Import Substitution Without Self-Isolation

19 march 2015

How to Benefit from the Crisis

Vladimir Yevtushenkov is Chairman of the Committee on Scientific-Technological Innovations and High Technologies under the Russian Chamber of Commerce and Industry.

Resume: Russian enterprises for years have ignored innovative potentialities of R&D and academic science and are now far behind their foreign counterparts. There is no lack of equipment, but – and this is much worse – the lagging behind has perpetuated existing organizational structures in management.

Several years ago, Russia adopted an economic policy that prioritized modernization and innovation-based development. Despite all the difficulties encountered on the way, the Russian government has persevered in pursuing this policy and even strengthened some of its key aspects, primarily in the military-industrial complex.

I would hate to think that some of Russia’s partners or competitors in the world market disliked this fact. But this is exactly how the attempts to cut off the Russian economy from common channels of international cooperation and mutually beneficial trade by means of the so-called sanctions look like. Now the initiators of that move are counting their losses, whereas for Russia it was a blessing in disguise.

AVOIDING MANAGERIAL BACKWARDNESS

Russia mobilized and used domestic resources to counter threats to its plans to make modern and competitive products, thus broadening opportunities for  its science and industry. The drive for import substitution has embraced all economic sectors. However, it should not be interpreted as a call for simple replacement of all products that were previously purchased abroad. Russian producers of goods and services had to turn to the world market not only because they were behind other countries in making innovative products but also because many foreign-made products were cheaper and came along with affordable and efficient after-sale services.

The extraordinary conditions created for the Russian economy by artificially limited access to foreign markets should be used as a catalyst for innovative development both in the public sector and in private business. After World War II, we did a great service to Germany when we took all of its outdated factory equipment as reparation, thereby opening its national market for a complete renovation of its production assets.

Experts are now working on specific issues requiring inter-sectoral coordination and/or on joint innovation projects geared towards import substitution. Russian enterprises for years have ignored innovative potentialities of R&D organizations and academic science and now they are far behind their foreign counterparts. There is no lack of equipment, devices, computers, etc., but – and this is much worse – the lagging behind has actually perpetuated existing organizational structures in management. For example, engineering, as a key element of modern management practices, is only beginning to be introduced in Russia now. Great difficulties are encountered in the contracting system, and particularly with the so-called life cycle, in government procurement, price-setting (especially for goods produced through cooperation), etc. For example, in the military-industrial complex where actually all products are the result of joint efforts by a large number of contractors and associate contractors, the final selling price drew even the president’s attention and was mentioned in his annual address to the Federal Assembly.

Conservatism in public administration results in a situation where each new organizational problem is addressed using standard approaches and methods. The same is with import substitution: state, municipal and economic management bodies of all levels have begun to urgently draft special programs to organize the production of goods and services similar to those available in the market but banned from import. Indeed, some goods, equipment and technologies can be produced in Russia at existing manufacturing facilities. However, Russian purpose-oriented programs, including national ones, raise doubts as a large number of them are never implemented completely. For example, by November 2014 only 86.3 percent of contracts had been concluded under federal purpose-oriented programs, and only about 65 percent under the federal targeted investment program. This can generate a bureaucratic avalanche of paperwork and inspections rather than real production.

But this is not yet the worst part. Import substitution is generally understood as self-reliance, which most often leads to production and technological autarky. However it is common knowledge that even the most developed economies produce virtually all modern goods through cooperation networks, reserving for themselves only exclusive competences. In fact, there is hardly any watch manufacturer that does not use at least some Swiss mechanisms,  if  this manufacturer wants to succeed in the market, of course. Similarly, the production of any gadget involves electronic components manufactured by Japan’s Murata which has for many years been engaged in aggressive acquisitions abroad. Autarky – no matter voluntary or forced – exacerbates the economic lag which cannot be overcome by mobilizing all domestic resources, both financial and intellectual.

The only way to become, and remain, an economy recognized by the market as a leading one is not to wait for an effect from one’s size but to ensure high competitiveness of the national production and technological potential. At the same time, competitiveness as such has now acquired fundamentally new features: achieving and especially keeping it at the required level depends entirely on incorporation into transnational cooperation.

Even the extraction of minerals has long been practiced by a large number of industrial enterprises that create and use the latest high technologies in various fields ranging from space surveillance to the transportation of end products to consumers. A poll conducted by McKinsey last year among the chief executives of 60 companies in Europe and North America showed that the efficiency of work in the fields of high technologies, assembly operations, pharmaceutics, and retail trade is several times higher if this work involves cooperative supply chains (Vestnik McKinsey, № 30, 2014). As the director general of Russia’s company Kronos, Andrei Lapin, said: “In today’s world it is not goods or brands that compete with each other, but chains – the one who organizes them more effectively wins” (Kommersant-Dengi, № 50, 2014).

Hence an important practical conclusion: the chief task of the management system from top to bottom should be making its production and technological facilities as attractive for cooperation as possible.

Unfortunately, the current state of the market is quite grave if assessed in terms of the classical theories of ideal competition, because its regulating mechanisms are grossly trampled upon by politics both in individual countries and in international associations, particularly when it comes to local markets. Nevertheless, while interfering with market mechanisms, politicians cannot completely ignore the interests of producers, especially those who make innovative products.

IMPORT SUBSTITUTION THROUGH OUTSOURCING

Considering all attendant circumstances, the issue of import substitution can be viewed from a different angle. The ban on the free movement of capital, goods and services limits the possibilities of industrial cooperation. The solution can be found in forming technological chains through merger or absorption of their links in markets not affected by sanctions.

The paradox is that the political interference in market operations has impacted not only Russian producers but also their foreign partners. The losses caused by the forced decrease in demand for their products and by the failure to meet contractual obligations have brought  their corporate capitalization and even financial stability to a critical point comparable to an economic crisis.

In these circumstances, it would be advisable for Russian businessmen to adopt a new strategy of import substitution. It should specifically provide for acquisition of foreign-based assets and organization of contract manufacturing abroad using Russian suppliers of components for the production of end products. Thus import substitution will turn into export integration when components, raw materials, funds and even personnel will be supplied by Russian companies to their foreign-based facilities and then to the world markets. Such import substitution can be described as additive outsourcing, meaning that unidirectional market forces are combined to increase the economic effect from each partner’s work. As Alexander Shokhin, the president of the Russian Union of Industrialists and Entrepreneurs, has aptly noted, any well-organized import substitution may in the future become an export-oriented business.

In fact, large Russian corporations have been using this strategy for a long time to  enter foreign markets. For example, a bankrupt German shipyard in Mecklenburg-Vorpommern has been sold to a Russian shipbuilding company in Otradnoye. In another example, the St. Petersburg-based Kirov Plant bought two bankrupt companies in Germany, which were known in the petrochemical, electricity, building materials and other markets. In 2011, Russia’s KuibyshevAzot bought a German company that made polyamide yarns. In late 2014, the TechnoNICOL Corporation bought an Italian roofing materials factory. In this case, the corporation sought not to acquire foreign technologies but to export its own products, made using more advanced technologies, to the European market. According to TechnoNICOL Director-General Vladimir Markov, his corporation views this factory as “a springboard for further development in European and other foreign markets” (Ekspert, № 40, 2014). Another Russian company, Lukoil, is planning to invest U.S. $50 billion abroad between 2015 and 2024, and the KamAZ truck maker intends to open an assembly factory in Argentina.

Switzerland is implementing a government program called Location Promotion Switzerland to promote the country as an advantageous place for doing business. Program directors in ten countries, including Russia, offer free consultations to businessmen who want to open their headquarters, trading company or research center in Switzerland. Swiss cantons compete for new businesses, giving priority to information technology, communications, health care, biotechnology, and mechanical engineering.

During the global financial crisis China devised, and is now successfully implementing, a comprehensive development strategy for the transportation sector, including airport networks. Experiencing a severe shortage of modern aircraft design technologies, Chinese manufacturers began to buy many small family-owned companies in Europe which were facing serious economic problems. As a result, they received big orders for their products and were not only saved from bankruptcy but also received a strong impetus for innovative development.

The Russian president’s proposal to scrap the South Stream gas pipeline project and build a Gazprom center on the Turkish-Greek border to sell Russian gas to Europe reflects the same tendency. Also, Summa Group is building an oil terminal in the port of Amsterdam. Another Russian company, R-Pharm, is buying a Pfizer plant in Germany to advance its products to the European market. Even Russian banks are planning to launch retail lending programs in Europe. For example, VTB is considering such plans for Germany and Austria.

In addition, the sanctions against banks do not apply to loans intended for maintaining the solvency and liquidity of companies registered in the EU and owned more than 50 percent by Russian banks. So when implementing its program of assistance to banks from the National Welfare Fund, the government could select those of them which are planning to give Russian companies soft loans for acquiring productive assets abroad. However, this would require an amendment to the National Welfare Fund’s Statute, which now allows investing its money only in long-term infrastructure bonds.

This model is particularly suitable for organizing the production of oil and gas equipment, components for the aircraft and automotive industries, pharmaceuticals, wood products, and even fish processing. Its introduction will also help to solve the aforementioned problem of overhauling corporate governance, above all in state-owned  and strategic companies,  re-arranging their financial structure, including the restructuring of debts and loan commitments, and divesting non-core assets. On the whole, this will help to withstand external political pressure and even reap some benefits.

IMPROVING PUBLIC-PRIVATE PARTNERSHIP

Government support to companies that choose this model of import substitution will be much more effective than direct use of gold and foreign exchange reserves and the National Welfare Fund to compensate for their losses from the sanctions. Indirectly, this will also help to solve the dilemma of controlled foreign companies as it has already been recognized that the law regulating their tax regime needs some major adjustments. At present, changing tax residence is proposed as the simplest way to bypass the law. However, many countries, including Russia, have moved to renounce the use of offshore mechanisms as a top priority measure aimed at improving their financial systems.

It is difficult to ignore the fact that a full (!) amnesty for offshore capital returning to Russia and its legalization in 2015, proposed by the Russian president in his address to the Federal Assembly, does not imply the sale by Russian companies of their foreign-based assets. Therefore, production facilities purchased by Russian businessmen abroad are not viewed as taken out of the country illegally.

The outsourcing model offers additional opportunities for developing public-private partnerships. At present, this mechanism is interpreted very narrowly – the state invites businesses to take part in the implementation of major projects mainly as a source of additional funding. Instead, private business should be given a greater role to play in such partnerships, using its experience in corporate governance, market risk assessment, competitive struggle, and resource and personnel management.

No import substitution is possible without private business actively engaged in the process. Moreover, considering budget restrictions, many government programs, including import substitution ones, will hardly achieve their goals any time soon unless business gets actively and fully involved. As a result, public-private partnerships will no longer be reduced to concession agreements but will have much broader applicability.  And this  may necessitate the adoption of a public-private partnership law.

Naturally, the proposed model cannot be regarded as an alternative to other methods and forms of import substitution such as the establishment of joint ventures with foreign partners in Russia or localization of production by large foreign companies in our country. This mechanism, first used in the automotive industry, has spread to other sectors. The production of heating systems in the Saratov Region by Robert Bosch GmbH is just one of the examples. Another option is the sale of Russian assets to foreign companies as was the case with the Russian pharmaceutical company Veropharm purchased by the U.S. giant Abbott after the West had imposed its sanctions. The planned privatization of 19.5 percent of the state-owned oil company Rosneft also opens up good prospects.

The advance of Russian manufacturers abroad rather complements other ways of organizing import substitution designed to serve one common goal stated by the president in his address to the Federal Assembly: “Our goal is to have as many equal partners as possible, both in the West and in the East. We will expand our presence in those regions where integration is on the rise, where politics is not mixed with economy, and where obstacles to trade, to exchange of technology and investment and to the free movement of people are lifted.” So only an economically justified combination of various forms and methods can provide the best way to build an optimum model of import substitution.

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