Closing Some Doors in Russia

A new law barring foreign companies from "strategic sectors" could actually help investors by clarifying the rules

In a matter of days, the Russian Cabinet is due to discuss, and most likely approve, a new law that will impose limits on foreign investments in so-called "strategic sectors" of the Russian economy. Paradoxically, that could be welcome news for foreign investors, because after months of uncertainty they want the rules of the game clarified.

If passed, the law will mark the latest example of a broader movement in the U.S. and Europe to protect vital industries. Last year, U.S. congressional opposition forced Chinese energy company CNOOC to drop its bid for U.S. oil major Unocal.


  Recently, DP World abandoned its plan to take over management of six U.S. ports after lawmakers warned of security risks. In Europe, Spain is moving to block a bid by Germany's E.On (EON) for energy giant Endesa (ELE), while France is engineering a takeover of Suez (SZE) by Gaz de France to keep the company from falling into the hands of Italy's Enel.

The new Russian law has been in the making for close to a year. The impulse for the law came last April, when in an annual address to the Russian senate, President Vladimir Putin instructed his government to prepare a list of sectors that would be out of bounds to foreigners -- enforced by law.

"It's time to define clearly those areas of the economy where the interests of Russia's independence and security dictate the need for primarily national capital," Putin said.


  His speech came at a time of mounting confusion about the rules for foreign investors. Shortly before, a plan by German engineering giant Siemens (SI) to acquire Power Machines, Russia's largest machine-maker, was blocked at the eleventh hour on national security grounds, sparking open disagreements inside the Kremlin.

Even more damaging for the investment climate was the confusion over Russia's policy towards natural resources. One effect of Putin's long-running crackdown on oil company Yukos, which dominated the headlines in 2003 and 2004, was to scotch any possibility of Yukos' acquisition by an international oil company. (A deal involving ExxonMobil (XOM) was widely rumored in 2003.)

That led many investors to suspect that the Kremlin didn't like the idea of Russia's natural resources falling into foreign hands -- although in 2003, Putin had warmly endorsed BP's (BP) acquisition of a 50% stake in TNK-BP, Russia's third-largest oil company.


  Adding to the concerns, Russia's Natural Resources Ministry began to draft regulations banning foreign investors from bidding for "strategic" deposits of natural resources. That had investors, including existing ones such as BP, scratching their heads.

So it's a welcome sign that Putin's ministers have finally been able to agree on a draft that they are willing to submit to Parliament -- or almost. The draft was due to go to the Cabinet on Mar. 9 but was postponed for several more days for last-minute amendments.

No surprise there. According to Putin's original instructions, the law was supposed to be ready for parliamentary discussion by Nov. 1, 2005. And last year the law was sent to the Cabinet three times, only to be returned for further work.


  Such are the normal workings of Russia's laborious policy making process. Policies invariably emerge after months of bickering between competing ministries, all keen to defend their turf and see their own interpretation carry the day.

"The whole process grinds forward very, very slowly," says Christopher Weafer, head of research at Russia's Alfa-Bank. "There appear to be several different groups at the top of the government who, while broadly agreeing on the main goals, try to pursue different ways to achieve them."

For the law on strategic sectors, the main disagreement has been between Russia's Economic Development & Trade Ministry, generally a stronghold of free-market values, and the Industry & Energy Ministry, which favors a more interventionist approach to economic regulation.


  Economy Minister German Gref has been arguing that investors should be allowed to invest anywhere that was not expressly forbidden, while Industry Minister Victor Khristenko has insisted on greater governmental discretion. Adding to the complications are the various other interested state agencies keen to add their two cents to the debate -- such as Russia's security-obsessed intelligence service, the FSB.

Now it seems the two main players, Gref and Khristenko, have finally found a compromise. And the result, according to details leaked to the local media in recent days, looks reasonably benign from the point of view of foreign investors.

"From a pure economics point of view, if economic growth is your only objective, you should simply have no restrictions on foreign investment," says Christopher Granville, chief strategist at Russian investment bank Deutsche UFG.

"But if you do have other objectives -- obviously sovereignty is one -- this is coming out fairly sensibly. At least they won't get really extreme like the French, who regard yogurt as a matter of national security."


  The essence of the Russian plan is that investors will still be allowed to invest, without government permission, in any sector or industry that isn't specified in the law (subject to normal regulatory requirements such as antimonopoly legislation). Even in the off-limits sectors, they may still be allowed to invest if they get the blessing of the President.

In general, foreigners will be blocked from owning equity stakes of more than 25% in companies on the forbidden list, although the government will retain the right to block investments altogether in individual cases.

So what are the sectors? According to a list published in the Russian daily Kommersant on Mar. 2, there will be 39 distinct activities organized into a dozen categories.


  Activities include codes and cryptographic materials, electronic transmission infrastructure, armaments production, industrial explosives, hydrometrical and geophysical processes, infectious diseases, aviation security, nuclear power and materials, space technology, aviation technology, natural monopolies, and -- last but not least -- natural resources "of federal significance."

Of course it's the last point -- restrictions on access to natural resources -- that matters to most big investors. After all, there are a lot more investors interested in Russia's oil, gas, and metals than there are in its infectious diseases.

And here, as so often happens in Russia, there's one more catch. The natural resource deposits deemed to be "of federal significance" still need to be defined in a separate law.


  For years, Russia has been working on the Subsoil Law, meant to decide which deposits the government deems so large or important that they are off limits to foreigners. What's more, Russia's lawmakers recently got around to defining which deposits would qualify.

The criteria are refreshingly clear: for example, 1 billion barrels of proven reserves for oil and 150 trillion cubic meters for gas. In practice, the criteria will only affect about half a dozen very large deposits.

That's the good news. The bad news is that the eagerly awaited Subsoil Law has been holed up in Parliament for months. "After three or four years of discussion of this fundamental reform, now that it comes to the crunch, there are a lot of bureaucratic interests that figure they don't quite like it," says Granville.


  For example, regional governments are upset about losing their role in licensing investments, and are lobbying to have the law changed.

So even if the Cabinet gets around to approving the new law on strategic sectors (which also has to be approved by Parliament), Russia's natural resource investors still won't know where they can invest until the subsoil legislation is adopted. And when that will happen is anyone's guess.

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