Russia: A Prime Belt and Road Investment Destination

The Russian economy has been undergoing a wave of diversification over the past decadeto reduce its dependency on oil and gas. This has seen its government try to improve theclimate for investors through generous incentives and huge infrastructure projects. In aclassic win-win situation for both Russia and China, most of these projects arecomplementary to those that come under the scope of the Belt and Road Initiative (BRI).This potentially creates a whole new world of opportunity for Hong Kong investors andprofessional service providers.

Bridging the FDI Funding Gap

The double blow of the oil and gas price crash and the imposition of internationaleconomic sanctions sparked a crisis in confidence in the Russian economy oninternational finance markets. It led to a huge sell-off of Russian assets, a staggeringdepreciation of the Russian ruble and a subsequent recession in which real GDP growthfell from a yearly average of more than 3.5% between 2011 and 2013 to -2.8% in 2015and -0.2% in 2016.

While the crash and sanctions had the effect of bringing the Russian economy to ashuddering halt, they also led to an acceleration of the pace of economic diversificationand reform. Although mining and quarrying remains the most popular sector for foreigninvestment in Russia, with a 22% share of the country’s total FDI inflows as of mid-2017,the combined non-energy sectors now account for more than half the nation’s FDI.Manufacturing (21%), wholesale and retail trade (16%) and financial and insuranceactivities (15%) are becoming increasingly popular with global investors.

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To restore investor confidence and alleviate the effect of Western sanctions, the Russiangovernment has put in place new measures and reforms designed to attract investment.These include the privatisation of state-owned businesses, the provision of cheap bankcredit to SMEs, digitising and streamlining government services and boosting strategicstate-assisted investment in sectors such as high-tech industries by developing newtechno and industrial parks and upgrading existing ones.

The staging of the 2018 FIFA World Cup in June/July 2018 should help improve thenation’s international image and raise global awareness of the various investmentpossibilities available over its vast land mass. Russia is also supporting the BRI and isready to actively participate in its implementation.

The international sanctions on Russia, such as asset freezes and travel bans on seniorRussian officials and oligarchs with ties to President Vladimir Putin, have been led by theWest, mainly the US and the EU. As a result, Russia has seen a significant fall in FDI fromthe EU, particularly between the second half of 2014 and the first quarter of 2016. Thisdownward trend, has, however, been offset by FDI inflows from Asia, which once soaredfrom US$595 million in 2008 (less than 1% of the total FDI inflows in Russia) to US$17.4billion in 2016 (more than 53% of the total). This trend has continued despite the sharprebound in FDI inflows from Europe in 2017, a time when Asia still accounted for 12% ofthe country’s total FDI inflow. Ultimately, this had helped Russia diversify its FDI sourcesbeyond its established European investors.

With few Asian countries supporting the economic sanctions imposed by the US and theEU, the continent has become a crucial source of investment for Russia. According tofigures from the CBR, Singapore was the largest Asian investor in Russia in 2017, with anFDI inflow of US$2.4 billion, followed by mainland China (US$573 million), Kazakhstan(US$205 million) and Hong Kong (US$136 million).

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Asia’s FDI is becoming increasingly important in Russia.Source: CBR

Strong Sino-Russian Ties

The close relationship between China and Russia serves as a solid foundation for theinterplay of Russian and BRI investment projects. China does not support theinternational economic sanctions on Russia, and is actively investing in various sectors ofthe Russian economy.

An indication of this two-way economic co-operation is the inclusion by Russia of theChinese yuan or Renminbi (RMB) in its foreign exchange reserve since the end of 2015.Furthermore, in March 2017, the CBR gave its approval to Chinese bank ICBC becomingthe official RMB clearing bank in Russia. ICBC is the only Chinese bank with institutions inboth Moscow and St. Petersburg which holds brokerage, dealership and depositarylicenses.

These developments, together with the presence of private Chinese business venturessuch as China Business Centre in St. Petersburg and the emergence of key jointinvestment funds such as the Russia-China Investment Fund (RCIF) by the Russian DirectInvestment Fund (RDIF) and the China Investment Corporation (CIC), have greatlyfacilitated Chinese investment in Russia and made China the leading source country forRussian FDI announcements in recent years.

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China has become Russia’s top source country for FDI announcements in recent years, contributing morethan one-sixth of the total number of announcements in 2016.Source: Russian Direct Investment Fund

The China Business Centre in St. Petersburgprovides a one-stop platform for new-to-the-marketChinese companies to kick-start their businessventures in Russia. As well as spacious exhibitionareas, the centre also provides a slew of businessservices (1).

The China Business Centre in St. Petersburg providesa one-stop platform for new-to-the-market Chinesecompanies to kick-start their business ventures inRussia. As well as spacious exhibition areas, thecentre also provides a slew of business services (2).

With US$2 billion received in commitments from both the RDIF and CIC, the RCIF hasbegun some 20 investment projects worth US$1 billion in various sectors since itsinception six years ago. One landmark scheme is the Amur River Bridge project. Launched in December 2016, it is the first ever railway bridge crossing the Sino-Russianborder. When completed in October 2019, it will create a new trade corridor betweennorth-east China and Russia’s Far East.

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The Amur River Bridge Project is the first ever railway bridge across the Sino-Russian border, connectingthe Russian Far East city of Blagoveshchensk with the city of Heihe in north-east China.

Infrastructure projects aside, the RCIF also invests in Russia’s financial and retail sectors.In February 2013, the fund invested in the initial public offering (IPO) of the MoscowExchange – the largest stock exchange in Central and Eastern Europe (CEE). Aftersuccessful investments in leading Russian retailers like Magnit and Lenta, the RCIF madeits first partial exit from an investment in February 2017 when it sold a portion of itsstake in Detsky Mir, Russia’s leading children’s goods retailer, and played a significantrole in the company’s IPO. This helped to showcase how Chinese investment can helpRussian companies grow and scale up to gain access to the stock market.

The RDIF, which is Russia’s sovereign wealth fund with reserved capital of US$10 billionunder management, has attracted more than US$40 billion of foreign capital into theRussian economy through long-term strategic partnerships. It has a portfolio of morethan 50 investment projects in 95% of Russia's regions, and is estimated to haveinvested US$26 billion[1] (1.2 trillion rubles) in the Russian economy over the past sixyears, with almost 60% of its target projects technology-related.

In order to facilitate Sino-Russian investment, the RDIF and the China Development Bank(CDB) agreed to set up a China-Russia RMB Investment Cooperation Fund in July 2017.This created a simplified framework for direct investments with settlements in nationalcurrencies, which would invest up to US$10 billion in Russian and Chinese projects,including those under the umbrella of the China-led BRI and the Russia-led EurasianEconomic Union (EAEU).

Other examples of growing Sino-Russian co-operation are the possible launch of a jointinvestment fund partnership between the RDIF and CITIC Merchant, and the creation of aRussia-China Investment Bank with a wide range of investment banking servicesdesigned to strengthen economic co-operation between Russia and China. These includeM&A advice, debt finance and capital market services such as IPOs.

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Incentives and Infrastructure

As part of Russia’s new industrial policy to overcome the effect of sanctions and enhancelong-term industrial competitiveness, the Moscow government is promoting the gradualsubstitution of imports by local production. It has developed more than 2,000 individualprojects in 19 sectors involving up to 800 selected products and implemented policiessuch as higher local content requirements to encourage domestic manufacturing.

Some Chinese companies, such as Anhui Conch Cement, Great Wall Motors, Lifan Motorsand Van Chen (flour processing and lysine production), are already trying to takeadvantage of these Russian initiatives. They hope to exploit the opportunities ofmanufacturing relocation to both capture the 143 million-strong domestic Russian marketand also to reach other markets in the Eurasian Economic Union (EAEU) such asKazakhstan, Belarus, Armenia and Kyrgyzstan by using Russia as a manufacturing hub.

One special incentive measure that has been introduced to try to reduce importdependence in industrial activity is the use of Special Investment Contracts (SPICs). Theyare designed to encourage (i) the establishment of new (or the upgrade of existing)production facilities; (ii) the localisation of advanced technologies and (iii) themanufacture of products that have no comparable local substitutes. SPICs allow investorsto operate under favourable conditions in terms of taxation, regulation and supportguaranteed by the Russian authorities.

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A SPIC provides investors with a stable business environment and sturdy support for investment projects ofnot less than RUB700 million (approx. US$11 million) for a period up to 10 years.Source: Ministry of Industry and Trade of the Russian Federation (MINPROMTORG)

One example of how this is working in practice is Russia’s biotechnology industry. Manyinternational pharmaceutical manufacturers, including some from the Chinese mainland,are exploring how they might take advantage of the import substitution campaign andrelated incentives such as SPICs – as well as the relatively low operating costs in Russia– to start production there.

Long Sheng Pharma, with its divisional offices in Hong Kong, Beijing and Moscow, havebeen considering expanding pharmaceutical production in Russia with imported materialsfrom mainland China. Valery Mandrovskiy, General Manager of the company’s Hong Kongoffice and Chief Representative of the Association of the Russian PharmaceuticalManufacturers in China, said: “The target of increasing the share of local manufacturingof finished formulations in Russia’s pharmaceutical market from the current 35% to 70%in five years paints a very rosy picture for international producers considering productionrelocation”.

He added: “By better exploiting Russia’s labour cost advantage over many otherproduction bases, made-in-Russia pharmaceutical and healthcare products can also behighly competitive in international markets”.

Other opportunities on offer in Russia involve land and physical infrastructure. Thecountry has 25 Special Economic Zones (SEZs) with an array of lucrative incentivesdesigned to bring international investors into the country’s priority sectors, such as thehigh-tech sector. These SEZs are granted a special legal status by the Russiangovernment, providing companies based in them with tax preferences, free customsarrangements, land plots with ready-to-use infrastructure and free connection to energyresources. All this translates into cost savings of up to 30-40% on average.

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There are 25 SEZs in Russia, hosting companies from 32 foreign countries and economies.Source: Association of Clusters and Technology Parks

In addition to SEZs, the Russian government has been increasing its efforts to developindustrial parks across the country, doubling the number from 80 in 2013 to 166 in 2017.Mostly created by local administration or private entrepreneurs, these industrial parks arewell-equipped with the necessary industrial, transport, warehousing and administrativeinfrastructure for manufacturing. As of 2017, 275 foreign companies from 27countries/economies (including 8 from China) were operating localised production inthese industrial parks.

PPP Projects Seeking Foreign Partnership

When it comes to mega infrastructure projects, Russia has a long history of developingprojects on a private-public partnership (PPP) model with local and foreign investors. Oneof the forerunners in the use of PPP projects, the St. Petersburg City Administration relieson PPP to deliver mega-sized projects while adopting global best practices.

Successful examples include the US$5 billion Western High-Speed Diameter (WHSD) –the first urban high-speed toll highway in Russia and one of the world’s largest PPPprojects in the field of road construction – and the St. Petersburg Pulkovo Airport (LED),the only airport in Russia developed on a PPP basis.

The WHSD enhances transport connections between the regions of St Petersburg andprovides a crucial link to the new deep-water port of Bronka, situated on the city’soutskirts on the Gulf of Finland. As such, it is vital to the city’s attempts to strengthen itsstatus as a regional logistic hub in CEE.

Pulkovo Airport, one of the largest and busiest air terminals in Russia and EasternEurope, is run by the Northern Capital Gateway (NCG) consortium – an internationalgroup made up of Russian, Greek and German companies and banks. It has the contractto manage and develop the airport on a 30-year operating lease that runs until 30October 2039.

Russia’s project developers are now actively looking at different PPP models that could be

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prove more attractive to international investors in other countries. For example, Chineseinvestors usually prefer build-transfer (BT) projects rather than build- operate-transfer(BOT) or build–own–operate–transfer (BOOT) projects.

While transport infrastructure will continue to be a key development area for Russia andthe BRI, Russian authorities, especially at local levels, have been paying more attentionin recent years to fostering sustainable, inclusive social and economic development. Thisincludes the development of satellite cities such as the Yuzhny Satellite Town project insouthern St. Petersburg.

The only project in Russia where a new multi-functional development (R&D, industry,business and housing) is planned on an area exceeding 2,000 hectares, the “smart city”elements such as energy-efficient transport, intelligent lighting, smart parking andelectronic healthcare are central to the Yuzhny development plan.

This is a greenfield project, and as such, the project owner is open to proposals in whichHong Kong investors and professional services providers can act as partners in terms ofproject financing, urban planning and transport management. The city’s strongconnection with mainland Chinese and other Belt and Road investors is also highlyappreciated.

The Yuzhny Satellite Town is one of the most ambitious multi-functional development projects in Russia.Source: START Development

Chinese Investment Success

Given the geographical proximity and close political and economic relations between thetwo countries, it’s unsurprising that there is already a great deal of successful Chineseinvestment in Russia. The US$1.3 billion-plus Pearl of the Baltic Sea project in thesouthwest of St. Petersburg – a multi-functional residential and commercial complex formore than 30,000 people, financed by the Shanghai Industrial Investment Company

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(SIIC) – is to date China’s largest foreign non-energy development project in the country.

The Pearl of the Baltic Sea Project is to date China’slargest foreign non-energy development project inRussia (1).

The Pearl of the Baltic Sea Project is to date China’slargest foreign non-energy development project inRussia (2).

The Hua Bao International Investment Company, formed by Russia’s Hua Ren Invest Ltdand China’s Shandong Dongbao Group, is reportedly implementing a number ofinvestment projects, including the development of a convention and exhibition centre andan industrial park targeting companies from China, Russia and other ShanghaiCooperation Organisation (SCO) member states such as India, Pakistan and Central Asiancountries.

These projects provide solid building blocks for Chinese investors looking to achievegreater success in the Russian market. One area where this may prove crucial is theArctic, which is becoming increasingly globally significant given its strategic and economicimportance, especially as regards scientific research, environmental protection, seapassages, and natural resources.

China’s Arctic Policy White Paper, released in January 2018, sets out Beijing’s aim ofcreating greater collaboration with other Arctic and near-Arctic states such asRussia. The objectives are to build a “Polar Silk Road” as a shorter alternative to existingChina-Europe voyages via the Suez Canal, to participate in the exploration for andexploitation of oil, gas, mineral and other non-living resources, to conserve and utilisefisheries and other living resources and to develop tourism.

A Greater Role for Hong Kong

As its economic recovery continues to gather steam and the anticipated World Cup-related spending spree kicks in, Russia’s international image may well be bolsteredsomewhat, while the global profile of several of its lesser-known cities is also certain tobe raised.

In 2017, Russia was Hong Kong’s eighth most important European trading partner,having placed orders for a record US$2.8 billion worth of goods. With the Russianeconomy’s upward trend set to continue, its trade with Hong Kong will almost certainlygrow. As an early indicator of this, in the first five months of this year, trade between thetwo enjoyed growth of 84%, which breaks down into a 91% rise in Hong Kong’s exportsto Russia and a 61% increase in imports from Russia to Hong Kong.

With Western sanctions still in place and European and American investors remainingreluctant to commit to any Russia-based projects, it is highly likely that those looking forbacking for new initiatives within the country will seek to make wider use of Hong Kongas a fund-raising platform and as a means of striking deals within the wider Asian capital

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pool. The help of Hong Kong’s professional service providers is also expected to besought out with regard to advising upon, executing and managing future projects withinRussia, particularly with regard to infrastructure development, finance, logistics,information technology, environmental protection and urban planning.

Among the key elements that paved the way to greater Hong Kong-Russian economiccollaboration was the early 2016 signing of a Comprehensive Double Taxation Agreement(CDTA) between the two, which then came into force in the July of the same year. Ataround the same time, a further boost came when the Hong Kong Stock Exchange(HKEx) approved Russia as an acceptable jurisdiction of incorporation for listingapplicants. At present, an Investment Promotion and Protection Agreement (IPPA) is alsobeing negotiated between the two. Once signed, it is believed, this will optimise thesynergy between the two trading partners, while also offering greater protection to bothHong Kong and Russia-based investors.

[1] According to the average RUB/USD exchange rate between 2011 and 2017

Copyright©2018 Hong Kong Trade Development Council. Reproduction in whole or in part without priorpermission is prohibited. While every effort has been made to ensure accuracy, the Hong Kong TradeDevelopment Council is not responsible for any errors. Views expressed in this report are not necessarilythose of the Hong Kong Trade Development Council.

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