Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm ISBN-13: 978-951-40-2009-4 (PDF) ISBN-10: 951-40-2009-X (PDF) ISSN 1795-150X Factors Affecting Investments in Northwest Russian Forest Sector and Industry Päivi Holopainen, Pekka Ollonqvist and Jari Viitanen www.metla.fi Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Working Papers of the Finnish Forest Research Institute publishes preliminary research results and conference proceedings. The papers published in the series are not peer-reviewed. The papers are published in pdf format on the Internet only. http://www.metla.fi/julkaisut/workingpapers/ ISSN 1795-150X Office Unioninkatu 40 A FI-00170 Helsinki tel. +358 10 2111 fax +358 10 211 2101 e-mail julkaisutoimitus@metla.fi Publisher Finnish Forest Research Institute Unioninkatu 40 A FI-00170 Helsinki tel. +358 10 2111 fax +358 10 211 2101 e-mail info@metla.fi http://www.metla.fi/ 2 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Authors Holopainen, Päivi, Ollonqvist, Pekka & Viitanen, Jari Title Factors affecting investments in Northwest Russian forest sector and industry Year 2006 Pages 49 ISBN ISBN-13: 978-951-40-2009-4 (PDF) ISBN-10: 951-40-2009-X (PDF) ISSN 1795-150X Unit / Research programme / Projects Finnish Forest Research Institute, Joensuu Research Unit / 3384 Development of forest sector in Northwest Russia and its impact in Finland Accepted by Timo Karjalainen, Head of the Consortium “Development of forest sector in Northwest Russia and its impact in Finland”, 18 August 2006 Abstract While most of the equipments, machinery and capacity investments in Russian forest sector dates back to 1970’s, they are mostly out-of-date, wastefully, environmentally damaging and the productivity of them is weak. Domestic possibilities to finance forest investments in Russia are still under developing, and the forest sector is not attractive among Russian investors due to the more profitable sectors such as energy, technology and metal clusters. Therefore, the forest sector calls urgently for forest investments to develop, to create more value added production and to survive in international competition in final product markets. Along with the global profit maximisation many foreign forest enterprises have established especially in Northwest Russia during 1990’s and 2000’s. However, most of these investments are of small-scale (saw- and veneer mills, packaging plants), and they can be seen as pilot investments to test market environment and, especially, the working of wood procurement. This study shortly considers the factors affecting foreign forest sector investments in Russia, and especially in Northwest Russia. The viewpoint is mostly of Finnish forest enterprises and investors. Forest resources, competitive other factors of production and developing domestic final product markets can be seen as supporting factors for forest investments in Russia. Also, the vertical integration strategies and wood procurement of international forest companies over the national boarders are important factors to determine the location of investments. The impeding factors in Russia are incompleteness of Forest Code giving at the moment unclear rules for forest leasing, management and silviculture, unpredictable political system and trade policy, deteriorating external price competitiveness in international markets, business culture and weak infrastructure. Keywords Russia, forest investments Available at http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Replaces Is replaced by Contact information Pekka Ollonqvist, Finnish Forest Research Institute, Joensuu Research Unit, Yliopistokatu 6 (P.O.Box 68), FI-80101 Joensuu, Finland. E-mail: pekka.ollonqvist@metla.fi Other information 3 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Contents Contents.........................................................................................................................4 Preface ...........................................................................................................................5 1 Introduction ..............................................................................................................7 2 Background of Joint Activity between Finnish and Russian Forest Sectors and Industries ..................................................................................................................9 2.1 Co-operation in Soviet Period.............................................................................................9 2.2 Trade and Business during Russian Era............................................................................10 2.3 Alternatives to Process Russian Roundwood....................................................................14 3 Russian Macroeconomics .....................................................................................16 3.1 General Economic Development ......................................................................................16 3.2 Exchange Rate Effects ......................................................................................................19 3.3 Financial Markets..............................................................................................................22 3.4 Threats for Economic Development in Russia .................................................................23 4 Forest Sector and Its Development in Northwest Russia...................................24 4.1 Forest Resources in Northwest Russia – Accessibility and Use .......................................25 4.2 Other Factors of Production..............................................................................................29 4.3 Infrastructure and Logistics ..............................................................................................31 4.4 Forest Product Markets .....................................................................................................33 5 Institutional Factors Affecting Investments .........................................................35 5.1 Legislation Aspects...........................................................................................................35 5.1.1 General Legislation................................................................................................35 5.1.2 Investment System Guarantee ...............................................................................36 5.1.3 Forest Legislation and Its Reform .........................................................................38 5.2 Social Responsibility ........................................................................................................39 6 Business Culture.....................................................................................................40 6.1 Decision Making System ..................................................................................................40 6.2 Time and Quality Management.........................................................................................41 6.3 Attitudes towards Foreign Business Partners....................................................................42 7 Conclusion...............................................................................................................43 Acknowledgements ....................................................................................................45 References...................................................................................................................45 Appendix: Key Factors and Their Relative Importance for Forest Investments...48 4 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Preface During the last fifteen years, operational and business environment in Russia has been under rapid unexpected changes. The collapse of the Soviet Union and the followed financial crises after the free-market experiments introduced business uncertainty. Changes and aims behind political decisions, depreciation of rouble in 1998 together with rapid economic growth during 2000’s have also been partly unpredictable and challenges especially for foreign investors. Even though development towards more transparent business culture is progressing in Russia, operators, both domestic and foreign ones, in many cases have still to make their operational decisions under unpredictable circumstances and high business risks concerning the operational profits. In spite of the difficulties to operate in Russia, several western firms, including many Finnish ones from different kinds of economic activity, have been attracted by profitable possibilities of Russian markets. Establishment in Russia has been carried on by direct green field investments, purchasing existing capacity and operational chains, or by joint ventures with Russian partners. Among those enterprises are also several foreign forest industry companies, which have been attracted especially by Russian unused allowable cut reserves and forest product markets with low current consumption. Also, Finnish forest industry enterprises have built few saw- and veneer mills and packaging plants in Northwest Russia. Nevertheless, Finnish forest industry enterprises have been claimed for too slow progression to establish in Russian markets. While plans and background information for more extensive investments, such as paper and pulp mills, have been prepared, the investments themselves have been firmed up. Also, small and medium sized enterprises have been quite reluctant to increase their activity in Russia or to joint to co-operation projects. Legislation reforms, especially Forest Code renewal, are undoubtedly among the most important factors for the development process of Russian forest sector. From foreign investors’ point of view, issues such as availability of property rights, leasing contracts, forest management and silviculture, labour legislation, customs policy, taxation system and main features of trade policy are essential criteria while planning investments and establishment to Russian market. Often foreign operators claim that they cannot receive equal position and possibilities to operate in Russia compared to the local operators, though on the basis of the spirit of current legislation, operators should not be discriminated. Russian culture in general and business culture in particular are challenging to western business partners and have clearly impacts on operators’ working habits and manners. Therefore, understanding and considering cultural differences could help to solve at least some of the appearing problems during establishment to new market area. The aim of this survey is to shortly consider the factors behind the slow progression of direct forest investments in Northwest Russia, and evaluate the convenience and rationally behind this policy. Unlike many other foreign forest enterprises, Finnish forest companies have avoided several essential problems and conflicts related to social responsibility of investments, cultural 5 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm differences and, especially, to wood procurement with slow progression in Northwest Russia. This does not mean that Finnish forest enterprises would have managed to handle their establishment to Russia totally without difficulties, but slow adjusting process has undoubtedly been beneficial in avoiding biggest mistakes in Russian market. This survey describes those features of economy and societal system, which can be estimated to be the most significant from foreign forest operators’ standpoint despite the strategy operator has decided to use while entering to Russian market. 6 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm 1 Introduction Russian forest sector has undergone a deep structural change since the collapse of Soviet Union. The forest sector in Russia has adapted to new market and competition based business environment along with the changes in social and political systems, institutional settings and general economic development. Even though the forest sector in Russia has developed during the recent years, there are still many fundamental issues which hinder further development. Some to mention, the inherited machinery, equipments and technology from the Soviet era are mainly out of date or economically inefficient, the business culture are still proceeding towards market orientating thinking, the management of forests and legislation related to forest leases are under construction, and the lack of infrastructure calls for investments to better access to forest resources. The role of Russian forest sector in the global scale has so far been mostly as a raw material producer for export or as a producer of low value added products (Mutanen et al. 2005). Therefore, Russian forest sector urgently calls for maintaining and green field investments, either from domestic or foreign origin, to survive in international competition and to provide higher value added domestic production The Federal Government of Russia has taken a new initiative to promote the modernisation of Russian forest sector and business related to it. The adoption of the Forestry Development Concept for 2003 – 2010, and Timber Industry Development Guidelines for the period up to 2015 has been presented by the President of Russia to be adopted as agendas towards progressive forest sector in Russia (Putin 2006). The objective is politically one of the main aspects to develop Russian forest sector, and the immediate promotion was an announcement of increase in tariffs for roundwood exports. Recently, an extensive literature has explored the economic development and success of Russia and other Eastern transitional economies, and it is even not possible to summarise all the recent contributions (among others, see Sutela 1998, 2003, and Alapuro et al. 2004). Also, there are many studies concentrating on the investments, investment behaviour and business activity in Russia (World Bank 2004, Filippov et al. 2005). However, those studies are typically depicting general economic development with multi-sectoral approach, or describing case studies of experiments of foreign firms to establish in Russian markets (Karhapää-Puhakka 2004, Mäkinen 2005). Even though they provide a good understanding of the background of the economic development and give general aspects for investments in Russia, a closer forest sector specific analysis for investment behaviour is needed. This follows from the specific characteristics related to forest sector in general, and the use of forest related resources in particular, such as requirements for logistics, wood procurement and accessibility to forest resources. The existing studies concerning Russian forest sector either do not account investments (World Bank 1997, Unece 2003), their purposes are somewhat different (Ovaskainen et al. 1999, Nilsson and Kleinhof 2001, Piispa et al. 2006), or they need updating (Dudarev et al. 2002, 2004, Makkonen 2003). To our knowledge, however, Nilsson and Söderholm (2002) and Filippov et al. (2005) are only attempts to evaluate the institutional obstacles for direct forest investments in Russia. 7 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Typically, an investment decision in market orientating business strategy is based on the careful planning, where the profitability of investment is assessed from different perspectives. The global forest industry companies do not make any exception from this working. The rate of return and discounted present value of the investment are most commonly used indicators to evaluate the profitability of the investment decision. However, in the background there are many aspects that are affecting on these indicators, such as stability of the economy including legislation and its enforcement, infrastructure, business climate and the availability of the factors of production. In forest sector, perhaps the most important factor is the Forest Code, the content of which is still under reconstruction. This paper tries to give a short overview of the factors which are likely to impede or support investment behaviour in Russian forest sector. The viewpoint of the study is mainly from Finnish perspective and concentrates only on Northwest Russia. The latter is due to the ongoing forest investments of Finnish enterprises. Most the recent investments of Finnish forest firms to Russia have been implemented in Northwest Russia, while some of the investment possibilities are under evaluation. The main conclusions, however, can be applied with some cautions for other regions of Russia as well as for some other industries. The paper is organised as follows. Chapter 2 gives a short review of the history of the co- operation and trade between former Soviet Union, Russia and Finland. The Chapter also shortly describes how Northwest Russia has been a competitive source of roundwood for Finnish forest industry complementing partly domestic supply, and how the recent investments in Northwest Russia has been gradually integrated as a part of the global strategy of forest companies. In the light of this overview, it is then easier to understand the current state of the forest sector and industry, and the investment requirements the sector in Northwest Russia needs to be able to develop and survive in international scale. Chapter 3 gives a general description of the development of macroeconomic fundamentals in Russia from the viewpoint of economic interests of forest sector enterprises. A special emphasis is given to the close connection of the foreign trade, which is dominated of oil exports and exchange rate development. The economic policy executed in Russia is highly dependent on the oil sector success and income, which gives challenges as well as opportunities to the current forest sector investment options. The Russian industrial forest resources are frequently referred to when forest investment options are discussed. However, the commercial use of Russian forest resources is limited by the poor infrastructure what concerns logging, hauling and transportation. The challenges related to the improvements in the commercial use of timber resources, that is, availability and accessibility of wood resources for the new capacity investments, as well as other necessary factors of production are discussed in Chapter 4. The chapter also includes an overview on the forest product markets. In Chapter 5 we characterise the institutional factors which affect investments and establishment of foreign enterprises in Russian markets. In forest sector, among the most important institutional factors are social responsibility of business, which slightly differ from that of the western corporate social responsibility, general legislation and, especially, Forest Code, which defines the rights and responsibilities for operations in forest sector. 8 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Chapter 6 concentrates on analysing business culture in Russia, and how it differs from western business culture. Also, we give a short review on other general Russian-specific characteristics, which are likely to have effects on business and establishment of the enterprises in Russia. Finally, Chapter 7 concludes with some critical remarks. In Appendix we present a profile for investment environment, especially from the standpoint of forest industry, which shortly summarise the main findings and their relative importance for investment decisions. 2 Background of Joint Activity between Finnish and Russian Forest Sectors and Industries There have been two main reasons why Finnish forest companies have been interested in Russian roundwood resources. The first reason relates to the deficit between domestic supply and (planned) industrial use, and the second one is due to the price competitiveness of imported roundwood with respect to the domestic supply. The roundwood imports during the Soviet period was for the most based on shortages of domestic pulpwood, mainly hardwood. This period is discussed in Section 2.1. During the Russian era, enhanced price competitiveness of logs increased both absolute and relative shares of log dimensions in roundwood import. This period is discussed in Section 2.2. The current import shares of softwood and hardwood are about 16 and 53 percent of the total annual industrial use of roundwood in Finnish forest industry, respectively. The alternative of processing of that amount of roundwood in Russia instead of import it to Finland is discussed in Section 2.3. 2.1 Co-operation in Soviet Period During the Soviet era the co-operation between Finnish and Russian operators in forest sector was highly controlled and limited. The first increase in volumes of imported roundwood to Finland was from 3 million cubic meters to 6 million cubic meters during 1973 – 1976. This growth was closely connected to the adoption of price contracting system between the major Forest Industry Firms (FIF) as buyers and the organisation representing Non-Industrial Private Forest Owners (NIPFO) as sellers (Kahiluoto 1988, Viitala 2002). Because of the increased import volumes a need of public management of roundwood market became obvious, and a committee was nominated to manage import (Komiteamietintö, Tuontipuutoimikunta 1977:50). Public management was institutionalised by establishing a permanent advisory group, Tuontipuulautakunta from 1978 to 1987, to control roundwood imports in order to stabilise the domestic market equilibrium. The second type of market contracting to govern all timber species and markets in the whole country was introduced in 1977. At that time, forest industry counted import volumes before making any wood procurement contracts from domestic markets. Average annual import volume grew to 6 million cubic meters, and the peak volume at 1984 was 7.6 million cubic meters (Fig. 1), of which 86 % originated from Soviet Union. 9 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm 0 5 10 15 20 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 Mill. m3 0 0.25 0.5 0.75 1 Impor t share Impor t volume Import shareprice cont ract type I price contarct type II reg price cont r Fig. 1. Industrial use of imported wood material (roundwood and wood residue) to Finland, 1955 – 2004 In general, the growth in roundwood import volumes to Finland until 1991 was rather modest even though some annual deviation existed due to the contract policy and domestic wood supply. The import volumes were involved partly in the five year barter contracts between Finland and Soviet Union, and annual trade volumes were decided beforehand among major Finnish roundwood importers. Thus, the significance of real demand and supply was marginal, and due to the contracts involved in barter trade it would be therefore misleading to discuss about market forces in roundwood trade between Finland and Soviet Union. 2.2 Trade and Business during Russian Era Under the price contracting regime in Finland, roundwood import comprised almost exclusively pulpwood timber species. Almost parallel with the collapse of Soviet Union, the domestic roundwood price contracting was ceased in 1991. In Finland, public evaluation in 1993 considered that 3.5 million cubic meters annual hardwood pulpwood import is a necessity to complement domestic wood procurement. However, immediately after the structural breaks in price contracting system in Finland and political system in Russia, the volumes of imported roundwood increased rapidly (Fig. 1), and the distribution of timber assortments started to diversify parallel with the increase in total volume (Fig. 2 and 3). Among other things, the reason for the increased roundwood trade can be understood by the societal changes in Russia in the beginning of 1990s. The change in policy regime in 1991 in Russia was rapid and the adoption of new societal system together with the market-base way of thinking, the challenges to survive in international competition and to ensure price competitiveness of domestic forest sector also challenged the forest industry enterprises. Most 10 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm of them were privatised in the beginning of 1990s, and the domestic forest products markets were opened for free competition. While the products of the Russian forest industry were rarely competitive with foreign products mainly due to the inherited lack of incentives to respond to customer-orientated demand, only low value added products, such as roundwood, plywood and sawn timber were relatively high competitive export products (Vinokurova et al. 2005). To be able to maintain the existence of business and to avoid bankrupt, the Russian enterprises were eager to increase co-operation and trade with foreign partners and receive currency income. This, among many other things, explains the vast increase of roundwood trade to Finland and many other countries.1 0 2000 4000 6000 8000 10000 12000 14000 16000 1989 1992 1995 1998 2001 2004 Pine logs Spruce logs Birch logs Pine pulp Spruce pulp Birch pulp 1000 m3 Fig. 2. Distribution of imported roundwood from Russia, 1989 – 2005 As can be seen from Figures 2 and 3, the export volumes from Russia to Finland as well as the distribution of timber assortments has increased after the beginning of 1990s. Even though birch pulpwood is still the most significant article in Finnish-Russian roundwood trade, the coniferous logs have become more important in trade. Especially the share of spruce logs, accounting about 15 percent of the total roundwood trade to Finland in 2004, has increased considerably after the devaluation of rouble in 1998. The large share of birch pulpwood is explained by the fact that in Russia there is not any consequential hardwood utilising forest industry capacity. As discussed in Vinokurova et al. (2005), while the stands in Russia include mixed species and while the legislation obligates to cut all the wood from the stands, logging companies do not hesitate to sell hardwood even for low price to receive at least some income. For Finnish forest enterprises, the roundwood imports from Russia offered a way to achieve cheap raw material. Also, while there were some lacks to acquire deciduous pulpwood in Finland, imported birch pulpwood complemented domestic hardwood procurement. Import growth has been stabilised 11 1 Viitanen et al. (2006) describe that the roundwood trade volumes in Northern Europe originates mostly from east (Russia, Baltic States) to west (Finland, Sweden, Norway). Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm from 2001 on mainly because of the difficulties on the accessibility on the new high quality stands in Northwest Russia, and increased unit prices for the imported assortments. Especially, because of the increased demand and competition of spruce logs and revaluation of rouble, the unit price of them has increased considerably in recent years (Metinfo 2006). 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 0,62 0,44 0,05 0,29 0,13 0,15 0,09 0,03 0,01 0,05 0,14 Spruce pulp Pine pulp Spruce logs 0,00 regional/ f irm price cont ractsprice cont r Percent share Hardwood pulp Hardwood logs Pine logs Fig. 3. Percent shares of imported roundwood from Russia, 1989 – 2005 The transition from barter trade to market base competition did not go along without complication. During the period of barter trade between Finland and Russia, only the big Finnish merchant houses had prominent positions in roundwood trade operations. Since the collapse of the Soviet economy, these merchant houses, which were among the major Finnish firms, had adequate experience, knowledge and contacts to directly continue the co-operation and trade from the base of barter trade tradition. Clearly, immediately after the change in policy regime in Russia, this experience from Soviet time generated competitive advantage for Finnish forest companies with respect to other foreign competitors. From the Russian side, the transition to market orientating trade and business was not that easy. During the Soviet time, only Soviet merchant institute managed all international trade contracts. This institution was divided into major economic sectors and experts there had only limited engineering knowledge of barter trade activities. The firms typically had no direct business contacts to abroad. Also in Soviet Union, the total separation of international trade and domestic forest sector activities in industry and timber management complicated the adoption of comprehensive international co-operation. Thus, only limited number of experts, who had some experience from roundwood trade, was able to attend international trade and acquire competent trade partners from 1992 on. Majority of roundwood suppliers were totally unaccustomed with features of market trade such as pricing, delivery and quality rules. During 1990s, because of 12 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm the learning from mistakes and continuous doing on business, the trade infrastructure has however gradually become more stable improving the quality of trade co-operation. Table 1. Physical forest investments of Finnish origin in Russia Plant Capacity, per year Year Investor Sawmills Impilahti 100 000 m3 2003 StoraEnso Nebloch 100 000 m3 2004 StoraEnso Pestovo 300 000 m3 2004 UPM-Kymmene Podporodzie 200 000 m3 2005 Metsäbotnia Suda 100 000 m3 2007 Metsäbotnia Vologda 20 000 m3 2007 Koskisen Veneer mills Tshudovsky 60 000 m3 1988 UPM-Kymmene Tshudovsky 10 000 000 m3 2003 UPM-Kymmene Vologda 40 000 m3 2008 – 2010 Koskisen Cardboard Balabanovo 105 000 000 m2 2002 Stora Enso Arzamas 120 000 000 m2 2004 Stora Enso Lukhovitsky 150 000 000 m2 2008 Stora Enso Board shells St. Petersburg 4000 t 2001 Ahlström Along with the increased roundwood trade to Finland, Finnish forest industry has also focused on the investments of forest industry process capacity in Northwest Russia. Table 1 depicts the recent forest investment projects of Finnish origin.2 While these investments, comprising of small-scale saw- and veneer mills and cardboard production, can be seen so far more as pilot projects and tests for the fluent wood procurement, other factors of production and development of forest product markets, the interests of the Finnish firms has also partly been due to the changes in the business infrastructure in Russia. Federal Government of Russia has started to support development towards increased domestic use of roundwood and more value added production in Northwest Russia (Kivelä 2006). In the future, this new political infrastructure may dramatically change the usage and export of roundwood from Northwest Russia, and consequently have economic impacts both on Finland and Northwest Russia because of the relocation of roundwood industry production. 13 2 Finnish origin companies, such as Thomesto, have also bought or they are partners in many wood procurement firms in Russia. The total value of Finnish based forest sector investments in Russia is about 300 million euros. In 26.6.2006 Ruukki Group signed preliminary contract to build sawmill and veneer mill in Kostroma area. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm 2.3 Alternatives to Process Russian Roundwood The use of coniferous logs imported from Russia to Finland has gradually increased. As can be seen from Table 2, dependence on imported logs has increased in Finnish wood product industries from an average of 3 percent in 1995 – 1998 to 13 percent in 1999 – 2005. Theoretically, current import volumes of coniferous logs will feed 6 – 8 large industrial sawmills in Finland annually. However, the realised use of imported logs has been distributed to numerous mills implying that there does not actually exist any strict dependence on imported coniferous logs. The dependence on imported deciduous logs (mostly birch) is more drastic. In 2004, 32 percent of total industrial deciduous log use in Finland was based on imported logs. This share is not easily substituted from domestic stands. In future, multinational Finnish forest companies have different alternatives to ensure wood procurement for sawmills and paper and pulp mills. The first strategy is – ceteris paribus – to continue import of logs from Russia. Second, the distribution of sawmill capacity can be reorganised by processing the current import volumes in new invested plants in Russia, and by importing the sawmill residue as a by-product to pulp and paper mills in Finland. The third alternative is to centralise sawmill capacity to Finland, and purchase the needed volumes of logs from domestic market. All of these alternatives include risks and many uncertainties. The first strategy is unlikely to be fulfilled because of many economical and political reasons discussed in more details in the following chapters. The second alternative implies lease contracts that may become more predictable in the future (depending on recent authority decisions and operating in inferior infrastructure with expensive investment requirements together with many societal and political uncertainties discussed also in the following chapters). The third alternative concerns purchasing the required log volumes from diversified NIPFO markets in Finland, where log supply can change over the time, but where the operational environment (infrastructure, TGM applied in harvest and transports) is rather stable.3 The profitability of each of these strategies requires calculations, evaluations of the possible risks and then comparisons of investment alternatives. Majority of annual variable costs of sawnwood production are lower in Russia than in Finland. On the other hand, fixed costs are the most important costs supporting production in Finland. Investments to sawmill capacity in Finland are currently replacement investments in the existing plants diminishing the infrastructure costs of investments. In Russia, majority of investments are green field implying outlays to construct infrastructure (roads, roundwood storages, mill transportation…) in addition to the direct investment costs (see also Piispa et al. 2006 and their Appendix 2). These costs must be compensated by the discounted differential in the annual costs of production between Finnish and Russian mills. 3 See Ollonqvist et al. (2006) for more on the delocalisation strategies of Finnish forest enterprises. 14 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Table 2. Volumes (Mill. m3) and share of imported logs from Russia used by Finnish wood product industries, 1995 – 2004 Softwood Domestic Import Total %-share of imports 1995 – 1998* 25,0 0,8 25,8 3% 1999 – 2004* 27,9 3,2 31,1 10% Change 2,9 2,4 5,3 2004 27,7 4,0 31,7 13% Hardwood Domestic Import Total %-share of imports 1995 – 1998* 1,3 0,2 1,5 14% 1999 – 2004* 1,2 0,5 1,7 30% Change -0,1 0,3 0,2 2004 1,2 0,6 1,8 32% * Average values Table 3. Volumes (Mill. m3) and share of imported pulpwood and sawmill residue from Russia used by Finnish pulp and paper industry, 1995 – 2004 Softwood Domestic Import Total %-share of imports 1995 – 1998* 20,8 1,9 22,7 8% 1999 – 2004* 21,4 2,4 23,8 10% Change 0,6 0,4 1,0 2004 22,0 2,9 24,7 12% Hardwood Domestic Import Total %-share of imports 1995 – 1998* 5,2 5,2 10,4 50% 1999 – 2004* 5,9 7,2 13,1 55% Change 0,7 2,0 2,7 2004 6,7 7,9 14,5 54% Wood residue Domestic Import Total %-share of imports 1995 – 1998* 10,1 0,7 10,8 6% 1999 – 2004* 11,2 1,4 12,6 11% Change 1,1 0,7 1,8 2004 10,9 2,2 13,1 17% * Average values 15 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Dependence on imported roundwood in Finnish pulp and paper industries is more complicated, because it is also dependent on the investment strategies and location of wood working industries. Table 3 depicts the domestic use of pulpwood and wood residue, import volumes and their percent shares of total use in Finland. As can be seen from the Tables, the share of imported coniferous pulpwood has slightly increased during the last ten years. In 2005, the use of imported coniferous pulpwood (3,8 mill. m3) still increased and constituted about 20 percent of the total use in Finland. The dependence on imported hardwood is even higher constituting over 50 percent of the total use. In addition, the combined volumes of the imports of wood residue (4,3 mill. m3 in 2005) and residue produced in Finland from imported softwood logs (1,9 mill. m3 in 2005) are higher than the imported coniferous pulpwood from Russia to Finland. The following chapters concentrate to analyse the factors which are likely to affect forest investments in Northwest Russia. While it is not possible in this survey to go any details behind the investment decision4, the accessibility to the aggregate wood resources as well as macroeconomic indicators and other societal specific factors give insight of the profitability and risk of forest investments. 3 Russian Macroeconomics 3.1 General Economic Development To understand thoroughly the investment behaviour, financial possibilities and other factors supporting and impeding sectoral investments in Russia, it is essential to describe and understand the general economic development, and anticipate the factors which are likely to affect this development in the near future. Macroeconomic indicators give insight on the directions towards the country is proceeding, and about the general circumstances and atmosphere for investments. The beginning of the Russian Federation was not an economic success. Starting from 1992 the GDP was ever decreasing in Russia, and in 1998 it amounted to only about two third compared to that in 1992.5 During the same time period investments collapsed about 60 % (see Fig. 4). The reason for this regressive development was manifold. During the Soviet era, the domestic production was controlled and determined by the central planning authority, which mainly promoted large scale industry complexes. While most of the industrial production was based on the standardised products, there were little incentives for research and development activity or production innovations, the only exception being the military sector. Also, domestic industrial sector was protected from import competition, which reduced further the need for innovations. 4 For example, the rate of return calculations is specific for firm, location, production article and final market, among others. 16 5 According to Shleifer and Treisman (2005) Russia’s economic performance in the 1990’s is underestimated. They argue that the size of unofficial economy, underreported production and other statistics reveal that the actual economic development has been far better than officially reported. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Due to the socialistic system and idea, the unemployment rate in Soviet Union was low. However, the productivity of labour was low as well, and enterprises were committed to maintain and finance many social responses such as schools and public infrastructure. The lack of cash flow and finance possibilities impeded and delayed investments. 0 20 40 60 80 100 120 1992 1994 1996 1998 2000 2002 2004 GDP Investments Production Fig. 4. Annual GDP, investments and industrial production, 1992=100 (Source: BOFIT and Rosstat) After the fundamental change in policy regime in 1992, enterprises were largely privatised, domestic markets were opened and they were challenged to the international competition. While the Russian standards and most products did not meet the demand in international markets, the domestic enterprises plunged into difficulties together with increasing import volumes, and out- of-date and inefficient production technology. Only raw materials were relatively highly competitive products and their exports, dominating the total exports, increased until the year 1997 (see Fig. 5). The income from export surplus were largely invested abroad to avoid income taxes. In turn, this led to the Federal budget deficit. In August 1998, a financial and economic crisis broke out in Russia.6 As will be discussed in more details in the next section, one consequence of this crisis was a devaluation of Russian rouble. As can be seen from Fig. 4, the immediate impacts of the change in exchange rate regime was that GDP and, especially, investments in Russia started increasing. The monetary external surplus was achieved in spite the modest increase in the total export because the aggregate annual volume of import nearly halved (see Fig. 5). The external surplus materialised in a rapid economic recovery and aggregate domestic GNP recovered rapidly back into the 1997 level in 1999. This was a result from low exchange rate which improved price competitiveness of export business and at the same time provided competitive advantage on domestic industry towards import. The average annual GDP growth has thereafter exceeded 6 percent. 17 6 See Komulainen and Korhonen (2000) for a thorough understanding of the reasons, background and effects of the crisis. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm 0 50 100 150 200 250 1992 1994 1996 1998 2000 2002 2004 Import Export USD Billion Fig. 5. Russian foreign trade, USD billion (Source: BOFIT, Rosstat) Since the economic crisis, Russia has rapidly achieved strong positions of trade, current account and federal budget surpluses. The current account surplus, which increased from zero in 1998 to over 60 billion USD in 2004, has been based on the production of raw materials and export incomes from gas, crude oil and other low value added products (Fig. 6). The strong export market competitiveness has increasingly been based on low costs of production supported by the depreciation of rouble. During 2000’s, Russia has earned over 40 % of total export incomes from crude oil and gas exports. While the annual growth of crude oil export volumes has been only few percents, the sharp increase in world market prices has accelerated the trade surplus to surge to about USD 100 billion at the end of 2005. -10 0 10 20 30 40 50 60 70 1993 1995 1997 1999 2001 2003 0 50 100 150 200 250 Current account Inflation USD billion % Fig. 6. Current account and inflation in Russia (Source: BOFIT, Rosstat) 18 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm The sharp decrease of import after the devaluation of rouble in 1998 has recovered through the increased purchasing power of all social groups in Russia. Part of these earnings has been directed to increased consumption that has also boosted domestic inflation. Even though there are large regional differences between income distributions, the demand for Western goods and services has remained strong. Especially, transport equipments and machinery constituting investment commodities comprise over half of the imports from non-CIS countries and about one fourth from CIS countries in 2004. While the production machinery in forestry sector is largely out-of-date in Russia and the domestic forest sector lacks of finance and technical innovations, it is suspected that most of the forest investment goods are of foreign origin also in near future. During 2000s, general macroeconomic development has been stabilised in Russia. After the hyperinflation in the beginning of 1990’s and the peak due to the economic crisis in 1998, the annual inflation rate has decelerated slightly above 10 percent in 2000’s (Fig. 6). Foreign currency debt, that increased throughout the late 1990’s and recorded in 1999 (88 % of GNP), has been repaid at good international level (18 % of GDP) in 2004 by the help of positive trade balance. The growing world market demand for oil and gas together with increasing unit prices of oil has accumulated foreign currency surplus in Russia. The real lending interest rate has been zero or negative from 2001 on and made costs in loan financing favourable what concerns debt financing of investments. Also, the term of payment of loans has increased. On the other hand, negative deposit interest rates since 1997 have boosted non-monetary domestic investment financing. 3.2 Exchange Rate Effects In August 1998, due to the massive capital outflow, sharp decrease of equity prices and increase in interest rates, rouble was allowed to float and it depreciated from 6 to about 20-25 RBL for one USD. An immediate consequence of the crisis and the change of the exchange rate regime was the collapse of the banking system, default of debts, and decrease of asset and saving values. Because of the devaluation, and especially, increase of the world market prices for raw materials, such as crude oil and gas, Russia’s current account has turned to surplus and thereafter there has not been any strong external pressure against the nominal exchange rate. As can be seen from Fig. 7, the exchange rate of rouble against dollar has been rather stable since March 1999. During the same time period, the market development between euro and dollar can be seen as a main reason for rouble’s depreciation against euro. Between 2002 and 2005 rouble has depreciated about 28 percent against euro even though during 2005 it appreciated about 10 percent. 19 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm 15 20 25 30 35 40 1999 2000 2001 2002 2003 2004 2005 €/Rbl $/Rbl Fig. 7. Nominal exchange rate of rouble versus euro and USD (Source: CBR) To understand and to evaluate the anticipated changes in exchange rates, it is necessary to understand the relevance of capital in- and outflows. As discussed in previous section, Russia benefits from high world market prices for crude oil, gas and other raw materials.7 Theoretically, an extensive energy and mineral exports increase current account of the country together with extensive currency inflow. This leads supply for foreign and demand for domestic currency, respectively, and to the appreciation of domestic currency. Currently and in the near future, Russian export sector is still dominated by oil and gas exports. According to several studies (among others, see Plekhanov 2005, Sutela 2005, Westin 2005 and Korhonen 2006), there seems to be a wide understanding and consensus that rouble is currently either close to its equilibrium level or slightly undervalued, but due to the increasing revenues from oil and gas exports, there is a high pressure for it to appreciate in the near future. According to the standard macroeconomic definition, real exchange rate or the price competitiveness can be formulated as a ratio (1) P ePR f = , where e is the nominal exchange rate, and Pf and P are prices of the foreign and domestic commodities, respectively. If the increase in prices is higher in abroad or if the nominal exchange rate becomes higher (that is, the domestic currency devaluates meaning that one should pay more per unit for foreign currency), a country gains price competitiveness and its commodities become cheaper relative to those produced in competitor countries. 20 7 The Russian Stabilisation Fund was established in 2004 to prevent the currency inflow from exports of natural resources to funnel and overheat the Russian economy. Currently, the size of this Fund is about 7 percent of GDP. See Ollus (2005) for more details and success of this Fund. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Using equation (1), Fig. 8. depicts the evolution of real exchange rate of rouble against euro.8 After the devaluation of rouble in August 1998, the price competitiveness increased and eased domestic industrial production to recover. However, while the inflation in euro zone has been close to zero and domestic inflation in Russia was running over 10 percent annually, the real price competitiveness was rapidly lost. Between 2001 and 2004 the real exchange rate and price competitiveness was rather stable mainly due to the depreciation of rouble against euro, which cancelled out the inflation effect. During 2005 the appreciation of rouble against euro has weakened the real competitiveness of Russian products. 0 20 40 60 80 100 120 1999 2000 2001 2002 2003 2004 2005 Fig. 8. Rouble real price competitiveness in euro area, 1999M1=100 (Source: Metla) In the future, the anticipated appreciation of rouble together with increase of domestic purchasing power and consequential inflation, real exchange rate will gradually continue to deteriorate, price competitiveness will weaken and domestic production can be surpassed by increased import growth. This development, on the other hand, may lead Russian Federation to implement some protectionist policies to protect and cover domestic production. Also, changes in exchange rate regime or policy are not impossible in the future. In general, anticipations of the appreciation of the nominal exchange rate can attract capital inflows, from which some may be allocated to different investment projects. Also, it is noteworthy that while forest investment goods, such as logging harvesters and paper machines, are mainly of foreign origin, the appreciation of exchange rate is rather a supporting than impeding factor for forest sector investments as far as the final goods are primarily allocated to the domestic markets. If the production of the final goods is export orientated, the exchange rate development then weakens their price competitiveness in world market. Especially, the exporters of sawnwood may lose market shares to Finnish, Swedish and German competitors. 21 8 Calculations are based on indexes of consumer prices in Russia and euro zone, and on index of nominal exchange rate between rouble and euro. Thus, this illustrative calculation depicts only real price competitiveness in euro zone, and differs from the standard value weighted foreign trade and currency basket calculations (see e.g. Korhonen 2006). Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm 3.3 Financial Markets Well working financial sector is typically an essential requirement for sustainable business making and, especially, for investment behaviour. According to Bevan et al. (2004), foreign direct investments in transition economies have been positively related to the development of banking sector along with other institutional reforms such as liberalisation of trade and legal institutions. Under the socialistic system, the role of banking sector in Soviet Union was fundamentally different from that of the western banking system. As discussed in more detailed in Ollus (2004), primarily the state owned banks were monitoring the internal account money flows between production plants and bureaus, and ensuring that these account flows were in line with the five-years-plans given by Gosplan, a central planning authority. Another task for the banking sector was that they were responsible for monetary transactions with foreign countries, and to ensure that the cash reserves enabled the payment of wages, which were typically given to employees as cash. After the change of economic system, the banking sector in Russia was wild and without any binding legislation and supervision.9 In the mid 1990’s, the number of banks in Russia amounted over 2600, and most of them were rather small concentrating only on making short- run business by operating with interest rate marginal. Also, some of the banks were established only to run business activity and cash flow of one single enterprise. Typically, the banking system was suffering from inexperience of free market behaviour and incapability to recognise reliable and solvent customers from those of the adventurers and speculators. Together with general difficulties to anticipate political and economic development in Russia, liquidity problems and lack of deposit guarantees and risk management, it is therefore not surprising that deficiency of confidence against banking sector led to bank runs and was one of the leading factors for the economic crisis in August 1998. Even though the banking and credit sector in Russia has developed since the end of 1990’s, many of those structural and fundamental problems mentioned above still exist. In 2005, the number of banks still amounted over 1000. With respect to the size of Russian economy, banking sector is inadequately small to contribute economic development and, especially, investments. The aggregated assets of Russian banks are only about 40 percent of Russian GDP, while the same ratio in industrialised countries is between 100 and 300 percent (Ollus 2004). The understanding of market behaviour has increased among the finance institutions, but there are still difficulties to analyse solvency, confidence and repayment ability of customers. To compensate this risk, the lending interest rates and marginal between borrowing and lending interest rates has been high, which has sometimes led to additional problems such as adverse selection. Also, the loan periods have been short in maturity terms (about one year or shorter). 22 9 For more thorough understanding of the development of banking system and financial markets see Komulainen and Korhonen (2000), Korhonen and Ollus (2004) or Mahlamäki (2005). Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Main problem for the development of Russian banking sector is however the lack of general trust and confidence, which is consequence of several financial crises and bank runs after the change of the economic system. According to some recent inquiries, about 70 percent of the total household savings are not allocated to banks. Rather, they are held either in cash or in other assets.10 Even though the Central Bank of Russia has tightened the rules for banks (see Mahlamäki 2005 for details) and created a guarantee for deposits, the bank legislation as well as monitoring of the sector and accounting system needs additional reform. The lack of trust to domestic financial institutions has also led to massive net outflow of private sector capital from Russia which, in turn, weakens the possibility for financing domestic investments (see Korhonen and Ollus 2004 for more details). The scantiness of total funds on deposits, short maturities and high interest rates of loans and general thinness of Russian financial markets have clearly impeded and prevented domestic investment behaviour. For example, only 14 percent of corporate bank loans are currently longer than three years in their maturity (Orlova 2006). Especially, SMEs have suffered from undeveloped financial markets and investments are established mostly by net cash reserves. While international banks have been established in big cities, bigger enterprises and foreign companies, who have also access to the international markets, are able to finance the investments through foreign debt, which, of course, involve another risk, namely, that of change in exchange rates or policy regime. 3.4 Threats for Economic Development in Russia During 2000s, Russia has benefited high crude oil and gas prices in world market. Along with the continuing economic growth in Asia and emergent growth in Europe, it seems that demand for crude oil, gas and other raw materials will remain high in the near future. Therefore, Russia will strengthen its strong position in current account surplus, and currency inflow as well as the size of the stabilisation fund is likely to increase. To prevent overall currency inflow and, thereby, increase of domestic inflation and appreciation of rouble, Russia established The Russian Stabilisation Fund in February 2004. This Fund has increased rapidly, and in December 2005 it was already 7 percent of GDP. Even though the neutralising effect of The Stabilisation Fund prevents overheating of the Russian economy, it is evident that part of the oil revenues will channel to economy through the Federal budget. According to the Funds rules, the first 500 billion roubles accumulated in the Fund may only be spent on financing Federal deficits caused by two consecutive years of low oil market price. Above the 500 billion ceiling, the government is free to spend revenues for repayment of foreign debt and spending on certain structural reforms (Ollus 2005). Therefore, it is a great challenge for political decision making to enforce the domestic cost level (especially in main cities) to remain low, and to prevent a dutch disease type of deterioration of international 23 10 While the real interest rate has been negative, there is no incentive for bank saving. Therefore, most of the earnings and incomes of households are channelled directly to consumption. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm competitiveness.11 In case of currency inflow together with strong current account surplus, Central Bank of Russia can only fight against appreciation of rouble or towards increase of domestic inflation. Resource based economy or mineral economy is a specific type of structure, where the macroeconomic growth is based on the incomes from the trade of a single natural resource. The potential to alleviate the social costs of structural development of the economy through the rent on deploying the resource stock depends on the timing in the use of these resource potentials. Extraction incomes support balanced economic restructuring when used by increasing the use of underutilised resources. The latter is frequently achieved in infrastructure investments with long payback period. When income from export together with unused domestic factors of production is used, their inflation effects can be minimised. The opposite may happen if the current account surplus boosts demand for private consumption or full use of domestic production inputs. Value of rouble in Euro area is a challenge to the Russian non-oil export industry’s real price competitiveness. While it seems evident that rouble has a tendency to appreciate in the near future, majority of Russian non-oil export of low technology type take price competitiveness of primary concern. At the same time, high rate of currency make foreign goods and services relatively inexpensive and support foreign technology intensive investment solutions. Other threats, which may slow down the economic development in Russia and imbed investment activity, are deceleration of reforms in legislation concerning finance sector and other institutions, difficulties in operational preconditions for foreign companies in Russia, protectionist trade policy to cover domestic production, and other trade and economic operations for political purposes which are likely to weaken the general trust and confidence on economy. Also, corruption and bureaucracy are factors, which should not be belittled when considering economic and business development in Russia. 4 Forest Sector and Its Development in Northwest Russia Production of forest sector has increased rapidly in Northwest Russia after 1998, as discussed in Mutanen et al. (2005) in more details. There are numerous supporting factors behind that development. First, the devaluation of rouble in 1998 boosted the utilisation rate of forest industry capacity and increased roundwood exports. It also improved investments in Russia what concerns investment outlays in rouble terms, and increased export incomes of Russian forest industry companies offered the possibilities for financing investments. The modernisation of production capacity in turn increased productivity in forest industry companies and helped them to keep their business profitable irrespective of the high rate of domestic inflation. Second, 24 11 The concept dutch disease originates in Holland after the discovery of North Sea gas in 1970s. Generally, it means that because of the massive exports of natural resources, the surplus of current account increases and the exchange rate of currency revaluates making other industries less competitive in international markets, thus increasing imports and decreasing exports. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm the smooth depreciation of rouble in Euro area markets from 2001 to 2005 has also supported export competitiveness. The following chapters discuss briefly on the recent development and problems regarding the forest resources, their economic accessibility, infrastructure and logistics. Also, we discuss on the impact of other factors of production on the willingness to invest in forest sector in Northwest Russia. 4.1 Forest Resources in Northwest Russia – Accessibility and Use Russia has by far the largest forest resources in the world. According to FAO, approximately 22 percent of the world’s forest area and 25 percent of wood resources are under governance of Russian Federation. From the Finnish and other Baltic Sea area investors perspective, forest sector in Northwest Russia is of special interest due to its close location to the European markets and, especially, because of the unused vast forest resources. In addition, huge growth potential of wood based product markets in Russia and geographical nearness have been incentives for Finnish firms to establish in Russia. Smaller enterprises have been more interested in lower costs and sufficient raw material resources than the international enterprises, which were more market oriented. (Nilsson & Söderholm 2002, Laakkonen et al. 2005) For sawmill or paper and pulp investment decision, it is essential for the investing enterprise to ensure continuous wood flow to the production plant. While a modern sawmill of 100 000 m3 capacity needs over 200 000 m3 of logs, and 400 000 ton pulp mill requires about 2 million cubic meters pulpwood or wood residue, the economic profitability calls for unbroken wood procurement together with other factors of production. In a case of pulp and paper investment, for example, the enterprise should ensure wood procurement process at least for 30 – 40 years. Therefore, the size of the forest resources and their economic accessibility, in addition to the transportation possibilities and other infrastructure, challenge the investment possibilities and determine the location of production plant. Due to the geographical position, coniferous assortments dominate the Forest Fund in Northwest Russia. The main tree species are pine, spruce and birch.12 Table 4 depicts the regional forest areas, total growing stock and the percentage share of the coniferous assortments of the total growing stock in 2003. As can be seen from the figures, Republics of Karelia and Komi together with Arkhangelsk and Vologda Regions have the most extensive forest resources in Northwest Russia. To compare and give perspective of these forest resources, total forest area in Finland was 26.3 million ha in 2005, which is only about 29 percent of the total forest area in Northwest Russia. The total growing stock in Finland in 2005 was 2091 million cubic meters accounting only about one fifth of that in Northwest Russia. 25 12 The share of coniferous assortments differs between the regions in Northwest Russia. See Dudarev et al. (2002) and Mutanen et al. (2005) for more detailed information on regional forest resources and their economic utilisation in Northwest Russia. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Table 4. Forest Resources in Northwest Russia, 2003 Forest Area Total Growing Stock Coniferous Growing Stock 1000 ha Million m3 % share Republic of Karelia 9737 940 79,3 Republic of Komi 30635 2965 75,3 Arkhangelsk Region 22713 2488 83,4 Vologda Region 10266 1594 53,2 Kaliningrad Region 265 41 32 Leningrad Region 4593 790 51,8 Murmansk Region 5372 229 68,3 Novgorod Region 3574 612 31,5 Pskov Region 2112 334 48,1 TOTAL 89267 9993 Sources: Karvinen et al. (2005), www.idanmetsatieto.info Table 5. Annual Average Growth and Fellings in Northwest Russia, 2003 Annual Average Growth Total Fellings Final Fellings Roundwood Export Million m3 Million m3 % share Million m3 Republic of Karelia 14,14 7,1 85,9 3,56 Republic of Komi 30,94 6,8 92,6 0,03 Arkhangelsk Region 25,05 10,1 89,1 0,04 Vologda Region 17,31 6,6 93,9 2,20 Kaliningrad Region 0,92 0,4 25 na Leningrad Region 10,04 6,3 63,5 na* Murmansk Region 2,52 0,1 100 0,06 Novgorod Region 10,71 3,5 82,9 1,18 Pskov Region 3,26 1 70 0,03 TOTAL 114,87 41,9 The annual average growth is for year 2004. * According to unofficial statistics 6,8 million m3. Sources: Karvinen et al. (2005), www.idanmetsatieto.info, www.roslesinforg.ru As can be seen from Table 5, total fellings, comprising mostly on final fellings, are less than 40 percent from the annual average growth in Northwest Russia.13 Due to the difficulties for accessibility, the stands are somewhat undisturbed, and the age structure of the forests is biased towards mature and overmature forests. Therefore, the annual growth rate of old trees remain 26 13 The terminology and definitions in Russia differ from that of the western countries and the direct comparison of the figures are not justifiable. See Karvinen et al. (2005) for more detailed description of the terminology. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm slow and make the comparison between annual growth/allowable cut potential biased and consequently a misleading picture of the efficient sustainable potential usage of the forest resources. Recently, some of the investment projects of forest industry enterprises in Russia have been postponed due to the uncertainty related to continuous availability of suitable raw material. The famine of industrial roundwood in the investors’ projection does not mean lack of allowable cut reserves. Technically, adequate resources normally exist, but harvesting, transportation logistics as well as logging leases are problematic. Also, insufficient and weak road network causes difficulties for roundwood procurement. While the forest road network is often poor or it does not even exist in many areas, the economic utilisation of the forest cannot be increased easily. For example, in the Republic of Karelia the annual average growth of forests is twice that of the total fellings, but the economic accessibility to the new stands needs additional investments in infrastructure. According to Pulliainen (2004), especially the scarcity of coniferous logs and birch logs of good quality will lead to higher competition for them in the near future and increase their prices, thereby challenging the investment plans. In Russia, forest resources are owned by the Federation and permissions for using the resources are available through long and short term agreements, and through direct distribution by state author. Operator can buy short-term (shorter than one year) cutting rights by auctions. Longer permissions (leasing), up to 49 years, are also possible, but normally operator is then also obliged to arrange forest regeneration and other similar duties. Partly because of this, unit prices are remarkably lower in longer term agreements compared to that of permissions sold in auctions, though price level of auctions is still quite marginal when compared with western markets.14 While the forest road network is poor and, therefore, the accessibility to new stands is difficult, regeneration of forests has raised as a one of the main issues for forest investors to ensure wood procurement also in the future. In short-term leasing contracts, all costs and responsibilities of regeneration after logging activities remain on authorities’ responsibility. Forest regeneration duties are frequently undone in practise due to the lack of adequate financing possibilities. Also, the lack of tradition and know-how of regeneration is a problem. Therefore, forest authorities have gradually become aware of the fact that despite of the existing accessible resources of mature and overmature forests, they will be consumed in the near future without sufficient investments on regeneration and forest management. After a couple of decades, structure of age classes of Russian forests would not offer a strong basis for production of forest industry – especially for sawn- and veneer mills – if all accessible forest stands have already been cut and the quality of young stands does not fulfil the need and requirements of forest industry. The Forest Code, which is still under reconstruction, will include a possibility for long-term leasing of forests together with strict rules for the responsibilities on regeneration and silviculture. Regeneration works after cutting have typically carried out by the leshoses, an authority responsible of forestry administration in local level, which have forest management, protection 27 14 Short and long term agreements and direct distribution by state authorities cover 20, 45 and 35 percents of the wood procurement, respectively. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm and monitoring as main tasks. Regeneration works are financed by Forest service from the forest lease or auction stumpage incomes. The balance between the sales income and regeneration and forest management costs have increasingly become deficit because of the increased forest management costs. The same challenge is related to the investments into forest roads (construction and repair investments). Thus, there is a pressure and need to increase stumpage prices to cover the increasing costs of forest management. Question about adequacy of roundwood supply is at least partly governmental and of regional character. In some parts in Northwest Russia, for example in Republic of Karelia, all easily available forest resources are already in efficient use in practise. Lack of sufficient infrastructure causes regionally uneven usage of forest resources supporting the concentration of economic activities to the most developed areas, and keeping majority of distant resources unattainable. Recently, some Russian politicians and high-level authorities have restated willingness to restrict export of Russian roundwood and encourage foreign operators to invest in Russia.15 At the same time, there has been discussion about threat of foreign owners for Russian society, including forest resources, if proprietary rights will become internationally available. These two lines of political rhetoric are contradictory. If the rules and managerial patterns, applied by Russian government as the owner of raw material resources, are not predictable, there are no incentives among the potential investors to carry out their plans. Table 6. Production of Forest Products in Northwest Russia, 2003 Sawnwood Plywood Fibreboard 1000 m3 Operating Rate 1000 m3 Operating Rate Milj. m2 Operating Rate Republic of Karelia 741 36 23 94 Republic of Komi 638 62 249 100 20 91 Arkhangelsk Region 1979 62 72 100 18,8 83 Vologda Region 919 54 149 98 25,4 57 Kaliningrad Region 16 na Leningrad Region 491 65 135 na Murmansk Region 19 23 Novgorod Region 336 82 134 100 Pskov Region 148 27 TOTAL 5351 46 763 92 60,6 77 Operating rate is given as a percentage share of the production volumes with respect to the available capacity. Sources: Karvinen et al. (2005), Rosstat, Karelijastat Table 6 depicts the production volumes and operating rates for different forest products in 2003, respectively. As can be seen from the Table, only about half of the total capacity is in usage in 28 15 While writing this paper, Russia has announced an increase of tariffs for coniferous roundwood exports. Since 1.6.2006 the tariff will be 4 euro per cubic meter. At the same time, Russia will abolish the import tariffs for machinery and investment goods for forest industry. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Northwest Russia, even though there are substantial differences between the regions. In plywood, chipboard and cardboard production, the existing capacity is nearly in full usage. Also, a volume of paper production is difficult to increase without any substantial green field investments in capacity. The low operating rates for some products are partly due to the outdated technology, which urgently requires at least repair investments. Table 6. Continues Pulp Paper Chipboard Cardboard 1000 t 1000 t Operating Rate 1000 m3 Operating Rate 1000 t Operating Rate Republic of Karelia 430 759 70 106 na 65 13 Republic of Komi 506 526 100 295 100 183 100 Arkhangelsk Region 1895 333 99 705 100 Vologda Region 42 43 34 382 80 26 100 Kaliningrad Region 216 71 89 23 95 Leningrad Region 510 448 97 104 na 379 97 Murmansk Region Novgorod Region 13 81 14 59 Pskov Region 4 95 TOTAL 3599 2193 - 887 - 1399 - 4.2 Other Factors of Production Even though roundwood supply and well working wood procurement are among the most significant and major factors for economically sustainable production in forest industry, other factors of production such as skilled labour and energy are also important. Despite the fact that forest industry is often seen as a capital intensive sector, role of labour is significant at least in mechanical wood working industry. Relative unit costs of labour are among the criteria determining the location of new mills. Competitive price and availability of labour are among the reasons for forest industry enterprises to start co-operation projects with Russian partners, or to invest and participate in modernisation of Russian factories. Especially foreign small and medium sized enterprises, Finnish ones among others, can utilise low cost level of Russia as a reason for beginning of subcontracting. It enhances their competitiveness and gives to them knowledge about operating in different environment. If circumstances allow deeper co- operation later in the future, that knowledge would be a significant benefit for a new investor (Ivanova et al. 2006). On the other hand, assumption about remarkably lower cost level is partly flawed, because lack and competition of skilful employees has become a reality at least in the biggest Russian cities and, therefore, wages, especially those of the managers, will soon overtake the western level (Suomalaisten yritysten …2005). 29 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Professional skills can be expected to become crucial factor when investments are planned to expand from, say, basic routines in sawmills to more advanced fields of forest industry. Educational level of available labour has, partly for that reason, been set as a critical point when evaluating possibilities to start production in Russia. On the other hand, significance of labour costs varies remarkably between different parts of production chain, and those most expensive, labour intensive parts can be handled by vocational education.16 Recently, western enterprises have been especially interested in transferring the most labour intensive parts abroad and entrust, for example, research and development activity to domestic staff. While development of Russian society progress further, supply of highly educated labour will also increase in the future. Younger generations acquire knowledge about western business culture for example by educating themselves abroad, and if difference between labour costs in Russia and western countries remains on same level as it is today, in the long term also R&D activities will undoubtedly be transferred, at least partly, to Russia. Investment plans should also give preliminary answers to the questions concerning the availability of energy and, especially, that of electricity. The need for energy depends highly on the branch of forest industry. For example, sawmilling industries as well as mechanical pulp industry are energy intensive branches while chemical pulp industry can even be a net producer of energy. In Russia, the State has monopoly of transportation and energy supply. This dependence can turn out to be a risk for the forest industry, as well as for other industries, to operate in Russia, especially if the interests and targets of enterprises are not in line with those of the State’s preferences. Otherwise, Russian Federation is net supplier of energy and energy resources are extensive. Even though the domestic consumption of energy will increase along with the general economic development, it is hard to recognise any direct lack of energy availability in the near future. New power plants are under the planning and the use of standard sources of energy will be intensified. Only the price of energy, as a part of administrative economical control tool, may challenge the profitability of the use of different energy sources. In Northwest Russia, the basic infrastructure for transportation system of electricity does exist, but the system calls for repairing investments as well as rationalisation. Due to the underdevelopment of power transmission grids, many large power plants in the region are not operating at their full capacity (Dudarev et al. 2004). Thus, the key issue for the utilisation of electrical power industry is the development of transmission system.17 Most of the physical capital equipments and machinery are inherited from the Soviet era. Therefore, they are typically out-of-date, wastefully and environmentally damaging, and the sector calls urgently for modern investments. Dudarev et al. (2002) have estimated that even 70 – 80 percent of the equipments and machinery used in forest industries in Northwest Russia are worn down and obsolete. Especially, the modernisation investments in pulp and paper processing are urgent. However, the transition towards more modern technology is also in the 16 As shown in Anttonen et al. (2005), franchising has been one popular business type for foreign enterprises to penetrate in Russian markets. However, according to our knowledge foreign forest industry companies have not applied this type of business in Russia. 30 17 Dudarev et al. (2004) give excellent description of the different clusters in Northwest Russia, including forest and energy sector and their recent development. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm process in forest harvesting. The old and work intensive full-length method, inherited from the Soviet period, is giving way to Scandinavian cut-to-length method, which is seen the most profitable technology and basic condition for forest investments by foreign investors (see Karjalainen et al. 2005). As discussed in section 3.3, the Russian financial markets are rather underdeveloped and the possibilities of domestic operators to finance the needed investments are weak. The foreign enterprises have more opportunities to find finance for the investments. Availability of factors of production can be seen as a kind of critical variable among other facts impacting on investing decision. In the areas, where infrastructure is weaker than on average, demand of roundwood is usually also lower than on average. This means lower raw material costs of wood procurement. On the other hand, constructing of needed road network and other logistical connections, and advantaging a modern technology can turn out to be remarkably expensive. Each investor should evaluate the trade-off between maximising reduction of production costs and minimising of costs caused by creation, or buying of needed factors of production. 4.3 Infrastructure and Logistics Along with the consideration of availability and accessibility of forest resources, a profitable forest investment decision includes well-designed wood procurement logistics. As well as final product logistics, a well working wood procurement process require viable infrastructure. Compared to other regions in Russia, the transportation infrastructure is relatively well developed in Northwest Russia. Especially, the railroad network provides good base for the wood logistics, even though the density of the railroad network is not that high as in Finland and in the Baltic States and the density also differs highly between the regions. Considering the amount of forest resources the density is highest in the Leningrad Region and in the Republic of Karelia, and lowest in the Arkhangelsk and Vologda Regions and in the Republic of Komi (Table 7., see also Dudarev et al. 2002 for more details). A clear advantage of railroad transportation is the same gauge of railway in Russia, Finland and the Baltic States due to the historical reasons. To provide continuous wood flow from the stands to the mill, it is essential that the railroad network is working. Recently, in spite of its relatively well functioning, however, the network has been overburdened in some regions and there has been lack of cargo wagons.18 In the future, along with the general economic development and growth, the overburden is likely to be worsening in the main growing areas and centres without any considerable investments. Especially, the transportations around Leningrad Region, as a major traffic centre in the Northwest Russia, will increase significantly due to the several new seaports and increased cargos. 31 18 To avoid problems and to maintain persistent roundwood trade, Stora Enso Ltd, for example, has its own cargo wagons. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm Russian railroads are owned by the monopoly JSC Russian Railways, which is under the governance of the Russian Federation. Due to the economic unprofitability and low efficiency, there is a pressure to increase railroad tariffs in the future, even though the government has an ambition to support the competitiveness of the local industrial companies by low tariffs and tariffs discounts. According to Dudarev et al. (2002), the drawbacks for the low efficiency are high deterioration rate of the railroad car fleet, shortage of specialized cars, inefficient logistics and low level of operations transparency. The latter, for example, culminates to the multi tariff pricing – the foreign enterprises who can afford pay more are typically paying higher tariffs than the domestic customers. Table 7. Information on transportation networks in Northwest Russia Public Roads Forest Roads Density of Railroads* Length of Inland Navigable Waterways* 1000 km 1000 km km/10000 km2 km Republic of Karelia 7,9 17,8 122 3645 Republic of Komi 12,1 14,2 41 3962 Arkhangelsk Region 7,5 22,9 30 3221 Vologda Region 8,1 6 53 1581 Kaliningrad Region 2,7 0,6 377 357 Leningrad Region 9,6 3,1 327 1888 Murmansk Region 4,2 2,3 61 0 Novgorod Region 3,6 0,8 208 627 Pskov Region 8,6 0,6 198 503 TOTAL 64,3 68,3 15784 * The figures correspond the year 1998, other figures are for year 2003. Sources: Karvinen et al. (2005), Dudarev et al. (2002) The water transportation offers relatively cheap solution for big transportations of roundwood. However, the navigable river transportation is available only on few months in summertime, and the tugboats, owned by the local river-shipping companies, are typically worn-out and unreliable to work. Due to the lack of finance, the waterways have also worsened in their conditions, and the maintenance of them requires financing which is difficult to arrange from the regional budgets. Also, the roundwood transportation can be arranged only via certain rivers and canals inside the regions and the best forests nearby them are already partly harvested. The forest road network inside the regions in Northwest Russia is weak or it does not even exist.19 The budget financing is hardly sufficient to maintain the conditions of main roads between the regional centres, and the responsibility of investments in forest roads are given to the forest usage operators. Thus, to ensure adequate wood procurement, investments in forest 19 Karvinen et al. (2005) describe the division between different types of forest roads more thoroughly. 32 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm roads are necessary and among the first investment targets. However, depending on the region, the forest road constructing can be difficult, for example, due to the lack of gravel and sand, which perhaps should be imported from long distance away. These investments also require clear legislation and guarantee for the investor to utilise the forest stands around the constructed forest roads, at least for certain time period. The legislation, on the other hand, culminates to the Forest Code and is discussed in more details in the following chapters. 4.4 Forest Product Markets Wood resources and procurement, other factors of production and general economic climate are important determinants to affect profitability of forest industry and to attract new investments. The other side of the coin is the final products and their markets, which can be crudely divided between domestic and foreign markets. If the final products are allocated to the foreign markets, ex ante exchange rate behaviour together with other estimated costs (logistics, custom tariffs) play an important role on profitability. Therefore, it is among the most important strategic decisions of investment planning to forecast the demand for forest products, and to decide whether these products are allocated to the domestic markets or under the international competition abroad. In Russian domestic markets, the general economic growth is propagating the available income of citizens, even though the growth and welfare are concentrating on big cities and centres. Therefore, it is likely to suspect that part of this purchasing power increase is also allocated to the forest products directly (e.g. construction) or indirectly (e.g. containers and packaging material). Many socio-economic factors, however, have intensive influence on the demand for different forest products. For example, the growth of population and demographic distribution of age structure affect demand for furniture, house building, repairing and country cottage (datsha) construction.20 Table 8 comprises the estimated increases in demand for different forest products. According to these FAOs (UNECE 2003) classified forecasts, Russian domestic demand for different forest products is considerably increasing.21 The demand for sawnwood is estimated almost to triple up to 2015 compared to that in 2000. Partly this is due to the increase in new construction, but mainly the increase is in connection to the repairing of existing housing facilities. Because of the economic reasons and lack of repairing investment in recent years, the need for urgent repairing has accumulated. The demand for plywood and particle board is estimated to increase 110 and 130 percent up to 2015, respectively. Both of these products depend highly on the demand for furniture. At 20 It is also a matter of question, how wood material can replace other materials (brick etc.) in construction. Until now, wood material has been only a secondary and not very popular element in construction in Russia. 33 21 The figures in Figure 5 must be interpreted with caution. It is often argued that the scenario is highly political and forecasts are overestimated. Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm present, along with the increase in wealth and housing construction, the demand for furniture has remained high. In the 1990’s, a large fraction of the furniture was imported, but the development, investments (e.g. IKEA) and increased competitiveness of the domestic furniture industry and, especially, the improvement of quality of furniture, has reduced the share of imports. While the demand for plywood will increase also in construction, the investments to meet the demand for both plywood and particle boards are necessary. Table 8. Estimates of demand for basic forest products in the domestic markets in Russia Sawnwood Plywood Particle board Fibreboard Paper and paperboard Market pulp Mill. m3 Mill. m3 1000 m3 1000 m3 1000 t 1000 t 2000 12 548 2430 695 3490 429 2005 18 770 3200 832 4700 540 2010 23 950 4300 1184 6800 600 2015 31 1150 5600 1920 10200 720 Source: UNECE 2003 Domestic consumption of fibreboard and paper and paperboard are estimated to increase slightly less than one hundred percent. Regardless of the magnitude of the estimated volumes, it is evident that along with the general economic growth the demand for both fibre- and paperboard will increase. Even though some new plants have been established to meet the increased demand, new investments are still needed in future. Since the end of Soviet era, Russian’s forest sector export has been dominated by low value- added products such as roundwood and sawnwood. After the devaluation of Rouble in 1998, Russia has increased its exports and market share in German coniferous sawnwood markets while Finland and Sweden, as a traditional exporters, have lost their market shares (Mutanen et al. 2005, Mutanen 2006). However, as discussed in section 3.2, there is a high pressure of appreciation of rouble in near future due to the oil and energy trade, and large surplus of current account. Together with higher domestic inflation rate with respect to that in abroad, the external price competitiveness is likely to weaken in the future. Thus, this development will also affect Russian sawnwood exports, if the exporters are not willing to adjust downward their unit prices and profits. While the domestic demand for other forest products will increase and there is urgent need for investments to meet this demand, it is unlikely that those products – such as paper or paperboard – are exported in high volumes in the near future. In long run, depending on the 34 Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm relative price and exchange rate development, it is possible that some forest products are increasingly exported.22 5 Institutional Factors Affecting Investments 5.1 Legislation Aspects 5.1.1 General Legislation When Russian legislation is considered and assessed from foreign investors’ standpoint, a couple of issues are in special emphasised. Among the most important is the possibility of foreign enterprises to operate in Russia in general. If position of foreign operator is remarkably weaker than that of domestic competitor, motivation and economic attraction for investments will be diminished. Other important legislation questions are related to enterprises, taxation, currency, labour, custom and competition policy (Filippov et al. 2005). Foreign investors have claimed that in practise their possibility to operate in Russia is not equal compared to those of domestic firms. On the basis of existing legislation, however, both domestic and foreign enterprises should have equal rights and liabilities to operate. Nevertheless, Russian legislation includes several levels, and in some areas existing norms can differ more or less from those of the whole federation, even though regional norms should not contravene federal ones (Ivanova et al. 2006). In forest legislation, regional authorities can for example provide that foreign operator has to be registered as an regional operator before it is allowed to get logging permissions or other similar documents (Nystén-Haarala 2001). Because it is not always clearly clarified which level of legislation is the most significant, there can be real inequality between the areas where foreign enterprises are operating. This leads up to differences between favourabilities of regions from foreign operator’s standpoint. Some regions or even cities have decided to attract foreign investments with help of governmental decisions (e.g. Novgorod) and special supporting systems while some others regions have been remarkably more passive or even reluctant for such incentives. (Laakkonen et al. 2005, Ivanova et al. 2006). As well as general legislation Russian taxation system is often said to be too complex for foreign operators to live with. Federal Tax Code draw basic lines and principles of taxation, but local municipalities are given to interpret and slightly modify federal principles in a way that regional special features will be taken into account. However, principles of taxation system are, at least partly, dependent on a size of the enterprise and a business field in which it operates (see Ivanova et al. 2006 for more details). Anyway, scale of different criteria related to taxation practise is very wide: in some cases taxation principles are undoupted while in other cases 35 22 For example, China as a growing economy has been mentioned as one export market for Russian forest products (Kivelä 2005a). Working Papers of the Finnish Forest Research Institute 32 http://www.metla.fi/julkaisut/workingpapers/2006/mwp032.htm enterprise can itself affect taxation base and rates. In Russia, it is a common practise to use accounting system to hide profits and avoid paying taxes. Even though the needed licences, taxation and all kinds of permissions are in order, competent personnel is still needed for creating successful business. Compared to Soviet era, status of labour unions in Russia has diminished remarkably but, in general, the role of labour unions and their association in Russia is still stronger than it is, for example, in Finland. Employer, especially foreign one, should be prepared to co-operate with labour unions and their local representatives. Unions have to be heard while making significant changes to employees’ working environment or core interests of them. In any case, it is easier for employer to hire domestic employees. In case of a foreign worker, employer has to have a permission for hiring and employee has to get a working permission before coming to Russia. Possibilities to fullfill free vacancy by hiring domestic worker have also to be ensured properly (for more details, see Ivanova et al. 2006). Russian labour legislation apply to all labour relations occuring in Russia. Thus, relations between foreign employee and foreign enterprise operating in Russia are also normally under these regulations. In 2005 labour legislation was changed by making hiring of foreign employees more difficult than it was in previous years. At the same time new regulations, like mandatory medical testing and residence registrations, came in force, but impact of those regulations on business in practise can be estimated to be quite moderate (Ivanova et al. 2006).