Transcript by Federal News Service, Washington, D.C.
FRED KEMPE: Thank you very much. I’m Fred Kempe, president and CEO of the Atlantic Council of the United States. We will use this new teleconference forum to bring together decision-makers from both sides of the Atlantic, business leaders, policy experts, military leaders, and others around a virtual conference table with some of the world’s best thinkers to talk about critical, timely issues of the moment that have longer-term consequences.
Mike Calvey and Charlie Ryan have both been in Russia for more than 15 years. They’ve seen a lot of crises come and go. They’ve seen the size of the economy multiply. Mike runs the biggest private equity operation in Russia, which has their hands in 20 business, consumer, media, financial services, oil and gas, and other vital domestic, medium-sized companies.
Charlie started up the United Financial Group. Deutsche Bank acquired it. He’s now the chairman of Deutsche Bank Russia. Clearly they know the market, they know the Russian economy as well as others. They’ve been through a lot.
MICHAEL CALVEY: My basic conclusion is that I’m pessimistic about the stock markets and foreign investment outlook in the short term, but I’m still relatively optimistic about domestic economic growth and business profitability overall, at least in comparison with most other countries globally. The last nine years Russia’s experienced extraordinary growth from about a $300 billion nominal size GDP in 1999 to about $1.75 trillion or $1.8 trillion this year.
Over the next few years growth will inevitably decelerate for three or four reasons. The first is that the law of large numbers, when you get to – when you’re a smaller sized economy it’s easier to grow at a faster pace, but I think the more important reasons are that the next phase of growth in Russia is going to be much more capital intensive than the last phase, and Russia’s facing a decrease in availability of capital. The biggest reason by far is because of the global credit crunch, which is affecting Russia as it is affecting many other countries. Most Russian banks besides the three or four big state banks have limited access to capital markets funding, and the big three or four state banks control a disproportionate amount of the deposits in the country. What we’re seeing is a serious tightening of credit availability in Russia, which is affecting some sectors more than others, but clearly it’s a major factor. Also portfolio investor capital outflows will probably increase and foreign direct investment inflows will probably decrease to some extent due to political reasons.
This is going to be uneven in its impact on the economy. Commercial property is a sector which is likely to be hit very hard because of its dependence on credit really for the basic economics to make sense. But other sectors like retail and consumer spending should continue to grow.
So overall the trend is toward a deceleration, but nevertheless, we think that Russia’s going to continue to grow at a rate that’s significantly faster than most developed countries, for several reasons. The first is a demand from Russia’s mostly unleveraged consumers remains very strong. The second is that there’s still significant under-utilized assets and resources in Russia, people and natural resources, physical assets. And what this means is that the return on investment for most capital investment projects in Russia is still very high compared to most other countries. And the third is that Russia’s got an incredibly strong balance sheet overall. Corporate debt in Russia as a percentage of GDP is low compared to most countries. Retail or individual debt is extremely low, and as we all know, the government has substantial net savings, substantially more cash than they have debt.
So I think that you look over the last 25 years, most of the emerging markets’ economic crises have been triggered directly or indirectly by too much debt, and that’s just a factor which doesn’t exist in Russia today. At the same time, because Russia’s banking sector and capital markets are still relatively under-developed compared to most other countries, the share of fixed investment that’s financed by bank loans is only about 10 percent and the capital markets is about 3 percent. FDI is about 6 percent. So about 80 percent of all fixed investment or capital investment in Russia is financed by retained earnings and government investment. The government part is about 20 percent and 60 percent is retained earnings.
It’s a country that’s been starved of capital for a long time, so I think that the decrease in capital availability will have only a limited affect on investments overall. We probably won’t see the 20 percent year on year growth in fixed investment, which we’ve seen for the last five or six years, but 10-15 percent growth is still quite realistic. I think it’s extremely unlikely that there’s going to be a fall in investments overall, as retained earnings continue to grow, and government investment is also growing. Government investment, of course, is the least efficient form of investment, particularly in Russia, but it does have some clear positive effect on the economy.
In conclusion, I think that we’re about 15 years into a 30- or 40-year transition cycle as Russia moves from being in a kind of state or command economy into something that resembles a normal market economy. In the latter years of that period the growth in Russia is likely to be in line with developed markets. But for the meantime I think that Russia should continue to still grow at rates that are significantly faster than most of the developed world.
MR. KEMPE: Thank you, Mike. Just very quickly, what’s happened in Georgia, are you feeling that in what you’re doing? And if so, how?
MR. CALVEY: The capital markets in Russia are very nervous now, not mainly because of the Georgian situation but because of the weak global credit environment and a few business-specific issues in Russia over the last couple of months. It’s not a good time to sell assets unless you have no alternative. Out of the 20 businesses that we own, there were two or three that we were planning to take public in IPOs over the next year, and clearly we’ve now put any such plans on hold indefinitely. We are a substantial buyer of assets now and we’re reducing the prices on the things that we have been negotiating by 30 percent, 25 percent. It’s definitely a buyer’s market.
We own a substantial stake of a housing developer in St. Petersburg and I went this week to one of their sales offices and there are five sales desks and four buyers deep at each sales desk, waiting to pre-pay in cash one year in advance before the apartment’s even built. Ninety percent of their buyers have no mortgage financing. They’re just paying cash. So it’s a strong sign of the underlying consumer demand. I don’t see how this change in capital markets can affect the demand from the underlying population in their ability to mobilize savings or to improve their quality of life.
MR. KEMPE: Thank you, Mike. Charlie, over to you.
CHARLES RYAN: I mostly agree with a lot of what Mike said. Two things that I would elaborate on. One is that when we talk about this transition from sort of a catch-up economic growth story to one that’s more dependent upon fixed investment, the simple way to look at that is you have an awful lot of under-utilized capacity in the economy, and making minor investments to get a plant that was mothballed up and running is a much easier way to generate growth than having to build a whole new plant.
In fact, when you’re trying to build a whole new plant, then you come to banks like Deutsche Bank, typically the payback periods on those sorts of larger investments are much longer and it requires more stable capital markets, longer tenure on the credits, and those sorts of things have really only been available in this last four- to five-year period of relative stability.
Obviously up until this past summer the news was that that the transition was occurring pretty smoothly. We saw a fixed investment, as Mike noted, go up all the way to 20 percent of GDP, and generally speaking it looked like the level of confidence was leading not only foreigners, but more importantly, Russian investors themselves to make these longer-term commitments to building new capacity.
In terms of direct effects, one thing that we have seen is that 20 percent fixed investment rate drop to what we’re now predicting could be around 16 or 17 percent. So there has been a material drop in the growth in fixed investment. I suspect that it’s hard to divine what of that drop is a function of global economic problems, and what would be a function of this recent outbreak of fears related to geopolitical risks, direct result of the problems down in the Caucasus, but nonetheless, it’s happening.
Along those same lines, if previously people were thinking that this year’s GDP growth in Russia would once again be above 8 percent, long consistent with that drop in fixed investment growth, people are now calling for the GDP growth to fall to around 7.5 percent. But in terms of what’s actually driving the economy, in addition to this increase in fixed investment, one of the big untold stories of the last several years in Russia has been what you could almost argue was Jack Kemp’s dream scenario. Russia has seen an amazing supply side effect of tax policy. By lowering the tax rate for everybody to 13 percent, and eliminating a lot of taxes on corporate – limiting taxes on capital gains, et cetera – you’ve essentially resulted – it’s one of the things that’s driven this amazing consumer boom in the country.
The way I often look at that is that 80 percent of the average Russian’s income is disposable because of the way they privatize the housing and because of the tax rates. So it means that Russians, even though the country only has a GDP per capita of about $12,000, consume like a country with a far, far higher GDP per capita because of the wages going to Russians. They just can spend a lot more of it.
And along those same lines, the Russian consumers, as Mike said, are under-leveraged, but even so, that’s a huge, huge driver of their spending habits, which have the knock-on effect of irritating a lot of Europeans who have Russians showing up at their holiday resorts in Western Europe, and obviously is a huge business opportunity for anyone who’s providing a good or service that Russians want to procure in Russia. Despite the fact that we hear so much about the oil and gas industry, the reality is most of what’s happening in the country today that’s most interesting has been happening on the consumer front.
One last thing on the subject of hydrocarbons, one of the interesting points obviously has been that we have seen a marked increase in the role of the state in the oil and gas sector, but nonetheless, compared to most countries Russia has a very large proportion of its oil and gas resources owned by private investors. Clearly those investors have been reacting to a pretty bad tax environment, where a huge proportion of revenues are taken by the state in taxes.
One of the interesting stories to follow looking forward is what changes the government makes to the tax policy re: the oil and gas industry because, quite frankly, I think that will have at least as much of an impact on Russia’s relative strength in the global energy markets as pipelines and other infrastructure that people tend to focus on because we have seen real declines in output from most of the Russian oil companies, and they’ve not been sustaining the same kind of growth that they had years ago because they’re having to move into greenfield projects instead of working over old fields and they haven’t had the incentives to do it because of the bad tax policy.
The last point I would make about the growth story in Russia, again echoing something Michael said, is that the other driver, aside from this consumer demand, has been that for many years the state simply accumulated its reserves. If you talk to government officials privately, they would tell you the reason they weren’t putting more of the money back into the economy was they were afraid the government officials would simply steal all of it. One of the latest trends has been to try and put a lot more of the resources, the windfalls that they’re getting from high commodity prices into infrastructure projects – roads, railroads, et cetera. Again, there on the one hand that’s going to be a big driver of growth. On the other hand, clearly it highlights one of the biggest problems in the country today, which is this persistent corruption. It’s pretty telling that before pretty much anybody went to Sochi to get ready for the investments for the Olympics, President Putin sent a prosecutor to make sure that he was ready to prosecute everybody who tried to steal the money.
So in terms of the big driver to the economy, it’s consumer demand, and these infrastructure projects, a bit of a wild card, is how much of the investment in infrastructure gets misappropriated. And also a bit of a wildcard is what they’re going to do to try and turn around the decline in growth in the oil and gas sector.
I suppose on the economic front that’s my view. It’s pretty consistent with what Mike said. I noted he and I both sort of skirted the geopolitical issues associated with the troubles in the Caucasus, so perhaps that will come up in the questions. But I think on the economic front it’s primarily, as Mike said, a story of domestic demand and incentives to domestic investors. And even if we’re going to see an outflow of capital from foreigners, I actually think that the story’s a lot more mixed. I think Russians themselves are going to continue to invest in the economy.
I think the very last thing I would say is we’ve actually noticed a bit of a cleavage between the view of American-based foreign direct investors, and European and Asian investors. We recently advised an Asian oil and gas company on the acquisition of a Russian-owned gas company, and something that really struck me was in all the conversations with them, there was really never any discussion around the Caucasus, so they seemed to pretty much be ignoring it. I think Europeans are a bit more concerned than the Asians, but far less concerned than the American strategic investors. American strategic investors seem to be much more worried about it.
MR. KEMPE: That’s a very interesting point, and two fascinating ways to get us into this discussion. As we’re winding up, I urge people to ask questions. I’ll withhold my own long list of questions at this point and let people on the line get at the two of you a bit with their questions.
Q: If you could advise Bush and Cheney on one hand and Putin and Medvedev on the other hand, what would you tell them with regard to the Georgia mess?
MR. RYAN: My somewhat succinct view of the Georgia mess is that the U.S. government probably over-encouraged the Georgians to have an exaggerated view of what capacity we had to help them. I think Saakashvili was certainly provoked, but he obviously dramatically overstepped in deciding to go outside diplomatic channels. Clearly the Russians massively over-reacted, having tanks get within the suburbs of Tbilisi.
But if you’re looking at it from the U.S. standpoint, the frustrating thing about it is that there are places in the world where we have allies that we have no choice but to support. It’s never good to send a message that we’ve put our credibility on the line to back someone up and don’t have the capacity to do so. So maybe being slightly overly realist about it, I’d prefer that we make sure that we’re reassuring friends of ours around the world where we would be able to have the capacity and the interest to support them, make sure they understand that we would treat them differently than what’s happened in Georgia.
I think in terms of what we might do about Georgia in particular, I suppose there we have to accept the fact, which is that Georgia will only be able to develop normally if it has some sort of modus vivendi for its relationship with Russia, and you know, even if we might want to make sure that they’re given the protection they need to develop into a democracy and become a normal country, the more we can give them the space to develop their relationship with Russia, while at the same time knowing that we’re going to back them up as we can, we’d be better off. But I think escalating it to a big geopolitical matter for this tiny little country that hasn’t really fully cohered into a proper nation-state isn’t going to help anybody.
And the last thing I would say is we should be very careful how we deal with Ukraine, because obviously as the negotiations come up over the base in Sebastopol we’re going to want to make sure that we don’t end up in a similar situation of misunderstandings vis-à-vis our relationship with Ukraine.
Q: How likely do you think it is that the Russian domestic savings and wealth can be utilized by the banking system to make up for any limitation on the availability of long-term debt from international investors and banks? Either due to geopolitical risk perceptions, or just the overall credit crisis?
MR. RYAN: At this point the Russian banking system – along with inflation – is one of the big weak spots in the Russian economic story. The reality is that today you have very large and essentially dominant state-owned banks and some smallish but developing private banks. And the government hasn’t done a great job pushing forward with implementing the pension reforms that they talk so much about. And the result of all that is that a lot of the Russian banks continue to primarily fund themselves with loans from people like Deutsche Bank and funding in the international capital markets, which obviously is not very broadly available today.
It’s from a very tiny base, but we have seen deposits increase about 40 percent, but it’s from such a low base that the reality today is that it will be a long time before those deposits in the population are playing the same kind of role in Russia that they do in other developed markets. So I think the answer is that, as Mike said, it’s probably going to continue to be dependent upon the big state-owned banks, and also on the retained earnings. You’re not going to have a lot of leverage come in the system until international capital markets are going to be once again willing to provide funding to these Russian banks.
MR. KEMPE: This does get to the geopolitical question, and since I have been talking to people here in Washington, there’s a question of how one actually influences Russia. And the term that I mentioned in the introduction, self-sanctions, is something that the U.S. Treasury is talking about. So they think that Putin’s sort of shot himself in the foot, and then they point to the $21 billion of foreign capital that seems to have pulled out of the country.
So I guess I have two questions. First of all, have you seen that foreign capital pulling out, and is it slowing now? What do you see in those trends? And secondarily, do you see this economic pain that the Bush administration in any way is achieving anything at this point through it politically? I realize that’s not really your business, but we’re talking off the record here. It would be interesting to know whether you’re observing any influence at all from this.
MR. CALVEY: I would make maybe two points. The first is, I believe that the Russian government views what happens in its neighboring countries as being of vital strategic interest, and even if there would be a $200 billion or $400 billion capital outflow, and the result of that was the ruble crashing, they would still act in the same way because they view this as a vital strategic interest.
And the second point is that there’s a big difference between the way portfolio investors and direct investors look at this type of decision. We’ve had a situation in the last few years when portfolio investors placed a much lower risk premium on Russia than strategic investors or direct investors did. We could see that in the businesses that we owned and we would consider taking it public in an IPO, or selling it to a strategic investor, we could always get a much higher valuation doing an IPO.
I think we’re going to see the reverse of that in the future. Portfolio investor capital is the first to leave, but for strategic investors, especially those that already have investments in Russia, they’re generating much higher growth rates with the businesses they own in Russia than they are in most other countries in the world. The net profit margins in percentages of sales are much higher, and their competitors in the same industry are either in the Russian market already or they’re eyeing the Russian market. So I think that foreign direct investment will be quietly moving ahead in any event. They will have some impact, clearly, at the sort of board level discussions with strategic investors, but most of the reason why portfolio investor capital has left is not because of the political environment. It’s because portfolio investors need that capital now urgently in their home markets, and because other markets around the world have also gotten much cheaper. If you look at the PE ratio of the Chinese market now, for example, it’s extremely compelling, so I think the portfolio investors are just making a calculation, saying, there are enough reasons not to own Russia now that I’d rather take my profits that I’ve experienced for the last four years and put the extra money back into China and some other place like that.
Q: What are the best and worst case scenarios of the Russian intervention in terms of the stock market and the economy?
MR. CALVEY: First of all, there’s a serious lag time between GDP activity and investment figures, so because there’s been such big investment, increasing investment three years ago, two years ago, this year, we’re likely to continue to see strong economic growth anyway this year, next year, and into the following year. So whatever slowdown there is in investments for the remainder of this year and next year, it’s only going to show up in the GDP figures, I think, well into the future.
So my guess is that the worst case scenario is that we’ll see next year 5 percent real GDP growth, and the best case scenario is 7.5 percent or 8 percent.
MR. RYAN: I would definitely agree that we’re probably looking now at a scenario where this sort of run of 7.5 to 8 percent GDP growth is probably going to be more in the range of five to six. Again, hard to say how much of that is Georgia and how much of that is the difficulties in the global economy.
In terms of the stock market Mike made an important point, which is that portfolio investors are always looking in Russia in relative terms compared to the other markets, which have all become much cheaper. In terms of the optimistic scenario, Russia is still one of the few places in the world where you have accelerating earnings growth, particularly in companies that are exposed to Russian consumer demand.
On the optimistic front, the situation in the Caucasus will quiet down, and although you’re always now going to have somewhere in the discount rate people will apply to assessing Russian risk some fear of these sorts of problems, it would in a slightly dampened way kind of get back to the trajectory that we had before.
I think on the negative front, and again, Mike made a good point, at the level of the Kremlin they don’t tend to differentiate. They’re not really willing to look at what they view as core strategic interest through any filter of consequences related to the economy or private sector interest. To the extent that they view the situation in Georgia through that filter, it means that we have the risk that this could spread. You could have some sort of dispute erupt over the Crimea, and as people start to feel that we’re entering in a period of a clash between Russia and the West over the West’s relationship with the former Soviet republics, you can have a scenario where investors really start figuring out the relative cheapness or not of Russian assets. Any assessment must include a huge discount by virtue of the fact that the country is going to be in constant conflict with Europe and with the U.S. and NATO over the relationship with what they call the near-abroad.
MR. CALVEY: I think that clearly the change in the markets, the stock market decline, the outflow of capital and the impact on the ruble are clearly having an effect on the Russian government and on the government’s actions with respect to the economy itself, where there’s been stagnant economic reforms over the last five or six years. I think that the government’s become over-confident. This is shaking that over-confidence, and I think it will result in some steps being taken to try to lead to better longer-term economic growth conditions.
MR. RYAN: One immediate impact was that in an attempt to try and put some good news out there, had the government precipitating a conclusion to the fight between BP and AR. Now, obviously people will make of it what they want, how properly BP was treated, but the fact that that thing came to conclusion and they announced the conclusion now, I think is partly a function of the government trying to put some positive news out there. And interestingly enough as well, there’s a relatively unknown, obscure economic forum held in Sochi in the fall, and this year the Kremlin is trying to encourage a whole group of Western CEOs to come to Sochi on the 18th of September in order to, A, reassure them, and, B, demonstrate that despite the tensions between the different governments, Russia is still keen to continue business.
Q: Have the US been guilty of sticking their thumb in Russia’s eye?
MR. RYAN: What I would say, I’m reluctant to say anything directly about what our government did vis-à-vis Georgia, but I definitely can say there are very important strategic issues that are, in my opinion, substantially more important than our interest in the Caucasus, namely nuclear proliferation in Iran and other areas where I think we have a vital interest in working with the Russians.
MR. CALVEY: All I can say is that if our goal is really to help Georgia, it’s hard to argue how American involvement there has helped Georgia so far and it clearly hasn’t furthered American strategic interests either.
Q: In relation to Putin’s attempts to reassure investors and Western CEOs by inviting them to a forum, I would like to know what is the best way to decline, because we do have operations there?
Also, what can Putin possibly say in Sochi that would make people around this virtual table feel reassured?
MR. RYAN: Ironically, one of the things I’ve come to feel more and more strongly about is we have this idea in our heads – I think mostly a function of Gary Kasparov and Spasky and all these great Russian chess players – that the Russians are very strategic thinkers, and we like to think of their approach to challenges as chess players. The more I watch them, the more I’m convinced that they’re actually almost always purely tactical, and that they’re kind of making it up in response to the most recent set of inputs.
I think in terms of what Putin might say to people, he’s got from a business standpoint two things to really address. One is, what does someone do whose Russian partner – if your Russian partner is going to be allowed to use organs of the state against you, isn’t that something the government should stop. That was the thing that most worries people out of the whole BP scenario. And then the second thing is, you’ve got a weird dissonance between macro and micro. I don’t think the market would have reacted so negatively if the government had come out and said that they wanted to change the rules on transfer pricing more broadly across the whole economy, but to have the president directly – or the prime minister rather – directly attack one particular company for transfer pricing policy raises a risk in investors’ minds that if you invest in a company, it might be the one that gets attacked.
I think that one of the signs of, sort of, immaturity in how they go about their policymaking is that they don’t make enough of an effort to differentiate between a broader macro decision to change the way they’re going to tax or regulate industry and having those attacks be directed at one particular company. Because obviously when boards think about this, they’re not going to be so worried about changing the rules that affect everybody equally, but will obviously be very worried about an environment where you could have a particular – you could be singled out for a particular attack.
I think that before the Georgian crisis, two things that were really on the minds of most strategic investors were what happened to Mechel and what happened to – what was happening to BP.
MR. CALVEY: I would say outside of the oil and gas sector and the big oil and gas companies, there really haven’t been, you know, big top-level government problems for foreign investors in Russia. There have been loads of micro-level problems, with some local competitor or labor unions or things like that, which mostly have gotten sorted out. I think that by meeting with CEOs it would send a positive signal that ultimately it’s the underlying results in the profitability and the size of the underlying market that are going to drive strategic investors’ interest.
Q: Do you see any further steps on the horizon of the state trying to control temporarily long-term industries or companies or whatever? Not regulatory control, but ownership.
MR. CALVEY: The trend towards greater state ownership in the economy has been one of the more disturbing trends in the last few years, and it’s been driven by two things. One is, you know, overconfidence among state bureaucrats. They’ve had such a strong run that they believe that it’s mostly because of their own brilliance, so that should translate into their ability to run companies more efficiently than the private sector.
The second reason in some cases has been, you know, individual motivations or greed in some respects. But I think that at least the overconfidence part is likely to be dented by the recent market splash of reality or dose of reality, so I think the pendulum is going to keep swinging in that direction a little bit, but it won’t be too long before it starts swinging back in the other direction. In the sectors where we invest, we co-exist with state companies in some cases. We own businesses in the media sector, we own some small oil and gas businesses, and there is a role for small players in the same industry. There’s a role for foreign investors in the same industries, as long as you understand the rules of the game and your goal of investing is to make profits rather than exercise political influence. And foreign investors have probably a broader range of investment opportunities in Russia than they do in any other comparably sized emerging market.
MR. RYAN: I think the one place where we have seen some disturbing elements of this, to echo what Mike said, is in situations where some Russian investor or business player will have some venal interest, he will dress up an argument to the state around national interest that is an attempt to – and sometimes succeeds in getting the Russian government to help them. They don’t typically go to the state and say, look, I’m really greedy, help me get this company so I can get richer. It’s often couched in terms that are meant to appeal to the nationalism of decision-makers.
Unfortunately in a system that has so much power and has so few people who are very busy and are human beings, they can get picked off and make bad choices. But I would say in a broader sense what Mike said is true, which is that, you know, yogurt is not a strategic good in Russia like it is in some countries. It’s a very liberal economy in many respects, and more or less the problems people confront are kind of local problems with competitors or a local mayor or something like that, that are frustrating and are an indication that Russia is still a country in transition, but they get worked out.
It isn’t a place where everything is getting decided in the Kremlin, and sometimes when it does get decided there, they make the right calls, and sometimes when they try and decide things there, they screw it up.
MR. KEMPE: Thank you very much. On behalf of everyone on this call, I really want to thank you, Michael Calvey, Charles Ryan. Mike and Charley, this was great. We’re in a situation – in many high crisis situations you get more heat than light. I think you’ve given us more light than heat. As Sarah said, a dose of reality. We’ve got a much more three dimensional, sophisticated view of the Russian economy and the forces on it, not just from post-Georgia, but also in terms of the global economic situation credit crunch, and other competing markets. We got a good feeling of how this could feed strategic investors at the moment, even though portfolio investors might be – some may be looking for the gate.
We got a good look at future risk in the situation that Putin may not be looking at his strategic decisions – what he views as strategic decisions from a prism of how it has impact on the economy. But we also got a good feeling through the TNK-BP and other issues of how there already may be some impact on economic decision-making. So I think all in all this was a hugely successful call.
Thank you for calling in. Thank you to you two gentlemen. And for those on the call, if you have ideas or suggestions of other ways we can use this call, we’re happy to listen to them.
Thank you very much.