The cul-de-sac of foreign industrial investments to Russia

The aim of this article is to determine the rationale for the 'irrational' investment behaviour of multinational corporations (MNCs) in Russia. During the on-going recession in a number of major sectors, MNCs have undertaken only a very limited number of divestments and, instead, have commissioned a record number of new manufacturing facilities (by opening new plants and expanding the capacities of existing plants). To explain this phenomenon, we first provide an overview of existing theoretical and empirical studies on investments in difficult locations and divestments of foreign subsidiaries, and identify the major weaknesses of the prevailing approaches and underlying assumptions of such studies. Next, we present a detailed picture of both industrial investments and divestments in Russia from January 2015 to March 2017. Finally, we indicate how a combination of systemic and contingent factors (pressure from the host country's government, subsidiaries' orientation towards the host country's markets, and the absence of potential local and international acquirers for existing Russian manufacturing facilities of Western MNCs) has created 'cul-de-sac' conditions for foreign-owned industrial assets in Russia.

Keywords: Manufacturing subsidiaries; investment and divestment; economic recession; Russia

Introduction

A glance at the socio-economic situation in Russia gives the impression that the country has lost its attractiveness to foreign investors. Indeed, overall inward foreign direct investment (IFDI) declined in 2014 by 70% compared with 2013 (i.e. from US$70 to US$21 billion; UNCTAD, [19]). A further 40% decline (to US$12 billion) was registered in 2015. Although overall IFDI increased in 2016 from US$12 billion to an estimated US$19 billion (UNCTAD, [20]), this figure was inflated by the obscure sale of a 19.5% stake in the state-owned oil company Rosneft – valued at approximately US$11 billion. Thus, the remaining volume of IFDI of US$8 billion is lower than that of 2015. In addition, the twofold devaluation of the local currency at the end of 2014 not only significantly impaired the tangible and intangible assets of foreign companies operating in Russia (so-called foreign exchange effects), but also severely eroded local consumer and industrial markets. In consumer markets, overall retail trade turnover contracted during 2014–2016 by 15% in local currency terms and by 51% in US dollar terms, and the physical sales volume of many consumer goods categories declined by 30–50%. For example, annual sales of new cars declined from 2.5 million in 2014 to 1.4 million in 2016. In some industrial markets, the decline was even more spectacular. For example, the road construction equipment market shrank by 65% over 2013–2015 and by a further 7% in 2016 (STROYTEH, [17]).

In such unfavourable market conditions, an exodus of foreign companies from local markets or, at least, from local industrial assets might have been expected to have occurred. However, the reality was the opposite: the number of divestments of foreign industrial assets in Russia from 2015 to the beginning of 2017 was very limited (not more than 20 cases), whereas the number of completed significant industrial projects in the same period (90 commissioned new plants and 62 significant extensions of MNCs' existing plant facilities) overweighed the number of divestments.

The aim of this article is to attempt to solve this puzzle and to find a rationale for the 'irrational' investment behaviour of MNCs in Russia. To achieve this goal, we first provide an overview of the strategic choices faced by corporate parents regarding their manufacturing subsidiaries during economic recessions in host countries. Next, we present a detailed picture of both divestments and investments in Russia from January 2015 to March 2017. Finally, we indicate how the combination of systemic and contingent factors (e.g. pressure from the host country's government, absence of possible buyers for Russian manufacturing facilities of Western MNCs, obstacles to expand market domains) has created 'cul-de-sac' conditions for foreign-owned industrial assets in Russia when continuing operations is a superior option to divesting major types of businesses in which MNCs in Russia are active.

Strategic options for overseas manufacturing subsidiaries during host country economic downtu...

In this section, we outline possible strategic options for overseas manufacturing subsidiaries during host country economic downturns. The academic literature is of little assistance because the major option proposed for foreign subsidiaries of MNCs during a downturn is divestment and market exit (Berry, [2], [3]; Coudounaris, [4]; McDermott, [14]; Song, [16]). In addition, even when evaluating divestment actions, continuous attempts are made to propose techniques that are too sophisticated for executive decision-making during difficult times, especially 'real options' for assessing divestment alternatives for foreign subsidiaries (see Belderbos & Zou, [1]; Damaraju, Barney, & Makhija, [5]). Yet, simply the definition of a real option – 'the right – but not the obligation – to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project' – contradicts the reality of foreign investment projects through which most business initiatives confront all types of obligations.

As a result, we turned away from the international business literature and instead used the strategic literature. The most attractive concept was that of 'strategic agility' (see Weber & Tarba, [21]), which is worth applying in healthy economic periods and becomes necessary in difficult times. By operationalising the concept of strategic agility for foreign manufacturing subsidiaries, we discerned the following types of strategic choices pertaining to manufacturing assets (plants) in difficult host market conditions:

• • to maintain the existing limited market domains of a subsidiary, or to expand the subsidiary mandate and to transform a local subsidiary into a dual-option subsidiary serving both local and foreign markets;
• • to abandon on-going investment projects of erecting new plants, or to complete on-going investment projects until the successful commissioning of new plants;
• • to maintain existing plant facilities, or to expand existing manufacturing facilities of existing plants;
• • to continue operating existing manufacturing facilities, or to stop operating existing manufacturing facilities; and
• • to maintain manufacturing capacity in corporate ownership, or to divest such capacity.

The two last options are easier for subsidiaries that own more than one similar factory in the host country (the likely case for corporations in construction materials, food production, for instance). During difficult economic periods, such multi-plant subsidiaries can concentrate production in a smaller number of the most effective sites.

We should add that most mentioned options are not always adopted at the complete discretion of corporate parents. This is especially applicable to new factory openings or expanding the manufacturing facilities of existing factories as 'forced' options. For example, to maintain its presence in a particular local market, the corporation must launch new or expand existing local manufacturing facilities. Import restrictions imposed by host country governments can also force the substitution of imports by intensifying manufacturing in their countries.

To develop a proper solution to the puzzle, we had to categorise corporate actions into the mentioned strategic options and, when possible, provide explanations for a particular strategic choice.

Method and data

This study employs a mixed methods approach by using both qualitative and quantitative data on the investment and divestment actions of Western MNCs in Russia. The qualitative data were obtained through interviews of 10 corporate executives from eight corporations (two executives were interviewed twice, in 2015 and 2016). In addition, we conducted a case study of an international company that performed both a significant divestment and a major investment project in Russia during 2014–2015 (see Gurkov, [9]). For this study, we interviewed the global CEO of that corporation and senior top executives of the parent and the Russian subsidiary, collected different types of information on the parent and its Russian subsidiary, visited the site to be divested, and were present at the formal opening ceremony of a new plant.

The quantitative data used in that study aimed to reflect the magnitude of investments and divestments by MNCs in Russia during the past 63 months (January 2012–March 2017) using a significant manufacturing project as a unit of observation (establishment of a new plant, significant expansion of an existing plant, closure or sale of an existing plant of a foreign MNC to another parent). The initial point of observations (January 2012) was selected because it marked the exact end of a period of intensive acquisitions of local companies by MNCs (see Gurkov, [7], pp. 223,224), and the emphasis of further development of MNCs in Russia was shifted towards extending acquired facilities and to greenfield investments.

The first database on plant openings of foreign MNCs in Russia was assembled by Gurkov ([10]). The database included data on 109 plants opened in Russia by foreign MNCs during 2014–2015, including 94 completed new plants and 15 'first stages of new plants'. Subsequently, Gurkov ([11]) extended that database backward and forward and recorded all new plant openings and extensions of existing plant facilities that occurred from January 2012 to June 2016.

We utilised this database and extended it further forward by adding information on all new plants and new facility openings at existing plants from June 2016 to March 2017. The complete database includes 316 cases: 208 new plant openings and 108 extensions of existing facilities that occurred between January 2012 and the end of March 2017.

Findings

Modest intensification of export activities of MNCs' Russian manufacturing subsidiaries durin...

This type of activity has been observed for a number of subsidiaries. For example, a Russian subsidiary of Danish ROCKWOOL increased its insulation material exports from its plant near the Russian–Finnish border. Hyundai, which owns one of a few Russian car assembly plants that worked at full capacity in 2015–2016, started to export cars from its car assembly plant in St Petersburg. Unilever managed to deliver ice cream and tea bags from its Russian plants to Australia. Oriflame (a Swedish-based beauty and cosmetic company) used its newly-established plant near Moscow for its worldwide supply of lipsticks and other products. In Russia in 2015 and 2016, the devaluation of the local currency and favourable harvest intensified agricultural commodity exports from Russia by the largest global grain traders. However, in general, the results of the transformation of Russian manufacturing subsidiaries into dual-option subsidiaries can be assessed as modest (we accounted for not more than 10 cases of such transformations). Objective reasons exist for this phenomenon: underdeveloped logistics, significant distances (on average, 1200–1400 km) from factories built to satisfy the local demand to export ports or land borders, high cost of exports' custom clearance, and non-tariff barriers imposed by the United States and the European Union for many types of Russian origin production. Subjective reasons also exist, in particular the ardent defence of foreign 'sister-subsidiaries' of their traditional market domains.

Investments projects completed during difficult times

To clarify the prevalent outcomes of the second and third strategic choices, we had to reveal the dynamics of completed investment projects during a period of economic growth (2012–2013), a period of fragile stagnation (2014) and a period of serious economic turbulence (2015–present).

Figure 1 (presented on the next page) demonstrates the dynamics of significant commissioned industrial investment projects from 2012 to the first quarter of 2017. The first quarter of each year is usually a 'dead season', whereas the second and third quarters are the busiest seasons. Two visible trends also exist. First, out of all observation periods, the second, third and fourth quarters of 2015 saw the most intensive commissioning of both new plants and extensions of new plants by MNCs in Russia. Second, although the dynamics of the commissioning of existing plant extensions in 2016 virtually replicated that of 2015, the total number of newly-commissioned plants declined in 2016, and the number of existing plant extensions exceeded the number of commissioned new plants in the second and third quarters of 2016.

An important point should be made regarding the data presented in Figure 1. Typically, a manufacturing plant cannot be designed and built 'until the last bolt'; therefore, the number of extensions of existing plants during 2012–2017 comprised seven extensions of plants opened during 2012–2016 (each of these seven plants experienced one major extension). All of these extensions were specified by the initial projects and are separated from the date of an official new plant commissioning by a relatively short period (between seven and 27 months, depending on the scale of the extension).

Graph: Figure 1. Dynamics of new facilities' installation by foreign multinational corporations in Russia in 2012–the first quarter of 2017.

We clarified the lags between including the plant in the parent (by greenfield investment or acquisition) and the significant extension of production facilities that occurred during 2015–2017 (see Figure 2).

Graph: Figure 2. Lags between the inclusion of a factory into its current corporate parent and a significant extension of plant's facilities executed in 2015–2017.

Two 'peaks' exist for the extension of foreign MNC plants in Russia. The maximum number of extensions occurred between the fourth and sixth years of a plant being owned by its parent. However, another extension peak is the tenth year of corporate ownership of a plant. On the one hand, a period of four–six years is sufficient for obtaining the maximum capacity utilisation of existing production facilities using different methods of gradual production efficiency improvement and to seek radical extensions of existing facilities. On the other hand, a decade is a typical period for significant (or even complete) 'moral depreciation' of the initial production scheme and dominant production technologies; therefore, the second 'peak' also appears logical. This means that even in difficult times foreign MNCs followed the general patterns for renovation of manufacturing facilities.

We also clarified which 'old' factories were extended in 2015–2017. Among 14 such cases, six cases were extensions of facilities in food and associated products and four cases were facilities for the production of chemical products.

For a comparison of territorial and sectorial distributions of new investments, we compared two periods of 27 months each – the 'peaceful' period from January 2012 to March 2014 and the turbulent period from January 2015 to March 2017. We should recall that at the end of December 2014, there was a twofold devaluation of the local currency. During the peaceful period, Western MNCs opened 78 new plants in Russia and significantly extended production facilities in 34 plants. During the turbulent period, Western MNCs opened 90 new plants in Russia and significantly extended production facilities in 62 plants.

For new plants commissioned, no statistically significant difference exists in sectorial distribution – in both periods, 'chemical and allied products', 'stone clay glass and concrete products', 'transportation equipment', 'machinery and commercial equipment', and 'food and kindred products' were the leading sectors that together accounted for 59% of new plants in the first period and 64% of new plants in the second period. Regarding existing plant extensions, 'food and kindred products', which occupied merely 20% of the cases in the first period, grew to 44% of the cases in the second period, whereas the absolute number of existing plant extension projects in all other industrial sectors remained the same.

Regarding the territorial distribution of investments, the major trend was the same for both new plants and extensions of existing plants: the region around Moscow (Moscow Oblast) became the ultimate destination for industrial projects of foreign MNCs in Russia. If in the 'peaceful' period Moscow Oblast accommodated merely 5% of new plants and 11% of new plant extensions of MNCs in Russia, in the 'turbulent' period the oblast accommodated 16% of new plants and 19% of existing plant extensions. The situation is understandable given that Moscow's agglomeration with a total population of approximately 17 million persons is among the 20 largest world consumer markets by consumer spending (US$165 billion in 2015). Moreover, Moscow's retail turnover (US$70 billion in 2015) was 16% of Russia's total retail turnover (The Government of the City of Moscow, [18]).

Investment projects abandoned during difficult periods

In this section, we examine the termination of projects that started with the entire set of necessary actions (signing investment contracts with the provincial administration, 'laying the first stone', realised significant construction work, and others). We were able to find only one significant abandoned investment project, which was abandoned because of a real 'force majeure' (sudden worsening of economic relations between Turkey and Russia, following the destruction of a Russian warplane by the Turkish air force in October 2015). This was a Turkish company that signed an US$200 million investment contract in October 2014 and laid the first stone in May 2015, and was asked in December 2015 to revise the investment plan that stipulated the active use of a Turkish workforce. The project was subsequently postponed and, in January 2017, the company finally refused to continue the project.

Divestments executed during 2012–2016

Although divestments were not that popular in corporate reporting as new plant openings and existing plant extensions, we used Russian sources to identify 20 divestments that occurred during 2012–2016. This number pertains to the two identified moves – stopping the operations of existing manufacturing facilities, and selling existing manufacturing facilities to another parent – because such options usually overlap.

'Classical' divestitures, i.e. the sale of plants for their further use by another parent, was observed only in two cases: (a) in 2012, when the beer giant SabMiller sold its Russian production capacities to its strategic partner, Turkish company Anadolu Efes, for a 24% stake in Anadolu Efes and further royalties for the use of SabMiller's brands in Russia; and (b) when in 2015, a major international food company sold its Russian bottling factory to a local company, and the buyer entered into a 'co-packing' contract and continued to manufacture the same products under the same trademarks.

A sale of production facilities to another parent that subsequently changes how the facilities are used was observed just in two cases. In one case, a beauty and cosmetics plant was sold to a local company for further use as a storage and distribution complex (see Gurkov, [9]). In the second case, a juice bottler was sold to another foreign MNC for further retooling into a large bakery for fast-food chains.

In all other 16 cases, the plants were simply closed down following a decline in local demand. The sale of those production facilities was unsuccessful. Most of the closed plants were dairies, breweries or juice and soft drink bottlers. A car assembly factory, a factory producing TV sets and refrigerators, a computer assembly factory, and a factory in construction details were also closed down. Some equipment was relocated to sister subsidiaries in Russia and abroad. In reality, the closure of breweries started in 2009 and of dairies in 2012. During 2014–2016, these processes intensified.

We should highlight three important features of these closures. First, with the notable exception of a GM plant that was a fresh greenfield investment (commissioned in 2009), most of the closed plants were old facilities established in Soviet times or the 1990s and later acquired by foreign MNCs. Second, most of the plant closures were executed by the largest corporations in their respective industries (GM, HP, Carlsberg, Heineken, SabMiller, Danone, Coca-Cola Corporation). Third, plant closures were quite costly because they were executed in a very civil manner with respect to dismissed employees; severance payments were between two and three times the amount stipulated by local labour legislation. For example, GM paid employees of its closed Russian factory a severance package of six months' salary; for the closure of its Chelyabinsk brewery, Carlsberg spent 300 million rubles to compensate 458 laid-off employees (severance payment equal to seven months' average salary; advance payment to women on maternity leave for the entire remaining period of their maternity leave; coverage of expenses related to job agencies for finding new jobs; and others) (see Gurkov, Morgunov, & Saidov, [12]).

Discussion

We presented a picture of attempts to increase exports from Russian subsidiaries, completed and abandoned investments projects, and executed divestments in Russia during the present crisis. The attempts to increase exports from Russian subsidiaries were quite modest given that they met both objective and subjective obstacles. For the second outlined strategic choice – to abandon on-going investment projects of erecting new plants or to complete them until the successful commissioning of new plants – preference was given to completion of on-going investment plants: during January 2015–March 2017, Western MNCs opened 90 new plants in Russia and abandoned just one on-going investment project related to the erection of a new plant. Regarding the third type of strategic choice – to maintain existing plant facilities or expand their manufacturing facilities – preference was given to maintaining existing facilities. Indeed, 62 extensions of existing plants have occurred since January 2015 (including six extensions as simply executions of the next stages of construction of recently opened plants), which is not too high a figure considering that such investments affected merely 10% of the total number of Russian MNC factories.

The fourth and fifth types of strategic choices (divestments) were executed in a very cautious, more expensive manner (not as sales but simply as plant closures).

We are approaching the solution to the puzzle. The preference for completing on-going projects of new plant erections can be attributed to the following factors. First, the liquidity of 'construction-in-progress' of manufacturing facilities during the economic recession is extremely low; thereby, abandoning 'construction-in-progress' usually means that the entire amount of the already made investments should be written off. The closer the abandoned projects of new plants are to their completion, the higher are the 'invisible' parts of the total costs. For example, usually a year before opening, the core personnel for a new plant are hired, with hired engineers and technicians usually spending prolonged and expensive training at sister subsidiaries in Russia or abroad. Such expenses also should be written off when a project is abandoned. We should add problems with land given that most new plants are built on leased land of 'industrial parks' and 'special economic zones'. Earlier termination of land lease contracts also increases the costs for abandoning a project.

The second factor that contributes to explaining the preferences for completing investment projects launched in 'good times' is related to the contractual obligations of MNCs in car assembly to achieve a 70% level of local costs in finished production to maintain the preferred custom regime of car part imports. This requirement caused numerous car manufacturing suppliers to build new plants (producers of aluminium parts for engines, car glass, car electronics, tires and others). We should also note that achieving the 70% threshold of locally occurring costs moves a foreign-owned plant into the category of 'local company', which is entitled to state aid. For example, in 2015, one German company extended its existing plant in agriculture machinery, achieved the 70% level of locally occurring costs and immediately applied to the Ministry of Agriculture of Russia for participation in a state aid programme for local agriculture machinery producers.

The third factor that contributed to the accelerated completion of investment projects is related to the growing restrictions on access to government-financed procurement for many types of imported goods – machinery and equipment (imposed by the Russian government in July 2014), medical devices (imposed by the Russian government in January 2015) and pharmaceutical products (imposed by the Russian government in December 2015) (see Gurkov & Saidov, [13]). Thereby installing a local manufacturing facility was a necessity to remain in a lucrative market of government-financed procurements. Foreign MNCs seem to have considered all three mentioned factors and opted to either implement as quickly as possible their on-going projects (Russian engineers and technicians are famous for their ability to 'rush launch' industrial projects ahead of schedule (see Gurkov & Kossov, 2014)) or simply decide to call projects near completion as commissioned. This explains the rapid increase in the number of opened plants in the last three quarters of 2015 and the sharp decrease in the number of opened plants in 2016: the pool of projects launched during 2012–2013 was exhausted and the number of new investment projects launched during 2014–2015 was minimal.

Explaining the increase in facilities extensions is also straightforward. A careful look at the figures reveals that the overall rate of facilities extensions remained relatively small (5% of the total number of Russian MNC plants was annually affected by production facility extensions). The increase was mostly the result of accelerated production facility extensions in food and kindred products because self-imposed import restrictions created a window of opportunity for Russia-located producers, and foreign MNCs demonstrated sufficient agility in seizing these opportunities. One good example is the activities of Olam International (a Singapore-based global food commodities trader) in Russia. During 2014–2016, using opportunities offered through self-imposed food import restrictions and increased competitiveness of local agricultural exports resulting from the local currency devaluation, Olam extended its diversified portfolio of manufacturing and logistics facilities and expanded a large milk farm in Central Russia, an export grain and oil seeds terminal on the Black Sea, a coffee packaging factory near Moscow that operated as a contract manufacturer for several well-known brands, and others (Olam, [15]). In 2014, Olam International joined the Foreign Investment Advisory Council (FIAC) – an elite club of 'preferred investors' that encompasses the 50 largest global companies and several international financial institutions. FIAC members meet annually with the Prime Minister of Russia and, between such meetings, operate several working groups to improve custom and tax laws, technical regulations, financial regulations and capital markets, among others (see FIAC, [6]).

Additionally, an explanation should be provided for the very limited number of divestments during difficult times. Here, we demonstrated that most divestments were carried out in a very costly manner as plant closures (necessarily, because of the absence of potential acquirers of assets in declining markets). Obviously, such activities can be afforded primarily only by very large corporations, for which the net losses related to such actions present a very small fraction of the corporate-wide financial results.

Conclusions

We presented a snapshot of the recent investment and divestment projects executed in Russia by foreign MNCs. In most cases, seemingly irrelevant moves turned out to be carefully assessed and properly executed strategic choices that accounted for the best possible relations between opportunity benefits and opportunity costs. In addition, the accelerated completion of on-going industrial projects can be a sign of the strategic agility of both Russian subsidiaries and their corporate parents.

At the same time, despite eliminating unacceptable losses from abandoning on-going projects, minimising the corporate-wide effects of plant closures, discovering new opportunities and some markets, and finding temporary solutions for working at sub-optimal capacity utilisation in declining markets, foreign MNCs are still incapable of finding a plausible solution to the low liquidity of their Russian industrial assets. This is what we call the 'cul-de-sac of foreign industrial investments in Russia'. The appearance of new entrants into the Russian markets, especially second-tier multinationals from emerging markets, may increase the liquidity of existing assets for foreign MNCs in Russia. However, the most reliable way to increase the liquidity of Russian indusial assets is the at least partial removal of subjective obstacles to intensifying exports from such subsidiaries.

Disclosure statement

No potential conflict of interest was reported by the authors.

Acknowledgements

The authors acknowledge the valuable research assistance of Prof. E. Morgunov.

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By Igor Gurkov; Alexandra Kokorina and Zokirzhon Saidov

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