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26 Jul, 2011 13:08

Infrastructure, funding and the productivity dividend

With the Russian government looking to promote infrastructure investment Business RT spoke with Takouhi Tchertchian, Director and Portfolio Manager, Renaissance Asset Managers about the drivers and factors for investors to consider.

RT:  How desperate is Russia’s need for infrastructure, and what do you think are the most critical sectors?TT:  “Russia’s need for infrastructure is actually quite severe.  What we have had is decades of underinvestment in infrastructure.  During Soviet times there was very little that was invested, probably for two or three decades post the collapse of communism, again infrastructure was not top of the agenda, so we have had many years of underinvestment.Just to give you an idea, the World Bank recently produced a report which ranks different countries in the world on their infrastructure, on the quality of their infrastructure, and Russia comes out 95 out of 125 countries.  So it clearly highlights Russia is very far behind other countries on infrastructure.  In terms of what sectors need to see the investment first, everybody who lives in Russia would know that the quality of the roads network is terrible, and indeed that report by the World Bank broke down different sectors of infrastructure.  And specifically on roads, Russia came out 112 of 125 countries.  So, not quite last, but almost last.  So I would say that roads is probably the area that needs to see the biggest investment.  That is probably followed by ports and airports, we know that the country is in need of more housing, so social infrastructure needs to be built up as well.  And telecommunications is not a priority, it probably comes further down the list, because we have had quite good development, especially in mobile telephony.  Utilities, electricity specifically, is also quite far behind.  Again we have an estimate by the World Bank, which says that something like 40% of electricity generation is lost in transmission, showing you that the transmission companies are operating with very old equipment , very inefficient, and if Russia was to invest in that specific area it could save about 45% of its total energy bill over the next ten years.”RT:  How does this need differ from region to region? Are some regions doing better than others?TT:  “This is absolutely right.  One of the reasons that it is also so difficult to improve infrastructure in Russia is because of its vastness, having such huge territory makes it very difficult to invest.  Firstly because the amounts needed are that much greater, but secondly, you need to prioritise, and it is always a question of do you address the bigger cities where most people live, because this is where you get most of the efficiency gains from investing in infrastructure, or do you invest in areas where very few people live but, for those who do live there, or for the development of the economy, such infrastructure is needed.I recently went on a trip to Yakutia, and as you know Mechel is developing a coal mine there, in an area called Irga, and we had to fly there by helicopter, because it is impossible to reach it in any other way.  And what you are seeing is that companies are having to resort to investing in their own infrastructure.  So, for example, Mechel  is building a railway to get them to the site.  So in terms of where is that infrastructure spending needed the most, I would say it is needed everywhere.  This is why Russia comes out as number 95 out of 125 countries.  However it is true to say that in the bigger cities you will get better return on that investment, in terms of improving economic growth, improving the standard of life, much faster than in remote areas, where it is equally needed but you will not quite get the same benefit, as in the big cities.”RT:  Has Russia’s infrastructure rating improved over the last ten years?TT:  “I don’t actually have the ratings for ten years ago.  This report was produced in 2009.  We will see when the 2010 report comes out, I don’t expect there to be a huge change, because it is only one year and we know that it was still a difficult year, Russia was coming out of the financial crisis, just like other countries in the world.  So I don’t expect to see big change in the next report, but, over time, over the next ten years, given what the government has committed to in terms of spending, and what we are expecting on infrastructure spend, I expect to see some improvements.  And it is worth highlighting actually – we have done a study on how other emerging market countries have benefitted from investment in their own infrastructure – a very good example is Chile.  A country in Latin America which very early on in the process, privatized a lot of national industries, they invested a lot in specific infrastructure and industries, mainly roads, actually.  They invited foreign companies to participate in these projects, building new roads, giving them concessions – contracts to operate the roads – and as a result Chile came out number 20 out of 125 countries.  So, it is possible to make the jump, and to achieve the result, as long as the right policies are taken.”RT:  How should the Russian government be attracting investors?  How critical are foreign investors in developing Russian infrastructure?TT:  “I think foreign investment is absolutely crucial, not only because it brings fresh capital, and those investors can invest alongside government funds, and Russian funds, but also because they bring know how.  Again, given that Russia has a reasonably short history of a capitalist society, and a free economy, it is of crucial importance to get the necessary skills and know how. From abroad because these countries and companies have operated for a very long time, they can be great partners for Russian companies when constructing new infrastructure.  There is something we refer to as PPP – Public Private Partnerships – these are projects where a private company is invited, could be foreign, could be Russian, to participate alongside the government and the public funding, to develop the project.  And usually what these companies bring to the party is, firstly, great skills, because they have done this in other countries – so they know how to, for example, build a road or operate an airport – and, secondly, provide monitoring, if you like, to make sure that the standard is met, and things are not done for the short term, but rather these assets will last longer term.  So probably the first thing that the government needs to do is to improve the legal structure and legislation for these PPP programmes to operate.  We have an example of the Moscow – St Petersburg road which is going to operate under such PPP scheme.  Unfortunately it has been very slow to start – we have had big delays and that has not been very good – however if this framework is sorted, this would be a very powerful model to operate. And again drawing on examples from Latin America, and other emerging market countries, that is exactly why Chile was successful, because they privatized quickly and the government worked very closely with private enterprises.”RT:  Have you other examples in Russia?TT:  “The airport in St Petersburg, is also going to be restructured and rebuilt in the same framework.  These are the two biggest noes at this stage.  We have heard a lot of proposals for new PPP projects, however at this stage nothing has been announced.”RT:  How attractive is Russian infrastructure investment for international investors?   TT:  “It is worth putting it into context infrastructure has done well everywhere in the world, it is the sort of industry which needs constant investment and reinvestment and depending on the needs, of course it delivers different returns.  However in Russia’s case, because we are starting from such a low level, because there is such a huge need, and the amounts that would need to be invested are so huge, we expect that the returns would be fantastic.  It is a little bit like – I give the example of a field.  When you have a barren field and you first want to cultivate it and to sow the seeds and to have some wheat, in the first year you get a lot of wheat.  The more years you run the field for, and the more populated it becomes the lower your returns are.  Well we are almost starting with the barren field.  So the returns are going to be very big to begin with.Just to give you an example.  Our fund which invest purely in infrastructure companies, we expect the values of these companies to at least double in the next three years, so that gives you an indication of what the potential returns could be.  Of course we need to see improvements in the investment climate, further changes and deregulation of the market, but if all of that happens, which the government has clearly stated that they want to push ahead with, then we expect the returns to be significant.”RT:  How has it done so far in the trading on the London Stock Exchange?TT:  “We only listed the fund yesterday, so today it is only a day after the listing – we hope that everything goes well.  The fund has been in existence for three and a half years, it was started at the end of 2007.  And the return that the fund has provided so far is an increase of 12 and a half percent, which is pretty good considering that the general Russian market over the same period of time has declined by 12%.  So in absolute terms it could be viewed as disappointing because, we would expect much better returns,, however when you take into account the fact that for most of its life we had the financial crisis of 2008 – 2009, and we see the broader Russian market having done so much worse, a return of 12 and a half percent is pretty good, and so it has actually done 20% better than the broader Russian market.”RT How does lack of appropriate infrastructure limit economic growth in Russia?TT:“Infrastructure is very very important to any economy.  There was a report published recently which estimated that 2 percentage points of GDP growth is lost annually in Russia because of the poor infrastructure in the country.  In other words for this year most analysts would expect GDP growth to be about 4- 4.5%.  If we had good infrastructure we would have had about 6% or over 6% of growth.   So we would have had 50% higher economic growth as a result.   So how it limits economic growth is mainly because production processes are inefficient, labour mobility is limited, you lose, as we mentioned, huge amounts of money in, for example, lost electricity, generated by the time it is to the factories or production centres.  So the nation as a whole would be far better off, and incomes would be higher, if we had better infrastructure.”RT:  How big an impact will the major events being lined up for Russia – such as the Olympics, the APEC meetings and the Football World Cup  – have on Russia’s infrastructure?TT:  “These events provide a great stimulus for infrastructure spending.  We often talk about these as new infrastructure spending but it is worth highlighting that a lot of that spending would happen anyway.  This is all part of the modernization and improvement of Russia.  What the sports events do is that they put a timeframe work to how this spending is actually being done.  Because we have the Winter Olympics in 2014, it means that Sochi needs to be built to the final stage by that year, because we cannot have an embarrassing situation where things are not built or stadiums are not constructed or there is not enough hotel rooms for the visitors.  So they provide the great stimulus for the investment and make sure that it actually gets done.  In terms of the size of it, we expect that on Sochi, the spending will probably be in the region of about $20 billion.  We started with a smaller number but usually these events end up attracting far more than were originally discussed.  For the World Cup, this is a much bigger event, we expect spending on this to be double what it would be on Sochi, and that provides an even more visible improvement in infrastructure, because there are several cities involved.  It is not just about the new stadiums that need to be connected but the government has plans to build high speed rail links between six of the cities involved in the games.  There will obviously be a lot of tourist development in terms of hotels and residential construction.  All of that trickles down the companies all the way down to metals for example.  You wouldn’t think of a metal company such as Evraz, for example, as an infrastructure, but something like 40-60% of steel goes into the construction sector, so absolutely it is an infrastructure beneficiary.  So, in terms of how these events will help Russia, firstly obviously they will result in better infrastructure, but secondly you get a multiplier effect, amounts of money get spent, that means higher employment, higher income generally, and all of that means higher consumer spending etc, and then the economy can continue to grow faster.”RT: Can other value adding sectors also benefit from the infrastructure projects being implemented, such as manufacturing?  Can Russian companies benefit from skills acquisition related to infrastructure spending?TT: “To the extent that infrastructure spending helps economic growth, it will probably have a beneficial impact on the whole economy, and on many different sectors.  Again, just to draw the analogy of the multiplier effect, if you have a construction boom that means that more people are employed in that industry, that means that incomes rise and consumer demand increases.  So it means that people will be buying more cars, for example, so you could expect an increase in car production, people would be looking to buy more property, so you would have a residential construction boom, and manufacturing specifically all need, from the infrastructure sides, would obviously result in a manufacturing boom to some extent.  Whether it is making plastic seats for the stadium, or whether it is in other areas such as furniture, for example,  to fit out the hotels that would be built for the events etc.  So for sure manufacturing would benefit.In terms of what skills Russia could take, and especially to apply those overseas, that is harder to judge, and harder to see the direct link. Obviously what Russia needs is more know how, and that could be acquired from working with foreign partners.  Infrastructure improvement would result in more efficient production processes.  You could look at the Japanese, the just in time Japanese system, is reliant on perfect infrastructure, things being delivered in time so that you don’t keep inventories, you don’t lose resources, on inefficiency.  So learning that for the Russian manufacturing sector would be of great help.  As to whether they can take these skills to apply them abroad, and gain international recognition – that is quite a big task, it took the Japanese a very long time, but they have gotten there so maybe it can be done.  But it would need quite a lot of investment and change in attitudes.”RT:  What are the risks involved when there is a big wave of investment spending? TT:“The biggest risk involved with any investment – it doesn’t need to be just Russia, but any other country – is of course, that the legal system is not welcoming for this type of investments.  Of course this is a risk in every emerging market, and I guess the biggest concern for any foreign investor would be that they would not be able to see the return on their investment coming out.  However the policy changes that we expect over the next few years and what we have heard from both Mr. Medvedev and Mr. Putin, that risk is getting smaller and smaller with every day.  So I believe that the investment climate for international investors is improving all the time, so that risk is declining.  Other risks, obviously there is always the risk that all the money that has been promised by the government doesn’t get spent because these are long term projects  -we are talking about the spending needs for the next ten – twenty years, and we don’t know what the economic situation in the world will be over that time, if we get another financial crisis for example, or a general slowdown in the economy everywhere in the world then that could  result in delays in these projects.  So that is another risk.”RT: Do you think the Russian government will be able to handle the inflationary risks involved?TT: “That is true.  Nevertheless, because we are starting from such a low level, there is probably enough capacity in the economy to absorb all that.  I don’t believe that it will be a huge issue.”RT: Do you think that changed infrastructure could result in better administrative systems?TT:“I think it absolutely does.  I think it not only helps but it is absolutely essential, because again drawing from the experience of the Japanese economy and the super efficiency of the Japanese system is a derivative exactly of the fantastic infrastructure that they have built over time.  I think improving infrastructure not only facilitates a better quality of life but it also changes attitudes of people, and having the needed technological improvement absolutely contributes to the reducing corruption.  Just to give you the example, if we had very good roads, as majority of Moscow does, but in other places we don’t.  If we had good quality roads, well signposted roads which tell you exactly what the rules are and how it should be, how people should drive, and you invested for example in speed cameras, you remove the need for policemen, administering whether the drivers are going over the speed limit or not.  Firstly that reduces costs for the government, of course you have to have an initial investment into that system, but in the longer term, it reduces costs, it makes the administrative process of drivers being fined for breaking the speed limit more efficient   because the camera can tell you exactly what you have done, you would be able to pay the fine and the case is closed.  So this is just a very small example. Obviously on a much greater scale there will be similar processes which can become far more efficient with the improvement of infrastructure.    So I think it is absolutely crucial, it would be of great benefit.”