KONSTANTIN TUBLIN RECALLS THE heady atmosphere of Russia in the early 1990s, after the collapse of Communism. Like many of his countrymen, the St. Petersburg book publisher brimmed with excitement at the prospect of freedom after seven decades of totalitarianism. Over time, however, he grew disillusioned by the political and economic chaos. Now, with President Vladimir Putin cracking down on oligarchs and terrorists alike and authoritarianism in the air, Tublin has tailored his ambitions to fit the new Russia.
“Freedom for Russians will only come with economic growth,” he says over drinks at a rooftop bar on a mild autumn afternoon. “Now I am thinking the most important thing is to get rich.”
Tublin is far from alone in his materialism. Russia is in the fifth year of a vigorous recovery, fueled by high oil prices, that has unleashed an unprecedented consumer boom. Russians are splurging: Personal consumption has grown at 8.5 percent a year on average since 2000, well above the 6.6 percent economic growth rate for
that time. The central bank forecasts that consumer spending will rise a further 9.9 percent this year, to more than $270 billion -- a remarkable total given the estimated GDP of $544 billion. Foreign and domestic makers of everything from refrigerators and televisions to automobiles and fine jewels are reaping the benefits.
One particularly popular item is mobile phone service. Some 60 million Russians had subscribed as of mid-2004 -- double the total of a year earlier and well above industry predictions. “A month rarely goes by without a revision of the forecasts of Russian mobile subscriber growth,” noted a July analysis by Pyramid Research, a Cambridge, Massachusetts, firm that keeps tabs on telecommunication companies around the world.
The former slaves to Communism now seem quite content to be slaves to fashion. Slava Zaitsev, the 66-year-old dean of the capital’s fashion designers, recently played host to an overflow audience, including youthful relatives of Russia’s oligarchs, for his winter ready-to-wear show at his central Moscow loft. Athletic men strutted down the runway in britches and knee-length jackets that evoked the czarist style in vogue among oligarchs and wanna-bes. Towering female models were swathed in rainbow-colored coats, an homage to peasant folklore. Receiving kisses and kudos backstage after the show, the impish designer, dressed in black with shirttails trendily exposed, insisted that his clientele is as eclectic as his collection.
“I don’t just work for the oligarchs and the politically powerful,” says Zaitsev. “My clothes are also for ordinary people.” Or, at any rate, those who can afford the $1,000-to-$10,000 price tags.
Many Russians can, and their spending power is attracting the attention of the country’s tycoons. These so-called oligarchs, most of whom made their fortunes from the country’s oil and mineral wealth, are expanding rapidly into the consumer sector, looking for the next bonanza. They also hope to stay clear of the state’s reach in the wake of Moscow’s aggressive pursuit of tax claims against Yukos Oil Co. and the jailing of its boss, Mikhail Khodorkovsky.
Mikhail Fridman, an oil billionaire with banking and telecom holdings, contends that consumer industries are a politically safer investment than hydrocarbons. He has been pouring money into consumer-related businesses, such as phone companies, banking and department stores, since selling a 50 percent stake in his oil interests to BP for $7 billion last year. “It’s a good idea to diversify away from natural resources into high-tech, finance, retail,” he says in an interview withInstitutional Investor(see box, opposite).
Other wealthy Russians have drawn the same conclusion. They include aluminum king Oleg Deripaska, who has branched into insurance; steel magnate Alexei Mordashov, who now manufactures cars; Andrei Melnichenko, who has spread his fertilizer earnings into finance and is a co-founder of MDM Bank, the largest commercial bank after Fridman’s Alfa Bank; and Yelena Baturina, who is the wife of Moscow Mayor Yury Luzhkov and rumored to be Russia’s wealthiest woman thanks to her real estate holdings.
Foreign fund managers are capitalizing on the trend. “We’re overweight in anything that has to do with consumer spending and consumer goods,” says Peter Elam Håkansson, chairman of Stockholm-based East Capital, which manages $450 million in Russian equities. His holdings include mobile operators Mobile TeleSystems and Vimpel-Communications, brewer Sun Interbrew and motor vehicle company Severstal-Avto, headed by Mordashov.
To be sure, Russia’s economy, which grew by 7.3 percent in 2003 and is estimated to expand a further 7 percent this year, remains largely oil-driven. “We estimate that the underlying base growth of the economy is about 3.5 percent -- the rest comes from the rising price of oil,” says Petr Smida, CEO of Alfa Bank. Putin, however, has made doubling average incomes over the next decade a top priority, and some analysts say that looks readily achievable, based on current trends.
It remains to be seen whether Russia’s consumer boom will lead to the production of domestic cars, electronic goods and clothes capable of competing with imports in price and quality. For now, too many Russians clearly believe that foreign means better. “Most Russians would choose a seven-year-old imported car over a new Lada or book themselves on British Airways instead of Aeroflot,” says William Browder, CEO of Hermitage Capital Management, a $1.5 billion fund based in Moscow.
Private sector manufacturing and services -- many catering to consumers -- are creating many more jobs than the public sector and are mainly responsible for the drop in unemployment, from 12.9 percent in 1999 to a projected 7.7 percent by the end of this year. Residential and commercial construction in big cities offers the most visible evidence of a sustained consumer boom. “In Moscow property prices are going crazy and there seems to be a crane on every block,” says James Fenkner, chief strategist at Troika Dialog, a brokerage based in the capital.
Nevertheless, Russia’s consumer boom may seem surprising given that in 2003 the country’s GDP amounted to just $433 billion, or $3,031 per person, about the same as that of Belize. “Absolute income levels in Russia are still low compared to those in developed countries,” says John Litwack, the World Bank’s chief economist for Russia.
What’s more, disparities are huge. One third of Russians live below the World Bank poverty line. That is especially likely if they don’t live in Moscow. Per-capita GDP for the capital’s 9 million inhabitants was $6,600, or more than twice the national norm, last year. A mere 23 oligarchs -- almost all of them Muscovites -- control 35 percent of the country’s sales, according to a World Bank report issued in April.
Look behind the data, though, and a more optimistic picture emerges. “Russians have much greater purchasing power than analysts imagine,” says East Capital chairman Håkansson. Start with the minimal cost of housing. After Communism collapsed most Russian families were given title to their dwellings. Electricity, heat and public transportation remain heavily subsidized thanks to huge government budget surpluses from oil and gas sales -- an estimated $20 billion this year on a $200 billion budget. “Oil revenues also permit the government to keep taxes low, and that helps private consumption,” says Willem Buiter, the London-based chief economist of the European Bank for Reconstruction and Development.
Russia has a flat income tax of only 13 percent, compared with marginal rates of up to 50 percent in Western Europe. Under the country’s socialized medical system, citizens pay no health insurance premiums. And almost nobody contributes toward a pension plan. Personal debt is only 3 percent of GDP, or $71 a person, compared with levels of up to 100 percent in the West.
“In effect, virtually all the cash Russians receive is available to spend,” says Neil Withers, a consultant at Vozrozhdeniye Bank, a Moscow private bank. “And why would they want to save it, if they don’t trust their banks?”
That’s a good question, considering that millions of Russians lost their savings in the 1998 financial crash and witnessed a run on deposits as recently as this summer, when a brief banking crisis erupted. Banks, for their part, are increasingly disposed to trust Russian consumers. “They are dramatically expanding their consumer credit activities,” says Ekaterina Trofimova, who covers Russian banking for Standard & Poor’s from Paris. According to her figures, Russian retail loans vaulted from $4.5 billion at the end of 2002 to $15 billion in mid-2004.
Yet with consumer spending estimated to reach above $270 billion this year, bankers think there is a lot more room for loan growth. “Most of the rise in consumer spending is coming from increased earnings capacity, not bank loans,” notes Nandan Mer, head of consumer business in Russia for Citibank.
Banks’ aggressive new courting of consumers is already conspicuous in the malls and at the large electronics and household goods stores that are sprouting in cities and suburbs. A June study by A.T. Kearney, a Chicago-based management consulting firm, ranked Russia as the top emerging market for direct retail investment -- ahead of China and India -- for the second year running. “A larger share of income here goes into shopping than in those other countries,” says Ruslan Korzh, Kearney’s Moscow director. “And a growing number of retailers are inviting banks to set up in-store facilities to extend credit to consumers.”
M.Video, a privately held, nationwide Russian chain of 41 stores selling household appliances and electronics goods, demonstrates how the outsourcing of consumer credit works. On a recent Saturday afternoon in its 1,800-square-meter store on Sadovaya-Spasskaya Street in Moscow, about a dozen blocks north of the Kremlin, shoppers lined up at the adjoining stands of five banks to apply for loans -- almost invariably for the first time in their lives -- to purchase refrigerators, televisions and stereo equipment. In most cases credit was granted within 15 minutes, allowing customers to finance their purchases in installments spread over six months. M.Video’s sales jumped 63 percent, to $573 million, in 2003, and consumer loans from banks financed 40 percent of those sales -- double the percentage in 2002.
By the end of this year, M.Video will have opened 12 more stores, giving the chain 27 outlets in Moscow and 26 elsewhere in Russia. While M.Video is the largest of the electronics retailers, it has several other large chain-store competitors, including Eldorado, MIR, Partia and Technosila -- all Russian-owned. All outsource their consumer credit operations to banks.
How do banks extend loans to consumers with no credit history? “Frankly, there is very little to go on, and that’s why consumer interest rates are as high as 30 to 50 percent a year for unsecured sales finance,” says Citibank’s Mer. With those kinds of rates, banks can easily afford to take risks on first-time loan applicants.
About a dozen banks, almost all Russian-owned, have embedded consumer loan officers in store chains. The pioneer is Russian Standard Bank, which has granted more than $1.5 billion in instant loans at retail outlets since 1999 and has issued more than 1.1 million credit cards, or about 75 percent of the country’s total.
Russian Standard reporteda profit of 1.98 billion rubles ($68.2 million) for first-half 2004, a stunning 373 percent rise from first-half 2003, mainly because of retail-outlet loans. These results persuaded France’s BNP Paribas to buy 50 percent of Russian Standard for $300 million in July.
Other foreign lenders are joining the hunt. In November, GE Consumer Finance, the global consumer lending unit of General Electric Co., completed its acquisition of DeltaBank, a Moscow-based retail bank, for an undisclosed sum. Delta reported profits of 65 million rubles for this year’s first half -- a big reversal from 2003’s 60 million-ruble loss, linked mainly to expenses involved in shifting toward retail-outlet lending.
Sberbank, the state-owned behemoth that accounts for 35 percent of all retail loans, has steered clear of store-based lending, as have most foreign banks, including Citibank. One reason is the absence of a Russian credit bureau that would allow banks to share clients’ financial histories. Although a law creating a credit bureau may pass early next year, banks will still have to engage in guesswork because so much of Russians’ income goes undeclared.
Employers are supposed to contribute 26 percent of employees’ salaries as U.S.-style social security payroll taxes, but many evade the law by encouraging workers to take pay in cash."We can’t always get a full declaration of income when customers apply for a personal loan or credit card,” says Citibank’s Mer. To help decipher real earning capacity, banks ask clients which neighborhoods they live in and which car models they own. They also look at bank statements to determine loan applicants’ cash flows. Mobile phone bills are particularly valuable for extrapolating income.
Indeed, mobile phone companies have emerged as one of the biggest beneficiaries of the consumer boom -- and one of the consumer plays most sought-after by portfolio investors. Nonexistent a decade ago, Russia’s mobile phone market is growing by about 3 million subscribers, or 5 percent, a month. Mobile companies expect that pace to persist until early 2006, by which time 70 percent of urban dwellers and 60 percent of Russians as a whole will own mobiles.
“After that the new growth wave in the business will be driven by value-added services, such as data transmission, mobile Internet and multimedia,” says Alexander Izosimov, CEO of Vimpel-Communications, the country’s second-largest cell phone operator, with a 33.7 percent market share as of September 30, just behind Mobile TeleSystems’ 36 percent.
Both VimpelCom and MTS are held by almost every Russian fund. “These are probably the most transparent companies in Russia and provide high levels of information to investors,” says Nadezhda Goloubeva, telecom analyst at Aton Capital, a Moscow brokerage. Fridman’s Alfa Group is VimpelCom’s biggest shareholder, with a 33 percent stake, and Telenor, a Norwegian telecom, owns 30 percent.
Fridman’s three-year-old investment has been fabulously profitable: The mobile operator’s share price rocketed from $15 in May 2001 to almost $127 last month. VimpelCom’s market cap is $6.8 billion. The company posted an 81 percent gain in income in 2003, to $234 million, as revenues rose 74 percent, to $1.34 billion.
But as the mobile telecom business demonstrates, Russia’s consumer sector is not immune to political interference. Thesiloviki-- former KGB officials who have gained influence in Putin’s administration -- seek to restore a measure of the Soviet state’s economic power. Other senior bureaucrats are following the lead of the siloviki. “Those in power want the state to penetrate every field of economic activity,” complains Fridman. “And there is nobody to resist them.”
The Alfa chairman has crossed swords with Telecommunications Minister Leonid Reiman over two major telecom companies -- state-owned fixed-line operator Svyazinvest and OJSC MegaFon, the private sector company that is Russia’s third-largest mobile operator, with 20 percent of subscribers. The battle began in the summer of 2003 when Reiman indefinitely postponed the sale of the government’s 75 percent stake in Svyazinvest, which had been planned for 2004. The minister said privatization would have to await further “internal reforms” to improve Svyazinvest’s efficiency. Alfa Group had been viewed as a likely buyer because it already owned a controlling 30 percent share of a private sector fixed-line operator, Golden Telecom.
Shortly after the postponement, in August 2003, Fridman and Alfa startled the industry by paying $310 million for a 25.1 percent stake in MegaFon, a mobile operator that was founded by Reiman and is 31 percent owned by a St. Petersburgbasedinvestment firm, Telecominvest, that also was founded by the minister. Alfa bought the stake from an investment firm, LV Finance. A Bermuda-based trust, IPOC International Growth Fund, which itself owns 6.5 percent of MegaFon, filed suits in Russia, Switzerland and the British Virgin Islands to block Alfa’s purchase, claiming it had an option to buy the stake.
In a November 11 news conference in Moscow, Reiman stated that although he was indeed the founder of Telecominvest and NorthWest GSM, which later became MegaFon, neither he nor any family members still held shares in either company.
The minister also lashed out at Alfa and Fridman, accusing the conglomerate and its chairman of seeking to pressure him into backing Alfa’s 25 percent purchase of MegaFon. He said he might consider going to court to defend his reputation. A spokesman for Alfa responded by saying, “We aren’t avoiding litigation if someone seeks to reveal the truth, because we feel that our position is very strong.”
For his part, Fridman says Reiman’s past ties with Telecominvest and MegaFon “are causing me problems.” He insists his main motive for buying the MegaFon stake was short-term profit, and he estimates that Alfa’s $300 million holding has doubled in value over the past year. But Fridman could reap other, bigger benefits. “If peace prevails between us and Telecominvest, there might be a merger between impelCom and MegaFon that would create the largest mobile telecommunications company in the country,” says the Alfa chairman.
With Fridman’s political clout -- like that of other oligarchs -- on the wane, VimpelCom is seeking to distance itself from Alfa and develop its own ties with the government. “Too often we are thought of as part of the Alfa Group, which we are not,” says CEO Izosimov. “It’s in the interest of all shareholders to see VimpelCom standing on its own feet.”
Some telecom analysts, however, contend that the outcome of the MegaFon battle will largely determine whether the market accepts VimpelCom’s assertions of political independence. “The most important issue facing VimpelCom is who will win out, Fridman or Reiman,” says Aton’s Goloubeva.
Clearly, investing in the Russian consumer sector poses complications worthy of a Russian novel. Yet Fridman maintains that it still holds ample opportunities. Gøran Olson, head of the Moscow office of Telenor, VimpelCom’s other big partner, goes so far as to say that Russia’s very unpredictability is part of what makes it so attractive, at least for his company.
“Even if the political situation is stable, nobody can say for certain what economic direction the country is taking,” says Olson. “But then again, if there were no risks, there would be a lot less upside to investments, wouldn’t there?”
