Russia2007 Investment Climate Statement - Russia Russia's economy continued to expand in 2006. It posted a 6.7 percent GDP growth rate, as compared to 5.8 percent in 2005. Fixed capital investment increased by 12.9 percent, as compared to 10.5 percent in 2005. The lion's share of investment in Russia is going to energy, transportation, real estate and services. Manufacturing received 13 percent of total fixed capital investment in 2006. Foreign direct investment in Russia is rapidly increasing, approximately equal to 3% of GDP. The Central Bank of Russia estimates that FDI inflows reached $31.0 billion in 2006, a more than two-fold increase over last year's $14.6 billion. While about 40% of investment continues to go the energy sector, an increasing percentage is directed toward other fast-growing sectors, including machinery, banking and retail. According to the Central Bank of Russia, net capital inflows for 2006 reached $40 billion, up sharply from $300 million in 2005. These inflows, facilitated by capital account liberalization that took effect July 1, contrast dramatically with the capital flight of the 1990s. According to the federal statistics service RosStat, the UK and the Netherlands continued to be the top source countries for investment inflows in 2006, reflecting these two countries' continued heavy investments in Russia's energy sector. Although these figures indicate that the Russian investment climate has strengthened in recent years, many structural improvements remain necessary. These include: judicial reform to establish a truly independent and effective judiciary; banking reform to improve the capacity of the financial sector; accounting reform to promote greater transparency and integration with the international business community; and further improvements in corporate governance. In addition, reducing government bureaucracy and corruption has long been high on the agenda of businesses, large and small, Russian and foreign, operating in this country. Although the government has also embraced this cause, it has made only limited progress to date. Openness To Foreign Investment Russia's economic growth and rising incomes have attracted increasing interest from foreign investors despite the difficulties of doing business here. Russia's Federal State Statistics Service estimates that real disposable incomes grew 10% in 2006, outpacing real GDP growth of 6.7%. This upward trend is fueling the growth of the retail and consumer sector. Many U.S. companies report significant annual growth rates and plan expansion of their Russian operations. The Russian government has repeatedly emphasized foreign investment's critical role in Russia's economic development. The 1991 Investment Code guarantees foreign investors rights equal to those of Russian investors (although some industries have limits on foreign ownership - see below). The 1999 Law on Foreign Investment also affirms this principle of national treatment. In practice, the GOR tends to favor joint ventures with local entities or direct cash injections. At times, it has been reluctant to permit investment strategies that keep project control in foreign hands. This has been most obvious in the energy sector. Over the past year, the GOR has tightened its grip on the sector and has shown little inclination to allow foreign companies more than minority stakes (and often only 20 to 25 percent) in larger projects. Nevertheless, because of the absolute size of these projects, even these small stakes add up to hundreds of millions, if not billions, of dollars. At the regional level, many local governments have developed laws and programs to attract FDI, including plans to establish techno-parks near universities and export zones near ports and borders. Although tax reforms at the federal level aim to create a level playing field for all investors and limit the scope of incentives regions can offer, large foreign investors in practice continue to receive such incentives from local authorities. However, a completed investment project is often later expected to provide social services and other benefits to the local population. While there is little doubt FDI inflows have picked up substantially since 2004, the slow pace of structural reforms and the increasing role of the state in some sectors of the economy (such as the energy sector as noted above) continue to restrain foreign investment. The lack of clarity in Russian tax law and administration, inconsistent government regulation and enforcement, unreliability of the legal system, underinvestment in infrastructure, and high levels of corruption all can dissuade investors. Rule of law, corporate governance and respect for property rights, although improved over the years, remain key concerns for foreign investors. While there is increased interest, some U.S. companies remain cautious about investing in Russia due to these concerns, as well as fears of liabilities associated with existing operations (especially environmental cleanup) and inadequate bankruptcy procedures. In recognition of widespread corporate governance problems, the Federal Service for Financial Markets put corporate governance code in place in 2002 and endorsed an OECD White Paper on ways to improve corporate governance in Russia. Some large Russian companies have developed their own corporate governance policies, although implementation is not always robust. International business associations such as the American Chamber of Commerce and the International Business Leaders Forum, as well as Russian business associations such as OPORA and the Russian Managers Association, stress corporate governance as an important priority for their members and for Russian businesses overall. Explicit restrictions on foreign direct investment are in effect for certain sectors. A 1998 law on the aerospace industry limits foreign ownership to 25 percent of an enterprise. Foreign investment in the electric power giant Unified Energy Systems (UES) is also limited to 25 percent, although it has not been enforced to date. UES Chairman Anatoliy Chubays is in fact pushing to attract foreign investors to the divested electricity generating companies that will emerge from the restructuring of UES. The GOR eliminated foreign ownership restrictions in natural gas monopoly Gazprom as of January 1, 2006. This action followed the GOR's assumption of a direct majority stake in the company. Despite years of debate, the Russian government failed to enact a new Law on Subsoil Use in 2006. It now appears likely that the government will simply amend an existing law. In addition, the government seems intent on pushing through the Law on Strategic Sectors that would usefully clarify for investors the rules for foreign investment in "strategic sectors." In November 2006, the Ministry of Industry and Energy (MIE) submitted a draft of this law to the government. It designates 39 types of business in the aviation, nuclear energy, military-industrial complex, natural resource and natural monopolies sectors where transactions that give foreign investors more than a 50 percent equity stake would be reviewed by the Anti-Monopoly Service. The government must still approve the draft law before it moves forward to the State Duma for consideration. Currently, prior approval by the relevant government authority (e.g., State Property Committee, Ministry of Industry and Energy, Ministry of Natural Resources) is required for foreign investment in new enterprises using assets of existing Russian enterprises, defense industries (which may be prohibited in some cases), and the exploitation of natural resources. Approval is also required for all investments over 50 million rubles, investment ventures in which the foreign share exceeds 50 percent, or investment to take over incomplete housing and construction projects. Additional registration requirements exist for investments exceeding 100 million rubles. Projects involving large-scale construction or modernization may also be subject to expert examination for environmental considerations. In sectors that require licensing (e.g. banking, mining, oil and gas extraction, and telecommunications), procedures often can be lengthy and non-transparent. As Russia's oil and gas sector accounts for more than 40 percent of its export revenues and comprises a major share of the world's undeveloped energy resources, it holds tremendous potential for foreign as well as domestic investment. Whether this potential is realized depends on the receptivity to such investment by the Russian government, which has increased its role in the sector over the last several years. Production Sharing Agreement(PSA) legislation was adopted in 1999, but PSA amendments to the tax code passed in mid-2003 sent a very mixed message. The amendments provided a firmer foundation for three already operating projects and a few new projects supported by domestic companies, but greatly restricted the possibility of future PSA projects. PSAs are not likely to re-emerge as a tool for attracting investment, as the current Russian government views existing agreements unfavorably. The best public evidence of this view were negative comments made by senior Russian officials in late 2006 in the context of the GOR's environmental investigation into the Sakhalin-2 PSA project. Elsewhere in the energy sector, shareholders in the Caspian Pipeline Consortium (CPC) have still not agreed - after years of negotiations -- on the terms of a deal that would allow an expansion of the consortium's pipeline, although a deal seems close now. With the forced sale of Yukos's assets, Sibneft's de-merger with Yukos, Gazprom's subsequent purchase of Sibneft, and ConocoPhillips' purchase of twenty percent in Lukoil, the oil and gas landscape has changed substantially compared to only a couple of years ago. The industry no longer exerts extensive influence on the government but, on the contrary, it is the government that appears to have reasserted some control over oil and gas firms. It has become conventional wisdom that foreign investors who want to do business in Russian energy now must work through the state companies Rosneft (oil) and Gazprom (gas), although ConocoPhillips enjoys a significant and growing relationship with private oil company Lukoil. In 2003, Russia enacted several amendments to the insurance law that effectively liberalized the market, allowing majority-owned Russian subsidiaries of insurers from the European Union to sell life and mandatory forms of insurance in Russia. Although the law only permits those companies with offices in the European Union to open subsidiaries in Russia, the regulator has interpreted the legislation as allowing any foreign insurer to set up life insurance operations in Russia as long as the company has an office in the EU via which the investment is made. As a result of bilateral WTO negotiations with the U.S., Russia agreed to allow foreign insurance companies to operate through subsidiaries, including 100% foreign-owned non-life insurance companies, and branching after a transition period. The Russian government in 2005 significantly reduced customs tariff rates on automotive parts imported for industrial car assembly purposes. Earlier, GM and Ford had individually negotiated such treatment when establishing their assembly operations in the country. Many major auto manufacturers have taken advantage of the tariff reductions and set up assembly operations in Russia, including Toyota, Peugeot, Isuzu, Kia, Nissan, Volkswagen and Renault, which is helping to meet the growing demand for foreign-brand cars in Russia. Russia's largest auto manufacturer, Avtovaz, though initially strongly opposed to the tariff reductions, successfully lobbied in November 2006 for the benefits to be extended to its operations as well. Roughly three-quarters of the Russian economy has been privatized, although the state continues to hold blocks of shares in many privatized enterprises. The privatization of remaining state holdings is scheduled to continue. Foreign investors participating in Russian privatization sales often are confined to limited positions and face problems with minority shareholder rights and corporate governance. Moreover, the treatment of foreign investment in new privatizations is likely to remain inconsistent. Potential foreign investors are advised to work directly and closely with appropriate local, regional and federal ministries and agencies that exercise ownership and other authority over companies whose shares they may want to acquire. Given the extent of privatization to date, it is no longer a favored vehicle for foreign investment. The investment climate for agriculture has looked brighter in the last two years. Domestic demand for food products is increasing as a result of an upward trend in per capita income. This is in turn stimulating investments in food processing, food wholesale and retail infrastructure. Food processing is expected to continue expanding at 15 percent annually and retail growth is forecasted to grow at 8 percent annually for the foreseeable future. Chain stores are exploding nationwide and mergers and acquisitions are reported nearly each day. The upward trend in food processing and retail is also sparking growth in intermediary distribution such as transportation, warehousing, retail packaging, and logistics. Growth in advertising, marketing, promotion, and training companies have also resulted. Agricultural financing has improved, though investment mechanisms such as banks are still not strong enough, which keeps agriculture undercapitalized. The demand for investment in agriculture currently outstrips the domestic banks' capacity to provide the necessary project financing, forcing project developers to use a consortium of financial institutions. The practical inability to use land as collateral further constrains investment in agriculture. Vertically-integrated companies do continue to support the development of agriculture, but large non-agriculture-based holding companies have begun to turn toward other sectors. The GOR has launched a National Priority Project in Agriculture aimed at strengthening Russia's livestock sector. This project is expected to benefit the dairy, pork, beef, and poultry industries in the short term. After nearly three years of discussions, a new Forest Code entered into force on January 1, 2007. Backed by President Putin, the code is expected to stimulate foreign investment in the forestry sector by providing tax breaks and facilitating modernization efforts. According to the Federal Forestry Agency, total investment in the forestry industry is likely to reach $4 billion by 2008, up from roughly $ 2.4 billion in 2005. However, forestry analysts estimate that Russia needs $24 billion new investments in the next four years in order to modernize the sector, 80 percent of which will need to come from the private sector, including foreign investors. Russian law allows foreign ownership of non-agricultural land that is not located near international borders. Direct sales of agricultural land to foreigners are prohibited, but the Agricultural Land Code allows foreigners to lease agricultural land for 49 years. The Prime Minister must approve sales of federal land to any entity. Despite supportive statements by GOR officials on investment in agricultural processing facilities, some projects have not taken off due to entrenched interests and legal ambiguity regarding land procurement and control issues. Experience has shown that one of the most important factors determining success or failure of a foreign investment project in agriculture is the degree to which the local administration supports it. Almost all administrations invite investment into their regions, but few are prepared to allow business to operate in a relatively open market without interference in matters such as pricing inputs and contracting for services. Many local administrations still view foreign investors as sources of cash for the support of local government and favored businesses. The GOR requires visas and residence permits for investors. Work and residence permits must be renewed periodically, which can sometimes be a cumbersome process. Investors in some sectors also may face restrictions requiring that a certain percentage of staff be Russian citizens. Conversion and Transfer Policies The Central Bank of Russia instituted a capital account liberalization program on July 1, 2006 that has simplified capital flows into and out of Russia. The ruble is the only legal tender in Russia, but in general companies and individuals face no significant difficulty in obtaining foreign exchange. Finding a bank licensed to conduct foreign currency transactions is relatively easy. While the following discussion represents a "snapshot" of current requirements, investors would be well advised to seek expert advice on controls in effect at the time. Currency controls exist on all transactions that require customs clearance, which in Russia applies to both import and export transactions. The procedures involved have been greatly simplified in recent years. The importer or exporter presents the "passport of deal" documents to a bank licensed to provide foreign currency transaction services. The bank bears the responsibility of ensuring that the flow of funds related to the import or export complies with CBR regulations. A "passport of deal" is a set of documents that importers and exporters provide to authorized banks to review whether the transaction meets currency control regulations. Once an authorized bank signs the passport of deal, it monitors the entire transaction for compliance with currency regulations, and the importer/exporter must use that bank for all parts of the transaction. The importer/exporter then presents the signed passport to clear shipments through customs. The Federal Customs Service notifies the bank once the shipment has been cleared. The authorized bank then monitors compliance with payment regulations. Only authorized banks may carry out the sale or purchase of foreign currency transactions. According to currency control laws, the Central Bank retains the right to impose restrictions on the purchase of foreign currency, including the requirement that the transaction be completed through a special account. The Central Bank has eliminated security deposit requirements on foreign exchange purchases. Expropriation and Compensation The 1991 Investment Code prohibits the nationalization of a foreign investments except following legislative action and where deemed to be in the national interest. Such nationalizations may be appealed to the courts of the Russian Federation, and are to be paid with prompt, adequate and effective compensation. At the sub-federal level, expropriation has occasionally been a problem, as has local government interference or lack of enforcement of court rulings protecting investors. The embassy is tracking a small number of cases in which U.S. companies are seeking compensation for the loss of their investment or property due to regional government action or inaction. Dispute Settlement Russia's body of conflicting, overlapping and rapidly changing laws, decrees and regulations has resulted in an ad hoc and unpredictable approach to doing business but many practitioners cite incremental improvement over the past five years. Independent dispute resolution in Russia can be difficult to obtain since the judicial system is still developing. Regional and local courts are often subject to political pressure. Court decisions are at times not executed and the bailiffs, who are charged with enforcing court judgments, are administratively not part of the court system and sometimes fail to enforce judgments due to legal restrictions and limited trained personnel. President Putin has undertaken an initiative to increase the number of bailiffs in order to improve enforcement of court judgments. As part of this plan, the number of bailiffs is expected to increase significantly by the end of 2007. It is still too early to assess the impact of this initiative. Many attorneys refer their Western clients who have investment or trade disputes in Russia to international arbitration in Stockholm or to courts abroad. A 1997 Russian law allows foreign arbitration awards to be enforced in Russia, even if there is no reciprocal treaty between Russia and the country where the order was made. Russia is a member of the International Center for the Settlement of Investment Disputes and accepts binding international arbitration. Russia is also a signatory to the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards. However, the enforcement of international arbitral awards still ultimately requires action from Russian courts and follow-up by bailiffs, which, as discussed in the paragraph above, has yet to become a consistently effective enforcer of court judgments. As for legal avenues available in Russia through Russian arbitration, one choice is the Arbitration Court of the Russian Federation. It has special procedures for seizure of property before trial so that property cannot be disposed of before the court has heard the claim, as well as for the enforcement of financial awards through the banks. Additionally, the International Commercial Arbitration Court at the Russian Chamber of Commerce and Industry will hear claims if both parties agree to refer disputes there. A similar arbitration court has been established in St. Petersburg. The Russian Union of Industrialists and Entrepreneurs, an organization representing some of the largest Russian companies, is also developing an alternate dispute resolution (ADR) system. As with international arbitral procedures, the weakness in the Russian arbitration system lies in the enforcement of decisions. Bailiffs report to the Ministry of Justice, rather than the courts, and the courts can do little to ensure that their decisions are executed. The Embassy is currently aware of several cases where, despite repeated favorable court decisions for financial restitutions, foreign investors have not been able to get a judgment enforced against another private party or a local government. Performance Requirements and Incentives Performance requirements are not generally imposed by Russian law and are not widely included as part of private contracts in Russia. However, they have appeared in the agreements of large multinational companies investing in natural resources and in production sharing legislation. There are no formal requirements for offsets in foreign investments. However, as approval for investments in Russia frequently depends on relationships with government officials and on a firm's demonstration of commitment to the Russian market, in practice this may result in offsets. The PSA chapter of the Tax Code stipulates that 70 percent of purchased goods in each calendar year must be of Russian origin or the investors would be refused cost recovery (Purchased goods are considered Russian by origin if they have at least 50 percent Russian content). The amended PSA Law acknowledges, however, that changes to these rules are needed for Russia's WTO accession. Right to Private Ownership and Establishment Both foreign and domestic legal entities may establish, purchase and dispose of businesses in Russia. As mentioned in earlier sections of this report, investment in some sectors that are regarded as affecting national security, such as natural resources, energy, power, communication, transportation, and defense-related industries, may be limited. Protection of Property Rights The Constitution and a 1993 presidential decree give Russian citizens general rights to own, inherit, lease, mortgage, and sell real property. Mortgage legislation enacted in 2004 makes it easier for lenders to evict homeowners who do not stay current in their mortgage payments, which in theory should make mortgage lending (and the housing market) more attractive to lenders and developers. Nevertheless, mortgage lending, although growing, is only in its initial stages. The rights of Russian citizens to own and sell residential, recreational, and garden plots are now clearly established, with over 40 million properties of this type under private ownership. Land ownership rights and limitations for foreign investors have been discussed in previous sections of this report. While Russia has made significant advances in improving its intellectual property rights (IPR) protection regime, many challenges remain. Copyright violations (films, videos, sound recordings, books and computer software) are particularly rampant in Russia. However, legitimate DVD sales are on the rise, thanks in part to reduced pricing, increased law enforcement action against pirates, and a growing middle class's preference for high quality products. The local business and entertainment software industries have also reported declining levels of piracy. On the other hand, Internet piracy has become a growing concern, but is still largely limited to the music industry. Investigation and criminal cases against the operators of one of the more infamous Russian pirate websites, allofmp3.com, are on going, though their prospects are uncertain. As part of a November 2006 bilateral agreement on IPR, the Russian government has made the commitment to take criminal actions against commercial scale piracy, with the objective of permanently closing down production of optical media containing pirated and counterfeit material. It has also undertaken commitments to enact legislative amendments to provide broader authority to order the seizure and destruction of machinery and materials used in the production of infringing goods. Russian law enforcement has gradually taken a more aggressive approach toward pirate optical disk producers in the last few years. Seizure of production lines and equipment used for IP infringing activities, though still rare, is on the rise. The number of police, prosecutors, and judges with relevant expertise is still small but expanding. While in the vast majority of cases, alleged infringers receive miniscule fines or suspended prison sentences, the trend is starting to change. In December 2006, a criminal court in Rostov-on-Don sentenced two retail distributors to four and six years in prison respectively for copyright violations. These were the highest prison sentences handed down for IPR crimes to date in Russia. On June 19, 2006, the Russian Supreme Court Plenum adopted a long-awaited resolution issuing guidelines on the application of civil IPR legislation on copyright and neighboring rights. While the law enforcement situation is improving, many problems remain, especially during the prosecution stage. Judges and prosecutors frequently lack expertise in IPR cases or do not always regard them as serious crimes. Corruption continues to be a problem. In addition, judges often impose unreasonable proof requirements, such as asking prosecutors to prove damages down to the kopeck and that every item (as opposed to a representative sample) in a seized shipment of counterfeit goods is illegal, even if the shipment contains thousands of items. U.S. and multinational companies continue to report counterfeiting of patented and trademarked goods as a problem, especially for consumer goods and pharmaceuticals. Several U.S. firms have also experienced problems with trademark piracy, with Russian enterprises attempting to take over well-known foreign trademarks not currently active in Russia. Rights holders have been moderately successful in countering trademark and patent infringements through the Russian court system or with the Russian Federal Service for Intellectual Property, Patents and Trademarks (Rospatent). The Federal Customs Service (FCS) -has also recently improved its focus on IPR issues. Several Western companies reported in 2006 that they had a good working relationship with the FCS, with Customs making more timely notifications to trademark holders of shipments of good suspected to be counterfeit before the cargoes cleared Customs points. In general, U.S. firms should proactively take steps to protect their intellectual property in Russia, including registering their trademarks with Rospatent and FCS. Russia's IPR regime lacks an explicit protection for pharmaceutical test data. An amendment to address this concern is pending Russian government interagency approval. The GOR has made a legally binding commitment within the context of an U.S.-Russia bilateral IPR agreement to enact the amendment by June 1, 2007. Russia has acceded to the Universal Copyright Convention, the Paris convention, the Berne convention, the Patent Cooperation Treaty, the Geneva Phonogram Convention, and the Madrid Agreement. Russian law on topology of integrated microcircuits protects computer programs and semiconductor topologies for 10 years from the date of registration. As part of its WTO accession process, the Russian government is working to ensure its IPR laws are consistent with the requirements of the WTO Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS). It has also made commitments to join the Internet conventions of the World Intellectual Property Rights Organization (WIPO). Transparency of the Regulatory System The legal system in Russia is still in a state of flux, with various parts of the government continuing to create new laws on a broad array of topics. In this environment, negotiations and contracts for commercial transactions are complex and protracted. Investors must do careful research to ensure that each contract fully conforms to Russian law and embodies the basic provisions of the new, and where still valid, old codes. Contracts must likewise seek to protect the foreign partner against contingencies that often arise. Keeping up with legislative changes, presidential decrees and government resolutions is a challenging task. Uneven implementation of laws creates further complications; various officials, branches of government and jurisdictions interpret and apply regulations with little consistency and the decisions of one may be overruled or contested by another. As a consequence, reaching final agreement with local political and economic authorities can be quite a burdensome process. Corruption is widespread in Russia (see separate section below). Officials may demand bribes in exchange for regular governmental services such as registration of businesses, utility hookups, development permits for real estate, etc. However, more and more small and medium businesses in recent years have reported fewer difficulties in this regard, especially in the Moscow region. Russian officials at both the federal and local levels appear to raise environmental concerns more frequently now as considerations in the approval process for investments. In some instances, it is difficult to say whether such concerns are genuine. The Russian Tax Code underwent a major revision in 2001, which reduced the overall tax burden. Six taxes were abolished entirely: the 1.5 percent social and housing turnover tax; the Employment Fund tax; the state border clearance fee; vehicle tax; vehicle acquisition tax; and oil and lubricant product sales tax. The revision also moved Russia to a flat individual income tax rate of only 13 percent for residents and 30 percent for non-residents, one of the lowest rates in the world. Deductions are allowed for, inter alia, home purchase or construction and exclusion of earnings on the sale of real property held for more than five years. Since 2005, the Unified Social Tax, which is paid by employers and covers pensions, healthcare and social security, has been set at a top rate of 26 percent on salaries up to 280,000 rubles (about $10,000) per year. Excise duties are levied only on alcoholic beverages, tobacco products, cars, motor fuel, and oil. Oil production is subject to two main taxes -- the Mineral Extraction Tax (MET) and an export duty, which are tied to the level of Urals export prices. Given the tax structure at the beginning of 2006, the marginal tax rate on a barrel of exported oil was 90 percent for every dollar over $25/bbl. Following complaints from Russian oil companies, the Russian government in 2006 made some revisions to the MET to take into account the level of depletion at fields and the quality of the crude. These changes will lower the tax burden -- and increase output -- at some of Russia's older fields. The Corporate Profits Tax, as amended in 2001, sets corporate profit taxes at 24 percent. Regions are allowed, at their discretion, to grant a 4 percent tax reduction, effectively lowering the tax rate to 20 percent. Many regions have made use of this provision. For dividends/interest earned by non-residents, the profit tax rate is 15 percent. Since the Yukos affair, companies have become more reluctant to engage in aggressive tax optimization schemes. In addition, market forces are driving businesses toward more transparent accounting practices, prompting firms to review their accounting procedures and improve their tax behavior. For example, firms with clean books have an easier time accessing local credit and foreign capital than their shadier competitors. As a result, tax compliance levels are gradually increasing. Nonetheless, problems in the tax environment remain. Surveys have shown that small and medium entrepreneurs' number one complaint is the complexity of the tax code. Well- intentioned SMEs often go out of their way to follow the law but are then penalized for making mistakes in documentation. They complain the tax police make no distinction between hard-core tax-evaders and inexperienced small business people who don't fully understand the bookkeeping requirements. Companies often have little recourse other than the courts during tax disputes. While firms have successfully appealed to the courts, tax authorities are often slow to implement judicial decisions. Penalties for non-compliance include confiscation of property and a company's bank accounts can be frozen relatively quickly. In early 2005, President Putin acknowledged the negative impact of the tax environment on the business climate when he called for an end to "tax terrorism." In response to the President's order, the GOR submitted a substantial package of amendments to the Duma designed to increase transparency and consistency in the tax environment. Russian legislators are currently still reviewing these amendments, many of which will take effect in 2007. For instance, tax authorities will have the right to freeze only amounts equal to disputed underpaid taxes, fines and penalties. Tax audit rules have been codified with more details, thus limiting inspectors' discretion. Moreover, the amendments prohibit what had been called "perpetual audits." The changes introduce formal time limits for audits and specify the terms and conditions for their extension. Nevertheless, audits may still last as long as six months. Efficient Capital Markets and Portfolio Investment The Russian banking system remains relatively small, with RUB 561 billion ($21.3 billion) in aggregate charter capital as of December 1, 2006. In April 2005, the GOR and the Central Bank of Russia adopted the Banking Sector Development Strategy through 2008. According to official sources, the strategy seeks to enhance the stability and efficiency of the banking sector by: increasing the protection offered to depositors and creditors; enhancing the banking sector's role as a primary intermediary for household and commercial credit operations; improving the Russian banking sector's competitiveness; protecting the financial sector from illicit activity such as money laundering and the financing of terrorism; improving transparency in the sector; and building up investor, creditor, and depositor confidence in the banking sector. In September 2005, the CBR completed its review of all banks that sought admission to the recently established Deposit Insurance System (DIS). To gain admission to the DIS, a bank has to demonstrate verifiably to the CBR that it complies with Russian identification and transparency requirements. Currently, 927 of Russia's estimated 1200 banks have been admitted to the DIS, effectively weeding out over 200 banks from the banking system. The successful implementation of the Deposit Insurance System has proved a critical psychological boon to the banking sector, evidenced by growth in overall deposits. However, the sector remains one of the weakest parts of the Russian reform program. Despite measured progress, the Russian banking system is not yet efficiently performing its basic role of financial intermediary (i.e. taking deposits and lending to business and individuals). Approximately one third of the population still prefer to keep their personal savings "under the mattress" rather than trust their savings to banks. Although Sberbank remains the largest bank in Russia by a large margin, the sector has made some progress toward diversification. Sberbank faces increasing competition from the second largest state bank, Vneshtorgbank, as well as from several other significant contenders such as Gazprombank, Alfa Bank, and MDM Bank. Recent data indicates that only 51 of Russia's 1,203 banks are wholly foreign-owned. Twelve stock exchanges currently operate in Russia. The dominant exchanges are in Moscow, and include the Russia Trading System (RTS) and the equity trading floor on the MICEX (Moscow Interbank Currency Exchange). RTS grew 60% during 2006, with market capitalization reaching $1 trillion before the end of the year. The average daily trading volume for the year was $58.22 million, compared with $44 million per day in 2005. Although the RTS is more diversified, average trade volumes on the MICEX stock exchange are much higher than on the RTS. In 2006, the average daily trading volume through November was $2.87 billion, up from $556 million in 2005. Gazprom, Lukoil, Rosneft, and Surgutneftegaz dominated MICEX trading during the year. The level of trading activity at the Moscow Stock Exchange historically has been low, with Gazprom shares accounting up to 95 percent of trades from 1997 to 2003. The exchange began a restructuring process in 2005, and the new managers have been attempting to diversify the trading activity. Several Russian regional centers have their own stock exchanges, but trade volumes outside Moscow tend to be low. Regional exchanges are still dependent on Moscow-based participants. The Law on the Securities Market, as amended in 2003, includes definitions of corporate bonds, mutual funds, options, futures and forwards. Companies offering public shares are required to disclose specified information during the placement process as well as in quarterly reports. In addition, the law defines the responsibilities of financial consultants helping companies with their stock offerings, and holds them liable for accuracy of the data presented to shareholders. The corporate bond market is currently the most rapidly and dynamically developing sector in Russia's capital markets. High and increasing demand from enterprises for funds in the absence of an effective bank lending system is the main driver of growth. It is also boosted by weaknesses in other sectors of the capital market: the absence of more attractive ruble-denominated alternative asset classes, low and even negative real interest rates on the secondary OFZ/GKO market, the absence of speculative opportunities on the currency market, and a large and increasing volume of rubles from oil export earnings. 2006 set another record for bond issuances with RUB 542.7 billion raised, compared to RUB 270 billion in 2005. However, while the corporate bond market is rapidly developing, it suffers several problems. The market is still quite narrow. It is thus difficult to provide the necessary level of liquidity for relatively small issues, even if the issuer is a blue-chip company. Another problem is the expense of preparations, including development of each issue's parameters, prospectus registration, underwriting services, etc. A 0.8 percent issuance tax adds to that expense. Another barrier to the growth of the market is a provision of the federal law "On Joint Stock Companies," which requires the volume of a bond issue not to exceed a company's authorized (charter) capital. Political Violence Although the use of strong-arm tactics is not unknown in Russian commercial disputes, post is not aware of cases where foreign investments have been attacked or damaged purely for political reasons. Russia continues to struggle with an ongoing insurgency in Chechnya, and the Chechen Republic and neighboring regions in the northern Caucasus have a high risk of violence and kidnapping. Corruption Corruption remains a serious problem in Russia, with the country ranking 121th on Transparency International's (TI's) 2006 Index. Russia's score of 2.4 remained statistically flat from 2005 to 2006, indicating that the perception of corruption level in Russia stayed the same over the past year. U.S. firms have identified corruption as a pervasive problem, both in number of instances and in the size of bribes sought. Under Articles 290 and 291 of the Russian Criminal Code, giving and receiving bribes are criminal acts punishable by up to 12 years of incarceration depending on circumstances. Article 291 further provides that a person who pays a bribe is relieved of criminal liability if the bribe was extorted from him or if he voluntarily informs law enforcement about it. Russia is a signatory to the UN Convention against Corruption. It has not criminalized bribery of foreign officials, and the Organization for Economic Cooperation and Development's (OECD) Anti-Bribery Convention has been on President Putin's desk awaiting signature for over a year. The Government of Russia has repeatedly designated the fight against corruption and the enforcement of law as priorities. However, initiatives to address the problem, either through regulation, administrative reform or government-sponsored voluntary codes of conduct, have made little headway in countering endemic corruption. While there are prosecutions related to bribery, the lack of enforcement in general remains a problem. There have been few dismissals and prosecutions of high-level corrupt officials that would send a clear deterrent message. In addition, bribery and other corruption issues are investigated by the Ministry of Internal Affairs and the Federal Security Service, both of which are themselves widely perceived as corrupt. Corruption in commercial and bureaucratic transactions and problems with the consistent implementation of laws and regulations greatly inhibit investment in Russia. The investment climate would benefit from improved dispute resolution mechanisms, the systematic protection of minority stockholders rights, consistent enforcement of regulations, a more transparent judicial system, fuller conversion to international accounting standards, and the adoption and adherence to business codes of conduct by companies. More transparent implementation of customs, taxation, licensing and other administrative regulations would also help. During the last year, Russian government officials have discussed the problem of corruption openly. President Putin met with the Cabinet of Ministers in April 2006 to address the issue. In May, in his annual address to the Federal Assembly, Putin called corruption a major obstacle to Russia's economic development. In August, Prosecutor General Chayka called on prosecutors to combat the practice of commissioned prosecutions, that is, filing criminal charges because the prosecutors have been bribed to do so. He also asked for a re-evaluation of cases that appeared to have no legal foundation. In November, President Putin met with the heads of all law enforcement agencies and called for new initiatives to combat corruption, including more public disclosure of assets and property by law enforcement officials. In December, First Deputy Prosecutor General Alexander Buksman estimated that corruption costs the country $240 billion annually and disclosed that prosecutors had uncovered 28,000 cases of corruption among state officials in the first eight months of 2006. Bilateral Investment Agreements Russia inherited from the Soviet Union 13 bilateral investment treaties (BITs) with Austria, Belgium, Luxembourg, Great Britain, Germany, Italy, Canada, China, Korea, the Netherlands, Finland, France, and Switzerland. They were ratified in 1989-90 and came into force in 1991. Russia has since negotiated over 35 new agreements, of which 29 have been ratified - with Greece, Cuba, Romania, Denmark, Slovakia, Czech Republic, Vietnam, Kuwait, India, Hungary, Albania, Norway, Yugoslavia, Lebanon, Macedonia, the Philippines, Egypt, South Africa, Moldova, Argentina, Turkey, Sweden, Armenia, Yemen, Bulgaria, Lithuania, Laos, North Korea and Mongolia. However, in 2002 Russia requested that all treaty partners re-negotiate BITs, expressing concerns that existing language may not be compatible with future WTO obligations. The United States and Russia currently do not have a bilateral investment treaty. OPIC and Other Investment Insurance Programs In an agreement ratified in 1992, the U.S. Overseas Private Investment Corporation (OPIC) was authorized to provide loans, loan guarantees and investment insurance against political risks to U.S. companies investing in Russia. OPIC generally insures against three political risks: expropriation; political violence; and currency inconvertibility. In 1994, to meet the demands of larger projects in Russia and worldwide, OPIC doubled the amount of insurance and quadrupled the amount of finance support - to USD 200 million in each case - it can commit to an individual project (for a total of USD 400 million). In the event OPIC would need to pay a currency inconvertibility claim, it would use the exchange rate in effect on the date the claim is submitted. OPIC also makes equity capital available for investments in Russia by guaranteeing long-term loans to private equity investment funds. In FY 2006, OPIC approved $202.8 million in new loans, guarantees, and insurance for 11 projects in Russia, compared to $156.9 million for 14 projects in FY 2005. Labor The Russian labor market remains fragmented, characterized by limited labor mobility across regions and consequent wage and employment differentials. Although statistics are often unreliable and many forms of unemployment are not counted, unemployment, using International Labor Organization (ILO) standards, was 6.7 percent of the workforce at the end of 2006. In parts of the north Caucasus, unemployment estimates run as high as 40 percent. In Moscow, however, unemployment is less than one percent, and average monthly incomes are more than two times higher than the national average of approximately USD 430 per month. Labor mobility continues to be restricted by an under- developed housing and mortgage market and the continued existence of residency permits and registration. The availability of subsidized housing and cultural ties in certain regions often make workers reluctant to move, and a lack of information about employment or housing opportunities in other regions exacerbates the situation. Limited labor mobility across regions negatively affects wage rates and employment. Nonetheless, labor mobility across professions and within regions is improving, as workers attempt to adapt to the needs of a market economy. The mortgage lending system is also improving and has slowly begun to put home ownership in the reach of many middle-class Russians. The labor force is generally well educated, though skilled labor has been in increasingly short supply. Strikes in the private sector are now less frequent than they were in the mid-1990s. Workers have increasingly pursued their demands through the court system or used methods such as rallies and days of action to call attention to their plight. The number of workers who went on strike decreased from 84,600 in 2005 to 2,800 in 2006. Enterprises that pay wages in full and on time generally have smooth labor-management relations. Approximately 65% of Russia's workforce is unionized. The trade union movement is still largely dominated by the Federation of Independent Trade Unions of Russia (FNPR), an inter-professional umbrella organization which consists of formerly governmental unions and now represents 93% of total trade union membership. Despite the trend of declining unionization (FNPR alone has lost 10 million members in the past five years), a number of relatively new trade unions outside this confederation have begun to make strides in defending their members' interests. The Russian Confederation of Labor (KTR) and the All-Russian Confederation of Labor (VKT), formed in 1995, are two such organizations. The KTR, VKT, and the FNPR are all members of the International Confederation of Free Trade Unions (ICFTU). The Russian government generally adheres on paper to International Labor Organization (ILO) conventions protecting worker rights, though enforcement is often lacking. The 2002 Labor Code governs labor standards in Russia. When it was adopted, it was meant to diminish the role of government in setting and enforcing labor standards, with trade unions and a more flexible labor market playing a balancing role in representing workers' interests. However, enforcement mechanisms for an employer's failure to engage in good faith collective bargaining. The enforcement of worker safety rules has been a major issue as well, as enterprises are often unable or unwilling to invest in safer equipment or to enforce safety. In June 2006 the Labor Code was revised to include a new requirement that businesses employing more than 50 workers must establish a work safety division and create a position of "work safety specialist. The previous requirement only applied to employers with more than 100 workers. Amendments were also added to improve the procedure for investigating industrial accidents. In the spring of 2005, President Putin announced plans for four National Priority Projects in health, education, housing and agriculture. These projects are meant to spread to ordinary Russians the benefits of the recent energy-fueled economic boom and to tackle some of Russia's most pressing social and economic needs. While there so far have been few evident improvements arising from the projects, experts say it is still too early to expect tangible results. The National Projects provide potential investment opportunities, especially in medical equipment manufacturing, agricultural equipment sales, and housing construction. The 2007 budget for the projects is USD 9.4 billion. Foreign Trade Zones/Free Ports In 2005, the Russian government passed the Law on Special Economic Zones (SEZs), which proposed the establishment of industrial-production zones and R&D focused progressive-technical zones for twenty-year periods. Management of the zones is shared by the Russian Federal Special Economic Zones Management Agency and its territorial bodies, a real estate management company and a supervisory board with assistance from representatives of SEZ residents. In November 2005, the government announced the results of a tender and the establishment of six SEZs: in Zelenograd and Dubna in the Moscow region (focused on microelectronics and nuclear technology, respectively), St. Petersburg (information technology), Tomsk (new materials), Lipetsk (appliances and electronics), and Yelabuga (auto components and petrochemicals). Enterprises operating in industrial-production zones (20 square kilometers) will pay lower unified social taxes, with the highest rate reduced from 26% to 24%, and those within progressive-technical zones (2 square kilometers) are allowed to write-off all R&D expenses. Both types of zones will benefit from reduced land and property taxes and a waiver of customs duties on imports and finished exports. The tender process will continue in 2007, with more SEZs to be designated. In addition, the Federal Agency for Administering Special Economic Zones in 2006 announced plans to create technology parks in Novosibirsk, Tyumen, Kazan, Sarov (Nizhny Novgorod Oblast) and Obninsk (Kaluga Oblast). In December 2006, a tender committee approved creating seven special tourist economic zones in the Krasnodar, Stavropol, Altai, Kaliningrad and Irkutsk regions, as well as in the constituent republics of Altai and Buryatia. The SEZ in Kaliningrad, which allows goods to be imported duty-free as long as they are not re-exported to the rest of Russia, has been able to attract some moderate investments. An SEZ in Magadan has attracted minor amounts of investment and the SEZ in Nakhodka has reportedly never been implemented. Foreign Direct Investment Statistics Table 1 shows flows of foreign investment by country for the first nine months of 2006, compared to the same period in 2005. Consistent with the trend of recent years (except for 2005), the first nine months of 2006 showed a healthy increase in foreign investment over the same period in 2005. Note that Russian statistical practice counts total investment as including direct investment, portfolio investment, and "other" investment (largely trade credits). Cyprus consistently figures high as an investor because most investment coming from Cyprus is actually returning Russian capital. Table 1: Top Ten Investors - By Year (in USD million)
(Note: As of 2001, the Federal Service for State Statistics stopped providing breakdowns of direct and portfolio investment in its yearly statistics, and started instead providing this for accumulated investment (table 2).) The numbers in Table 2 can only be taken as a general indication of the stock of investment activity identified with a given country. This does not represent an accumulated stock of direct investment because these figures include portfolio and "other" investment and do not reflect any withdrawal of funds or decreases in value of assets. Although the U.S. fell behind the Netherlands and Cyprus in terms of direct investment in 2005 and 2006, this is largely due to Royal Dutch/Shell's USD 11 billion investment in Sakhalin and returning Russian capital from Cyprus. Note that although Germany and the UK continue to show a larger stock of total investment than the U.S., a large proportion of their investment consists of "other" investment, primarily trade credits. Table 2: Top Investors - Accumulated Basis (Amounts in USD Million)
Source: Federal Service for State Statistics (FSSS) Table 3 shows foreign investment by region over the first nine months of 2006, compared to the same period in 2005. Moscow continues to attract the largest volume of investments, mainly due to concentration of companies' headquarters that guarantees attraction of investments and the largest concentration of consumers with high purchasing power. Table 3 - Foreign Investment - Top Regions
Source: Federal Service for State Statistics (FSSS) (Note: Includes direct, portfolio and other investment.) Table 4 shows investment by sector over the first nine months of 2006, compared to the same period in 2005. Total investment in trade decreased in 2006 compared to the same period of 2005, however trade continued to lead all sectors as of September 2006. The fuel industry came in a close second, while consuming a larger percentage of total investment in 2006 over the same period in 2005. Table 4: Foreign Investment: Top Sectors (Amounts in USD Millions)
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