Russia’s fading competitive edge

Just came across my article published over a year ago – no real changes for better, and the tendencies indicated back than just got stronger or more visible.

Read the text of the article below or – with nicer pictures – in pdf.

As one of the largest consulting-engineering companies in the world, Pöyry* has always been placed “between an investor and a potential project”. This position provides a means of observing and comparing various regions around the world through the eyes of a potential investor, given that we can understand his requirements and expectations. How does Russia look from this perspective, and what future may it expect?

Over the last several years, Russia has been falling behind in the global competition for large scale investments in the forest industry. This is mainly driven by rapidly increasing production input costs (electric power, wood and labour) and an underdeveloped infrastructure as well as the country lagging far behind its main competitors – South America, Asia and Eastern Europe – in terms of business environment.
This article focuses on the situation in the wood-based panels sector, with occasional digression to neighbouring products, such as pulp, sawn timber and round wood.

What Does the Investor Want?

The investor wants a potential project to be successful and profitable, based on a reliable production process and secured sales for at least 7-10 years after commissioning. This means that the project must draw on:

  • the right product (including the right production process and site);
  • the right team, both administrative and technical;
  • availability and competitive prices for main production inputs (wood, electric power, labour);
  • desirable markets (including adequate logistical accessibility and size, promising future prospects, manageable competition, and predictable tax and transportation costs); and
  • favourable business environment – i.e. the existing legislation must protect the planned business against corruption, criminal elements and unfair competitive risks.

It is thus obvious that apart from the production process and a management team, there are only three main prerequisites for a project to be successful: production inputs, markets and the business environment. It is worth noting that these three prerequisites are mutually inclusive, as a failure to meet any one will ruin the entire undertaking).
Let us now discuss some of the aforementioned prerequisites from the Russian perspective.

[Fig. 1: Main prerequisites for a project to be successful]
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Production Inputs

Production costs have traditionally been considered a major attraction for potential investors in Russia, given its cheap and abundant forest resources, inexpensive gas and power, and low labour costs. Unfortunately, this “magnet” is no longer that strong. Moreover, it continues to rapidly lose its limited remaining holding power.

Let us scrutinize the major production element, namely wood.

According to various estimates, Russia holds from 18% to 25% of global forest resources. At the same time, the production of wood-based panels and pulp in this country is hardly over 5% of global levels. The production of logs and sawn timber – even if the non-official sector is taken into account – does not exceed 10%. It is not surprising that government bodies at various levels are becoming alarmed over such a prominent imbalance and are thus appealing for businesses to develop value-added capacities inside the country. The example of our neighbour Finland brings additional frustration, as the impressive forestry sector in Finland has been built under similar climatic conditions yet with higher labour costs, taxes and energy costs (see table 1).

[Fig. 2: Global availability of wood]
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[Table 1: Production of wood-based materials in Russia and in Finland, 2007/2008*]
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The overriding conclusion is that Russia needs to urgently develop additional harvesting and wood processing capacities, the core issue being the associated required investments.

For example, the amount of wood per hectare in Finland parallels that in Russia, i.e. about 100 cubic meters. At the same time, for Russia to be able to match Finland’s harvesting yield per hectare, the country needs to inject approximately 50 bln euro into harvesting machinery and forest roads. The forest area in Russia is almost 40 times more than in Finland, whereas the harvesting volume is only three times as much, meaning Russia is a twelve-fold underrun, even if “gray” operations are taken into account.

In order to be able to catch up with Finland in terms of the yield of sawn timber per hectare of forest, Russia needs investments totaling approximately 50 bln euro, which translates into more than a ten-fold underrun. A similar move for the wood-based panels sector requires about 20 bln euro. The conclusion is that to achieve Finnish performance levels, Russia needs more than 120 bln euro in the wood processing sector alone, as the pulp industry is lagging even further behind. Overall, one can talk about several hundred billion euros, which is more than ten percent of Russia’s GDP!

What needs to be done to attract investments of such an impressive scale? Is it enough to put one’s trust on Russia’s vast forest resources only and proclaim that “investors are here to stay anyway, as we have such plentiful forests”?

Russia’s main competitors for large scale investments in the forest industry are regions featuring fast growing plantations: mainly, Latin America and Asia. Let us put aside the difference in properties of the wood and forests growth rate and compare Russia against Brazil – which is considered to be its main competitor – in terms of the issues which each respective government is mandated to provide: legislation, infrastructure and long-term guarantees (see table 2).

[Table 2: Investment climate in the forest sector: Russia vs. Brazil]
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Both Russia and Brazil have quite similar macroeconomic conditions (GDP, population, forest resources); however, the legislation and forest industry infrastructure in these countries differ significantly.
Brazil’s legislation is the result of its government’s efforts to build an investor-friendly environment. This centers on Brazil’s significantly lower infrastructure requirements, a combination of the favourable investment climate, and natural conditions: the possession of environmentally sensitive tropical forests and rapidly growing species make it possible to establish intensive, plantation-based forest management practices, which result in significantly lower infrastructure-related costs.

The differences illustrated in table 2 suggest that the volume of investments of the two countries should differ substantially as well. And they really do. This is particularly the case with the pulp and paper sector, which is the most capital-intensive of all the forest industries. Russia has not seen any new pulp and paper mill construction for several decades, whereas in Brazil this sector was booming in the last years. On average, the plantation-based regions in the Southern hemisphere have increased their share of the global fibre supply from 17% in 1990 to 44% in 2008! As one would correctly assume, Brazil, Argentina, Chile, Uruguay, Indonesia, Malaysia and Thailand are among the countries which are developing most rapidly.

Unfortunately, apart from the much less investor-friendly environment – even though this alone would be enough – Russia is currently also losing its competitive edge to the rest of the world in terms of wood costs.

Wood costs are a measure of standing stock, harvesting, transportation (including forest road construction) and reforestation costs. High costs for erecting forest road networks in Russia combined with rapidly growing labour costs and a low productivity result in wood costs delivered to a mill being virtually equal with any other “forest” region of the world.

Take, for example, softwood pulpwood costs delivered to a mill in European Russia. They are only one and half times lower as in Finland (!) but equal to those in Brazil (Pinus elliottii), Chile (Pinus radiata) and Southern Africa (Pinus patula). This is especially surprising, if one remembers that the stumpage tax in Finland is almost ten times, and in Brazil, Chile and Southern Africa five times the Russian tax.
One may conclude that the government in Russia has already exhausted all possible means of keeping the wood costs at a low level (to further decrease the stumpage tax is impossible) meaning there is only one valid option left in order to attract investments for the forest industry: through enhancing the legislation as well as improving the image of Russia as a reliable country for long-term investments.

Unfortunately, one can hardly expect that the Russian government is ready to drastically change the situation in short term. Looking at what is happening in the Russian agricultural sector, which has traditionally been “one step ahead” of the forest industry in terms of land property rights, one can see that the situation is far from being “clear and transparent”. Russia is thus rapidly moving towards a situation wherein its investment environment becomes both too risky and unaffordable. And though the wood supply is becoming scarce in many countries with growing wood product markets, Russia’s competitive position for investments is hardly better than in these countries.

Let us now discuss other manufacturing inputs for the wood products industry: power, labour, natural gas and binding agents.

Over the last ten years (fig. 3, left), power and gas prices for industrial consumers in Russia have been keeping pace with the growth of wood costs. Costs of resins in Russia already exceed those in Europe, driven by growth in related manufacturing costs as well as the domestic supply/demand balance. Please note that the prices are expressed in euros, meaning that the influence of inflation is minimised.

[Fig. 3: Basic components of production cost in Russia, 1999-2009]
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According to official statistics, labour costs in Russia remain at relatively low levels, even despite their rapid growth from 1999 to 2008. They are approximately three times lower than in Eastern Europe and Latin America and almost ten times lower than in Western Europe and North America. The difference is impressive but one should further recognise that illusive: lower taxes, a considerably lower productivity and the fact that some salaries are never reflected in official statistics results in average total labour costs in Russia are approximately equal to those in competing countries and continue to grow rapidly.

Comparing all key manufacturing inputs indicates that Russia has already lost or will soon lose its “magnetic attractiveness” as a country with low production costs.

Markets

A direct consequence of rapidly growing labour costs is growth in personal income, which results in increasing consumption.

The Russian markets on average are quite attractive for wood-based panel projects, especially those targeted toward local markets. Between 2003 and 2008, the production of wood-based panels in Russia grew by 12% per annum, while annual consumption increased by about 11%. Since particleboard, for example, is mainly produced and consumed in domestic markets, Russia is seen as a suitable location for a potential project, as on the one hand it may offer abundant wood supply, while on the other hand it offers large and rapidly developing markets. With the cost of a cubic meter of MDF, OSB or plywood being higher than that of particleboard, the former can be transported greater distances with no significant increase in the final price for the consumer. This makes Russia an interesting investment opportunity for producing goods which can be sold both domestically and abroad. The more value that is added to the product (for example; an MDF panel, a faced MDF panel, MDF-based laminate flooring), the more accessible the export markets are. However, the competition is increasing as well.

See more details in pdf.

[Fig. 6: Population and new residential construction in Russia]
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Business Climate for Investor

For the purpose of our study, one may approach the business climate from two perspectives:

  • climate for investors; and
  • climate for producers.

The climate for investors in Russia remains challenging. The underlying problem has been traditionally attributed to corrupt government officials; however, this appears to be an oversimplification.

Let us offer an example which any producer would find easy to recognise and understand.

If a company establishes a simple, transparent and predictable sales policy, the climate within the company becomes resistant to corruption and open for potential new partners. An open price list, featuring fixed discount rates for additional volumes or loyalty as well as clear guarantees to sustain deliveries in the event of a backlog, leave no or little room for corruption. In order to attract potential partners, the system may not be just “equal to all” or “primarily friendly for newcomers”, instead simply being transparent and predictable.

If the situation is the opposite one – a closed price list with a complicated system of discounts for which unclear granting criteria are used, back-room fights over deliveries in case of undersupply etc. – we can see a perfect platform for corruption of all types.

Expanding this example to describe the situation on a country-wide scale, it becomes obvious that corruption will arise if the corresponding controlling legislation is complicated and responsibilities are ill-defined. This occurs not in a matter of just a few months, as it takes time for officials and the legislation to become corruption-oriented. This process is self-perpetuating and concerns many related issues: allocation of land, securing infrastructure needs, approvals and permitting documents. On top of this, the mere fact that certain infrastructure elements are donated by the government is prone to widespread abuse, as certain responsible individuals and parties would find it difficult to refrain from capitalising on their full control over such resources.

If we return to the sales policy example and imagine that a mill has only one distributor (which corresponds to a situation when there is a state monopoly entity), it would mean that the mill is fully dependent on the distributor and a significant portion of the profit goes to the distributor. But if the mill seeks any opportunities to directly sell its products, up to and including retail sales, it would mean that the sales process itself starts consuming significant resources and even becomes a non-core (albeit important) business for the mill. In other words, in the context of attracting investment at a national level, a dialogue between large- and mid-size businesses can be more beneficial than establishing state owned corporations or holding referendums. While there are exceptions to this rule, the forest industry can hardly be seen as one of them.

Business Climate for Producer

Let us now assume that an investor has managed to overcome all difficulties and – with the help of connections to numerous local authorities – a new mill has been constructed and is undergoing start-up operations. From this moment the range of potential prohibitions to continued operating is narrowed to excessive inspections, approvals and associated delays from authorities, who at the same time are vitally concerned to keep the mill successfully running, given it is a source of taxes.

Nevertheless, even «good connections» cannot be a guarantee for the business to remain successful in the longer term. Risks relating to an absence of predictable legislation are ever-present, which is especially ruinous for projects with a payback greater than 3-5 years. This is probably one of the major reasons for potential investors shying away from coming to Russia.

It is self-apparent that privatisation of forests would be the most reliable long-term guarantee for large forest industry players, as such is the case with Brazil (see table 2), because the requisite forest guarantees would no longer depend on the overall investment climate in the country. However, solving this problem firstly requires finding an answer to the potential consequences for middle and small-size forest businesses as well as developing a plan of practical actions to implement such privatisation. Fortunately, Russia can, if it so chooses, draw on the experiences of other countries.

[Fig. 7: Commissioning of new capacities in wood-based panels sector]
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The situation regarding investments in the Russian forest industry, although far from being ideal, is recoverable. The investment activity is low in the pulp sector but quite high in the less capital-intensive wood-based panels industry (see fig. 7): the relative share of new capacities that were built over the last decade is almost as high as it is in Eastern Europe, Latin America and China. Russia is one of the most attractive markets and one of the richest forest regions on the planet. One just should not ignore the fact that the situation is getting worse and capitalise on those advantages, which Russia so far can offer.

Footnote for the first page:
* Pöyry Group is one of the leading consulting and engineering companies with the focus on forest industry, construction and energy sectors. The company has over 50 years experience of consulting to pulp, paper, sawnwood and wood-based panel industries worldwide. Pöyry Group has a global network of over 7000 experts in 200 offices covering all major forest products regions in 50 countries. Net sales of the company were 673.5 million EUR in 2009. Pöyry Management Consulting is a consulting arm of Pöyry Group.

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