO accession process – are not useless. For example, one of Tatyana Kruglova’s criticisms of the arbitrary application of "white list" criteria is addressed in the FTS’s latest proposed refinement of this scheme – according to which a company with international credentials would be eligible for the white list even if that company did not have an existing track record on customs clearance in Russia.
Name |
Description |
|---|---|
|
Bosco di Ciliegi |
The private company runs a chain of boutiques selling luxury consumer goods, above all clothing, footwear and jewellery. |
|
Mercury |
The luxury clothing retailer has a 30 per cent share of the Russian market. |
|
JamilCo |
Founded in 1993 by an Iraqi entrepreneur, JamilCo is a private limited company involved in the retail market for luxury and casual clothing. |
|
Sprandi |
The private retail company specialises in sports footwear, clothing and accessories. It recently completed a private equity financing. |
|
Obuv Rossii |
Founded in 2003, Obuv Rossii comprises three retail networks: Vestfalika, Peshekhod and Emilia Estra. In all, it has a total of around 90 stores. Obuv Rossii plans an IPO in the next couple of years. |
|
Sela |
Sela is an international corporation with headquarters in Israel and its own production facilities in China. It is active in the mid-price segment aimed at, above all, young people. It has around 300 stores in Russia. |
|
Detsky Mir (DTMR RU) |
The joint-stock company operates a chain of around 70 retail stores across Russia (including 20 stores in Moscow). It sells products for young people, including clothing, shoes and sportswear. |
|
Soyuz-Viktan |
Together with fellow Ukrainian spirits producer Nemiroff, Soyuz-Viktan dominates the Ukrainian vodka market. It is the only vodka maker in Ukraine to have production facilities in Russia. Following the acquisition of that plant, its market share in Russia increased from 1.2 per cent in 2005 to 2.8 per cent in 2006. |
|
Nemiroff |
The Ukrainian spirits company is the leader on the Ukrainian market, alongside Soyuz-Viktan. It imports and distributes its brand in Russia. Nemiroff plans to open a distillery in Moscow from which it will supply the Chinese market as well as the Russian capital and the rest of Russia. |
|
Technosila |
The private company is the third-largest consumer electronics retail chain in Russia. In 2006, it grew at the fastest rate in the sector (69 per cent). Technosila announced in March 2007 that it plans to hold an IPO in 2008. |
|
Eldorado |
The private company is Russia's largest consumer electronics retailer. It has more than 1,000 stores in Russia and a 28 per cent market share. |
|
M.Video (MVID RM) |
M.Video runs a chain of retail stores selling consumer electronics and household appliances. It is the second-largest such retailer in Russia, with a 12 per cent market share. Market capitalisation (as of May 2008): US$1.4 billion. |
|
Severstal-Avto (SVAV RU) |
The joint-stock company (a part of the Severstal Group) imports kits for assembling automobiles and light trucks. It holds controlling blocks in the Ulyanovsk automobile plant (UAZ) and the Zavolzhye motor works (ZMZ). Market capitalisation (as of May 2008): US$2.1 billion. |
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