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ANDREAS WÖRGÖTTER, IHS

Russia Regional Risk Rating

Presentation Salzburg, June 22, 1998 Bank Austria CEEC and Investment Risk Rating

The macroeconomic stabilization of the Russian economy stimulated the interest of both academics and business circles resulting in more knowledge on economic development and opportunities in this country. The issue of foreign investments in the Russian Regions and the related legal and logistic frameworks has become a prominent subject of worldwide interest. However, the vast environmental, demographic, political, economic, financial and cultural diversity of the country, arising from its wide geographic spread, make it difficult to consider the Federation as a single entity.

The Russian Federation is the largest country in the world and extending over 9 time zones. The Russian Federation is home to a variety of different peoples and religions of all main European, Arab and Asian beliefs. Russia is combining its wealth of resources and high technological sophistication with the struggles to overcome the distortions of its central planning legacies. The Russian Federation exemplifies diversity, which is unique among all economies.

Therefore, the regional approach seems to be relevant and appropriate. This approach allows us to delineate the obstacles and risks for investment at the level of more homogeneous subjects of the Federation. The characterization of the 89 RF subjects by the use of a large number of various indicators is a challenging undertaking, and the presentation of its results needs special techniques. Despite the fact that some information could be lost for the reader, or is indistinguishably couched in technical procedures, our method of rating remains one of the most vivid ways to display investment risks. We see our task to condense available information in a similar way as a road map and to offer report a compass, which is showing the directions. We invite the reader of our study to accompany us on our adventurous travels through the world of information on the Russian Regions and share the results of a "beauty contest" of the Russian Regions from the point of view of an outside investor. Russia

Russia experienced substantial changes after the breakdown of central planning; some of which lead to positive developments and some can be identified as negative outcomes.

POSITIVE DEVELOPMENTS

According to the official economic statistics, the recession of the RF seems to have bottomed out in 1997. Inflation in the beginning of 1998 dropped below 1% per month. The RUR/US$ exchange rate has kept its value despite the heavy speculative attacks, now its volatility is under control of the Central Bank with the price of excessive interest rates. The discount rate was reduced nearly ten times, but it had to be increased temporarily to 150% at the peak of the recent financial crisis. Russian regions started to issue ADR and Euro-bonds, promoting the development of a full-fledged financial market in Russia. These and other steps have led to international recognition of the Russian security market. Now, several Russian stocks are quoted and traded internationally.

The Russian banking system is gradually improving its performance and efficiency. Some banks have begun to invest in productive assets. Large banks moved their operations to the regions and established branches throughout the country. So called financial-industrial groups were established with a potential for improving the financial basis of important Russian enterprise conglomerates. Finally, absolute individual savings have started to grow.

International trade activities were characterized by an impressive (and for transition economies unusual) positive export-import balance. Going hand in hand with increasing international trade, foreign investments have markedly increased although starting from an insufficient level and foreign and joint

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ventures activities expanded. Foreign activities were no longer confined to the RF capital, but have also occurred in the Russian regions and were often financed from abroad.

The Russian market is no longer characterized by supply and goods shortages ("deficits"), but in many regions starts to resemble Western markets for the consumer with enough purchasing power. In addition, the quality of domestic products has generally improved. Business services and utilities are now widely available. The quality of communication facilities has improved remarkably and modern communication services such as the Internet or cellular phone services are available today in most cities.

The state sector's share in the economy is gradual declining, and privatization is generally heading towards a successful direction. Today Russia is among the economies with the smallest share of GDP commanded by government. Center-region relations are more and more based on a legal framework, regulating the interactions between the entities of the RF. At the same time, the legal system more and more reflects market realities. The government oversees business activities, but refrains from direct interventions, and started to initiate anti-monopolistic policies. All these factors, in the eyes of the population, lend more creditability to the economic and political reforms in the country.

Finally, 20 months of war in the Chechen Republic have stopped.

NEGATIVE OUTCOMES

With the growth of the budget deficit, the instability of tax collection has increased. Many enterprises efficiently delay tax payments and the amount of collected taxes has decreased. There is generally a money shortage in the economy due to the tight monetary policy of the CBR and the insufficient financial intermediation capacities of the Russian banking system. Barter or money surrogates settlements are still common practice. The number of donor-regions to the Federal budget is decreasing, and federal-regional financial relations are generally unclear or not efficiently regulated.

Recently the consequences of investor withdrawal scared by fears of regional and federal bankruptcy has been shaking the Russian financial markets. This battle is not yet over and Russian federal and local authorities will have to come up with actions demonstrating their willingness to refrain from playing games with outside investors. International investors become increasingly aware of the risks of inadequate policies. This has also a positive side effect: governments cannot wait as long as in the past, until distortionary policies are changed.

Another major shock for the Russian economy has been caused by sharply decreasing energy export prices. Export revenues depend very much on energy and raw material export.

Labor productivity (GDP per employed) is generally declining countrywide. The technological and physical depreciation of the productive assets continues. Branch and regional developments are characterized by growing disparities. There are strong concentration tendencies, where specific branches are exclusively concentrated in single regions. The construction of a competitive, market oriented processing industry is still far from satisfactory.

There is a polarization of the population regarding an increasing range in net incomes. Wage, pension and social benefits arrears are growing. The number of poor people has become larger. Even homelessness is becoming a widespread phenomenon. Strikes have become a common feature of work life. The regional and Federal government cuts social support programs and social services, and the quality of these state-provided services has deteriorated. At the same time, an increasing share of the population is looking for social assistance. Hidden employment is flourishing, and the official and non-registered unemployment rates continue to rise. On the other side, there is a continuous decline of the life expectancy of the Russian population.

The shadow economy prospers criminal activities and financial frauds are on the rise. The population lacks an efficient protection from crime by official law enforcement bodies. The withdrawal of the state has generated a vacuum into which numerous organizations invaded by illegally exercising the state privilege to tax and apply force.

The transport sector has generally deteriorated. Custom barriers between the CIS states, and complicated custom procedures are impeding trade activities between the RF and the former Soviet republics. Russia's reputation in the political and economic sphere has suffered in Eastern and in its previous sphere of influence.

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The Russian State, the parliament (Duma) and some of its leading figures have lost authority among the population. The Russian population has demonstrated an astonishing amount of patience and ability to tolerate the burden of adjustment to market principles. Currently the confidence in market principles to favor the interests of "the man in the street" rarely can be delivered by the politicians, but has to be provided by the outcomes of economic development. Regions

The 89 objects of the Russian Federation differ in terms of their degree of independence granted by the constitution. The constitution mentions 49 Oblasts, 21 Republics, 6 Territories (Krais), 10 autonomous districts, 2 Metropolitan Areas and one Autonomous Oblast.

As explained already before, the regions differ vastly by climate, size, population, income, wealth, infrastructure and industrialization. However, it could be useful to give several concrete examples.

The Table 2 with the regional share in the total country area (%), the respective share of the population (%, 1996), GDP per capita (RUR mln per person, 1995), share of the Gross Industrial profit (%, 1996), km of paved roads per 1000 km2 (1995) is presented on the next page. Following the displayed data it is obvious to see the huge difference in areas between the Sakha (Yakut) Republic (18.14% of the RF territory) and St. Petersburg (0.0035%). The unbridgeable gap could be observed between the population shares of the capital (5.81%) and Evenki A.T. (0.01%). The large variance in GDP per capita over the country still remains. In this case, Tyumen Reg., Yamalo-Nenetz A.T. and Khanty-Mansi A.T. (35-36 RUR mln per person) can be contrasted with, say, Dagestan Republic, where the value of the respective index is less than 2 RUR mln. The tremendous gap also could be seen, for example, in Gross Industrial profit. Here Tyumen Region produces 9.96% of the country's total. However, the contribution of the Aginski Buryat A.T., Altai Republic, Evenki A.T., Ingush Republic, Komi-Permyak A.T., Koryak A.T., Taymyr A.T., Tuva Republic and Ust'-Orda Buryat A.T. is about zero. Finally, even the car road density is highly uneven over the Federation. Certainly the absolute leaders here are the metropolises of Moscow and St. Petersburg with nearly 500-km of paved roads per 1000 km2. In Moscow region the density is about 317 km of paved roads per 1000 km2. But, there are practically no roads in Koryak A.T. or Evenki A.T. All these contrasts point to the fact that we study an extremely heterogenial country.Table 1. Comments to the Table 2.

Area Share of the regional area in the RF territory, %. Population Share of the regional population in the RF territory, %. GDP/Cap Gross Domestic product per capita, RUR mln per person. Ind. Profit Share of the regional Gross industrial profit in the total RF industrial profit, %. 2 Car Road Car road density, km of paved roads per 1000 km . (6) The economic region consists of 6 regions. Share Share of the economic region in the RF total. Average Average value over the economic region. Maximum Maximum value over the economic region. Minimum Minimum value over the economic region.

Table 2. Differences between the regions and economic regions of the RF.

Economic Region Statistics Area Population GDP/Cap Ind. Profit Car Road North Economic Region (6) Share 8.57 3.99 3.16 Average 12,256.5 29 Maximum 2.43 1.00 16,250.7 1.54 73 Minimum 0.85 0.03 9,336.3 0.01 1 North West Economic Region (5) Share 1.268 6.06 3.05 Average 6,868.3 250 Maximum 0.5021 3.23 9,753.9 1.19 500

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Minim um 0.0035 0.50 5,538.9 0.15 117 (13) Share 2.90 20.14 15.64 Average 7,733.1 194 Maxim um 0.49 5.81 16,611.7 5.75 500 Minimum 0.01 0.54 5,070.6 0.25 82 -Vyatka Economic Region (5) Share 1.56 5.72 4.31 Average 6,494.3 130 Maximum 0.71 2.53 9,420.2 2.46 167 Minimum 0.11 0.52 5,124.8 0.22 65 Central Black Economic Region (5) Share 1.01 5.34 3.43 Average 7,671.7 176 Maximum 0.31 1.70 11,034.9 1.05 221 Minimum 0.15 0.85 4,987.3 0.23 135 Pre- (8) Share 3.16 11.46 11.65 Average 7,341.9 98 Maximum 0.67 2.55 13,611.7 4.87 152 Minimum 0.22 0.22 2,789.9 0.01 29 North Caucasus Economic Region (10) Share 2.10 11.94 3.31 Average 4,401.2 160 Maximum 0.59 3.38 6,835.1 1.15 285 Minim um 0.01 0.20 1,992.1 0.00 103 Ural Economic Region (8) Share 4.82 13.84 16.17 Average 9,463.0 74 Maximum 1.14 3.17 12,376.0 3.67 111 Minimum 0.19 0.11 5,690.9 0.00 10 West Siberia Economic Region (9) Share 14.19 10.24 26.03 Average 17,217.2 31 Maxim um 4.39 2.07 34,421.4 9.96 82 Minimum 0.54 0.14 4,512.5 0.00 1 East Siberia Economic Region (10) Share 24.10 6.19 7.84 Average 9,764.2 23 Maximum 5.04 2.06 14,173.8 4.75 79 Minim um 0.11 0.01 3,523.0 0.00 0 Far East Economic Region (10) Share 36.34 5.07 5.41 Average 11,329.9 14 Maxim um 18.14 1.53 19,756.0 2.01 44 Minimum 0.22 0.02 5,637.1 0.00 0 The Russian Federation (89) Share 100.00 100.00 100.00 Average 9,308.9 102 Maximum 18.14 5.81 34,421.4 9.96 500 Minimum 0.0035 0.01 1,992.1 0.00 0 Risks Natural Environment Climate, nuclear, water, air, soil contamination, epidemics

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Collective Ethno-Political Risk Ethnic conflicts, confession homogeneity, separatism, emigration, refugees Privatization Risks Enterprise capitalization, privatization performance and revenues Systemic Political Risks Voting behavior, nationalized industries, crime, reform minded local administration Infrastructure Related Risks Transport capacities, telephone lines General Economic Risks General regional economic indicators, output, inflation Individual Demography Population change, mortality, migration, refugees, life expectancy, urbanization Labor Market Unemployment rate and duration, wage arrears, labor force qualification Population Characteristics Education, age structure, health, homelessness, cultural institutions Social Risks Schools, hospitals, housing, share of expenditures for food, cancer Economic Risks Purchasing power, GDP per capita, unemployment/vacancy ratio, payment delays Risks of Population Behavior Military threats, voting for extremists, strikes, criminal activity Internationalization Joint Ventures Number of joint ventures, output, employment and productivity in joint ventures Foreign Investment FDI volumes and shares, foreign trade activities Rating

METHODOLOGY

All indicators used are calculated such that 0 refers to the lowest and 10 to the highest risks level. Indices are calculated by building weighted averages of the standardized indicators. The final regional risk score is again standardized between 0 and 10. The ranked regions are always grouped into 6 clusters, which are most homogenous for the respective risk index.

CHANGES IN METHODOLOGY COMPARED TO OUR EARLIER RATING

In recent years several qualified and thorough research reports on regional investment risk appraisal were published. The latter motivated us to revise our methodology and move on to a slightly different view of the causes of the possible risk. There are several methodological differences between the first and the second issue of the "Russian Risk Ratings". Generally, in contrast to the first version, all regional factors that could be seen as directly connected to investment (factors of productivity, for example) were deliberately omitted or interpreted differently because we are convinced, that these issues have to be considered for each investment project separately and individually. Next, recent studies on investment risk issues in Russia pointed to the growing importance of the factor of social tensions and disruptive behavior of the population. These phenomena have strong roots in current economic and cultural problems in the regions and are the strongest contributors to the social risk factor. This factor also could be helpful to explain the regional political orientation and sheds some light on the related political risk.

Extensive information on foreign investments as well as the development of joint ventures in the regions has been collected in recent years. This information provides an orientation for newcomers to the Russian market and increases the investment transparency of the regions. This information was not available for the first version.

The considered risk factors were restructured, and expanded in number. Now these factors are

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presented in four main hierarchical groups. In our view, this new structure makes it easier to follow the general logic of the study. Presentation of Maps and Tables with Risk Classes for General Risk Rating General Economic Risks General Social Risks General Political Risk General Environmental Risk

COMMON FEATURES OF THE LEADERS

Despite many differences between the leaders, they have several common features. All of them are Russian regions (all oblasts) and two metropolitan areas, located along the west-east belt with temperate climate, strong city agglomerations, Russia wide importance of the industry (mainly processing industry), and abundant skilled labor force. These regions have a relatively well-developed transport infrastructure (with some exception of the northern part of Irkutsk Region), and good communication facilities. These regions are also obvious leaders in the reform process.Table 3. Least risky regions.

Classification Classification Differences in ID# Regional Name Rating Old Rating New Old New Rating 49 Moscow 1 1 1 1 0 70 St.Petersburg 2 1 2 1 0 50 Moscow Reg. 7 2 3 2 -4 80 Tyumen Reg. 47 3 4 2 -43 67 Samara Reg. 6 1 5 3 -1 53 Nizhny Novgorod Reg. 3 1 6 3 3 72 Sverdlovsk Reg. 5 1 7 3 2 30 Kemerovo Reg. 46 3 8 3 -38 20 Irkutsk Reg. 45 3 9 3 -36 13 Chelyabinsk Reg. 4 1 10 3 6

COMMON OUTLOOK FOR THE OUTSIDERS

All outsiders are national units (Republics and Autonomous Districts) within the RF. Formally they could be divided into two groups. The first is the group of the North Caucasus republics close to the "nidus" of the Chechen conflict with social, political and economic problems, crucially sharpened during the last war. Despite the very favorable natural conditions, these regions are suffering from a historically underdeveloped economic infrastructure, traditional adherence to a nearly medieval subsistence , the catastrophic fall of production output (down to US$ 3 per capita yearly), and the enormous share of the population in utmost poverty. Given the strong anti-Russian feelings in the region, all these factors give rise to political extremism and provoke criminal activities as well as various conflicts on a nationalistic basis. The North Caucasus is the most disturbing and unstable area in the country.

The national units in Siberia with very severe climate conditions constitute the second group. These areas are scanty populated, mainly by small Northern tribes. Despite the natural riches in ores and non-mineral resources, these regions are traditional areas of the economic deserts. The development of any business activities in these regions is very problematic.Table 4. Most risky regions.

Classification Classification Differences in ID# Regional Name Rating Old Rating New Old New Rating 12 Chechen Republic 88 6 89 6 1 19 Ingush Republic 88 6 88 6 0 18 Evenki A.T. 78 4 87 6 9 2 Aginski Buryat A.T. 71 3 86 6 15

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78 Tuva Republic 87 5 85 5 -2 17 Dagestan Republic 86 5 84 5 -2 37 Koryak A.T. 79 4 83 5 4 Ust'-Orda Buryat 83 67 3 82 5 15 A.T. 25 Kalmyk Republic 69 3 81 5 12 75 Taymyr A.T. 72 3 80 5 8

COMPARISON OF THE TWO RISK RATING ISSUES.

Given the changes in the methodology, the expansion of the applied index set, and the use of updated information, the correlation between the old and present ratings is 0,6 and significant. The new rating still reveals the results and the deepened developments of the previous study with an astonishing degree.

Regions with improved rating results

The absolute winner is Republic, what occurred due to the stabilization in industrial processing, successful overcoming of social problems, improvements in its relation with the central authorities in Moscow as well as the sound financial policies. With the exemption of Leningrad Region, all regions where improvement occurred, are well endowed with natural resources: oil (Tatarstan Rep., Tyumen Reg., Tomsk Reg., , Sakhalin Reg.), coal (Kemerovo Region), wood (Krasnoyarsk Territory, Tomsk Reg., Komi Republic), sea resources (Sakhalin Reg., Kamchatka Reg.), gold (Magadan Reg.). This fact confirms the idea that, currently, the extraction branches are the backbone of the Russian economy and for generating social welfare provisions. The advantage transport position of Kemerovo Region in West Siberia and Krasnodar Territory in the south of the Russia's European part along with good natural climate conditions also help to consider these regions more positively. Table 5. The ten regions with the most improved ratings.

Classification Rating Classification Differences in ID# Regional Name Rating Old Old New New Rating Tatarstan 74 63 3 11 3 -52 Republic 27 Kamchatka Reg. 85 5 37 4 -48 66 Sakhalin Reg. 76 3 29 4 -47 76 Tomsk Reg. 66 3 23 4 -43 80 Tyumen Reg. 47 3 4 2 -43 Krasnodar 39 54 3 12 3 -42 Territory 36 Komi Republic 65 3 26 4 -39 Krasnoyarsk 40 53 3 14 3 -39 Territory 30 Kemerovo Reg. 46 3 8 3 -38 45 Magadan Reg. 64 3 27 4 -37

Regions with most worsened rating results

It is interesting to remark that all regions with the most strongly worsened rating assessment are located along the north and northeast sub-ring around Moscow in the European part of the country. In our eyes, this fact clearly points to the phenomenon that the traditional Russian regions with modest natural and human resources, shrinking population, outdated and depreciated industrial infrastructure at the backdrop of unfavorable climatic conditions are the main victims of the transition. The overall looser is the Ivanovo Region with its traditional orientation to light industry (now nearly destroyed), and stagnant social as well as demographic problems.Table 6. The ten regions with the most worsened rating.

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Classification Differences in ID# Regional Name Rating Old Classification Old Rating New New Rating 21 Ivanovo Reg. 12 2 65 4 53 10 Reg. 14 2 63 4 49 62 Pskov Reg. 28 2 75 5 47 79 Tver Reg. 8 2 54 4 46 84 Vladimir Reg. 10 2 51 4 41 34 Kirov Reg. 25 2 64 4 39 26 Kaluga Reg. 9 2 47 4 38 55 Novgorod Reg. 13 2 46 4 33 38 Kostroma Reg. 21 2 52 4 31 64 Reg. 15 2 45 4 30

5 years ago, when we prepared our first Risk Rating of the Russian Regions, we underestimated the difficulties of utilizing the available human and physical resources. Up to now industrial restructuring has made little progress and this remains an important obstacle for the future of these otherwise favorably located regions near Moscow. Conclusion

Generally, this publication should be useful for the assessment of the environment into which an investment project is planted. In our eyes, high-rated regions are very promising partners for international co-operation. However, our rating does not rule out investment in lower rated regions, but mainly makes the point that investors must employ precautionary measures to fulfil a proper appraisal of the business environment in the regions. Another purpose of this report is to provide some feedback for Regional Administrations. It must be clear to Russian Regional authorities that they have to present their regions as an economic location open to outside investors and observers. Our rating can be changed by the policy applied regionally and we are more than happy to revise a negative assessment in the future if we can observe the right measures from public authorities. These measures have mainly to do with a reduction of risk and uncertainty:

1. Correct assessment of the regional strength and weaknesses. This could best be done with a regional economic development report. It is important to understand that this should not be seen as a means of propaganda, but as providing information. 2. Predictability of government behavior. The rules of the game should be clear in advance and not changed ex post. 3. Social awareness means to care about people. The experience from mature market economies shows that educated and well-trained labor is the most important source of growth and wealth. Labor (that means people) should therefore be handled with appropriate care. The neglect of social issues is not a signal of tough market mindedness, but just a sign that one has not understood the most important basics of growth and development.

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