Foreign direct investment and institutional obstacles: The case of Russian forestry

Transcription

1 302 Mats Nilsson and Patrik Söderholm / Natural Resources Forum 26 (2002) Natural Resources Forum 26 (2002) Foreign direct investment and institutional obstacles: The case of Russian forestry Mats Nilsson and Patrik Söderholm Abstract This article examines why, in spite of vast forest resources, Russia has been unable to attract foreign investors into its forest industry. A survey of 32 influential Western European forest companies indicates that purely economic factors, such as labour or raw material costs, are not the main reasons these companies refrain from investing. Instead, the companies identify a number of institutional factors: ambiguous legal systems; difficulties in negotiating with local authorities; unfair tax enforcement; and general political instability as the main impediments to FDI in the sector. These factors have led many companies to abandon previously considered investments in Russia, and also to terminate existing business relationships with Russian partners. The survey results also indicate that, while many investors in forestry were attracted by the potential for a growing Russian market in the early days of the transition period, they have become more and more aware of the many institutional obstacles challenging growth in the sector. The article concludes, therefore, that FDI in the Russian forestry sector is likely to remain low until a fundamental change takes place in the legal and political systems. Keywords: Foreign direct investment; Russia; Forestry sector; Survey; Institutions. 1. Introduction From the time of the presidency of Mikhail Gorbachev, the former Soviet Union has gradually opened up to foreign investment. For example, by resolution of the USSR Council of Ministers in 1987, foreign direct investment (FDI) and foreign ownership of Soviet equity became possible. The 1991 USSR law on foreign investment permitted foreign companies to set up wholly owned subsidiaries and to repatriate profit (Gareyev et al., 1997). 1 After the collapse of the Soviet Union in 1991, its legal successor, Russia, has intensified the transition from a command-based to a market-oriented economy. Still, in spite of ambitious attempts to attract foreign companies into Russia, the level of FDI flowing into the country has remained very low compared to other transition economies (e.g., ECE, 1998). This article focuses specifically on the forestry sector. This sector is of interest for a number of reasons: Russia holds 23% of the world s forest area, and 22% of the world s Mats Nilsson is a Researcher at the Swedish Energy Agency, Stockholm. mats.nilsson@stem.se. Patrik Söderholm is Associate Professor, Division of Economics, Luleå University of Technology, Luleå. Patrik.Soderholm@ies.luth.se. 1 Other relevant laws include the 1995 Law on Additional Measures Toward Attracting Foreign Investment to Implement Large-Scale Projects in Material Production Industries, (Stern, 1996), and the new 1999 FDI law. wood inventory, including 55% of the inventory of coniferous forests (Gareyev et al., 1997). The vast Russian forest potential 2 should be able to attract foreign investors into the industry, but so far foreign investment activity in the Russian forestry sector has remained very low (see Section 2). Also, many recent forestry investors have experienced considerable problems, 3 which led to alarming headlines in the Western press, questioning the viability of the Russian economy and the Russian forestry sector. Why, then, has the Russian forestry sector been unsuccessful in attracting new FDI in spite of its rich resource endowment? This article argues that the lack of welldeveloped market institutions, such as well-defined and enforced property rights underlies this paradox rather than strictly economic factors. Given the importance of land ownership, long-term contracts and high capital intensity in the forest industry, one would expect property rights and contract enforcement to be a major focus of aid programmes geared towards the Russian forestry sector. However, most such programmes have targeted financial assistance rather than institutional capacity building. 2 See, for example, Backman (1994, 1995, 1996a, 1996b), Gareyev et al. (1997) and World Bank (1997). 3 Backman (1994), Tak (1994), Van Fossen (1995) and Section 4 in this article United Nations. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA.

2 million tons 12,000 10,000 8,000 6,000 4,000 2,000 0 Mats Nilsson and Patrik Söderholm / Natural Resources Forum 26 (2002) Production of Pulp for Paper Annual Harvest of Roundwood Figure 1. Production of roundwood and pulp for paper in the former Soviet Union and Russia Source: FAO Statistics. 450, , , , , , , ,000 50, ,000 cubic metres The present article discusses the results of a survey of 32 Western European forest companies and examines the reasons behind their investment decisions (or decisions to withdraw). Company responses indicate that the low level of FDI in Russian forestry primarily reflects uncertainty about the political and institutional environment, rather than the economic possibilities of the natural resource endowment. Before a strategy for increasing FDI in the sector can be formulated, these institutional obstacles must be addressed. The survey includes some of the largest forest companies in Western Europe, the majority being the Nordic forest companies (especially companies based in Finland and Sweden), who play a dominant role in Europe. 4 Although the number of firms included in the survey is limited, it is fair to conclude that the responses received are generally indicative of European FDI activity and strategies towards the Russian forestry sector. In addition, the inclusion of companies regardless of whether they have invested in Russian forestry or not allows us to understand not only why certain firms have chosen to invest in the sector, but also why others have refrained from doing so. 5 Although general conclusions about overall Western European FDI behaviour cannot be drawn based on the 32 selected cases, the material provides some tentative insights into how FDI into Russian forestry could be increased. The article reviews the Russian forestry sector and some recent general facts about FDI flows into Russia (Section 2); 4 In 1997, for example, total wood pulp capacity in the Nordic countries constituted approximately 70% of the total European Union capacity (FAO, 1998). Moreover, several forest companies in the European Union are subsidiaries of Nordic firms. 5 Most previous research efforts analyzing FDI in transition economies focus on the behaviour of firms that have actually undertaken an investment, and few studies highlight why the non-investing firms have chosen not to invest. See also section 3.2. then discusses recent literature on FDI in transition economies and the relevance of studies for the Russian forestry sector (Section 3). Section 4 analyzes the results of the survey, and section 5 presents concluding remarks and policy recommendations. 2. The Russian forestry sector and foreign direct investment Russia has historically been a major producer of forest raw materials as well as pulp and paper products. However, the on-going transformation from a command-based towards a market-oriented economy has had serious repercussions for the Russian forestry sector. Domestic demand collapsed in the early 1990s and, as a consequence, production volumes fell drastically. Figure 1 shows the production of roundwood and pulp for paper in the former Soviet Union. From 1992 and onwards the data include the Russian Federation only. Production of roundwood in the former Soviet Union remained fairly constant throughout the period 1960 to The mid- to late 1970s witnessed a slight decrease in harvest levels, partly explained by the difficult harvesting conditions due to severe winters (Blandon, 1983). The level of cutting decreased dramatically in the beginning of the 1990s, though, and only a fraction of this can be explained by the fact that the data from 1992 and onwards exclude the newly independent Central Asian republics. 6 Mainly, production declined as a result of diminishing domestic demand, following the macroeconomic shock in the early 1990s. Looking instead at processed material (pulp for paper), the historical pattern differs from that of roundwood. Production 6 For example, in 1991 the Russian share of total growing stock of roundwood in the former Soviet Union was 94%, and for the allowable cut the corresponding share was 96% (Nilsson and Kleinhof, 2001).

3 304 Mats Nilsson and Patrik Söderholm / Natural Resources Forum 26 (2002) of pulp for paper has increased substantially since the 1960s, reflecting mainly a modernization of the Russian forest industry towards more refined products. However, as in the case of roundwood, pulp production fell dramatically in the late 1980s following the collapse of communism. According to Backman (1994), the above drastic changes in the forest industry have led to an increase in the annual growth in Russian forest inventories, from 500 million m 3 in the late 1980s to 600 million m 3 in the early 1990s. 7 The threat of forest fibre shortages in other regions of the world has increased the interest in regions with an apparent surplus, such as Russia. However, so far the Russian forest companies have been unsuccessful in adjusting to a market-oriented environment and thus in raising productivity and output (Carlsson et al., 2000). Major problems include lack of modern equipment and technology as well as necessary management skills. FDI that introduces more efficient technology is therefore often seen as one way of increasing productivity in the sector (e.g., Backman, 1994). Also, the entry of foreign investors can help domestic managers increase their skills and subject them to commercial rather than administrative criteria. They can introduce more proactive management in the areas of product development, quality control and marketing, something that was more or less non-existent during the central planning era (McMillan, 1995). 8 For the above reasons, Russian forestry executives frequently invite Western companies to become joint venture partners (e.g., Clarke, 1996). However, the general level of FDI flows into Russia has so far remained very low (compared to investment flows in other transition economies), and the forestry sector has not been an exception to this trend. Meyer (1998) notes that during the period overall FDI constituted only 0.3% of Russia s GDP. The corresponding shares for the Czech Republic, Hungary and Poland were 3.7, 6.5 and 2.1% respectively. 9 By 1996, the Russian FDI/GDP ratio had increased to a modest 0.4% (ECE, 1998). Detailed data on FDI flows into the Russian forestry sector are meager and difficult to come by. Nevertheless, Stern (1996) reports that from the time Russia declared independence (end of 1991) to the first quarter of 1995, the total (cumulative) value of FDI into Russia was US$ 2.84 billion, and 7% out of this total (US$ 198 million) went into the wood and paper industry. According to Gorbachev (1998), FDI into the Russian forestry sector amounted to about US$ 112 million over the two-year period For comprehensive mappings of the physical accessibility of forest resources in Russia, see Backman (1994, 1996a, 1996b). 8 Foreign investments do not necessarily have only positive effects. Newell and Wilson (1996) note that in the extractive sectors of the Russian economy (including forestry), a number of foreign investments have had detrimental effects on the natural environment. This issue was also the concern for some forest interest groups discussed in Tak (1994). 9 Out of the 13 transition countries reported in Meyer (1998, Table 2.4), only Ukraine had a lower FDI/GDP ratio (0.2%) than Russia for the period. On an annual basis, this indicates an increase in FDI activity during the 1990s. However, it is generally difficult to compare results from different sources, as their definition of FDI may not be the same (see Section 3). Even if the figures indicate a significant increase in FDI flows to the forestry sector, levels were still insufficient for bringing about an effective change in the existing capital structure. 3. Foreign direct investment in the transition literature FDI is generally defined as ownership of assets by foreign residents for purposes of controlling the use of these assets. Actual control over what is owned thus distinguishes direct investment from portfolio investment. There is however no universally established definition of FDI (e.g., Brewer, 1994). For example, the question remains as to what share of ownership confers actual control. For the purposes of this article, FDI involves the purchase of a 10% (or more) equity stake (stock or full or partial ownership), with the expectation of active participation in the firm s management. The 10% limit, although arbitrarily chosen, is the most commonly used criterion among researchers (e.g., Stern, 1996) and institutions (e.g., US Department of Commerce). An extensive literature deals with the various aspects of FDI. Disciplines such as economics, finance, strategic management, marketing and organizational behaviour have all contributed to our understanding of FDI. This section reviews past research on what motivates firms to engage in FDI in transition economies, and what might prevent them from doing so. Thus, many of the issues raised in the above literature are omitted here A theoretical framework One can usefully distinguish between two categories of reasons for FDI, and assert that a foreign rather than a domestic firm will invest in a new factory either because it expects higher returns or because it requires lower returns. The first class is often referred to as the industrial organization (IO) reason for FDI. 10 This approach recognizes that even if the foreign firm has some disadvantages compared to its domestic rivals (e.g., language, cultural traditions, etc.) it may have some specific knowledge or other asset that enables it to be more profitable. It may also be that the factory has a specific attraction for a foreign firm that it does not have for the domestic firm, such as a potential role in the foreign firm s global strategy (e.g., vertical integration). The second class of FDI motives notes that the foreign firm might be willing to pay more for the factory simply because it applies a lower discount rate to expected cash flows. This can be referred to as the: cost of capital basis 10 The seminal study in this field is Hymer (1976).

4 Mats Nilsson and Patrik Söderholm / Natural Resources Forum 26 (2002) for FDI, and essentially it assumes that FDI is simply a matter of resources in search of the highest return (Graham and Krugman, 1991, p. 36). However, a foreign investor seeking a higher return can achieve that aim through portfolio investment instead. Moreover, many firms engaging in FDI finance their investment locally, something which would be difficult to justify in terms of their being motivated by capital cost differences only. For the above reasons, the empirical literature generally concludes that IO considerations rather than costs of capital motivate most FDI. Still, even within the industrial organization paradigm there are many theories that emphasize different aspects of FDI motives. 11 John Dunning (1980, 1981, 1988, 1994), who has undertaken important work, both theoretical and empirical, on the IO paradigm, suggests that the reasons for FDI are diverse and thus that no single theory can account for all such investment. He therefore proposes to integrate the different IO reasons into a general paradigm of international production. According to this framework, FDI is undertaken only if three conditions are met (otherwise exports, for example, may be a better strategy): The investing firm needs ownership advantages that make it competitive with local firms. This could be due to a production process which other firms do not have access to or it could be something more intangible, such as a trademark or a reputation for providing products of superior quality; The host country must represent a favorable location for foreign firms. Transport costs and factor prices are obvious sources of locational advantages; and Internalization incentives must make it advantageous for the foreign firm to use its competitive advantage by selling components internally rather than on the market. One source of internalization advantage is the technical knowledge about a production process that is embodied in a group of employees. This type of advantage cannot easily be transferred to another firm (through, say, licensing), and is therefore better exploited within the firm. Our investigation focuses primarily on motivational factors and obstacles to FDI, in other words, location advantages. These could include low input-costs, access to markets but also government policies (e.g., barriers to imports, investment incentives). In most post-communist countries, the lack of well-developed market institutions has hampered economic development and investment activities. According to the property rights literature (e.g., Pejovich, 1997), functioning markets require clear assignment of initial rights to resources and well-enforced rules of contract. For this reason, governments attempting to encourage FDI must make sure that an effective legal system is in place, one in which property rights are unambiguous and secure. 11 For a brief survey of this literature, see Graham and Krugman (1991). However, given the legacy from the communist past, it may be difficult for the Russian Government to make credible commitments to new property rights laws. Private investment will be enhanced only if the problems posed by contractual hazards are mitigated by cost-effective safeguards (Williamson, 1995). Given the short time frame since the reforms started, these safeguards are often lacking in transition countries. For example, civil laws protecting private investments are often unclear and there is little case law to supplement the civil codes. This implies that if infringements do occur, the transaction costs involved in seeking compensation would be very high and most infringements will not be contested (Rapaczynski, 1996). In other words, in most transition economies, there is a major difference between formal property rights and de facto property rights. In this article, we hypothesize that the problem of attracting FDI into the Russian forestry sector has to do mostly with inherent institutional problems such as those outlined above, rather than standard FDI motives (e.g., opportunities to extract low-cost resources, production and investment cost differences etc.) Previous research Earlier empirical research into motives and determinants of FDI in transition economies has employed econometric techniques, case studies and survey studies among Western firms with investments in Central and Eastern Europe. Table 1 summarizes the choice of method and the main findings in some of the most important empirical studies in recent years. The table is organized according to method. Many of the early studies focus on the potential importance of factor cost advantages as main drivers of FDI into Central and Eastern Europe. The emphasis has been on differences in labour costs, which have remained low in Central and Eastern Europe, not least in Russia (Meyer, 1998). Still, previous studies generally conclude that factor costs, in particular labour costs, do not constitute major motivations for FDI flows into the region. Instead, Western firms have been attracted mainly by market size, expected growth and, in some cases, by so-called first-mover advantages. For example, Lankes and Venables (1996) review seven earlier studies and conclude that; [... ] one pattern that emerges very clearly is the predominance of marketseeking activities as the prime investment motive [in transition economies]. Factor cost considerations appeared to be of less importance for the majority of investments, (p. 334). According to previous research, the most important barriers to flow of FDI into transition economies relate to the uncertain political environment and the volatile macroeconomic situation. Problems in implementing a market economy and unclear property rights are normally perceived as particularly serious. Additional obstacles include administrative and bureaucratic complexity. It is

5 306 Mats Nilsson and Patrik Söderholm / Natural Resources Forum 26 (2002) Table 1. Earlier empirical studies on FDI in Central and Eastern Europe Study Scope Method Main findings Wang and Swain (1995) Lansbury et al. (1996) Andreff and Andreff (1997) NERA (1991) Collins and Rodrik (1991) OECD (1994) Radulescu (1996) Lankes and Venables (1996) Pye (1998) Meyer (1998) Tak (1994) Van Fossen (1995) FDI into Hungary and China FDI from OECD countries in Central Europe, FDI into the former Soviet Union compared to FDI into CEE a, early 1990s. Western firm FDI in CEE, East Germany and the former Soviet Union, Western firm FDI in CEE and the former Soviet Union, Western firm FDI in CEE and the former Soviet Union, British firms FDI into Romania. Western manufacturing firms FDI in transition economies. Western firm FDI in Central Europe in British and German firms FDI into five transition countries. Hyundai s joint venture in the Russian Far East. Hyundai s joint venture in the Russian Far East. Econometric model Econometric model Econometric model Survey Survey Survey Survey Survey Survey Survey and logit model Case study Case study FDI mainly determined by market size, cost of capital and political stability. Past trade linkages, infrastructure and privatization encourage FDI. The macroeconomic environment is an important obstacle to FDI. Market potential primary FDI motive. Main obstacles are political and economic uncertainty. New markets and first mover advantages main motives. Political risk and unclear property rights primary obstacles. Key motive is market share gains, rather than low wage considerations. Main obstacles are administrative and legislative issues. Implementation of market economy crucial for encouraging FDI. Transition progress, political stability and perceived risk influence FDI activity. Market factors in host country main motives. Low labour costs and first-mover advantages also important. Attractive markets more important than factor costs in explaining FDI. Inertia in the legal system most important obstacle. Political instability causes uncertainty about the validity of contractual agreements Ambiguous delineation of authority in Russian legislation important obstacle. Note: a Central and Eastern Europe (CEE). important to note, however, that in most cases bureaucracyrelated problems arise from inconsistent guidelines for decision-making within the bureaucracy as well as from interests of the local administration and, in some countries, corruption, (Meyer, 1998, p. 45). In other words, difficulties with the local bureaucracy normally reflect deeper-rooted problems such as ambiguous delineation of authority within the political systems of the former communist countries. The contribution of this article to the above literature is primarily of an empirical nature, its main justification being the need for further sectoral analysis of FDI, to complement the growing volume of research on macroeconomic aspects, and on the manufacturing sector as a whole. As noted above, we estimate that, in the forestry sector, institutional issues such as property rights and contractual enforcement, are particularly important factors determining (and, indeed, deterring) FDI. Given the vast forestry resources of Russia, an investigation into the reasons why these resources are not exploited more fully is particularly appropriate. Also, in contrast to earlier studies, the present article analyses not only investments actually conducted, but also investments that were once considered but eventually not carried out; and investment projects that were terminated. 4. Survey results and analysis The survey, of 32 selected Western European forestry companies, was conducted in September 1998, addressed to the managing directors of the selected companies. The survey focuses primarily on investments in projects where long-term continuing interest and actual managerial control are key objectives. It does not consider pure portfolio investments. The questions in the survey address investment willingness; investment location (location advantages); and problems experienced in investing in the Russian forestry sector. All questions involve response alternatives that reflect both the traditional and the institutional approach to FDI determinants. 12 Throughout the work, the maintained hypothesis is that FDI decisions involve a two-stage process: first, the company decides whether to invest in Russia at all; and if so, a second step is to choose the exact location of the investment. This is a useful distinction, especially since many regulations and economic conditions are virtually the same across the 12 The article leaves aside the question of what has made some forest investments more successful than others (see, however, Ådahl and Anisimov, 2000), and touches only briefly on issues such as entry mode, ownership and internalization advantages.

6 Mats Nilsson and Patrik Söderholm / Natural Resources Forum 26 (2002) entire country, while others differ greatly between regions. 13 Thus, the factors that are important in determining the first decision are not necessarily given the same weight in the second decision. Most of the questions in the survey relate to the first decision, but some (e.g., see Table 3) also deal with factors that influence the exact location of the investment. The survey results are presented in three main parts. The first explores current investment activity, including important determinants in the choice of location, motivational factors, and certain basic characteristics of the investment. The second part analyzes the reasons for terminating certain investments and why some planned investments eventually were not carried out. The third and last part discusses the company s willingness to invest in the Russian forestry sector in the future Current forestry investment activities and business relationships with Russia Most of the companies surveyed indicated that they were engaged in some kind of business relationship in Russia. 15 Normally these relations take the form of exports and/or imports, but direct investments into the country s forestry sector are also made. The companies were asked when business links were first established. Here, two distinct groups emerged. One group of companies had done business with Russia (or the former Soviet Union) for a very long time (some for over 100 years), 16 while the other group consists of companies that had only recently (mid-1990s and later) established business relationships with Russia. The latter indicates that the final collapse of the communist system provided an important incentive for foreign investors to enter Russia. Still, one might suspect that companies that have considerable prior experience in the region find it easier to adapt to the specific characteristics of Russian society. Eight of the companies report that they have made a direct investment (defined as in Section 3 above) in Russia during the last ten years. Four of these stated that their investments were mainly directed towards raw material supply (e.g., logging), while others had invested primarily in the production of pulp and/or paper in Russia. There is thus no clear pattern of investment being aimed mainly at securing raw material supply rather than refining wood raw material in Russia. What is clear, however, is that almost all (seven out of eight) companies preferred to remain in control of the investment project, either through a majority owned joint venture (51 95% ownership) or through a 13 The two-stage approach is also common in investment studies that rely on so-called nested logit models. 14 The entire survey is available from the authors upon request. 15 Business links here include, for example, exporting, importing, licensing, franchising, management contracts, and investment. Only two companies stated explicitly that they have no business links whatsoever with Russia. 16 This first group consists primarily of Finnish pulp and paper companies. Table 2. Transfers from Western European investors to Russian partners Type of transfers Number of responses Marketing know-how 6 General management know-how 5 Technology transfer 5 Final goods 4 Raw materials 4 Intermediate goods 3 Permission for using brand names 2 wholly-owned subsidiary or branch (more than 95% share). Only one company reports that it owns a minority share (10 50%) in a Russian joint venture. In addition, two of the companies were also engaged in turnkey projects, which involve building and delivering a plant in ready-for-use condition. At the outset of this article, it was noted that FDI can have important beneficial impacts on the Russian economy. This requires, however, that the transfers from foreign investors be of the right kind, preferably involving efficient technology and know-how. The eight investors in our sample were confronted with a list of seven alternative transfers, and asked to mark all alternatives that were judged to be important in their specific case. The transfers from the Nordic investors to their Russian counterparts are presented in Table 2. The transfers ranked as most important include knowhow about marketing and management issues. These are likely to be very important in the on-going transition process. Clark and Baglione (1998) conclude that for Russian firms to become profitable in the long run it is probably more important to adjust to changes in the market (e.g., changes in consumer preferences and the resource base) rather than simply trying to cut costs. One way of building up this competence is to learn from experienced foreign partners about the workings of free markets. Survey respondents also indicated that transfer of technology, also part of improving the institutional setting at the micro level, is also common. This response is important in view of the deteriorating capital stock in the Russian forestry sector and the urgent need to modernize production and harvesting methods (e.g., Perez- Garcia and Backman, 1995). Of course, important transfers from Russian firms to foreign investors also take place; one question in the survey concerned what characterizes these. According to the European forest companies in the survey, the most important transfer from the Russian companies to their foreign counterparts is information about the local business environment (e.g., etiquette, culture, laws, etc.) (so reported in six out of eight cases). Russian partners could also supply raw materials (three cases) and final goods (two cases). In many respects, the above pattern of transfers mirrors traditional flows between a developing and a developed country. However, our results also tend to reflect more region-specific circumstances. For example, due to the lack of a mature

7 308 Mats Nilsson and Patrik Söderholm / Natural Resources Forum 26 (2002) Table 3. Factors that influenced the location of the Russian investment Factor Mean 4 1 Physical infrastructure (access to roads, railways, airports) Number of competitors present in the market Size of population in the region The existence of trade barriers Quality and level of education of local work-force Average level of income in the region Labour costs Prior contacts with future partner Political stability in the region Availability of information Cost of raw materials Ease of negotiations with local authorities Presence and success/failure of other FDI in the region Tax levels and/or tax enforcement Quality of local suppliers Regional conflicts Offers by privatization agencies Protection of trademarks domestic market system, non-monetary transactions (i.e., barter) are significant features in the Russian forestry sector, as are very informal relationships between producers and distributors (e.g., Carlsson et al., 2000). In trying to adapt to this system, the investing firm needs to learn from their Russian partners. Thus, information about the local business environment is particularly important in a post-communist country like Russia. Much of the earlier research on FDI in transition economies has dealt with whether the primary function of investment projects was to serve local and regional markets, or mainly to utilize low-cost opportunities (primarily for export purposes). As noted above in Section 3, most previous research concludes that, in general, investors tend to follow market-seeking motives. This seems to be the case for FDI into the Russian forestry sector as well. Our eight investors were asked two questions: Whether the company invested in Russia to utilize low factor-cost opportunities; or Whether the investments had been made primarily to supply local markets. Only one company responded in the affirmative to the first question, while seven confirmed that Russia offers interesting new market opportunities and that these motivated their investment decision. It is worth noting, that the one company that answered that low factor-costs were important to the decision also answered that the market opportunities mattered (in one of the cases, neither low factor-costs nor new market opportunities seemed to have mattered). Given the collapse of the domestic market in Russia, this result may at first glance seem paradoxical. However, the time frames of the investments are in most cases long enough to give the domestic market a chance to recover and grow, and the investors apparently expected a major recovery in domestic demand. Especially in the early 1990s, many companies expected the Russian economy to recover relatively quickly, and it therefore made sense to invest. Some investors also tried to gain so-called first-mover advantages, and decided to invest rapidly (e.g., Pye, 1998). Once a decision has been made to invest in Russian forestry, the exact location must be chosen. The survey asked the European investors to what extent a number of factors had influenced the location of their investment. The companies were given a list of 20 potential factors, and were then asked to grade the importance of each from 1 to 4 (4 indicating very important, and 1, not important). This type of exercise not only enhances understanding of regional differences in forestry-related FDI, but it also provides important insights into what policies are needed to attract FDI into the sector. Table 3 reports the answers to this question, both the mean grade and the exact number of high (4) and low (1) grades for each factor. Access to important physical infrastructure and the number of competitors present in the market, appear to be the most important factors influencing the investment location decision. The importance of a well-developed infrastructure reflects both the fact that some forestry resources are remotely located from important markets (which entails high transportation costs), and that important personnel may need to be flown in and out. Three factors that in various ways mirror market size all obtain high scores as well. These are the size of the population, the number of competitors present and the average level of income in the region. Prior contacts with future partners, availability of information and political stability also ranked among the top ten factors. As noted above, this reflects a desire to reduce risk. The volatile political situation in Russia requires investors to maintain contacts with insiders that have proven

8 Mats Nilsson and Patrik Söderholm / Natural Resources Forum 26 (2002) trustworthy in the past. For example, reliable Russian partners can substantially facilitate negotiations with local authorities, an aspect that was highly valued by the companies surveyed. On the other hand, cost of raw materials and tax levels tended to be less important for the location decision. This is consistent with our finding above that market-seeking motives are most important, and that low factor-costs are at best a complementary motive. Labour costs, on the other hand, appear to rank higher in determining investment location. Furthermore, we find that the existence of trade barriers has quite a high rank, which lends support to the view that multinational firms invest abroad to circumvent tariffs and quotas. According to this view, investment serves to replace home country exports with foreign production. Again, this would reflect the desire to serve local instead of international markets. These results provide some modest evidence that institutional factors, such as political stability, play an important role in determining FDI behaviour in the Russian forestry sector. The decision as to investment location seems, however, to be even more heavily influenced by traditional factors, including market size, production costs and trade barriers. Still, the results presented so far do not provide enough evidence to reject our notion that institutions are crucial investment determinants in Russia. There are at least two reasons for this. First, as noted above, before choosing the exact location the company has to decide whether or not to invest in Russia at all, and at this stage political stability, legal and fiscal institutions are likely to be even more influential (this is confirmed below). Second, it should be remembered that most of the investments discussed so far were undertaken in the early 1990s (or earlier) when the problems stemming from various institutional obstacles had not yet become fully apparent. Much emphasis was then put on future market size and growth, and accordingly, these variables had a major impact on investment behaviour, while institutional factors were not considered very important (Meyer, 1998). However, over time, companies have become increasingly aware that various informal and political institutions play the more significant role in determining overall investment success Business relationships that have been terminated in the past or abandoned The above section made clear, that in order to understand the determinants of and the obstacles to FDI into the Russian forestry sector, it is important not only to look at recent investment activities, but it is equally important to learn from projects that have been terminated, and planned investments that, for one reason or another, were not carried through. Thirteen of the companies surveyed indicated that they had terminated a business relationship with a Russian Table 4. Motives for ending business relationship with a Russian partner Motives Number of responses for each reason The Russian partner did not fulfill its obligations 10 Economic risks were too high 6 Legal system too ambiguous (e.g., property rights rules) 4 Negotiating with local authorities too problematic 3 Tax levels too high 2 Security of working staff could not be guaranteed 2 Costs of raw materials too high 2 Political environment too uncertain 2 partner during the last ten years. 17 From a list of 20 possible reasons for their decision, the companies were asked to identify all alternatives that played an important role in their specific case. Table 4 indicates the most important motivations for ending a business relationship with a Russian partner. The most important reason for ending a business relationship was, according to our case study, that the Russian partner was perceived to have failed to fulfill its obligations. One example of this is the investment that a Swedish company made in the Karelian region in north-western Russia. In early 1996, the Swedish pulp and paper company, AssiDomän (hereafter ASSI), announced that they had bought the Segezhabumprom paper and sack mills in Karelia. The mills were in serious need of maintenance and reinvestment; the paper mill produced low quality paper, given the available raw material. Still, the investment seemed to fit well into a strategy of meeting an increasing demand for paper sacks in Eastern Europe, and it also made ASSI the largest producer of paper sacks in Europe. At the beginning of 1997, ASSI appointed a Swedish manager to run the operations in Segezha. However, the pulp and paper mill had extended periods of down time due to disputes with the local government over tax issues, social arrangements and rights to cut forest. The main source of conflict was the disparate views on ASSI s commitment to the town of Segezha. In Russia, a major enterprise is often expected to be responsible for the overall social welfare of nearby towns and villages. This could mean that the enterprise in question includes schools, hospitals, etc. The town of Segezha had, in fact, been built up more or less from scratch during the Soviet era, and the township existed only because of the paper mill. This meant that the mill was not only the largest employer, but also the social, cultural and political centre of the town. Therefore, local authorities felt that ASSI had not only bought the buildings, production facilities etc., 17 Business relationships here include not only direct investment but also business links, such as licensing, franchising, and outward processing.

9 310 Mats Nilsson and Patrik Söderholm / Natural Resources Forum 26 (2002) but also acquired the responsibility for supplying day care for children, gymnasiums, almost rent-free apartments and even heating to the entire town. At one point, the Swedish manager in fact cut off the heat to residents, as he did not believe he was under obligation to supply it. This move, naturally, did not gain much local support. This discrepancy in defining what exactly ASSI had bought, and what obligations ensued from the purchase agreement, which stemmed from cultural differences, turned out to be fatal (Ådahl and Anisimov, 2000). The Russian counterpart went to court to solve the dispute over the legal aspects of ASSI s investment. ASSI finally decided to leave Segezha in February 1998, taking a loss of 549 million SEK (about US$ 70 million at the time). Interestingly, ASSI has also invested in a new corrugated paper plant near St. Petersburg, which is running smoothly (AssiDomän, 1998). This is a greenfield investment over which ASSI has full control, and thus, there are no hidden obligations. Many of the recent investments of the Swedish company, Tetra Laval, in the Russian paper industry follow a similar pattern. Full ownership has enabled the company to embark on necessary restructuring programmes without having to negotiate with the local bureaucracy (Ådahl and Anisimov, 2000). The second and third most common answers to the question of why some European companies have chosen to end a business relationship with a Russian partner were that the risks involved were too high and that the legal framework was unclear. The Russian Forestry Act of provides an example of the latter. In many areas, the Act simultaneously granted jurisdiction to both central and local governments. For this reason, it was difficult to identify the legitimate Russian partner, and often therefore politics [would] be played out at a very local level (Van Fossen, 1995, p. 550). For a foreign investor, this can be devastating as federal approval can turn out to mean very little. An example illustrating this is the joint venture of the South Korean company Hyundai with two Russian logging companies. In 1990, Hyundai signed a contract with the regional forest industry organization, which backed the project with support from the Federal Government. However, in practice it was very difficult for Hyundai to determine which government body had the legal right to dispose of land and resources. Even though Hyundai had formal federal approval, a change in the local regime effectively negated years of efforts, and the joint venture operations came to a complete halt (Van Fossen, 1995) In 1997, this Act was replaced by a new law. 19 The American company Weyerhaeuser experienced similar problems in far eastern Russia. Weyerhaeuser s main interest was in the raw material; the company wanted to buy timber and ship it out of Russia. The crumbling state planning system made it possible for Weyerhaeuser to negotiate directly with their local distributor. However, in the end these negotiations turned out to be of little value as the old power structure had not vanished entirely and sought to gain from the situation. It is also worth noting that, in two cases, firms chose to withdraw because the security of their working staff could not be guaranteed. This is again a consequence of the fact that it can be difficult for a foreign investor to know who is de facto in charge of the acquired company. In a considerable number of cases, illegal organizations may have effective control over substantial portions of the acquired company. As the acquiring company attempts to claim its contractual rights, local strongmen may begin to pose threats against the foreign company s employees and managers. The surveyed companies were also asked whether, during the last ten years, they had considered an investment project in Russia that they eventually decided to abandon. Eleven of the companies reported that this was indeed the case, and most of these planned investments were in pulp and paper production. The eleven companies were asked to check a list of 20 possible reasons for their decision not to invest. Here also, they were asked to grade the importance of each factor on a scale from 1 to 4. Table 5 summarizes the responses. Not surprisingly, the results show that for all companies unacceptable economic risks were the main cause for choosing not to invest. Of course, this is likely a reflection of more deeply rooted problems and it is useful to look at the other factors as well. 20 Table 5 reveals that technical problems (such as high restructuring and relocation costs, quality of workforce and local suppliers, etc.), have in general had little to do with the decision to cancel investment plans. Rather, companies emphasized institutional factors, such as an ambiguous legal system, difficulties in negotiating with local authorities and political instability. The weight given to high taxation levels and strict tax enforcement is related to the above institutional obstacles. The elaborate accounting procedures of most foreign companies make it easier for the Russian authorities to claim taxes from foreign firms than from Russian counterparts, over which they have little cost control. In addition, foreign firms normally have a much greater ability to pay the taxes. For these reasons, foreign firms often face very strict (sometimes brutal) tax enforcement (e.g., Carlsson et al., 2000), and in many cases this tends to discourage FDI. These results support our notion that when it comes to deciding whether or not to invest in Russia at all, legal and political institutions become important; but prospective investors seldom abandon a project because of high labour or raw material costs. Again, the problem for Russia s forestry sector is not the lack of natural competitiveness (i.e., availability of cheap forest resources), but the lack of institutional competitive advantage. Especially in view of the fact that many of the firms were looking at investment in pulp 20 One of the anonymous reviewers of this article pointed out that it can be questioned whether the responding companies were able to distinguish between the analytical concepts economic and political investment risks. For them economic risks may include political risks and therefore becomes a very broad concept. This is likely to explain the high weight given to the former factor.

10 Table 5. Factors that influenced the decision not to invest in Russia Mats Nilsson and Patrik Söderholm / Natural Resources Forum 26 (2002) Factor Mean 4 1 Economic risks too high Legal system too ambiguous (e.g., property rights rules) Tax levels and tax enforcement too high Political environment too uncertain Environmental liabilities too high Other FDI in the region had been unsuccessful Negotiation with local authorities too difficult Insufficient information about the market Lack of physical infrastructure (roads, railways etc.) Security of working staff could not be guaranteed Restructuring costs of local facilities too high No appropriate Russian partner was found Costs of raw materials too high Quality of local suppliers insufficient Trade barriers existed for important markets Labour costs too high Problems in repatriating profits Quality and level of education of local workers insufficient Financial constraints within own company Production processes could not be relocated Table 6. Factors influencing a company s willingness to invest in the near future Factor Mean 4 1 Political environment Development of the legal system (e.g., property rights) Tax levels and/or tax enforcement Physical infrastructure (roads, railways, airports etc.) Ability to repatriate profits Availability of information Ease of negotiations with local authorities Costs of raw materials Quality of forest raw material Quality and level of education of local workforce Presence and success/failure of other FDI Prior contacts with future partners Trade barriers Labour costs Quality of local suppliers Number of competitors present in the market Size of population in the region Average level of income in the region Protection of trademarks Offers by privatization agencies and paper production, which involves considerable capital expenditures and long-term commitments, it is essential that political risks are small Potential for future investments in Russia As noted above, Russia s ability to attract foreign investments in the future is important to the country s economic development for many reasons, including the transfer of technology and managerial know-how. Twelve out of the 32 companies surveyed indicated that they still seriously consider Russia a potential target for forestry sector investment before the year Whether or not the companies were actually interested in possible future investments in the Russian forestry sector, they were asked to what extent a number of factors were likely to influence such a decision. Again the importance of each factor was graded from 1 to 4. Twenty-two companies responded to this question and Table 6 summarizes their answers. The responses to this question reflect many of the abovementioned motives and obstacles. The highest ranked factors are mainly of an institutional and/or fiscal nature. The institutions in question are not only formal rules and laws, but to a considerable extent also informal relationships with