Notes from PBN Board Chairman Peter G. Kelly's Speech on "Doing Business Internationally: Have the Rules Changed?"

May, 2002

Scale

Most Americans are shocked to learn the relative position Russia has in the world. We remember it as the source of sustenance for huge portions of the world and as one of the centers of the bitter and often bloody conflict called the "Cold War".

Yet, Russia's population-now 160MM is likely to dwindle to 100MM by 2050 while the US population moves from 280MM to 400MM-a ratio 50 years from now of 1 for 4.

Russia's annual budget is in the area of $60 billion against a U.S. budget of $1.7 trillion-a ratio of 1 to 29.

The market capital represented on Russia's stock market does not exceed the market capital of Disney.

Russia's economy is characterized as being equivalent to that of Spain.

Why all the attention on Russia? Who cares?

The answers, of course, are multiple. Let me give just two:

First, a macro reason (that would never justify a specific business investment)-Answer a question that used to be asked by Secretary of Defense Deutsch-"If Russia fails, is Russia the only one who fails?" The honest answer to the question affirms the interest of the US in Russia's success.

Second, a practical, business reason-Russia's need for capital, infrastructure replacement, natural resource exploration and development, etc. presents a great opportunity for mutually beneficial commercial engagement.

WHAT'S DIFFERENT since 9/11?

US-Russia Relationship:

During the Clinton-Gore years, there were strong attempts at interactive political and economic interchange (remember the "Gore-Chernomyrdin" Commission?)

In January 2001, the Bush Administration took office with a clear objective of disengagement. Personal diplomacy was to be a thing of the past; nation development was no longer a function of the U.S.; Russia wasn't worth the focus we had put on it, except, perhaps, to expect simple acquiescence to such things as scrapping the ABM Treaty.

At the same time, Vladimir Putin started focusing his external activities on widening the gap between Russia and the West. Over the year prior to 9/11, Putin visited Cuba, Syria, Iraq and received senior visitors from North Korea-thereby making an emphatic statement of his desire to warm up old alliances with his country's debtor nations and historic allies.

What has happened in the past six months?

Reversal of Polarity

The events of 9/11 reversed the widening gap and brought Russia and the West back toward one another.

Recall that Putin was the first foreign leader to call President Bush immediately after the actual events of 9/11.

There was an immediate start of strong personal relationship between Putin and Bush, between Putin and Blair. ("I looked into his soul"). Bush and Putin clicked-each are about the same age and had been subject of doubt that they were not up to their respective jobs.

The US and Russia commenced what I would describe as "mutual uni-lateralism", each country doing what she wanted, but without the traditional sharp responses to negative actions of the others (i.e., Latvia and NATO; ABM Treaty annulment). Indeed, Russia has given up a great deal and yet quietly cooperated. Russia's refusal to go along with OPEC price increases or production limitations was of real help to Bush here at home.

The fact is Bush now knew how much he needed Russia on his side with the war on terrorism and became willing to do a lot to achieve that goal.

With that motivation in support of communication, Putin did what he had to do-namely, despite contrary expressions of virtually all of his Cabinet, he knew that the survival of the Russian Federation required it to turn West and embrace the opportunities the West could offer. In the words of one Russian leader (Grigory Yavlinsky, the head of Yablako Party), Russia is now pursuing adoption into its everyday life the key values which serve as the basis for Western Society.

And, so-for reasons that are clearly different for each side, we have come back together in what is probably a more comfortable arrangement, seeking what each wants most from the other without allowing the gnats of negative developments to divert their respective focus.

Economic Up turn in Russia

When the Asian Flu buried the Russian economy in August 1998, there was a tragic shut off of the growing optimism in Russia. In the case of younger Russians, they knew little of the past and were buoyed by the thought of unlimited opportunity inherent in what promised to be a replication of the West. Their hopes (and bank accounts, charge accounts, car leases and leaseholds) were dashed. If you worked with those young people (as I did), it was a crushing experience to feel the intense loss of faith and hope they suffered. I wondered if they could ever return to believe in this new system called "capitalism."

Happily, the Russian economy-lifted by ever increasing oil and gas production, the ongoing effects of devaluation in 1998 and the strong leadership of Putin leading to such reforms as adoption of an enforceable flat rate income tax-has recovered from those dark days. While European economies slid into recession and the rest of the world's economies slowed, Russia's economy continued to grow-8.3% in 2000 (GNP in$250.55 billion) and 5.5% in 2001. Its trade surplus is at an all time high ($40 billion at the end of September 2001). It's stock market, tiny in relative side, is up 50% while ours slides lower and lower.

The Continued Absence of a Sound Commercial Setting

Rule of Law, an independent Judiciary, IPR, absence of corruption, etc. are all subjects intimately tied to the future success or failure of Russia. To date, the record is rife with failure. Most business people simply won't put at risk substantial capital and reputation in an economic system that is unpredictable and not governed either by established rules or by honest regulators or judges.

Fully understanding that the authoritarian system of China is hardly "rule of law", it is order and predictable. A comparison of Russia and the Peoples Republic of China establishes the point-in the ten year period following 1991, Foreign Direct Investment in Russia totaled $17.6 billion and FDI in China totaled a staggering $350 billion!

A case in point: Smirnoff-so well known to us in Hartford as a long-time Heublein product-is the Poster Child of Intellectual Property Protection in Russia.

For over 8 years now, Heublein (now Diageo) has fought at every level of the Russian Federation to preserve its rights as the owner of the trademark "Smirnoff" and progeny-rights registered and protected in 144 countries of the second best known spirits brand on earth-against the contrived marks of Boris Smirnov.

The fight has gone on in Rospatent, in the Duma, in the offices of President Yeltsin and Putin, by the most senior representatives of the USA and UK (from President and Prime Minister down), and in a variety of courts-dishonest and honest-in Russia.

Finally, in the past several months, in a string of actions by the Prosecutor (a powerful creature in the Russian system) and decisions by the Supreme Court of the Russian Federation and Rospatent, officialdom has finally determined to recognize the legitimacy of Diageo's trademark "Smirnoff", creating a state of de facto co-existence with the other offending mark.

Despite the current status of those cases in Russia, that conflict is surely not over. More Tomfoolery is on the horizon.

As an aside, by way of contrast, while these conflicts were going on in Russia, in some 19 other jurisdictions in Eastern, Central and Western Europe, the exclusive rights to the use of the trade mark and style "Smirnoff" have been uniformly sustained. This is series of decisions-judicial and administrative-reflect a clear understanding of the terms of international treaty and the proper application of Western principles of Intellectual Property Protection. It's a good sign.

Opportunity

Russia has an extraordinary challenge ahead of it. Despite a lot of good things taking place, the net result still is a slowly strangling economic and political system.

Nonetheless, Putin has proven that he is serious about economic reform. Despite initial skepticism, he has started on what is an ambitious program of change and reform:

He promised and accomplished tax and land reform.

He pledged to take on the Gazprom monopoly and succeeded in ousting its director.

He finally got rid of the head of the Central Bank-viewed as a major obstacle to banking reform.

He isolated the Oligarchs, basically telling them "You can keep what you stole, but now you must play by the rules and stay out of politics."

All eyes are now on his pledge to implement true legal reform-enforcement of intellectual property rights, anti-counterfeiting, and cleaning up the judiciary (including rational pay and training).

Simply stated, the country in need of assistance, be it from partners, foreign investment, the World Bank, others.

These items of assistance-i.e., opportunities-include:" Urban and industrial infrastructure-Russia's infrastructure is in rapid decay or already obsolete. It will take trillions of dollars to accomplish a turn around. It can't be done domestically; it can't be done only by outside help; both inside and outside must partner to achieve this. The task is immense.

• Oil and gas production-traditionally a family jewel that isn't shared with anyone on the outside-cannot be done without external investment of substantial proportion. The Putin induced recovery by BP Amoco of its Sidanco investment in the East, now being enlarged by BP Amoco-or-the newly expressed interest last week of TotalFInaElf, a major French oil exploration company, to take steps toward acquisition of development rights in a major Siberian field-underscore a new understanding by Putin and his government of the absolute need for external investment to keep the oil and gas revenue growing. This is especially important to the West, since Russian oil exports will go a long way to stabilize the world oil market during these times of unrest in the Middle East.

• Segments of business are vastly underdeveloped and, in some quarters, appear to be ripe for external participation. Banking and insurance are among those opportunities, although the way has not yet been cleared to get there. Interestingly, ALFA Bank-one of the largest banks in Russia ($2.7 billion)-last week announced its intention to sell 10-20% of its equity to a foreign investor. No takers yet.

• Continued assistance in strengthening corporate governance. Russia has come a long way. Russian companies understand that growth requires foreign investment. Corporate Governance is a phrase often heard in Moscow today.

• YUKOS, the largest Russian Oil Company, used to be the poster child of abuse of minority shareholders. In the last two years, it has totally changed its image-by hiring western auditors, opening its books and operating in a transparent manner. And, in a classic American tradition, has invested millions boosting the image of the company and its CEO, Khordokovsky, as a good corporate citizen and business leader.

Russia is heading in the right direction.

There is a growing middle class.

Consumer spending is on the rise.

Small business, only 10% of current business activity, is growing and asserting itself.

Russia's capacity to increase surplus from expanding independent oil and gas production seems unlimited.

Putin is now a proven strong leader with a consistent favorability rating in the high '70's.

WTO Accession, likely by 2004, will be a boost to investment-foreign and domestic.