Effect of Foreign Direct Investment in the Retailing Sector

Effect of Foreign Direct Investment in the Retailing Sector The effect of foreign direct investment in the retailing sector  on the economy of Russia Abstract Following the dramatic, although sometime erratic growth of the retail sector in Russia, this paper provides an insight into the growth of this sector of the Russian economy, particularly concentrating upon the impact of foreign direct investment. As part of this process the research studies the potential benefits that are available to the foreign corporation together with the difficulties that making such an investment can experience. It is concluded that, providing Russia maintains a democratic political structure and can eliminate the adverse elements of their current system, such as corporate crime, the country provides an attractive market for retail globalisation, which will continue to benefit the Russian economy. Executive Summary Since the barriers of communism have been eradicated and a capitalist structure introduced, the Russian retail sector has experienced significant growth. As this report shows, much of this has been achieved through the relaxation of the Russian approach to foreign direct investment. From the research conducted for this paper it can be seen that FDI has contributed significantly to the present growth levels being experienced in Russia. Nevertheless, upon analysis of the benefits and disadvantages that face an international retailer wishing to take advantage of this emerging market place, it has been found that there are issues that need to be addressed if the current level of growth is to be sustained in the future. There is little doubt that, with the size of its consumer population and the continuing level of demand for western products, that Russia represents a major new market for the international retailer corporation. As revealed within this paper those who have already established outlets within this market place have already created a competitive advantage for their businesses. The report finds that there are some significant difficulties that still exist, which create a level of reluctance with new entrants. Most of these are based upon the demographic spread of the population, together with the cost of entry that is increased as a result of the current tax and regulatory regime. Similarly, the current domestic retailers are, in some instances, showing reluctance to participate in proposed mergers or takeovers. Whilst this low level of entry from external firms continues, the domestic retailers are also taking advantage of the situation by consolidating their own position within the market. This is being done by way of mergers and also by using the Western concept of retailing and extending their reach and coverage, not only through the main towns and cities, but also throughout the more rural areas. In reality, if they maintain these strategies, it will only serve to further increase the cost of entry to external firms and, from the FDI view, this would further delay their ability to benefit from the available market share. Therefore, we would suggest that two issues be addressed. That, if they wish to be active players in the increasing Russian retail market, the should evaluate whether the cost of immediate entry outweighs the potential loss of future competitive advantage. In respect of the Russian government, it is suggested that there should be consideration given to incorporating a more level of tariffs that is more in line with international standards, thereby increasing the attractiveness of their retail markets to foreign organisations. This is particularly important as they are also competing against other emerging countries and, if they want to benefit from the available investment, like the corporate retailers, they need to consider the advantage of early entry. Table of Contents Abstract Executive Summary Table of Contents List of Tables List of Figures List of Figures Chapter 1: Introduction 1.1 Motivation for the research 1.2. Aims and objectives 1.3 Overview Chapter 2: Literature Review 2.1 Russian change to capitalism 2.2 The Russian Retail Sector 2.3 Foreign Investment in Russia’s Retail sector 2.4 Summary Chapter 2: Methodology 2.1. Research method 2.2. Research material choice 2.3. Research performance Chapter 3: Findings and Analysis 4.1 Russian retail sector 4.2 Foreign Direct Investment 4.3 Problems and benefits to FDI 4.4 Advantages of FDI to Russian Retail Sector Chapter 6: Conclusion Bibliography Books Journals List of Tables Table 2 FDI in emerging countries in Europe Table 3 Russian major retailers. Table 3 FDI levels 2006-2007 Table 4 Potential FDI retail entrants List of Figures Figure 1 Russian retail growth Figure 2 Breakdown of retail sales Figure 3 Russia Hot Drink sales Figure 4 retail sales 2005 Chapter 1: Introduction 1.1 Motivation for the research Since the Russian political environment changed in the early 1990’s from the closed communistic approach to the more open capitalist format, which has allowed for the involvement of external financial institutions and corporations, the country’s economy has undergone a dramatic evolutionary process. As a result of this change, and notwithstanding the severe difficulties experienced in 1998, the Russian economy has achieved a remarkable pattern of growth over the past two decades. Nowhere has this growth factor been more noticeable that in the country’s retail sector, which according to recent research (RNOS 2006) has seen a recent growth of 30.8%, of which the food sector itself accounted for 22%. The same report forecasts a dramatic increase on these figures by the end of 2008, with food sector growth expected to double. However, such a dramatic increase in the rate of growth experience could not have been achieved solely by the privatisation of the internal marketplace. As with the economies of other emerging capitalists markets the Russian retail sector has attracted the attention of international corporate players, who have shown an interest in opening outlets in places like Moscow so that they can gain a significant share of the extremely large Russian consumer market. Many international corporations have already established a presence in this marketplace and other corporations such as the American giant Wal-Mart are seriously discussing projects that help them gain entry to this sector of the Russian economy. 1.2. Aims and objectives The purpose of this paper is to evaluate what effect this FDI[1] by external corporations has had upon the Russian retail sector. In conducting this research the objectives are to: To provide a better understanding of the economic forces that currently operates in the Russian retail sector. To evaluate the benefits and difficulties experienced by foreign corporations that have already established a presence in the Russian retail sector. To provide an indication of the issues that corporation intending to invest in the Russian retail economy will need to consider. To evaluate the impact that FDI has on the Russian Retail market It is intended that this paper will add to the existing literature available on the issues raised and provide an indication of areas whether further research needs to be considered. 1.3 Overview Following on from this introduction a review and evaluation of the current available literature relating to the issues raised will be conducted in chapter two. In chapter three the methodology for our research is explained in detail and this is followed by an analysis and discussion of the findings of that research. Chapter five concludes the paper and includes appropriate recommendations as well as indications of where the authors feel that further research on the subject may be beneficial. Chapter 2: Literature Review Within this literature review it is the intention to provide an understanding of the historical growth of the Russian retail sector economy since the capital free-market approach was adopted. As an integral part of this review will concentrate upon the political structure and how this differs from that of more developed countries, such as the UK and US. Furthermore, this chapter will review research that has previously been conducted in respect of the external organisations that have already began to operate within this sector of the Russian economy, outlining the experiences that they have had working within this relatively new capitalist environment. 2.1 Russian change to capitalism Following the collapse of communism in the late 1980’s, Russia began the slow steps towards building a free market economy, and this has caught the attention of numerous academic writers and observers. Many researchers, such as Dyker (2004), Medvedev (2000) and Gustafon (2001), have commented upon the fact that in the initial stages this free-market development was hampered by the continuing power struggle that was still taking place between the old hardliners and the new democratic factions. However, when Yeltsin defeated the attempted coup in 1992, power was finally wrestled from the central politicians and the process of conversion to capitalism could and did begin (Medevdev 2000, p.11). This forward move to a capitalist structure was reinforced in the same year by the â€Å"de-controlling† of prices (Gustafon 2001, 10). However, like fledgling free market economies, in the early stages of development the transition bought with it some difficulties. One of the major difficulties was the financial problem resulting from falling output. A Dyker (2004, p.5) and Granville and Oppenheimer (2001, p.3), comment in their research, it was expected that the transition would be â€Å"weak†, and they have expressed some surprise that the West â€Å"despite their expertise on communist regimes,† as Granville and Oppenheimer (2001, p.3) comment, were not prepared for this event. Others have also commented upon the levels of dishonesty in those early years. In Vadim Volkov (2002, p.3 and p.10) study of the Russian Mafia and organised crime, he reveals that there was a significant rise in business crime, particularly extortion and protection rackets. Volkov’s research shows that by the end of the 1980’s the reported incidences had exceeded 4,500 per annum and that it continued to grow dramatically during the early part of the 1990’s, reaching a peak of 17,169 cases in 1996 and the state was struggling to control this situation. The only beneficial effect of this racketeering as far as Volkov (2002, p.142) was that it led to a growth of a retail security sector. Russia also experienced a significant financial disaster in 1998, which saw the relatively new stock market index fall to 38 points, a 60% drop on its opening position, during which time the country fell back on it â€Å"familiar trade activities and exported natural resources, together with outside help to survive the crisis (Turnock 2005, p.130). Things began to change when President Putin came to power. Despite the fact that many researchers consider his approach to be the creation of a â€Å"managed democracy† (Terterov 2005, p.3), with observers being particularly critical of the lack of competition during the 2004 elections. Despite this perception, Putin was able to restore some measure of order to the process of transition. It is the general view that most of Putin’s reforms, perhaps with the exception of the variety of legislations that â€Å"restricted companies freedom of [financial] action† (Granville and Oppenheimer 2001, p.218), did contribute to a more positive free-market economy evolution (Dyker 2004; Granville and Oppeheimer 2001 and Turnock 2005). As Hoffman (2003, p.372), a trustworthy retail-banking environment was being built and additionally retailing outlets being released from state ownership into the hands of private owners. Granville and Oppenheimer’s (2001, p.511) produced evidence of this from a survey, which reported that, â€Å"by the end of 1995, 34 per cent of retail pharmacies had become independent juridical entities.† Oleinik (2005, p.214) confirms this position, revealing, â€Å"Roughly 50 percent of State-owned retailers, wholesale enterprises, public catering and transport enterprises were privatised as of July 1994.† In fact, in the early years much of the early change to capitalism was centred on internalised privatisation and restructuring of the various infrastructures, which researchers such as Burawoy (1996) and Turnock (2002) considered being a normal part of the process to be conducted before economic evolution can begin. 2.2 The Russian Retail Sector Whilst Russia has relied heavily upon its traditional manufacturing and natural resources to provide economic growth in the past, with the onset of capitalisation, it has been widely acknowledged within researches (Gufaston 2001 and Medvevev 2000 are two of these), the retail sector began to have an increasing impact. In fact it is held that in Moscow, which accounts for 27% of the country’s retail trade, this and â€Å"the growth of its consumer sector was the main factor in Russias economic turnaround† (Gustafson 2001, p.186). Many writers have studied the retail phenomena in an attempt to provide an understanding of the theory surrounding it, and how groups within the retail arena will react (e.g. Porter 1979, 1980; McGee Thomas 1986; Caves Porter 1977, 1978). Roth and Klein (1999, p.173), produce a general system theory that results in a multiple of outcomes irrespective of the fact that all firms may be subject to the same environment. The retail development in Russia over the past decade or tow certainly follows this theory. The growth of firms has been subjected to the many differing consumer demands, with a historical preference for open market and small store shopping. Similarly the geographical situation is Russia, whit a small number of major towns and cities dispersed over a wide area, has made also affected their growth patterns. Despite the fact that it is generally consider that the authorities approach to the retail sector has been correct (Terterov 2005, p. 28), there are others that argue that â€Å"business found it hard going, burdened as they were not only by taxes and the extortions of corrupt officials but also by the cruel racketeering that kept growing stronger† (Medvedev 2000, p.23). Similarly, others believe that there the development of the consumer sector was poor (Dyker 2004, p.57) and, in comparison with more developed economies, the levels of â€Å"integration were rather low† (Wehrheim 2002, p.19). Furthermore, this is said to have led to a wide variance of standards, with some improving and others not (Medvevev 2000, p.91). Thus it is little wonder that such researchers in the early 2000’s, should consider that â€Å"Russia was not the most successful country in pursuing the shift from plan to market( Wehrheim 2003, p.17). However during the last five years this position has begun to change, with the retail sector now growing at a dramatic rate. In fact its growth position is second only to India. This is being partially attributed to the increase in personal and disposable income (see table 1), GDP and the rise in the currency value. (Newswire Today 2007). This growth is encouraging attention from foreign businesses, who are looking for business or joint-venture opportunities in the Russian retail sector, such as the food industry (Wehrheim 2003, p.136) 2.3 Foreign Investment in Russia’s Retail sector Prior to Gorbachev’s accession to the Russian Presidency, FDI in Russia had been banned since the late 1920’s (Brady 2000, p.185). However, since this ban was lifted, and particularly during the past decade, FDI has become an increasingly important part of Russia’s economic growth (Dyker 2004, p.207), However, FDI interest was slow to begin with. Turnock (2005, p.3) advances the theory that this was due to the fact that â€Å"Whilst FDI and economic growth are linked, it does not necessarily follow that FDI helps in improving the investment climate, it usually requires the climate to be good in the first place.† Similarly, as foreign investors had learnt with other emerging countries, there is no â€Å"pain without Gain (Dyker, 2004, p.20). Nevertheless, once the free-market economy begun to flourish for internal organisations, Western corporation became interested, and this led to an increase in investment from overseas, which rose by â€Å"155 in dollar terms† by the end of 1994 (Brady 2000, p.205). Investors wanted to get a share of the market stock, â€Å"even though they often knew nothing about the companies , a situation encouraged by Russian tycoons (Hoffman 2003, p.207 and p.361). The one incident that did produce an adverse effect to FDI in Russia was the financial crisis of 1998 when, because of the apparent inability of the market â€Å"to restore order in its economy has forced foreign investors to take their money and head for the exit† (Medvedev 2000, p.296) However, once this crisis had been resolved, the flow of FDI continued to grow (see table 2). By the end of 1995 it had reached a position where five percent of the Russian consumer market was in the hands of foreign owners or their subsidiaries (Medvedecv 2000, p.156). Table 2 FDI in emerging countries in Europe Source: Turnock 2005, p.5 The position has also increased dramatically in the years post those in the above table. For example, the CIA Fact book (2007) showed that FDI doubled from $14.6 billion to $30 billion between 2005 and 2006. These figures were building on the back of a $9.4 billion FDI amount in 2004 (Special Report 2005), and there is little sign of this situation slowing down in the foreseeable future. In addition to the taking over of domestic retailers, foreign corporations are also setting up their own within the country, with Ikea, which â€Å"has 50,000 workers and 159 stores in 29 countries making and selling over 10,000 articles around the world and is one of the largest furniture companies† (Turnock 2005, p.237) being one of the most noticeable. 2.4 Summary It would appear from the literature that has been reviewed here that, whilst most academics agreed that Russia’s road to capitalism had a less than favourable start, and was also interrupted by the crisis of 1998, it’s economic growth has now become more stable and, despite the current political disquiet that exists about the country, the current levels of growth and FDI are set to continue for the foreseeable future. Chapter 2: Methodology 2.1. Research method Due to the complexities of the research being undertaken, together with the geographical and time constraints, it was felt that the best method of approach for this research was to use a quantitative approach. In view of the study being conducted, it is felt that this approach a wealth of literature, information that would span a sufficient level of governmental, independent observers and research sources to enable this paper to achieve its objectives. Similarly, such is the breadth of these resources that it is felt they ensure accuracy and ample range for comparative purposes. In the view of the author this approach has provided an adequate research base for purpose of this study. 2.2. Research material choice In terms of the government resources, the relevant data has been selected from various national international and global organisations. Other data in respect of FDI and the retail sector activity within the Russian market place, has been collected and researched using academic publications, together with industry news and press reports, supported by surveys and other technical data. Furthermore, we have used the data available on several corporate bodies that have secured a position within this market sector. 2.3. Research performance Using this data, the first step was to study the movement of the retail sector itself during the past few years, then to outline the events within the foreign direct investment factor, including a brief study of some of the external corporations that have sought to invest in this market place. During this process we have been able to also identify the benefits and disadvantage that such a move might bring to the investing corporation company. From these actions we have then been able to conduct analysis and outline areas for discussion. Chapter 3: Findings and Analysis 4.1 Russian retail sector The Russian retail sector, as previously indicated previously, has seen a period of continued growth since the beginning of this century. According to research carried out by RNCOS (2006), The market in 2004 grew to a value of $193.2 million, which represents a year-on-year performance increase of nearly thirty one percent, making in one of the most attractive retail markets globally. The same report also states that the expectation is for the growth rate to continue to exceed GDP during the course of the following years. Later resources available from the Russian Trade federation (see figure 1), show that this growth is continuing and is anticipated to accelerate in the next three years, with the major concentration on the main cities and towns. Figure 1 Russian retail growth Source http://www.russiantradeny.com/index.php?chapter=rtaction=showid=41 Additionally, the Russian statistics service (Rosstat) have released figures for the first quarter of 2007, which show that in that period alone the grown has been 13.6%, which at $117.456 billion, puts the sector on course to reach $500 billion for the who year. , in Russia, retail sales grew 13.6% YOY to reach the level of 3.043 Trillion Rubles (US$117.456757 Billion) from January to April 2007. However, retail sales grew 13.8% to reach around 814.8 billion rubles (US$31.4504652 Billion) in this April alone. A further report by Kuipers (2006) shows a further breakdown of these sales. From this analysis, it can be seen that, whilst food retail is growing appreciably at 17.6%, the non-feed area is doing even better (see figure 2). Figure 2 Breakdown of retail sales Of these amounts approximately 48% represent retail sales attributed to imported goods. The increases n this area has been brought about partially as a result of recent changes that the Russian authorities have made to various duties and levies. For example, as a recent Euromonitor (2006) study shows, the import duty on â€Å"raw coffee beans was abolished in 2006, with the direct intention of encouraging new players such as Nescafe and Starbucks. The following graph shows the effect that it is estimated this will have on the market for hot drink sales over the next few years. Figure 3 Russia Hot Drink sales There has been a significant growth of retail in the past few years in Russia and, as a result of this, Russia’s 76.3% increase in trade outlets is out-stripping the performance of other Eastern European countries (Czech 0% and Croatia 17%) and Europe as a whole (20%). The generally held view, as voiced by Vitaly Podolskyi, CFO of the Russian retailer Pyaterochka, during an interview with Kuipers (2006), is that by 2010 Russia could well become the largest retail market in Europe. However, in a later interview Vitaly Podolskyi, also stated that it was a difficult sector for domestic retailers, and for foreign entrants who were seeking to establish a profitable business in a reasonable timescale, simply because of the geographic fragmentation of the market place. In this respect his view was that for the foreseeable future, the best route for new entrants would be by mergers and acquisitions. As will be seen later this is a route already being preferred by some of the countries domiciled retail corporations. This view is supported by other research conducted by Kuipers (2006), which confirms that the country’s retail sales are still being generated upon old traditional lines. As can be seen from the following graph (figure 4) (Kuipers 2006), nearly half of all shopping is conducted in open-air markets, with modern trade outlets accounting for only around 20%. and the rest being generated through smaller outlets. Figure 4 retail sales 2005 Much of the reason for the slow pace of change in consumer buying habits is because of the fact that most development in this sector has taken place in the major cities such as Moscow and others mentioned in figure 1 above (see page 20). As mentioned earlier, with such a large geographical area and spread of population involved, it is difficult to impact these methods upon the larger population. However, as the growth rates in these metropolis begin to slow down, so the major retailers are beginning to look for growth further afield (Zeitung 2004), this is currentlu concentrated upon areas where the population is more than one million, but as this development continues, as with economies like the UK, smaller areas of population will no doubt be targeted in the future. As of 2004, as reported in a study conducted by Harri Larentz,, the major retailers within the Russian sector are still predominantly of domestic origin (see Table 3), with only three external competitors at that time. These can generally be broken down into three types of operators. †¢ discounters – developed by Magnit, Pyaterochka, Dixi and Kopeika. They feature a limited assortment (up to 4,500 SKUs), selling space of 250-1,000 m ², and a gross margin of 17-24 per cent. They are normally located in residential areas. †¢ traditional supermarkets – developed by Seventh Continent, Perekriostok, Ramstore, Rewe and, recently, by Auchan, with locations in city centres, along highways and in residential areas. Typically they generate a gross margin of 25-32 per cent and have an assortment of up to 20,000 SKUs. †¢ hypermarkets – developed by Auchan, Metro, Perekriostok, Mosmart, Lenta, Karousel and Seventh Continent – with selling space from 4,000-16,000 m ², 15,000-40,000 SKUs and a gross margin of 13-20 per cent. However, since this report was produced, the chains of Pyaterochka and Perekrestok have been merged to form the largest food retailer in the country by turnover.(X5 Retail Group NV 2007). Table 3 Russian major retailers. Source: Harri Lorentz 2004 From the consumers viewpoint, these new retail formats are having a beneficial effect, and not only in increasing the range of choice, but in the early days they increased the consumers purchasing power by bringing down price increases, although in latter years this has not been maintained (Anon 2005). Although the Russian economy experienced a downturn during the first half of 2005, from 7.6% to 5.6%, the position has improved since then, and the advances being made within the retail sector are driving much of this improvement. 4.2 Foreign Direct Investment As has been previously identified within this research, FDI is continuing to increase within the Russian economy (see table 2, p.16) and the latest figures produced by the Russian Federal state statistics service confirms this position for 2006-2007 (see table 3 below). However, as can be seen from this table. The amount of FDI directed at the retail sector is still a relatively small percentage of the overall investment. Table 3 FDI levels 2006-2007 Nevertheless, although this is the case, some of the balance of FDI is going to manufacturing industries that serve as production and supplier organisations for the retail sector. For example, in 2006 Nestle and their main competitor Kraft â€Å"launched and built† instant coffee production facilities (Eurmonitor 2006), which will no doubt encourage other foreign corporations to make the same move. Food Retailers There are already some international corporations already investing in the retail sector. As was noted in the report by Harri Larentz (2004), Auchan from France, Martloraf and Metro from Germany, Ramstore from Turkey, Spar from the Netherlands and Stockmann from Finland already have a foot in the door. But, apart from Ramstor and Metro, which have around 2 and six stores respec