Privatization in the CIS.

Investments in the former Soviet Union are on the block at a discount to their true value. But U.S. firms, uneasy about the region's volatility and a lack of financial data, remain on the sidelines. What will it take to lure them into the action?

Large-scale reforms sweeping the independent republics of the former Soviet Union pose a challenge to a new generation of politicians and entrepreneurs in the fledgling CIS. But Western investors, too, face a window of opportunity and a hard choice. They can cast aside their apprehensions about a market undergoing rapid transformation, and invest in a region with vast growth potential and a pent-up demand for everything from consumer goods to technical and management expertise. Alternately, they can play it safe, confining themselves to minor deals thai do not require large capital investments or remaining on the sidelines altogether.

Naturally, every potential investor must make this choice based on the needs and strategy of his business and his tolerance for risk. But keep in mind that CIS governments have made significant headway in eliminating some of the more stubborn investment obstacles. They have assumed the former Soviet debt and taken steps to ensure the convertibility of the ruble. They have created at least the rudiments of a legal infrastructure and moved to guarantee the security of foreign investment.

As a former deputy prime minister under Mikhail Gorbachev and, more recently, as president of the non-governmental International Foundation for Privatization and Foreign Investment, I have a unique perspective on investment and opportunity in the CIS. FPI functions as an investment bank, working to expedite deals between outside investors and operations formerly held by the Soviet government. But it also aims to bridge the information gap often encountered by outsiders--perhaps the most significant hurdle to business partnership. Toward that end, I will describe the deals with which FPI is involved and provide a ground-level view of obstacles to doing business in the CIS. I hope the effort will help prospective Western investors.

CAPITAL SHORTAGE

This much is certain: Under extreme economic hardship, the CIS has thrown open its doors to foreign capital and investment. A large-scale privatization effort is underway and opportunities exist in industries including telecommunications, mining and natural resources, financial services, and cargo air transportation. In many cases, such investments are available at a substantial discount to their true value. But this situation will not last forever.

Few large U.S. companies take seriously the notion of investment in the CIS: A short list includes Chevron, Coca-Cola, Marlboro, and Boeing. Overall, the U.S. continues to lag far behind West European investors, particularly Germany. According to data compiled by FPI, U.S. investments in the CIS last year failed to reach $500 million--that's less than U.S. investments in Hungary.

Indeed, outsiders have barely scratched the surface. More than $3 billion has been invested in the property of 5,000 post-Soviet enterprises with foreign participation. But the foreign capital actually working in the economy is less than a third of that sum. The share of joint ventures in foreign trade is less than 2 percent--their export share is slightly more than 1 percent. The share of machines and equipment in the exports of joint ventures does not exceed 20 percent, while the share of raw materials is 60 percent.

In an attempt to redress this imbalance, FPI employs a two-step strategy: privatization of an enterprise followed by the development of an investment project and attempts to attract Western capital, particularly in the forms of direct investment or an equity holding.

ONE-STOP SHOPPING

Some details about FPI, known in Russian as the "Interprivatizatsia" foundation:

We were conceived in October 1991 and chartered in February 1992. Our members and those with whom we have a working relationship include more than 300 large international banks, law firms, insurance companies, and trading and industrial concerns. Among these are Rothschild Bank and Deutsche Bank. At home, our co-founders include such business and trade associations as the Scientific and Industrial Union, the Union of Entrepreneurs, and the Union of Joint Ventures. Among our domestic members are truck manufacturer Kamaz, auto manufacturer Avtovaz, and major banking groups such as Promstroibank, Inkombank, and the All-Russia Stock Exchange Bank.

Originally we were capitalized at 15 million rubles and $500,000. That has since ballooned to 350 million rubles ($1.1 million) and $85 million. Perhaps most important, we have more than 50 offices in the 12 ex-Soviet republics. We have opened regional branches in 25 major industrial centers in the CIS and four representative offices in Kazakhstan, Uzbekistan, Tajikistan, and Kyrgyzstan. Abroad, the foundation has representative offices in Vienna, Zurich, and San Francisco. We are planning to open offices in Berlin, London, Japan, and Taiwan. We employ 250 people in Moscow and another 1,000 throughout the CIS. We insure or take a stake in some of the deals we arrange, and in some cases receive a percentage of any transaction.

Why would a Western investor want to work with us rather than working directly with a CIS partner? For one thing, while high-quality partners are available, they may be hard to find. FPI offers potential collaborators the advantage of one-stop shopping. We are equipped to cut red tape (no pun intended) and lead our partners through a deal from an initial study to a final agreement. In addition, we have contacts on the commonwealth, regional, and local levels.

PARTNERSHIPS IN PROGRESS

The foundation is involved in a number of projects, while many others are in the planning stages. Our largest project is with Siemens AG, the German telecommunications and electrical equipment manufacturer. It aims to place space platforms in near-Earth orbit and create from them a new system of telecommunications.

We have also completed the privatization of the Ust-Kamenogorsk lead and zinc mining works, responsible for 75 percent of the lead and zinc output of the former U.S.S.R. The company was converted to joint-stock status, and on June 18, agreements were completed to invest nearly $600 million in the plant. Naturally, the capital injection will change the plant beyond recognition.

At one time, the plant was as sick as the rest of our industry. It used backward technologies and was a heavy polluter. State organizations tried for years to solve these problems by using old, inflexible methods. They made futile attempts to attract foreign investors. However, as soon as it was rumored that the plant would be privatized, Japanese, Korean, U.S., and German firms began to line up at the door, along with FPI.

Among other projects, we are:

* Setting up sea terminals jointly with the Kensington Group for an annual shipment of 1 million tons of condensed gas.

* Constructing a facility in Siberia to tap a natural gas deposit and produce 1 million tons of methanol per year.

* Moving to tap the largest gas and oil condensate deposit in Siberia.

* Holding an international tender offer in conjunction with New York-based Bankers Trust to develop the Udokan copper ore deposit, the world's largest.

* Using technology to make the equipment used by oil and gas enterprises more efficient.

* Boosting the productivity of refineries in the oil-rich Samara region, and helping them to become more export oriented.

* Organizing and developing cargo air transportation between Western Europe and Southeast Asia.

* Jointly developing non-ferrous and polymetals in Kazakhstan.

ROADBLOCKS TO INVESTMENT

Typically, Western entrepreneurs say the risk of substantial losses surpasses any expected profits from cooperation. Some of their fears--and our assessment of the situation--are outlined below:

Political instability. This is what prospective investors in the CIS fear most. We maintain, however, there is no danger of a Communist coup in Russia--or of the expropriation, nationalization, and confiscation of property it would entail. We have passed the critical point. Any government will continue to push market-oriented reform.

In the other republics, the situation is improving.

Crowded capital markets. The CIS countries are scrapping for funds at an inopportune time. The markets are flooded with the property of former Communist nations in Eastern Europe, Latin America, and Africa. Many of these are better-equipped to attract investment because of their vast resources and higher-quality infrastructure.

Native paranoia. Some of our more naive domestic partners still believe that Westerners are scheming against us and seeking to buy our assets for a song. Old attitudes die hard.

In fairness, however, on occasion the state has failed to properly protect valuable properties. When Chevron kicked off joint development of the Tenghiz oil and gas deposit in Kazakhstan, the deposit was valued at 1.5 billion rubles. World-renowned experts later raised the appraisal to about $2.5 billion, but I think even that price understated the deposit's actual value.

There must be a fairer, more accurate method of valuation. For example, even if a dollar-ruble exchange rate of more than 160-to-1 were used to evaluate the research and production facility manufacturing "Buran" space shuttles--Russia's pride and joy--its purchase price would have been roughly equivalent to that of only 20,000 computers!

On the other hand, I agree with my Western colleagues that it would be fair to convert incoming investment dollars at the same rate as outgoing profits from investments. This would promote stability, facilitate negotiations, and enhance the predictability of profits.

Insurance and guarantee concerns. The problem of guarantees is extremely important, particularly to U.S. investors. Corporate America has repeatedly pressed Washington to create government insurance funds along the lines of those in Western Europe to support their endeavors in the CIS. Thanks to insurance programs by the French government, the Elf-Aquitaine and TOTAL oil companies have been among the leading investors in Russia.

To be sure, there are promising developments and possibilities in this area. For example, investments could be insured by granting credits and guarantees with the use of funds allocated by U.S. and Western European governments as part or assistance to the CIS, and also through powerful financial organizations such as the Overseas Private Investment Corp.

By themselves, post-Soviet insurance companies cannot carry the load. However, FPI tries to offer variants of insurance programs to its partners, sometimes in conjunction with an independent republic. One example: When republics pledge mineral deposits--oil, gas, gold, nonferrous metals, or diamonds--Western banks invest dollars, and we invest rubles. The result: A pool is created that reduces financial risks and opens up cooperation opportunities.

Simultaneously, the foundation develops contacts between foreign and domestic insurance companies. Under a collaborative arrangement, Russia's largest joint-stock insurance company, Rosgosstrakh, may soon offer large-scale insurance of foreign investment projects. FPI also organizes its own insurance companies, again, in conjunction with larger, Western insurance and financial-services companies.

Changing taxation policies. Large investments will not be made as long as there is a risk of a dramatic tax increase. This situation is aggravated by constantly changing legislation: Foreign and domestic entrepreneurs alike suffer greatly from our unpredictable taxation policy.

Under conditions of hyperinflation and significant price volatility, it would be wrong to demand absolute stability. Nonetheless, any tax changes should not affect agreements that have already been signed. Hopefully, the new law on foreign investments will include articles protecting investments from changes in taxation.

Other legislation. Firms justly complain about the apparent capriciousness with which laws are applied. Perhaps even worse, regional or local authorities frequently feel free to interpret, defy, or ignore laws. Firms also complain about uncertainties related to red tape, the distribution of powers, and the overlapping jurisdiction of central and local authorities. Some refer to the latter situation as the "War of Laws."

Simply put: Foreign businesses want to know who is authorized to sign contracts and issue licenses. They want to have permanent partners. Before they can begin operations, they are often forced to run a gauntlet of departments and agencies. Many of these businesses emerge more dead than alive.

Under present law, a government order is needed for any investment exceeding 100 million rubles. One must also get the visas of the Ministry of Economics, the Ministry of Foreign Economic Relations, Customs and the branch ministry, and the consent of the local administration. If all goes well, the whole procedure will take three to four months. But if something changes, the process must be begun from scratch.

Umberto Agnelli, chairman of the Vienna International Council, once correctly observed that in Russia, negotiations on foreign investment are frequently held but rarely completed. This must change.

Accounting difficulties. Our enterprises do not have much experience in Western-style profit and loss accounting. Thus, there may be discrepancies in their financial reports that hamper the analysis of a project's viability or performance.

In most of these areas, meanwhile, there have been great improvements. Compared with January 1992, when market reforms in Russia were launched, we have many achievements to our credit. The CIS countries' decision to assume Soviet debts restored the faith of some Western partners. Though certainly imperfect, laws guaranteeing foreign investments and those extending the possibilities of project insurance were adopted. Hard currency auctions have been introduced, making the ruble somewhat more convertible. Free economic zones have been created in Kaliningrad, Nizhni Novgorod, and Sakhalin, while major industrial centers, including Moscow and St. Petersburg, have upgraded their infrastructures.

Russia and its fellow independent states need to do more. But in general, the business climate in the CIS is getting better.

BLUEPRINT FOR PROGRESS

The basics are in place to ensure better cooperation between Western partners and their counterparts in the CIS. Perhaps most significant, there is a mutual desire among many senior government and business officials to continue the march toward market reform and eventually tear down remaining trade, legislative, and regulatory barriers.

Under pressure from the U.S. business community, political restrictions on trade with ex-Soviet republics were eliminated, including the Jackson-Vanik Amendment. At a meeting in June, President Bush and President Yeltsin agreed to explore additional cooperation between the U.S. and Russia. Bilateral trade and investment agreements have been signed, and U.S. firms have a chance to use in the Russian market the financial support of OPIC.

Yeltsin also promised to lower the tax on foreign investments, allow the sale of land to foreign investors, and introduce a single-ruble exchange rate. Bush told Yeltsin the U.S. was aiming to become more active in the Russian markets, a sentiment that has been echoed by Commerce Secretary Barbara Franklin.

At least at this stage, government has fulfilled its mission. It has built a launching pad for direct collaboration. Now private industry must pick up the bail.

We stand poised at the brink of a historic opportunity that will have decisive, long-term political, social, and economic consequences for the global community. At the risk of being accused of boosterism, I suggest we must not fail to take advantage of this opportunity.

Vladimir Scherbakov is president of the International Foundation for Privatization and Foreign Investment, roughly the private-sector equivalent of Germany's Treuhand. Scherbakov, also a former deputy prime minister of the Soviet Union, recently addressed a gathering of business leaders in New York sponsored by the Chief Executive. A question-and-answer session at the forum will be published in CE's January/February edition.