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The Paper Boom
// Trends
For the first time in five years, Russia’s forest industry has gone from successful to troubled. According to data from the State Statistics Committee (Goskomstat), all of the industry’ basic branches from the lumber processing complex to the pulp and paper industry showed lower growth rates than other sectors in 2003—1.5% versus 7%. Opinions on the future of the forest industry in the medium term vary: optimists think that what is taking place is preparation for future stable growth, while pessimists believe it is leading to a systemic crisis. Both may be right. Investors are waiting to see how the government plans to support the forest industry.
There were no signs of any surprises for the industry itself in 2003, which saw heated discussions on the Russian forest industry’s present and future place in the national industrial structure and international division of labor. Of course, nearly all industry economists said even at the peak of the forest industry’s growth in 1999–2000 (see graph) that sooner or later the phenomenon of postcrisis growth connected with devaluation and increased profitability of export deliveries would exhaust itself. This was clear even in 2001, when the most troubled and unstructured branch of the forestry complex, the logging industry, reverted to a 3–4% drop in volumes after recording fantastic 13% production increases in 1999.
Nevertheless, owners and managers in the forest industry had every reason to believe that there were many other factors on their side that would maintain growth over the next three years. Above all, this was a increase in domestic demand, unthinkable in the 1990s, for nearly all goods manufactured by the industry from building materials to healthcare products; reasonably optimistic forecasts of world demand for cellulose, the industry’s most important export commodity; a reduction in lending rates and a surplus supply of money in the country; and an improved investment climate and decreased insurance risks.
Also working in the forest industry’s favor was the fact that in 2002–2003, the Russian government first noticed there was another industry besides oil and gas production and products of the military-industrial complex and heavy engineering industry that, if actively developed, could become a GDP growth engine. Of course, no one forgot the sad experience of government meddling in forest industry development between 1996 and 1998, which ended in scandals and criminal cases against Roslesprom. However, this time market-oriented specialists from the Ministry of Economic Development and Trade (MERT), the Ministry of Trade, and the Ministry of Natural Resources (Minprirody), who could speak to the heads of forest industry corporations, if not in the same language then at least in a similar one, were planning to regulate the forest industry rather than Soviet-era lobbyists.
Expectations of a fast takeoff in the industry were so high that for the first time since the early 1990s, the phrase “Russian forest” returned to the lexicon of large investment banks investing in Russia. An announcement by partners and shareholders of the Continental Management Group of the creation of an $800 million forest industry investment fund, strategic partnership negotiations between YUKOS and industry leader Ilim Pulp Enterprise (IPE), a series of large deals involving pulp and paper industry assets, and multimillion-dollar investments in expanding chipboard and plywood production fueled expectations of a coming revolution on the forest product market no later than 2003. But the revolution never happened. Meager growth rates of 6% and 2% in the pulp and paper and timber sectors, respectively, stagnation in the woodworking sector, and a 5% drop in the logging sector suggest that there will be no revolution in the foreseeable future either. However, there are conflicting answers to the question as to whether 2004 will be the first year of a systemic crisis based on the observed dynamics: the forest industry’s lag behind industrial production growth rates in the country has too many components, some of which are not symptoms of a crisis but of preparation for significant growth.
A Poor Present and a Bright Future
According to Vladimir Chuiko, chairman of the board of RAO Bumprom, the main reason for the negative dynamics in the forest industry today is the low technological level of production. “For a long time, the industry was geared to mobilizing existing reserves of manufacturing equipment imported 25–30 years ago for the most part. Natural aging and retirement of this equipment has led to a decline in capacity,” he believes. However, this situation is not unique for Russia: according to Mr. Chuiko, investments in manufacturing equipment account for 79.5% of the capital investments in the industry.
At the same time, the Russian forest industry’s stellar performance between 1999 and 2002 coincided with a worldwide decrease in investments in the industry of 15% per year. The only region that has sharply increased forest industry production in the last ten years is Southeast Asia, mainly China, where paper and cardboard production has grown 2200% since 1992. Russia’s performance in this respect is closer to European and American producers: production volumes of paper and cardboard have increased an average of 40% worldwide and 49% in Russia. The payback on investments at a rate of $300–350 million per year for the period 1992–2002 was as low in Russia as in the rest of the world.
Meanwhile, 2003 was the year when “fresh” money began to arrive in the Russian forest industry complex and investors began talking about new large-scale projects in the most varied sectors of the industry, even against the background of a “statistical” depression. Analysts of the consulting group Lesprom.ru note that the production decline in the woodworking sector is occurring against the background of an inflow of large investments into the industry and a changeover to easier to manufacture and more expensive products like plywood, chipboard, fiberboard, and cement-bonded chipboard. Despite the physical production decrease in the sector, money turnover and profitability are increasing.
The industry’s attractiveness for strategic investors is continuing to increase along with the producers’ appetite for investments. Major investment programs at the Segezha Pulp and Paper Mill (Segezhsky TsBK; about $420 million), the Arkhangelsk Pulp and Paper Mill (Arkhangelsky TsBK), and the Arkhbum Group; increased activity at second-echelon forest industry companies and the formation of holdings based on them; and foreign owners’ plans to set up and expand production at AO Neusiedler-Syktyvkar, AO Svetlogorsk, and Stora Enso Packaging in Kaluga and Nizhny Novgorod regions show that investors do not anticipate a large-scale crisis in the Russian forest industry complex. Demand for forest industry products on the domestic market is currently increasing faster than the potential of Russian manufacturers, and investment activity can be regarded as investors’ orientation towards long-term projects in Russia’s forest industry.
The indicators for IPE, the traditional leader in the Russian forest industry, also preclude any talk of serious problems. IPE’s business has both export-oriented (61% of Russia’s cellulose production) and domestic market–oriented (77% of Russia’s cardboard) components. Despite the fact that China is IPE’s main export market (about 45% of sales, mostly on the spot market), after investing heavily in restructuring its corporate governance over the last three years, the company has gained access to new methods of financing its own projects previously unavailable to the Russian forest industry. For example, in September 2003, IPE signed a short-term syndicated credit agreement for $30 million with Moscow Narodny Bank (MNB) secured by export deliveries to Southeast Asia. In early March, MNB received a mandate from IPE to syndicate a three-year secured credit for $50 million. According to Aleksandr Emdin, IPE’s CFO, the company’s appearance on this market has set a precedent, since similar financing plans in Russia were previously only available to oil, gas, and metallurgical companies. Mr. Emdin predicts that other Russian forest industry companies will take advantage of this precedent, so that within two to four years, banks should no longer regard the domestic forest industry as a high-risk borrower.
Growth that Won’t Solve Anything
Despite investors’ favorable expectations, however, the “investment accumulation” effect alone will not entirely eliminate the lag in growth rates in the forest industry, which were only 1.5% in 2003 versus 7% in the economy as a whole. Calculations show that strategic investments in the country’s forest industry were mainly companies’ internal investments in their business; and based on current forecasts of industry profitability, in the period 2004–2015 these investments will at best amount to $5 billion (about $450 million per year). This is approximately the same as investment levels in 2003. Given this level of investment activity and increasing domestic demand, Russian forest industry companies can expect degradation, the failure of most import-substitution programs, and a possible loss of development prospects on foreign markets.
According to estimates of the Finnish consulting company Jaakko Pöyry, the average projected increase in consumption of forest industry products on the Russian market in 2004–2015 will be about 6% per year. And according to forecasts by Anatoly Chernovol, vice-president of RAO Bumprom, the estimated annual increase in consumption to 2015 in Russia will be 3.7–4.5% for commercial cellulose, 5–6% for paper, and up to 8% for cardboard. A comparison with production development rates in Russia shows that at current investment volumes, the Russian industry will lose all prospects of competing on the domestic paper market in the very near future, and part of its export flows will have to be redirected to the domestic market. Based on the pessimistic version of the development of events, by 2015, Russia may turn into a major importer of pulp and paper and lumber products, despite having enormous timber reserves.
Out of all possible sources of financing, the industry is presently making full use only of the resources of strategic investors and owners of sectoral capital. Hopes that the boom in information activity and increased interest in the forest industry in the period 1999–2002 would lead to the appearance of interindustry capital in various market sectors have not been justified: the forestry projects of investment funds, banking structures, and metallurgical- and oil-industry investors are local and do not have a leading role on the market. The objective limits on investment activity in the forest industry resulting from a combination of high capital intensity and low profitability made the demand for “an active government forest industry policy” the hit of the 2002–2003 season.
Three Roads to the Forest
Theoretically, there are three fundamentally different approaches to possible government actions in relation to this. The first is the one taken by a number of countries in Southeast Asia and South America: large scale financial investments by the government and paragovernment structures in setting up large new facilities, essentially developing the industry under government control and using government guarantees. This strategy requires the formation of a close alliance between the government and national forest industry leaders, that is, an actual joining of forces. There are quite a few supporters of stepwise development of the industry in Russia. For example, Miron Tatsyun, head of the Union of Timber Producers and Exporters, believes that a fundamental problem of the industry is “the absence of a clear leader” who could become a partner of the government in a similar development scenario. We note that numerous projects for setting up new pulp and paper mills in central Russia (Kostroma Region) and other regions proposed by MERT fit into this scenario.
Another option is an “evolutionary” development scenario for the forest industry, in which the government’s role in facilitating industrial expansion consists of creating an infrastructure for investments in the broad sense of the term, from granting tax concessions to new companies to building forest roads and making capital investments in new industrial companies in the form of forest and land plots. According to a plan developed by RAO Bumprom (it closely resembles a plan developed jointly by specialists at IPE, MERT, and Minprirody in 2002), in the period up to 2015, this kind of government investment in the “evolution” of the forest industry should amount to about $2.6 billion in monetary terms. Investments of strategic investors in this plan will amount to $3.8–5 billion; bank loans, to $3.8 billion; capital procured in the form of leased equipment, to $0.6–1.2 billion; stock market funds, to $500 million; and interindustry investments, to $600–900 million. This program is designed for increases of 1.7 times in commercial cellulose and paper production and 2.2 times in cardboard production in 2015, as well as 65–70% import substitution, while maintaining the positions of Russia producers on foreign markets.
The third and final approach, which has few supporters in Russia, assumes complete withdrawal of the government from the forest industry with extensive market liberalization and free access to all of the country’s forest resources for both domestic and foreign investors. Under this plan, the government appears exclusively as a regulator in the industry, with authority limited to export-import duties. Features of this approach can be seen in the development of the draft Forest Code, which contrary to expectations of a year ago, plainly assumes the existence of private ownership of forests. Obviously, this scenario is possible only with liberalization of all allied markets and a developed banking system. In addition, the government must actively cooperate in eliminating foreign trade barriers for private companies in operations on markets where export-import subsidies and protectionist measures to support home industries are the practice.
The government urgently needs to choose a strategy for dealing with the forest industry. The results of 2003 make it clear that under the present rules of the game, the country’s forest industry is still threatened in spite of rapid development, and investment activity in the industry is constrained by uncertainty about future government policy. For all its calculated risks, the “evolutionary” option theoretically allows the industry to reach a qualitatively new level with minimal government expenditures. The “government” option is initially a much riskier and more expensive game, but a potentially more profitable one, whose results will become known by 2015. The “liberal” option promises the greatest long-term benefits for an industry with uncertain prospects, which include the prospects of acute local crises in the very near future. One of these scenarios has to be chosen in 2004, since this year’s results are unlikely to be better than in 2003 if the current situation remains unchanged.
Dmitry Butrin
All the Article in Russian as of Mar. 18, 2004
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Photo: Vasily Shaposhnikov
