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August 28, 2009

F. John Mathis
Barbara S. Petitt

Foreign Investment in Russia:

Challenging the Bear
The Management Issue
In May 2008, the executive team of MLC Corporation (MLC) became deeply focused on the question of whether
to expand its production and distribution operations into Russia. The Russian economy had grown dramatically,
thanks mainly to rising natural gas exports to Europe. A sharp rise in energy prices had further accelerated the
growth of the energy sector, as well as supported the expansion of the economy. The Russian star was beginning
to shine again.
Thus, in early January 2009, Max Olexi, the CEO of MLC, was faced with three potential alternatives. The
first was to expand plant capacity at home and continue to export, as the company had done so successfully for
years. The second was to risk building a manufacturing plant and distribution center in Russia, and strengthen
the company’s competitive position abroad. The third alternative was to wait and delay both decisions due to
the uncertainties caused by the global financial and economic crises. Whether Russia could manage its economy
to avoid the worldwide recession and an internal financial and economic crisis was an open debate.
Despite the positive expansion of the Russian economy during most of 2008, several clouds on the horizon
had extended MLC executives’ discussions to the end of the year. One key concern was the leadership change, as
Vladimir Putin could not, by law, run for another term as president. How would Prime Minister Putin and his
successor, President Dmitry Medvedev, get along, and what would be their attitude toward foreign companies
operating in Russia? A second key uncertainty was the concern about what would happen to energy prices go-
ing forward. Some experts believed that the present price level was too high, while others talked of even higher
prices in the near future. Oil prices had already declined sharply during 2008, although natural gas prices had
remained more stable. A third worrisome factor was the deterioration of the U.S. relationship with Russia that
began in the last year of President George W. Bush’s administration. Finally, there was growing concern about the
serious trouble experienced by the U.S. and British financial systems following the subprime mortgage crisis of
2007. Because of declining international trade, the economic slowdown that began in the U.S. had spread and
was now adversely impacting economic growth in the rest of the world. MLC’s primary bank was Citi (formerly
Citibank), which was suddenly at the forefront of the deterioration of the financial system in the United States.
Although MLC had little bank debt, they were counting on Citi to provide operational support for global cash
management, foreign exchange, and other activities.
Max Olexi was soon to present his recommendation to the Board about the best management decision
for MLC. Should he advise increasing capacity at home or in Russia? Or just wait a little longer? But how long
could MLC afford to wait? He had to look at the facts, weigh the pros and cons of each alternative, and justify
his choice to the Board.

The Management Conundrum

U.S.-based MLC was a major producer of transportation, transmission, and utilities infrastructure equipment
and supplies. Over the years, the Russian federal and state governments had grown to become its major market.

Copyright © 2009 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professors F. John
Mathis and Barbara S. Petitt, with research assistance from Yulia Fenzl, for the purpose of classroom discussion only, and not to
indicate either effective or ineffective management.

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By 2008, the company’s exports to Russia represented $493 billion, more than 72 percent of MLC’s revenues.
The remaining revenues also included export sales to various Eastern European countries, including Georgia.

MLC was currently operating at full capacity, and could not keep up with the growing demand for its
products. As shown in the selected financial data in Exhibit 1, the company had become extremely profitable,
hitting new sales and net income records each quarter for the past four years. Not only was it extremely profitable,
but it had built up a large cash reserve and held a clear, dominant, and near-monopoly position in its market
niche. There were, however, growing concerns among the management team that this situation was unsustain-
able. Unless new capacity was added very soon, MLC would either have to turn down orders, delay them, or
outsource some of its production. Outsourcing was not a popular subject internally, as most middle managers
were truly opposed to it.

Exhibit 1. Selected Financial Data for MLC Corporation, Inc.

US$ billions

Income Statement
Year Ended Dec. 31 Revenues Net Income
2004 374.2 46.0
2005 418.9 59.1
2006 481.7 74.2
2007 568.4 97.8
2008 682.1 122.8
Balance Sheet (Year Ended Dec. 31, 2008)
Assets
Current assets:
Cash and securities 232.1
Accounts receivable 78.5
Inventories 33.6
Total current assets 344.2
Property, plant and equipment
Cost 526.8
Less: Accumulated depreciation (106.0)
Goodwill and intangibles 142.0
TOTAL ASSETS 906.2
Liabilities
Current liabilities:
Bank loans 2.0
Accounts payable 13.4
Notes payable 5.6
Long-term liabilities:
Debt 10.0
TOTAL LIABILITIES 31.0
Equity and retained earnings 875.2
TOTAL LIABILITIES AND EQUITY 906.2

MLC was mainly an equity-financed company, with only $98.7 million of interest-bearing debt vs. $875.2
million of equity at the end of 2008. This, in fact, had been an issue lately, as vocal shareholders were asking
for the company to distribute some of this cash either via an increase in dividends or a share buy-back program.
Though profit had been rising over the years, the dividend per share had been maintained, mainly because the
management team was reluctant to commit to an increase in dividends. A share buy-back program had been
contemplated as a more flexible way of returning cash to the shareholders. In light of the current financial and
economic turmoil, and the potential financing of the increase in capacity, Max Olexi was not sure whether such
a program was still on the agenda.

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The Russian Economy: Growing Concerns

Standard & Poor’s rating service lowered the Russian long-term sovereign credit rating to negative on October
23, 2008, because of the deterioration in the banking sector. This downgrading of the rating came as the yield
on 20-year Russian government bonds rose to 10.94 percent from 6.52 percent in December 2007. This rise
reflected the softening in demand for Russian bonds as investors looked for safer securities, and concerns were
growing about the deteriorating financial and economic outlook for the Russian economy. The yield on bonds
issued by Gazprom, Russia’s largest producer of natural gas, was 700 basis points above emerging market sovereign
debt, and the rating change would only raise the cost of funds for business in Russia. Furthermore, the Russian
stock exchange had fallen 80 percent since May 2008. Foreign investors in Russia were shaken by rumors of a
possible interest payment default on $250 million of bonds by Finance Leasing Co. (aircraft leasing)—the first
by a state-owned company on foreign debt since Russia’s 1998 financial crisis.

Recent Economic Performance

Over the last five years, the Russian economy had continued its sustained steady development with a stable
annual real GDP growth of around seven percent. The Russian economy still remained overly dependent on
oil and natural gas and other extractive sectors, such as timber, precious metals, nonferrous metals and steel,
despite the government’s renewed efforts to build more of a manufacturing base, especially in the automotive
and aviation sectors. Higher global prices for oil and natural gas continued to be the engine behind much of the
growth (the highest average global price for crude oil was recorded by the International Monetary Fund (IMF)
as $121.1 in the second quarter of 2008).1 Russia’s oil and gas industry continued to prosper from high
prices and increasing exports. Some of the recent mergers and acquisitions among top industry giants
Gazprom, Rosneft, and Lukoil had shown that the industry was consolidating, maturing, and emerg-
ing as a leading driver of growth within the energy sector in terms of operation, service, equipment,
and technological development.
Exhibit 2. Energy Prices
(US$ market prices at year end) 2004 2005 2006 2007 2008
Natural Gas (U.S. $/000 M^3)
Russian Federation 135.2 212.9 295.7 293.1 576.7
United States 212.7 319 242.7 251.1 210.1
Petroleum, spot (U.S. $/barrel)
Average annual crude price 37.7 50.0 58.3 64.2 99.7

The 2008 presidential election created a ruling “tandem” between the new president, Dmitry Medvedev,
and the prime minister and former president, Vladimir Putin. Despite the economic downturn triggered by
lower commodity prices (see Exhibit 3), restricted access to external financing, risk of steep local currency (ruble)
devaluation, and the overall condition of the
Exhibit 3: Commodity Prices with IMF Forecasts global economy, the government’s popular-
(1995 = 100) ity had not diminished. Moreover, a recent
constitutional change had extended the presi-
dential term from four to six years, which was
interpreted as a signal of the country’s possible
transition toward authoritarianism.

The country was still in the process

of transitioning from a socialist, centrally
planned economy, to a more open, market-
oriented one. Government bureaucracy,
underdeveloped rule of law, and corruption
affected such areas as establishing a business,
Source: IMF staff estimates. tax collection, dispute settlement, property
rights, product certification, and standards, as
1
International Financial Statistics, IMF, February 2009, p. 72.
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well as Russian Customs clearance.2 However, the government was taking steps to improve business condi-
tions in the country.3 Although data in Exhibit 4 show that the local currency had been appreciating in
recent years, the government had been unable to keep the currency from depreciating in 2008.
Exhibit 4. Monthly Average Exchange Rates:
Russian Rubles per U.S. Dollar

Source: Pacific Exchange Rate Service.

The sharp rise in energy prices since 2005 (see Exhibit 3) brought with it a sharp rise in Russian international
reserves, which at their peak in early 2008 almost reached $650 billion. Would the government use these funds to
stimulate the economy and restore financial stability? The incursion into Georgia cost the government more than
$16 billion and an estimated loss of more than $60 billion in foreign investments in Russia. So far, the Kremlin
had pumped more than $110 billion in liquidity into the banking system and the stock market in an attempt to
stabilize and turn the economy around. Despite this interest in supporting the economy, foreign investors had
stopped buying Russian bonds, making the Kremlin’s challenge even greater. To strengthen its financial hand, the
Kremlin had then turned to the oligarchs and pressured them to inject somewhere between 10 to 30 percent of
their personal wealth into the declining stock market and failing banks. This resulted in the oligarchs’ companies
becoming short of cash, making them vulnerable to financial problems and more dependent on the Kremlin for
aid. Consequently, many oligarchs would have little choice but to cancel their investment projects, leaving the
Kremlin as the only major source of funds left in the country—but would it step up to the task?

Total Russian external debt was about $527 billion and, as the ruble was depreciating, dollar-denominated
debt was becoming a problem due to the increased cost of servicing it. The ruble has gone from about 23 per
U.S. dollar in the third quarter of 2008 to 28 per U.S. dollar in December 2008—a 22 percent depreciation
of the ruble that seemed to be unstoppable. Most of Russia’s commodity exports were priced in U.S. dollars,
and with oil prices cut by two-thirds and nickel prices down about 80 percent from their peak, export revenues
continued to decline sharply. An important exception was natural gas, where Russia had more monopoly power
in maintaining, and even raising, prices to its European buyers. But overall, Russian foreign exchange reserves
had fallen from $582 billion in July 2008 to about $412 billion at the end of December 2008.

The Russian government was facing a difficult decision between spending the surplus it had accumulated,
when commodity prices were high, to shore up the economy, or not spending it (or spending too little), and
risking possible widespread banking and corporate defaults as well as a further depreciation of the ruble. The
latter would stop investment in capital expenditure projects in transportation infrastructure, and in replacing
maturing oil and gas fields, which could hurt MLC tremendously. At the end of 2008, it was believed that the

2
Country Trade Sourcebook, Official Export Guide, SGK, 2009 edition, pp. C2-1105.
3
At the start of 2009, the corporate tax rate was reduced from 24 to 20 percent, and the tax rate on small enterprises was
cut from 15 to five percent. http://portal.eiu.com/report_dl.asp?issue_id=1684276153&mode=pdf.
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government would spend about $200 billion to buy up a significant share of foreign debt outstanding estimated
at about $380 billion—of which a substantial share was bank debt and corporate debt.
Preliminary output numbers in early 2009 suggested a continuation of the slowdown in industrial produc-
tion and real GDP growth that began in the fourth quarter of 2008. Along with the fall in real GDP, private
consumption, investment, and exports had also declined. Nobody knew whether this economic situation was
temporary or going to be more long-term. Unemployment and high inflation had eroded consumers’ purchas-
ing power and triggered a decline in consumer confidence. Even so, corporations were reporting that credit was
still readily available, although more expensive for most of them. With inflation still persisting at a relatively
high level, around 15 percent, interest rates would continue to remain high for some time unless the economy
crashed more dramatically than expected.

Stimulative Monetary and Fiscal Policy but Growth Slows

In early 2009, fiscal policy became more stimulative. The government introduced a reduction in the corporate
tax rate of 20 percent, down from 24 percent, and it cut the tax on small businesses to 5 percent from 15 per-
cent. These new tax cuts, plus the reasons mentioned earlier for the decline in government revenues, suggested
that a large government budget deficit (as high as 6 percent of GDP) would be necessary if the Kremlin were to
stimulate the economy any further.
Monetary policy, which had been stimulative, began to tighten in order to protect the ruble. As the govern-
ment had injected an increasing amount of liquidity into the banking system to keep it sound and able to lend,
the result had been an increase in the supply of rubles and a depreciating currency. Consequently, the Central
Bank had been buying rubles and had reportedly spent about $200 billion to slow the depreciation. It had also
begun to tighten monetary policy, which resulted in a rise in interest rates and some stability in the value of the
ruble. The targets for Russian economic performance are based on an average of the past 15 years’ actual data
from the IMF. The data were then adjusted to a level to reduce unemployment to about five percent, and to
make Russian targets comparable to other countries in a similar stage of economic growth and stage of economic
development.
Given government policies, only a modest slowdown was expected in the economy, with real GDP growth
estimated at around 3 percent for the year, down somewhat from an estimated 5.6 percent for 2008 (see Exhibit
5). This would require the Russian government to maintain a strong fiscal stimulus; otherwise, real GDP growth
could slow sharply. The slowdown in the global economy, particularly in Europe, as well as the decline in com-
modity prices, would have a negative impact on Russian exports and on domestic growth. The depreciation
in the ruble would raise the cost of imports and put upward pressure on inflation (or at least limit its decline).
Consumer price inflation was at about 15 percent in mid-2008, but had eased somewhat since then, primarily
because of the tightening of monetary policy. The expected slight softening in the growth of aggregate demand
and the maintenance of tighter monetary policy entering 2009 were the main reasons anticipated for slowing
inflation in 2009.
Russian Real Growth and Inflation
Exhibit 5. Russian Real Growth and Inflation
Inflation
Year %¨GDP %¨P
2009e 3.0 12.0
2008 5.6 14.0
08
09 2007 8.1 9.0
+/-2% 2006 7.7 9.7
06
07
8%

- 0 + 8% Real GDP Growth

Source: F. John Mathis.

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Russian External Sector

The large current account surplus of almost $100 billion in 2008 began to weaken rapidly in the last quarter
as energy prices declined. The outlook for 2009 was heavily dependent on the outlook for oil prices, which
some experts believed would rise later in the year. Meanwhile, the relatively firm domestic growth in demand
would be offset somewhat by the higher import prices because of ruble depreciation. Thus, the current account
was expected to be a much smaller surplus for 2009. The financial account of the balance of payments, which
had seen strong capital inflows into Russian investments, had also been reversed later in the year as the outlook
deteriorated for the economy, energy prices, interest rates, stock prices, and the ruble. Preliminary data for the
fourth quarter of 2008 indicated that capital outflow may have exceeded $125 billion.

The net result had been a sharp decline in Russia’s international reserves, reducing the government’s abil-
ity to promote countercyclical policies. The weak performance of the global economy in 2009 was expected to
limit any recovery in the volume of any new foreign investments in Russia in the year ahead. Consequently, the
ruble would require occasional government intervention to prevent further selling pressure. In January 2009, the
government established a wide 26 to 41 ruble per U.S. dollar/euro currency basket trading range for the currency.
The expected rise in interest rates would also likely be dependent upon the timing and extent of selling pressure
on the ruble. Therefore, it was expected that the ruble would be more stable in 2009.

Russian
Russian International
Exhibit 6. Russian Accounts
International Accounts
International Accounts
09 09
++ %¨Fx
%¨Fx Year
Year %¨Fx
%¨Fx B/P%GDP
B/P%GDP
Depreciation
Depreciation 2009e 40 -10
2009e 40 -10
08
08 2008
2008 19.7
19.7 -2.9
-2.9
2007
2007 -6.8
-6.8 11.5
11.5
2006
2006 -8.5
-8.5 10.9
10.9

-- ++
B/P%GDP 00 B/P%GDP
B/P%GDP B/P%GDP
+/-5%
+/-5% 07
07
06
06

-- %¨Fx
%¨Fx
Appreciation
Appreciation

Source: F. John Mathis

The targets for the international side of the Russian economy are based on data for the past 15-year aver-
age. The target zone for policy purposes is comparable to other countries in a similar stage of economic growth
and stage of economic development.

Direction of Russian Trade

As indicated in Exhibit 7, the majority of the $152 billion Russian trade surplus was a result of natural gas and
oil exports, primarily to Europe. This surplus resulted in a net euro currency exposure in U.S. dollar equivalent
terms of an estimated of $76 to $93 billion. This meant that Russia would gain U.S. dollar purchasing power
if the euro were to appreciate, but would lose this power if the U.S. dollar were to appreciate instead. Thus,
for every one percent appreciation of the euro relative to the U.S. dollar, the exchange rate benefit to Russia in
U.S. dollar terms would be the equivalent of $760 to $930 million. This would be reflected, for example, as an
increase in the value of Russia’s international reserve holdings. During 2007 and into early 2008, when the euro
appreciated against the U.S. dollar, Russia potentially gained the equivalent of between $19 and $23 billion in
the value of its international reserves. However, the appreciation of the U.S. dollar since mid-2008 by about 23
percent had nearly wiped out this entire currency benefit for Russia.

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Exhibit 7. Direction of Trade—Imports and Exports, 2007

Direction of Trade - Exports (2007) Direction of Trade - Imports (2007 )

3% 1% 1% 4%

24%
34%

52% 50%

20%
9% 1% 1%

Industrial countries Africa Asia Europe Middle East Latin America Industrial countries Africa Asia Europe Middle East Latin America

Source: IMF, Direction of Trade.

Marc Olexi was looking at all the information he had gathered on the Russian economy. Was it the right
time to be bold, and build a manufacturing plant and a distribution center in Russia?

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Russia: Economic Performance 2001 to 2008

2001 2002 2003 2004 2005 2006 2007 2008e
National Accounts (% of GDP)
Household Consumption (Rbs, millions) 4,416,900 5,531,860 6,694,180 8,553,960 10,728,200 13,118,000 16,159,000 16,282,000
Consumption (%) 49.39% 51.08% 50.55% 50.18% 49.61% 48.80% 48.99% 40.26%
Investment (Gross Fixed Capital Formation)
1,689,000 1,939,000 2,432,000 3,131,000 3,837,000 4,968,000 6,951,000 7,407,080
(Private and public investment), (Rbs, millions)
Investment (%) 18.89% 17.90% 18.36% 18.37% 17.74% 18.48% 21.07% 18.32%
Government Consumption Exp (Rbs, millions) 1,469,960 1,911,330 2,330,570 2,847,490 3,590,720 4,589,100 5,703,000 7,250,000
Government (%) 16.44% 17.65% 17.60% 16.70% 16.60% 17.07% 17.29% 17.93%
Exports (Rbs, millions) 3,299,560 3,813,690 4,655,880 5,860,400 7,607,260 9,079,330 10,043,000 11,479,149
Exports (%) 36.89% 35.21% 35.16% 34.38% 35.18% 33.78% 30.45% 28.39%
Imports (Rbs, millions) 2,165,930 2,646,200 3,153,920 3,773,860 4,648,280 5,656,770 7,189,000 9,417,590
Imports (%) 24.22% 24.43% 23.82% 22.14% 21.49% 21.04% 21.79% 23.29%
Nominal GDP (Rbs, millions) 8,943,580 10,830,500 13,243,200 17,048,100 21,625,400 26,879,800 32,987,000 40,440,000
GDP (USD, millions) 236,117 340,749 449,616 614,375 751,338 1,020,838 1,343,874 1,599,210
Real GDP (Rbs millions, 2000 prices) 7,677,600 12,347,700 13,243,200 14,190,300 15,096,700 16,206,900 17,521,000 19,415,200
Population (millions) 146.7 146.2 145.4 144.7 143.9 143.2 142.5 142.0
Unemployment (% of labor force) 7.8 8.0 8.3 8.1 7.6 7.2 5.8 6.0

Balance of Payments (% of GDP)

Trade Balance (USD, millions) 48,121 46,881 59,860 85,825 118,364 139,269 130,915 176,500
Trade Balance (% of GDP) 20.38% 13.76% 13.31% 13.97% 15.75% 13.64% 9.74% 11.04%
Services, Net -3.87% -2.92% -2.42% -2.07% -1.85% -1.35% -1.47% -1.24%
Net Transfers -0.35% -0.20% -0.09% -0.14% -0.14% -0.15% -0.26% -0.22%
Current Account (USD, millions) 33,935 29,280 35,410 59,512 84,409 94,340 76,241 98.900
Current Account (%) 14.37% 8.59% 7.88% 9.69% 11.23% 9.24% 5.67% 0.01%
Net Foreign Direct Investment 0.09% -0.17% -0.39% 0.27% 0.02% 0.64% 0.68% 0.57%
Net Portfolio Investment 0.34% -2.07% 0.03% -1.34% -1.32% -0.31% -2.00% -1.68%
Other Capital Inflows -1.40% -0.67% -8.99% -7.48% -10.52% -7.80% -14.81% -12.45%
Financial Balance (USD, millions) -22,669 -22,072 -7,148 -12,622 -19,441 13,126 72,687 124,901
Financial Balance (%) -9.60% -6.48% -1.59% -2.05% -2.59% 1.29% 5.41% 7.81%
Overall Balance (USD, millions) 11,266 7,208 28,262 46,890 64,968 107,466 148,928 125,000
Overall Balance (%) 4.77% 2.12% 6.29% 7.63% 8.65% 10.53% 11.08% 7.82%
Total Reserves Minus Gold (USD, millions) 32,542 44,054 73,175 120,809 175,891 295,568 465,878 412,548
Total Reserves Minus Gold (%) 13.78% 12.93% 16.28% 19.66% 23.41% 28.95% 34.67% 25.80%
Months of Imports Covered by Int’l Reserves 7.3 8.2 11.5 14.9 16.8 21.6 25.0 22.2
Total Foreign Debt Outstanding ($ billions) 152.5 147.4 175.7 196.8 229.9 250.5 370.2 380.0
Total Foreign Debt Service ($ billions) 17.3 14.2 19.1 21.1 41.9 50.4 40.3 80.0
Debt Service Ratio 19.9% 11.8% 12.1% 10.0% 15.9% 14.6% 9.8% 20.5%

Exchange Rate, Money and Credit

Official Rate (Rbs/USD, end period) 37.878 31.784 29.455 27.749 28.783 26.331 24.546 29.380
Real Effective Exchange Rate (2000=100) 120.247 123.591 127.326 137.268 149.198 163.384 172.710 183.180
Money + Quasi-money (Rbs, millions) 2,138,210 2,860,000 3,962,000 5,298,700 7,221,120 10,149,300 14,636,800 16,774,800
Money + Quasi-money (growth) 33.76% 38.53% 33.74% 36.28% 40.55% 44.21% 14.61%
Domestic Credit (Rbs, billions) 2,064 2,689 3,513 4,247 4,461 5,799 8,326 10,788
Domestic Credit (growth) 30.27% 30.64% 20.89% 5.04% 30.00% 43.57% 29.57%

Prices, Interest and Inflation Rates

Lending Rate (annual) 17.908 15.700 12.975 11.442 10.683 10.425 10.030 15.000
Money Market Rate (annual) 10.100 8.192 3.767 3.325 2.675 3.425 4.430 5.480
Wages (% change) 27.3 26.1 13.2 22.0 19.2 24.2 19.7
Consumer Prices (Index 2000 = 100) 121.5 140.6 159.9 177.2 199.7 219.1 238.8 270.5
Share prices (2000 = 100) 144.97 204.08 275.44 343.78 660.38 828.8 296.96

Government Finances
Cash receipts from operating activities
1,598,480 2,219,270 2,577,930 3,456,730 5,138,840 6,286,960 7,770,000 9,252,000
(Rbs, millions)
Revenues (% of GDP) 17.87% 20.49% 19.47% 20.28% 23.76% 23.39% 23.55% 22.88%
Cash Payments for operating activities
1,323,160 2,040,050 2,263,680 2,630,800 3,515,530 4,290,340 5,164,000 6,472,500
(Rbs, millions)
Expenses (% of GDP) 14.79% 18.84% 17.09% 15.43% 16.26% 15.96% 15.65% 16.01%
Balance (Cash Rbs. billions) 275.3 179.20 314.30 825.90 1,623.30 1,996.60 2,002.50 1,961.60
Balance (% of GDP) 3.08% 1.65% 2.37% 4.84% 7.51% 7.43% 7.90% 6.87%

Source: IMF, International Financial Statistics, and Economist Intelligence Unit.

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