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 You are in: Under Secretary for Economic, Energy and Agricultural Affairs > Bureau of Economic, Energy and Business Affairs > Finance and Development > Organization > Investment Affairs > Investment Climate Statements: 2006

Russia

2006 INVESTMENT CLIMATE STATEMENT RUSSIA


INTRODUCTION

Russia's economy continued to expand in 2005, with the pace
of growth picking up considerably in the second half of the year.
Russia's Ministry of Economic Development and Trade (MEDT)
forecasts GDP to grow by 6.5 percent for the year, although this
is considered a conservative estimate by many. Fixed capital
investment from foreign and domestic investors increased by 12.4
percent year-on-year in January-November 2005, compared with an
11.1 percent increase during the same period in 2004, with higher
than expected growth in investment taking root in the latter part
of the year thanks to a widely perceived improvement in the
business climate.

Direct foreign investment in Russia is still quite low by
comparison with other transition economies in Europe and by
international standards generally. Russia's Federal State
Statistics Service estimates that FDI inflows reached $14.2
billion by the end of the third quarter of 2005. Applying
Central Bank of Russia methodology, this amounts to approximately
2-2.5% of GDP in FDI inflows in 2005. While this marks a
substantial increase over last year's $9.4 billion, the energy
sector continues to dominate the investment climate, comprising
40% of net FDI inflows in light of several multi- billion dollar
projects ongoing during 2005. Royal Dutch/Shell and Exxon Mobil
expect to spend USD 20 billion and 12 billion respectively on
their offshore oil and gas projects in Sakhalin, while
ConocoPhillips increased its stake in LUKoil from 7.6 percent
(for which it paid USD 2 billion in 2004) to 16.4 percent.

According to the Russian Ministry of Finance, net capital
outflows for 2005 are estimated to reach $5.4 billion, marking a
sharp decline from the $9.3 billion outflow in 2004. In contrast
to capital flight during the 1990s, the majority of current
outflows involve legitimate movement of money to more secure and
profitable investments abroad, reflecting the maturing of the
Russian business sector. As evidence of this trend, by third
quarter 2005 the U.S. was the number one destination for Russian
investment abroad, knocking Cyprus from its long-term lead to
fourth place. Investment inflow statistics also illustrate that
repatriated Russian money is no longer as significant a source of
foreign investment as it was during the mid/late 1990s. In 2005,
the United Kingdom and the Netherlands were the top two source
countries for foreign investment in Russia, a reflection of these
countries' heavy investments in Russia's energy sector.

Although these figures indicate that the Russian investment
climate has strengthened in recent years, pending necessary
improvements still include: establishment of a truly independent,
competent and effective judicial system; reform of so-called
natural monopolies in power, gas and community services; banking
reform to improve the effectiveness and capacity of the financial
sector; accounting reform to promote greater transparency and
facilitate integration with the international business community;
and further improvements in corporate governance. Furthermore, a
thorough overhaul of government bureaucracy aimed at streamlining
functions and reducing corruption has long been high on the
agenda of businesses, large and small, Russian and foreign, which
operate in this country. Although the government has also
embraced this cause, as evidenced by the ambitious spring 2004
Administrative Reform agenda, it has made only limited progress
to date.

OPENNESS TO FOREIGN INVESTMENT

President Putin has repeatedly foreign investment as a
critical element of Russia's economic development, though in some
cases the Government of Russia (GOR) is less willing to permit investment strategies
that keep project control in foreign hands. In practice, the GOR
has favored joint ventures with local entities or direct cash
injections. At times, however, Russia's commitment to foreign
investment has been called into question -- most obviously in the
energy sector. Over the past year, the GOR has tightened its
grip on the sector and has shown little inclination to allow
foreign companies anything more than minority stakes (and often
only 20 to 25 percent) in larger projects. Nevertheless, because
of the absolute size of these projects, even these small stakes
add up to hundreds of millions, if not billions, of dollars.
ExxonMobil and ChevronTexaco continue to press their case with
the GOR that they remain the rightful license holders of the
Sakhalin-3 field. [Background: On January 29, 2004 the GOR's
Commission on Production Sharing Agreements failed to confirm the
validity of a 1993 tender for the Sakhalin-3 oil and gas fields
granted to Exxon, Mobil and Texaco. Since that time, the
successor firms ExxonMobil and ChevronTexaco have invested more
than $60 million in exploration of these fields. The GOR has
indicated that they may re-tender this property in the future.
End background.]

In 2005, the government debated a new Law on Natural
Resources that represents an improvement over the current law (as
amended). In the current draft of the new law, the government has
included several of the key provisions sought by industry,
including a guarantee that licenses will carry over from the
exploration to the development stage, a provision that licenses
will be based on civil rather than administrative law, and a
limitation on the number of reasons for license revocation.
However, the draft includes language that would restrict foreign
companies from taking a majority stake in so-called "strategic
fields." The GOR has yet to define "strategic," but has
indicated that the list of such fields will be short.

As a practical matter, commentators report that the demand
for investment in agriculture outstrips the ability of domestic
banks to provide the necessary project financing, forcing project
developers to use a consortium of financial institutions or
request assistance from input suppliers. In addition, despite
supportive statements by government officials on investment in
agricultural processing facilities, some projects have not taken
off due to entrenched interests, lack of clarity, or attempts to
turn into an advantage legal ambiguity regarding land procurement
and control issues. The GOR's stated interest in substituting
domestic production for imported agricultural products provides
some encouragement for domestic investment in agriculture.
Additionally, though some agricultural sectors are struggling,
the food processing industry is more profitable, and is expected
to continue to grow as Russia's retail sector continues its rapid
expansion. Newly announced programs supporting agriculture as a
national priority may help strengthen the grain, oilseed, dairy,
and poultry industries in the short term.

A new Forest Code, expected to be adopted in spring 2006,
should stimulate foreign investment in the sector by providing
tax breaks. In 2004, total investments in the forest industry
were estimated at $1 billion, up from $825 million in 2003.
These investments included an estimated $280 million in foreign
investment, of which 70 to 80 percent was channeled into
downstream wood processing. According to the Federal Agency for
Forestry, $2 billion of total annual investment is needed to
modernize the Russian forest sector. Insufficient investment by
both the federal government and the private sector hinder further
development of the fisheries sector in Russia.

Russia's vigorous GDP growth and rising incomes have attracted
increasing interest from foreign investors, despite the
difficulties of doing business here. In addition, many regions
have developed laws and programs to attract FDI (including plans
to establish techno-parks near universities and export zones near
ports and borders). Although tax reforms at the federal level
aim to create a level playing field for all investors and limit
the scope of incentives regions can offer, in practice, large
foreign investors continue to receive such incentives (though a
completed investment project is often later expected to provide
social services and other benefits to the local population).

Although these positive factors increase Russia's ability to
attract FDI, chronic shortcomings in the investment climate
continue to dampen potential. The lack of clarity in Russian tax
law and administration, inconsistent government regulation,
unreliability of the legal system, and crime and corruption all
dissuade investors. In addition, recent economic reports have
all concluded that corruption is getting worse in Russia.

The 1991 investment code guarantees foreign investors rights
equal to those of Russian investors (although some industries do
have limits on foreign ownership - see below). The July 1999 law
on foreign investment confirmed the principle of national
treatment. This 1999 law includes a grandfather clause that
protects certain large investments (over approximately USD 33
million) from unfavorable changes in tax or other legislation
until the project's breakeven point, but for a period of not more
than seven years. However, in practice, these protections have
not been provided due to the lack of implementing regulations.

The Russian government is developing legislation to oversee,
and possibly limit, foreign investment in "strategic sectors."
What exactly constitutes a strategic sector is still undefined.
However, it seems clear that the defense industry and national
security sectors will fall into this category. While officials
had expected to have a draft law ready by late this year, the
timeline has slipped into early or mid-2006. For now, government
experts are still locked in debate about whether to review
individual investment deals on a case-by-case basis or to set
across-the-board limits to foreign ownership in key sectors.
Both positions have high-level backing and it remains unclear
which approach will ultimately prevail.

Explicit restrictions on foreign direct investment are in
effect for certain sectors. A 1998 law on the aerospace industry
limits foreign ownership to 25 percent of an enterprise, although
some existing joint ventures were "grandfathered." In late 2005,
legislation was passed eliminating foreign ownership limits in
the natural gas monopoly Gazprom. This action followed the GOR's
assumption of a direct majority stake in the company.

In 2003, Russia enacted several amendments to the insurance
law that effectively liberalized the market, allowing majority-
owned Russian subsidiaries of insurers from the European Union to
sell life and mandatory forms of insurance in Russia. Although
the law only permits those companies with offices in the European
Union to open subsidiaries offering life and mandatory forms of
insurance, the regulator has interpreted the legislation as
allowing any foreign insurer to set up life insurance operations
in Russia provided that the company has an office in the EU via
which the investment is made. Russian law does not permit
foreign insurance companies to establish branch offices in
Russia.

A 1998 law limits foreign investment in the electric power
giant Unified Energy Systems (UES) to 25 percent or less,
although it has not been enforced to date. UES Chairman Anatoliy
Chubays is pushing to attract foreign investors into the divested
electricity generating companies that will emerge from the
restructuring of UES.

Prior approval by the relevant government authority (e.g.,
State Property Committee, Ministry of Industry and Energy,
Ministry of Natural Resources) is required for foreign investment
in: new enterprises using assets of existing Russian enterprises;
defense industries (which may be prohibited in some cases); and
the exploitation of natural resources. Approval is also required
for all investments over 50 million rubles, investment ventures
in which the foreign share exceeds 50 percent, or investment to
take over incomplete housing and construction projects.

Additional registration requirements exist for investments
exceeding 100 million rubles. Projects involving large-scale
construction or modernization may also be subject to expert
examination for environmental considerations. In sectors that
require licensing (e.g. banking, mining and telecommunications),
procedures often can be lengthy and non-transparent. While new
business registration procedures go through a so-called "one-stop
shop" approach run by the Ministry of Economic Development and
Trade in effect since July 2002, the new law does not modify any
of the requirements for foreign direct investments noted above.

The 1998 bill "On Additional Measures to Attract Investments
into Russian Automotive Industry Development" includes a clause
that exempts foreign investors from customs duties on raw
materials used for car assembly or production of spare parts --
provided that their investments into such enterprises exceed USD
49 million during a five-year period. In July 2003, the Ministry
of Industry, Science and Technology requested that the Russian
Government lower the investment threshold entitling investors to
duty-free import of raw materials for car assembly to USD 4.9
million.

A new land code allowing ownership (including by foreigners)
of non-agricultural land was adopted in October 2001, although
some implementing regulations are still in development. In
addition, the GOR signed into law July 24, 2002 a land code for
agricultural land that permits long-term leases of agricultural
land (up to 49 years) to foreigners, but prohibits direct sales
of agricultural land to them. Sales of Federal land must be
approved by the Prime Minister. This requirement resulted in
several investment failures in agricultural processing in 2004
and 2005.

In the privatization of the mid-1990s, irregularities and
lack of transparency, as well as the perception of great
political risk at that time, limited foreign participation in
many of these transactions. This meant that the sale of
enterprises in oil, gas, and precious metals was de facto not
open to foreign investors. Subsequently, some foreign investors
purchased shares of privatized enterprises in secondary
transactions, including in oil and gas. For example, U.S. oil
firm ConocoPhillips bought the GOR's remaining stake of 7.6
percent in Russian oil major Lukoil in 2004 and has the right to
increase its ownership in the company to 20 percent.

Foreign investors participating in Russian privatization
sales often are confined to limited positions and face problems
with minority shareholder rights and corporate governance. The
treatment of foreign investment in new privatizations is likely
to remain inconsistent.

Roughly three-quarters of the Russian economy has been
privatized, although many privatized enterprises continue to have
significant state-held blocks of shares. Some privatization of
remaining state holdings is scheduled to continue, both as part
of overall government policy, and at local, regional and federal
levels as governments seek additional cash. Some of these
offerings may be considered good buys by some investors.

Potential foreign investors are advised to work directly and
closely with appropriate local, regional and federal officials
that exercise ownership and other authority over companies whose
shares they may want to acquire. According to a draft
privatization plan prepared by the State Property Committee, the
government intends to sell most of its minority stakes in
companies during 2004-2006, and plans to raise USD 1.1 billion a
year from the sale of state assets. In 2004, the GOR attempted
to sell all holdings of less than 25 percent. However, because
minority positions in very small companies may not attract
interested buyers, the GOR likely did not manage to sell all such
holdings.

Despite continued growth in 2004, the slow pace of
structural reforms and the increasing role of the state in the
energy sector have most likely been the main causes for the
continued disappointing results for foreign investment. Rule of
law, corporate governance and respect for property rights,
although improved over the years, remain key concerns for foreign
investors. Although there is some increased interest, many large
U.S. companies remain cautious about pursuing a strategy of
growth through acquisition in Russia, because of fears of
liabilities associated with existing operations (especially
environmental cleanup), inadequate bankruptcy procedures, and
weak property rights protection.

Growth in Russia's retail and consumer sector continues to
be a significant driving force behind overall economic growth,
propelled largely by the rapid growth in real disposable incomes
in recent years. Russia's Federal State Statistics Service
estimates that real disposable incomes grew 12.4% in 2005, thus
continuing to outpace GDP growth considerably. Many U.S.
companies here report recovery in their earnings, with some now
back to or above pre-1998 levels. Russia's macroeconomic
recovery has revived the attention of outside investors,
especially given troubles in other developing country markets and
sluggish growth in some developed country economies, although
only a few new major projects have materialized.

In recognition of widespread corporate governance problems,
the Federal Commission for the Securities Market (now called the
Federal Service for Financial Markets) adopted a new corporate
governance code in April 2002 and endorsed an OECD White Paper on
corporate governance that recommends further improvements in
corporate governance in coming years. Some large Russian
companies have developed their own corporate governance policies,
although implementation is not always robust.

As Russia's oil and gas sector accounts for more than 40
percent of its export revenues and comprises a major share of the
world's undeveloped energy resources, it holds tremendous
potential for foreign as well as domestic investment. Whether
this potential is realized depends on the receptivity to such
investment by private Russian oil companies and the Russian
government. One area of particular interest is Production
Sharing Agreements, which are designed to facilitate projects
that require high upfront capital investment, but a long payback
period for the investor.

Production Sharing Agreement (PSA) legislation was adopted
at the beginning of 1999, but PSA amendments to the tax code
passed in mid-2003 sent a very mixed message. The amendments
provided a firmer foundation for three operating projects and a
few new projects supported by domestic companies, but greatly
restricted the possibility of future PSA projects. The re-
emergence of PSAs as a tool for attracting investment looks
doubtful, even though the efficacy of this regime is shown by the
fact that U.S. and other foreign companies have poured several
billion dollars into two of the three existing PSA projects,
Sakhalin-1 and Sakhalin-2.

Elsewhere in the energy sector, shareholders in the Caspian
Pipeline Consortium (CPC) have still not agreed - even after
years of negotiations -- on the terms of a deal that would allow
for an expansion of the consortium's pipeline. The oil producing
companies in the consortium have agreed to virtually every demand
from the Russian Government. However, the GOR still refuses to
agree to the package and, without this agreement, both the long-
term profitability of the pipeline is in jeopardy and access to
world markets of an additional 750,000 barrels per day of oil
from Kazakhstan and Russia will be delayed.

Up until the attack on Yukos, changes in the ownership
structure of the Russian oil industry had resulted in new, more
market-oriented partners for U.S. firms seeking to invest in
Russia. Now, with the forced sale of Yukos's assets, Sibneft's
de-merger with Yukos, Gazprom's subsequent purchase of Sibneft,
and ConocoPhillips' purchase of the remaining government stake in
Lukoil, the oil and gas landscape has changed substantially
compared to only a year ago. The industry no longer exerts
extensive influence on the government but, on the contrary, it is
the government that appears to have regained control over oil and
gas firms. Clearly this will, at least in the short run, reduce
the number of competitors in the industry.

The investment climate for agriculture looked brighter in
2005, and better than in many other sectors of Russian economy,
due to several factors. Domestic demand for food products is
increasing as a result of an upward trend in per capita income.
This change is stimulating investments in the food processing
industry, and in food wholesale and retail infrastructure. Food
processing is expected to continue expanding at 15 percent
annually. Profits generated from these enterprises stimulated
investments and modernization of Russian agricultural production
as well as rural infrastructure.

Structural changes in farm ownership and financing have
created a more favorable climate for investment. By the
beginning of 2002, many former state and collective farms had
completed privatization and bankruptcy procedures, and it became
easier to acquire property as property ownership rights became
clearer.

Agricultural financing has improved, though investment
mechanisms for agriculture, such as banks, are still not strong
enough (keeping agriculture undercapitalized), and the practical
inability to use land as collateral further reduces investment in
agriculture. Vertically-integrated companies do continue to
support the development of agriculture, but large non-agriculture-
based holding companies have begun to turn toward other sectors.
The development of new rural credit cooperatives has been
declared a national priority, and nearly $70 million will be
funneled through them over the next two years.

Experience has shown that one of the most important factors
determining success or failure of a foreign investment project in
agriculture is the degree to which the local administration
supports the project. Almost all administrations invite
investment into their regions, but few are prepared to allow
business to operate in a relatively open market without
interference in matters such as pricing inputs and contracting
for services. Many local administrations still view foreign
investors as sources of cash for the support of local government
and favored businesses. They will also sometimes expect the
foreign firm either to pay outright a significant bribe or
undertake social or public works projects for the betterment of
the region.

CONVERSION AND TRANSFER POLICIES

Russia implemented a series of amendments to its laws on
currency controls in 2004. While the ruble is the only currency
that is legal tender in Russia, in general companies and
individuals face no significant difficulty in obtaining foreign
exchange. Authorized banks are not difficult to find as most
have licenses to conduct currency transactions. While the
following discussion represents a "snapshot" of current
requirements, investors would be well advised to seek expert
advice on the controls in effect at the time.

Generally, any payment obligation that lasts longer than 180
days is a "capital" transaction. "Current" forex transactions
include contracts in which settlements take place within 180 days
and loans not exceeding 180 days. Currency controls exist on all
transactions that require Customs clearance, meaning that in
Russia they apply to both import and export transactions.
Greatly simplified, the structure is the same: the importer or
exporter presents the "passport of deal" documents to an
authorized bank, which controls the flow of funds in and out of
Russia according to CBR regulations.

A "passport of deal" is a set of documents that importers
and exporters provide to authorized banks to review whether the
transaction meets currency control regulations. Once an
authorized bank signs the passport of a deal, it monitors the
entire transaction for compliance with currency regulations, and
the importer/exporter must use that bank for all parts of the
transaction. The importer/exporter must present the passport
signed by the authorized bank to clear shipments through Customs.
The Customs Committee notifies the bank once the shipment has
been cleared. The authorized bank then monitors compliance with
payment regulations.

In June 2004, the Central Bank put a number of regulations
into effect that were designed to implement amendments to Federal
Law No. 173-FZ "On Currency Regulation and Currency Control,"
dated December 10, 2003. According to the most recent
regulations, foreign currency transactions between residents and
non-residents involving non-cash settlements must be carried out
using special bank accounts. Authorized banks are permitted to
open special bank accounts for resident individuals ("F"
Accounts) and resident entrepreneurs and legal entities ("R1" and
"R2" accounts). Non-residents in Russia open the following
special accounts: "S" accounts to trade sovereign ruble bonds,
"A" accounts to trade shares in unit investment funds, "O"
accounts to trade non-sovereign ruble bonds, "V1" accounts to
receive ruble loans from residents, and "V2" accounts to give
loans to residents as well as to buy certain types of securities
from residents. In addition to establishing these new accounts,
the amendments declare that all currency controls will be lifted
on January 1, 2007.

Only authorized banks may carry out the sale or purchase of
foreign currency transactions. According to currency control
laws, the Central Bank retains the right to impose restrictions
on the purchase of foreign currency, including requirements that
a) the transaction be completed through a special account and b)
a security deposit be established (up to 20 percent and one year
for non-residents, and up to 100 percent and 60 days for
residents purchasing foreign exchange).

Special controls on current transactions proceeds from the
sale of exported goods for foreign currency must be credited back
to the exporter's account in an authorized bank. The latest
amendments to the Law on Currency Regulation And Currency Control
that took effect in June 2004 stipulate a ceiling for mandatory
surrender requirement at 30 percent of foreign currency proceeds.
The actual norm is to be set by the CBR, but in any event the
percentage may not exceed this ceiling. Effective December 27,
2004, the CBR set the surrender norm at 10 percent. Forex
proceeds must be sold for rubles within seven days of credit to
the exporter's account. If there are delays or discrepancies in
the receipt of export earnings (due, e.g., to price
fluctuations), or delays or non-shipment of prepaid goods, the
importer/exporter is liable to Customs sanctions. They can
submit documents to the Ministry of Economic Development and
Trade to explain or justify the delay or non-receipt.

EXPROPRIATION AND COMPENSATION

The 1991 investment code prohibits the nationalization of
foreign investments except following legislative action and where
deemed to be in the national interest. Such nationalizations may
be appealed to the courts of the Russian Federation, and are to
be paid with prompt, adequate and effective compensation.

At the sub-federal level, expropriation has been a problem,
as has local government interference or lack of enforcement of
court rulings protecting investors. The embassy is tracking a
small number of cases in which foreign companies are seeking
compensation for the loss of their investment or property due to
regional government action or inaction.

DISPUTE SETTLEMENT

Russia has a body of conflicting, overlapping and rapidly
changing laws, decrees and regulations, which has resulted in an
ad hoc and unpredictable approach to doing business. Independent
dispute resolution in Russia can be difficult to obtain since the
judicial system is still developing. Regional and local courts
are often subject to political pressure. In addition, court
decisions are at times not executed and the bailiffs, who are
charged with enforcing court judgments, are administratively not
part of the court system and sometimes opt not to enforce those
judgments.

Many Western attorneys refer their Western clients who have
investment or trade disputes in Russia to international
arbitration in Stockholm or to courts abroad. A 1997 law allows
foreign arbitration awards to be enforced in Russia, even if
there is no reciprocal treaty between Russia and the country
where the order was made. Russia is a member of the
International Center for the Settlement of Investment Disputes
and accepts binding international arbitration. Russia is also a
signatory to the 1958 New York Convention on the Recognition and
Enforcement of Foreign Arbitral Awards. However, the enforcement
of international arbitral awards still ultimately requires action
from Russian courts and follow-up by court officers through a new
system of bailiffs that, due to legal restrictions and limited
trained personnel, has yet to become a consistently effective
enforcer of court judgments.

As for legal avenues available in Russia through Russian
arbitration, one choice is the Arbitration Court of the Russian
Federation, which is part of the court system. It has special
procedures for seizure of property before trial, so property
cannot be disposed of before the court has heard the claim, as
well as for the enforcement of financial awards through the
banks. Additionally, the International Commercial Arbitration
Court at the Russian Chamber of Commerce and Industry will hear
claims if both parties agree to refer disputes there. Parties to
foreign trade agreements and companies with foreign investments
can make applications. A similar arbitration court has been
established in St. Petersburg. The Russian Union of
Industrialists and Entrepreneurs, an organization representing
some of the largest Russian companies, is also developing an
alternate dispute resolution (ADR) system.

As with international arbitral procedures, the weakness in
the system is in Russian enforcement of decisions. Bailiffs
report to the Ministry of Justice, rather than the courts, and
the courts can do little to ensure that decisions, once passed
down, are executed. The Embassy is currently aware of several
cases where despite repeated favorable court decisions for
financial restitutions, foreign investors have not been able to
get a judgment enforced against another private party or a local
government.

PERFORMANCE REQUIREMENTS AND INCENTIVES

While performance requirements are not generally imposed by
Russian law, and are not widely included as part of private
contracts, they have appeared in the agreements of large
multinational companies investing in natural resources, and in
production sharing legislation. There are no formal requirements
for offsets in foreign investments. However, as approval for
investments in Russia frequently depends on relationships with
government officials and on a firm's demonstration of commitment
to the Russian market, in practice this may result in offsets.
The provision of investment incentives has been problematic in
Russia, as the Russian government's interest in attracting
investment has been tempered by its tight financial situation,
concern about special privileges given to foreign investors, and
interest in complying with the rules of the World Trade
Organization and other international economic institutions.
Those investment incentives set out in the 1991 investment law,
including certain tax benefits, have never been implemented, or
have been largely eliminated or superseded by subsequent laws and
decrees.

Changes to the corporate profits tax code adopted in 2001
reduced overall corporate profits tax rates from 35 to 24
percent, but limit regional government incentives to reducing
corporate tax rates by up to 4 percentage points. The PSA
Chapter of the Tax Code enacted in June 2003 stipulates that 70
percent of purchased goods in each calendar year must be of
Russian origin. Purchased goods are considered to be Russian by
origin if they in turn have at least 50 percent Russian origin.
The PSA Chapter itself specifies that investors will be refused
cost recovery if they do not meet Russian origin rules. However,
the amended PSA Law acknowledges that changes will need to be
made to the Russian origin rules in case Russia joins the WTO.
The Russian auto decree, signed in early 1998, allows tariff
breaks for large investments in the auto industry (where
investment projects reach 50 percent domestic content levels
within five years). However, the Russian government has stated
that it does not intend in the future to enter into such
arrangements with investors. As mentioned above, the 1999
foreign investment law theoretically provides protection from
unfavorable changes in taxes or customs duties for certain
foreign investments exceeding USD 41 million. Implementing
legislation to enact such protections is still outstanding.

The GOR requires visas and residence permits for investors.
Work and residence permits must be renewed annually, which can
sometimes be a cumbersome process, as applicants may be required
to reapply at a Russian embassy overseas.

Investors in some sectors also may face restrictions
requiring that a certain percentage of staff be Russian citizens.

RIGHT TO PRIVATE OWNERSHIP AND ESTABLISHMENT

Both foreign and domestic legal entities may establish,
purchase and dispose of businesses in Russia. Investment in some
sectors, which are regarded as affecting national security
(insurance, banking, natural resources, communication,
transportation, and defense-related industries), may be limited.

The Land Code approved in 2001 allows foreigners to buy non-
agricultural land made available for private ownership and not
located near international borders. The Agricultural Land Code
allows foreigners to lease agricultural land for 49 years. In
2004, the Constitutional Court upheld the constitutionality of
the provisions of the Land Code permitting land sales to
foreigners, ruling that selling land does not affect sovereignty.

PROTECTION OF PROPERTY RIGHTS

The Constitution, and a presidential decree issued in 1993,
give Russian citizens general rights to own, inherit, lease,
mortgage, and sell real property (usually not including the land
on which it stands). Mortgage legislation enacted in 2004 should
make it easier for lenders to evict homeowners who do not stay
current in their mortgage payments. This should in theory make
mortgage lending (and the housing market) more attractive to
lenders and developers. Nevertheless, mortgage lending is only
in its initial stages. Land ownership is now regulated by the
October 2001 land code for non-agricultural land, although
development of implementing measures is still in progress. This
law permits foreign land ownership for non-agricultural land. A
land code for agricultural land was signed into law on July 24,
2002. This law does not permit direct foreign ownership of
agricultural land, but does permit leases of up to 49 years. The
rights of Russian citizens to own and sell residential,
recreational, and garden plots are now clearly established, with
over 40 million properties of this type under private ownership.

Intellectual Property Rights (IPR) violations continue to be
a serious problem in Russia. While Russia has made significant
advances in its efforts to improve its IPR protection regime,
many challenges remain. The U.S. is reviewing Russia's status as
a beneficiary country under the U.S. Generalized System of
Preferences (GSP) Program. Russia has also been on the Special
301 Priority Watch List since 1997, and will undergo an Out-of-
Cycle Review in early 2006.

U.S. copyright industries estimate they lose in excess of
$1.5 billion annually due to copyright piracy (films, videos,
sound recordings, books and computer software). Although five of
the six major U.S. film studios and several music producers now
produce and sell DVDs and CVDs in Russia at lower prices in order
to compete with pirates, this has not led to a noticeable decline
in the market share for pirate products, which U.S. industry
estimates at over 80 percent of for films and approximately 66
percent for music. The local business and entertainment software
industries, however, report declining levels of piracy. Internet
piracy has become a growing concern with the growth of internet
access, although the Russian government is beginning to make
efforts to combat both music downloading services as well as
websites that sell pirated music and software.

Russian law enforcement has recently taken a more aggressive
approach toward pirate optical disk producers. Since the start of
2004, law enforcement agencies have conducted raids on at least
half of the licensed optical disk plants in Russia. However,
cases often fail at the prosecution stage and few convictions for
IPR violations ever lead to prison sentences; judges are
prosecutors frequently lack expertise in the handling of IPR
violations or do not always regard them as serious crimes.
Corruption continues to be a problem; enforcement actions and
prosecutions are often undermined and products seized during
enforcement actions frequently return to the stream of commerce
even if they are found to be illegal.

U.S. investors also consider the Russian court system ill-
prepared to handle sophisticated patent cases. However, a
specialized higher patent chamber has been established at
Rospatent, which has brought greater expertise and efficiency to
resolution of patent and trademark disputes.

Despite concerted efforts, several other deficiencies remain
in Russia's IPR regime, including: a lack of explicit protection
for test data for pharmaceutical products and agricultural
chemicals; denial of national treatment for protection of
geographical indications; and problems with enforcement. As of
late 2005, the Russian government has proposed legislative
changes to address these concerns; however, these changes have
not yet made it through the Duma.

U.S. and multinational companies continue to report
counterfeiting of patented and trademarked goods as a serious
problem, especially for consumer goods, wine, distilled spirits,
pharmaceuticals and other products. Several U.S. firms have
also experienced problems with trademark piracy, with Russian
enterprises attempting to take over well-known foreign trademarks
not currently active in Russia, although rightsholders have been
moderately successful in countering these schemes through the
Russian court system or with Rospatent. U.S. firms need to take
steps to protect their intellectual property, including
registering their trademarks with the Russian Federal Service for
Intellectual Property, Patents and Trademarks (Rospatent).

The September 1992 law on topology of integrated
microcircuits, which also protects computer programs, protects
semiconductor topologies for 10 years from the date of
registration. Amendments to this law on topologies to bring
provisions into full WTO TRIPs compliance were passed in June
2002 and signed into law in July 2002.

Russia has acceded to the Universal Copyright Convention,
the Paris convention, the Berne convention, the Patent
Cooperation Treaty, the Geneva Phonogram Convention, and the
Madrid Agreement. The U.S.-Russia bilateral trade agreement
mandates protection of the normal range of literary, scientific
and artistic works through legislation and enforcement.

TRANSPARENCY OF THE REGULATORY SYSTEM

The legal system in Russia is still in a state of flux, with
various parts of government struggling to create new laws on a
broad array of topics. In this environment, negotiations and
contracts for commercial transactions are complex and protracted.

Russia has implemented only part of its new commercial code
(contained within the civil code) and investors must carefully
research all aspects of Russian law to ensure that each contract
conforms to Russian law and embodies the basic provisions of the
new, and where still valid, old codes. Contracts must likewise
seek to protect the foreign partner against contingencies that
often arise. Keeping up with legislative changes, presidential
decrees and government resolutions is a challenging task. Uneven
implementation of laws creates further complications; various
officials, branches of government and jurisdictions interpret and
apply regulations with little consistency and the decisions of
one may be overruled or contested by another. President Putin has
stressed the need for consistent application of national law, and
his seven regional Presidential Representatives have begun to
review regional legislation and regulations to ensure their
consistency with national law.

Legal requirements may be less burdensome than reaching
final agreement with local political and economic authorities;
registration of businesses can be a lengthy, bureaucratic
process, particularly where natural resources or defense
production are involved.

Corruption is widespread and the fears of some Russian
officials that foreigners will purchase Russian assets at below-
market rates can impede bureaucratic approval for foreign
investments. Environmental concerns are being raised more
frequently now by Russian officials at federal and local levels
as considerations in the approval process for investments.

A law on government procurement, adopted in May 1999,
contains a provision allowing foreign firms to participate in
public tenders if the product is not produced in Russia or if
Russian production is considered to be economically unprofitable.

The last major revision to the Russian Tax Code took effect
in 2001. It substantially amended chapters 21 (Value Added Tax),
22 (Excise Taxes), 23 (Personal Income Tax) and 24 (Unified
Social Tax). The effect of these reforms is to reduce the
nominal tax burden from 41 percent of GDP (only 37 percent
actually collected) to 31.5 percent in 2004. Six taxes were
abolished entirely: the 1.5 percent social and housing turnover
tax; the Employment Fund tax; the state border clearance fee;
vehicle tax; vehicle acquisition tax; and oil and lubricant
product sales tax. Further, the road users turnover tax was
reduced from 2.5 percent to 1 percent of turnover, and in June
2002 was abolished entirely, effective January 2003. With the
abolition of the road tax, no turnover (revenue) taxes remain in
Russia. The GOR plans to cut the total number of taxes to 15
(from the current number of 54), effective January 1, 2006.

Value-added tax (VAT) rates are generally 18 percent, but a
range of goods is taxed at 10 percent (largely foods, medicines,
and some items for children). Both domestic and foreign
companies exporting goods regularly complain that they are unable
in practice to receive refunds of VAT for exported goods.
Notable VAT tax changes include VAT tax relief for small
businesses, considerable clarification to deductibility rules,
reduction of import VAT exemptions, and an attempt to provide a
zero VAT tax on exports, although the VAT refund system still
does not function well. Effective 2006, the VAT rate will be
reduced to 16 percent.

In 2001, Russia moved to a flat individual income tax rate
of only 13 percent for residents and 30 percent for non-
residents, one of the lowest rates in the world. Deductions are
allowed for, inter alia, home purchase or construction and
exclusion of earnings on the sale of real property held for more
than five years. The GOR's strategy is to substantially expand
the current narrow tax base. In 2001, that strategy proved
successful as both compliance rates and revenues increased
substantially.

Excise duties are levied only on alcoholic beverages,
tobacco products, cars, motor fuel, and oil. Excise duties on
oil and natural gas increased considerably in 2005 -- oil and gas
duties rose from R5 to R66 per ton, and gasoline duties rose from
R585 to R1850 per ton. Excise taxes on natural gas exported to
CIS countries will fall from the current 30 percent to 15
percent. The new law expands the list of dutiable activities and
objects, but several additional transactions became exempt,
including exports performed by the producer of the goods (except
oil). In August 2004, the GOR introduced a new system of mineral
extraction taxes for oil and export duties on oil and oil
products solely dependent on the level of Urals export prices.

The two changes together mean the marginal tax rate on a
barrel of exported oil is 90 percent when the oil price is above
$25/bbl. However, the Russian government is considering a
revision of the tax structure following complaints from Russian
oil companies. There will likely be some easing of the tax
burden in 2006. These new rules heighten the sensitivity of
federal budget revenues to oil prices: the mineral extraction tax
and export duties (98 percent of which are oil and gas tariffs)
make up 33 percent of total budget revenues.

Amendments to the Corporate Profits Tax were signed into law
in 2001, effective January 2002. The amendment lowered corporate
profit taxes to 24 percent, and allowed many more deductions than
under the old law, but eliminated partial and full tax exemptions
(including the capital investment exemption). Regions are
allowed, at their discretion, to grant a 4 percent tax reduction,
effectively lowering the profits tax rate to 20 percent. Many
regions have, in fact, done this. For dividends/interest earned
by non-residents, the profit tax rate is 15 percent.

Several tax reductions came into effect starting in 2004.
The sales tax and the natural gas excise tax were both abolished.
To compensate for losses in federal revenue, the bill included a
gas extraction tax of 107 rubles (USD 3.52) per 1,000 cubic
meters, a five percent increase in the crude oil extraction tax,
and increases in various excise taxes. Lost local sales tax
collections were covered by increased federal government
transfers of revenues from taxes on small and medium enterprises,
excise taxes on motor fuel, land taxes, and 50 percent of the
alcohol excise tax. The export tariff on gas rose from 5 to 28
percent. Effective January 1, 2005 the Unified Social Tax, which
is paid by employers and covers pensions, healthcare and social
security, dropped from an effective rate of about 30 percent to a
top rate of 26 percent on salaries up to 280,000 rubles (about
$10,000) per year.

Since the Yukos affair, major taxpayers have been less
likely to engage in aggressive tax optimization schemes than in
years past. Nevertheless, the "fear" factor associated with the
Yukos case is not the only motivation behind most firms' decision
to review their accounting procedures and improve their tax
behavior. Straightforward market forces are driving businesses
toward more transparent accounting practices. For example,
firms with clean books have an easier time accessing foreign
capital and drawing foreign investors than their shadier
competitors. In addition, more companies, both foreign and
domestic, are taking their tax disputes to the courts, which are
reportedly becoming more competent at adjudicating tax cases
fairly. As a result, tax compliance levels are gradually
increasing, as evidenced by record high tax revenues in 2005.
Nonetheless, problems in the tax environment remain. Companies
often have little recourse other than the courts during tax
disputes. While firms have successfully appealed to the courts,
tax authorities are often slow to implement judicial decisions.
Penalties for non-compliance include confiscation and a company's
accounts can be frozen relatively quickly. In early 2005,
President Putin acknowledged the negative impact of the tax
environment on the business climate when he called for an end to
"tax terrorism." In response to the President's order, the
Government submitted a substantial package of amendments to the
Duma designed to increase transparency and consistency in the tax
environment. Russian legislators are currently reviewing the
amendments, which are scheduled to be put into effect in early
2006.

EFFICIENT CAPITAL MARKETS AND PORTFOLIO INVESTMENT

The Russian banking system remains relatively small, with
$14.2 billion in aggregate registered capital as of August 1,
2005. Recent data indicates that only 39 of Russia's 1,228 banks
are wholly foreign-owned. In April 2005, the GOR and the Central
Bank of Russia adopted the Banking Sector Development Strategy
through 2008. According to official sources, the strategy seeks
to enhance the stability and efficiency of the banking sector by:
increasing the protection offered to depositors and creditors;
enhancing the banking sector's role as a primary intermediary for
household and commercial credit operations; improving the Russian
banking sector's competitiveness; protecting the financial sector
from illicit activity such as money laundering and the financing
of terrorism; improving transparency in the sector; and building
up investor, creditor, and depositor confidence in the banking
sector. In September 2005, the CBR completed its review of all
banks that sought admission to the recently established Deposit
Insurance System (DIS). To gain admission to the DIS, a bank had
to verifiably demonstrate to the CBR that it complies with
Russian identification and transparency requirements. Currently,
927 of Russia's estimated 1200 banks have been admitted to the
DIS, effectively weeding out over 200 banks from Russia's banking
system.

Twelve stock exchanges operate in Russia. The dominant
exchanges are in Moscow, and include the Russia Trading System
(RTS) and the equity trading floor on the MICEX (Moscow Interbank
Currency Exchange). The RTS rebounded in 2005 with net profits
increasing by 100% over 2004. Turnover exceeded $57.7 billion in
2005, showing an increase of 50% over 2004. Over the year,
average daily volume on the RTS increased 44% to $31 million,
with greater average daily volumes of $44 million recorded in the
second half.

Although the RTS is more diversified, average trade volumes
on the MICEX stock exchange are much higher than on RTS. In 2005
(through November) average daily trade volume was $556 million,
up from $448 million in 2004. MICEX was still dominated by RAO
UES shares in 2005, though the UES share fell from about 50
percent in 2004 to 37 percent in 2005. Other leading stocks in
2005 were Lukoil (25 percent, up from 15 percent in 2004),
Norilsk Nickel (12 percent, up from 6.5 percent), Rostelecom (6.8
percent, up from five percent), Surgutneftegaz (6.5 percent,
slightly down from 6.7 percent in 2004) and Sberbank (avg 3.2
percent in 2005).

After not operating during 2004, the Moscow Stock Exchange
began a restructuring process in April 2005 and resumed trading
activity in August 2005, though the level of trading activity has
been low. Gazprom shares accounted for up to 95 percent of
trades on the MSE from 1997 to 2003, and the new managers are
attempting to diversify the trading activity. Several Russian
regional centers have their own stock exchanges, but trade
volumes outside Moscow tend to be low. Regional exchanges are
still dependent on Moscow-based participants.

Amendments to the law "On the Securities Market," which
entered into force in 2003, included definitions of corporate
bonds, mutual funds, options, futures and forwards -- all of
which provide a sounder legal basis for these markets. Companies
offering public shares are required to disclose more information
during the placement process as well as in quarterly reports. In
addition, the responsibilities of financial consultants helping
companies with their stock offerings are now clearly defined, and
they will be held liable for accuracy of the data presented to
shareholders. Also, the amendments define "price manipulation,"
giving the FSFM authority to investigate and punish violators of
this practice. However, the amendments did not cover insider
trading, which is the subject of another bill that is currently
stalled in the Duma, as there is strong lobbying against it. In
December 2004, the Duma also approved a number of amendments to
the law "On Mortgage Securities" as part of the housing reform
package in an effort to facilitate the issuance of mortgage-
backed securities while protecting individual investors.

The corporate bond market is currently the most rapidly and
dynamically developing sector in Russia's capital markets. High
and increasing demand from enterprises for funds in the absence
of an effective system of bank lending is the main driver of
growth. It is also boosted by weaknesses in other current
characteristics of the market: the absence of more attractive
ruble-denominated alternative asset classes, low and even
negative real interest rates on the secondary OFZ/GKO market, the
absence of speculative opportunities on the currency market, and
a large and increasing volume of rubles caused by dollar oil
export earnings flowing into Russia. 2005 saw a record high
amount of RUB 270 billion raised in the corporate bond market,
compared to RUB 145 billion in 2004.

Even though the corporate bond market is rapidly developing,
it suffers several problems. The market is still quite narrow.
It is very difficult to provide the necessary level of liquidity
for relatively small issues, even if the issuer is a blue-chip
company. Another problem is the expense of preparations,
including development of each issue's parameters, prospectus
registration, underwriting services, etc. Also, a 0.8 percent
issuance tax adds to the expenses of the issuer. Another barrier
to the growth of the market is a provision of the federal law "On
Joint Stock Companies", which requires the volume of a bond issue
not to exceed a company's authorized (charter) capital.

The banking sector remains one of the weakest legs in the
Russian reform program. Despite measured progress in several
areas, the Russian banking system is not yet efficiently
performing its basic role of financial intermediary (i.e. taking
deposits and lending to business and individuals). As
illustrated by the summer of 2004's mini-banking crisis, the
public still lacks confidence in the banking sector.
Approximately one third of the population still prefer to keep
their personal savings "under the mattress" rather than trust
their savings to banks. Yet, this year's successful
implementation of the Deposit Insurance System proved a critical
psychological boon to the sector, evidenced by this year's growth
in overall deposits. Although Sberbank remains the largest bank
in Russia by a large margin, the sector has made some progress
toward diversification. Sberbank faces increasing competition
from the second largest state bank, Vneshtorgbank, as well as
from several other significant contenders (including Gazprombank,
Alfa Bank, and MDM Bank). As evidence of this increasing
diversification of the banking sector, Sberbank's share of retail
deposits has dropped to less than 40 percent in 2005, compared to
the 60 percent it held less than two years ago.

POLITICAL VIOLENCE

Although the use of strong-arm tactics is not unknown in
Russian commercial disputes, post is not aware of any cases where
foreign investments have been attacked or damaged for political
reasons. Russia continues to struggle with an ongoing insurgency
in Chechnya, and the Chechen Republic and neighboring regions in
the northern Caucasus have a high risk of violence and
kidnapping.

CORRUPTION

Corruption remains a serious problem in Russia, with the
country ranking 126th on Transparency International's (TI's) 2005
Index (with a score of 2.4). TI's report noted that Russia's
drop from 2004 (from 90th place and a score of 2.8) was so severe
that it likely reflects a statistically significant drop in the
perceptions of corruption here. U.S. firms have identified
corruption as a pervasive problem, both in number of instances
and in the size of bribes sought.

Under the Russian Criminal Code (Articles 290 and 291)
giving and receiving bribes are criminal acts carrying prison
sentences of up to 12 years. However, Russia has not
criminalized bribery of foreign officials. While there are
regular prosecutions related to bribery, there have been few high-
profile, apolitical prosecutions that would send a clear
deterrent message. In addition, bribery and other corruption
issues are handled by the police, who are seen by the public as
one of the most corrupt government institutions. Strict
documentary requirements applied to tax deductions for business
expenses make it very unlikely Russians would be able to take tax
deductions for bribes.

Corruption in commercial and bureaucratic transactions and
problems with the implementation of customs regulations also
inhibit investment. Customs officials are extremely inconsistent
in how they apply the law. Investment would benefit from
improved dispute resolution mechanisms, the systematic protection
of minority stockholders rights, conversion to international
accounting standards, and the adoption and adherence by companies
to business codes of conduct. Successive Russian governments
have designated the fight against corruption as a priority task
of government due to its economic costs (particularly the
deterring of foreign and domestic investment and encouragement of
capital flight).

President Putin has repeatedly stressed that enforcement of
laws is a high priority of his administration, and has
periodically focused attention on corrupt practices. However,
initiatives to address these shortcomings, either through
regulation, administrative reform or government-sponsored
voluntary codes of conduct, have made little headway in
countering endemic corruption. More transparent implementation
of customs, taxation, licensing and other administrative
regulations is necessary.

Russia signed the UN Convention against Corruption in
December 2003. The OECD Convention is currently on President
Putin's desk awaiting signature. Transparency International and
other NGOs are interested to see if he will sign it before the G8
Summit in St. Petersburg in July.

BILATERAL INVESTMENT AGREEMENTS

In 2005 the Russian Duma did not actively consider signing
the Bilateral Investment Treaty (BIT) between the United States
and Russia that was signed in 1992 and ratified by the U.S Senate
that same year. Despite the passage of a new law regulating
foreign investment in June 1999, Russian foreign investment
regulations and notification requirements can be confusing and
contradictory. The law on foreign investment provides that a
single agency (still undesignated) will register foreign
investments and that all branches of foreign firms must be
registered.

Russia inherited from the Soviet Union 14 bilateral
investment treaties (BITs) with Austria, Belgium and Luxembourg,
Great Britain, Germany, Italy, Spain, Canada, China, Korea, the
Netherlands, Finland, France, and Switzerland. They were
ratified in 1989-90 and came into force in 1991. Russia has
since negotiated another 34 agreements, of which 20 have been
ratified - with Greece, Cuba, Romania, Denmark, Slovakia, Czech
Republic, Vietnam, Kuwait, India, Hungary, Albania, Norway,
Yugoslavia, Lebanon, Macedonia, the Philippines, Egypt, South
Africa, Japan, and Moldova. However, in 2002 Russia requested
that all treaty partners re-negotiate BITs, professing concerns
that existing BITs may not be compatible with future WTO
obligations.

OPIC AND OTHER INVESTMENT INSURANCE PROGRAMS

In an agreement ratified in 1992, the U.S. Overseas Private
Investment Corporation (OPIC) was authorized to provide loans,
loan guarantees and investment insurance against political risks
to U.S. companies investing in Russia. OPIC generally insures
against three political risks: expropriation; political violence;
and currency inconvertibility. In 1994, to meet the demands of
larger projects in Russia (and worldwide), OPIC doubled the
amount of insurance and quadrupled the amount of finance support
- to USD 200 million in each case - it can commit to an
individual project (a total of USD 400 million). OPIC also makes
equity capital available for investments in Russia by
guaranteeing long-term loans to private equity investment funds.

Russia is a member of the Multilateral Investment Guarantee
Agency (MIGA). In December 2000, OPIC resumed coverage in Russia
for currency inconvertibility, coverage that OPIC had suspended
in September 1998 after the financial crisis. During this
period, OPIC remained on cover in Russia for its other services.
In FY 2005, OPIC provided $119 million in guarantees and
insurance for 29 projects, compared to $99 million for 22
projects in FY 2004.

In the event OPIC would need to pay a currency
inconvertibility claim, it would use the exchange rate in effect
on the date the claim is submitted.

LABOR

The Russian labor market remains fragmented, characterized
by limited labor mobility across regions, and consequent wage and
employment differentials. Although statistics are often
unreliable and many forms of unemployment are not counted,
unemployment, using International Labor Organization (ILO)
standards, was 7.6 percent of the workforce in October 2005.

Estimates reach over 40 percent in parts of the north
Caucasus. However, unemployment in Moscow is about one percent,
and average monthly incomes are approximately three times higher
than the national average, which was about USD 290 per month.
The rate of increase for official real salaries was 7.9 percent
in 1H05, exceeding GDP growth for the period of 5.7 percent.

Labor mobility continues to be restricted by an under-
developed housing and mortgage market, affordable housing
shortages in many cities, and the continued existence of
residency permits and registration. The availability of
subsidized housing and cultural ties often make workers reluctant
to move, and a lack of information about employment or housing
opportunities in other regions exacerbates the situation. This
lack of labor mobility across regions significantly affects wage
rates and employment. Nonetheless, labor mobility across
professions and within regions is improving, as workers attempt
to adapt to the needs of a market economy. The labor force is
generally well educated, though skilled labor has been in
increasingly short supply.

Total wage arrears were USD 340 million as of October 2005.
Strikes in the private sector are less frequent than they were in
the mid-1990s. Workers have increasingly pursued their demands
through the court system or used methods such as rallies and days
of action to call attention to their plight. Enterprises that
pay wages in full and on time generally have smooth labor-
management relations.

The trade union movement is still largely dominated by the
Federation of Independent Trade Unions of Russia (FNPR), which
inherited the bulk of the property of its Soviet predecessors and
consists of formerly governmental unions. Many new free trade
unions outside this confederation have begun to make significant
strides in defending their members' interests. In an effort to
wield more influence on national legislation and government
decisions, several national and regional free trade union
structures formed in 1995 the Russian Confederation of Labor
(KTR) and the All- Russian Confederation of Labor (VKT). In
November 2000, the International Confederation of Free Trade
Unions (ICFTU) accepted as members the KTR, VKT, and the FNPR.

The Russian government generally adheres on paper to
International Labor Organization (ILO) conventions protecting
worker rights, though enforcement is often lacking. In December
2001, President Putin signed into law a new Labor Code that came
into force in February 2002. The new Code seeks to diminish the
role of government in setting and enforcing labor standards and
to move toward more flexible labor markets. In the conceptual
scheme of the new Code, trade unions are expected to play a
balancing role in representing workers' interests. However,
there are significant gaps in the proposed scheme, including no
clear enforcement mechanisms for failure or refusal by an
employer to engage in good faith collective bargaining or other
obligations and provisions that favor designation of a majority
union as the exclusive bargaining agent. Worker safety is a
major unresolved issue, as enterprises are often unable or
unwilling to invest in safer equipment or to enforce safety.

FOREIGN TRADE ZONES/FREE PORTS

In 2005, the Russian government passed the Law on Special
Economic Zones (SEZs), which proposed the establishment of
industrial-production zones and progressive-technical zones
(focused on R&D) for twenty-year periods. In November 2005, the
government announced the results of a tender and the
establishment of six SEZs. Enterprises operating in industrial-
production zones (20 square kilometers) will pay lower unified
social taxes (with the highest rate reduced from 26% to 24%) and
those within progressive-technical zones (2 square kilometers)
are allowed to write-off all R&D expenses. Both types of zones
will benefit from reduced land and property taxes and a waiver of
customs duties on imports and finished exports. The tender
process will continue in 2006, with more SEZs to be designated.

The SEZ in Kaliningrad, which allows goods to be imported
duty-free as long as they are not re-exported to the rest of
Russia, has been able to attract some moderate investments. An
SEZ in Magadan has attracted minor amounts of investment and the
SEZ in Nakhodka has reportedly never been implemented. Many
larger foreign investors see little advantage to establishing
within one of the proposed SEZs, as investment incentives offered
by local administrations are often more attractive than the SEZ
benefits.

FOREIGN DIRECT INVESTMENT STATISTICS

Table 1 shows flows of foreign investment by country for the
first nine months of 2005, compared to the same period in 2004.
Contrary to recent years, the first nine months of 2005 showed a
decrease in foreign investment flows over the same period in the
prior 2004. Note that Russian statistical practice counts total
investment as including direct investment, portfolio investment,
and "other" investment (largely trade credits). Cyprus
consistently figures high as an investor because most investment
coming from Cyprus is actually returning Russian capital.

Table 1: Top Ten Investors - By Year (in USD million)

Country Jan-Sept. 2004 Jan-Sept. 2005

UK 4,856 5,003
Netherlands 3,587 4,055
Luxembourg 6,757 3,630
Cyprus 2,850 3,255

Switzerland 1,048 1,546
Germany 1,168 1,388
USA 1,624 1,167
Virgin Islands (UK) 553 833
Bahamas N/A 559
France 1,925 540
Japan N/A N/A
Austria 568 N/A
All Others 4,767 4,853
Total 29,135 26,829

(Note: As of 2001, the Federal Service for State Statistics
stopped providing breakdowns of direct and portfolio investment
in its yearly statistics, and started instead providing this for
accumulated investment (table 2).)

The numbers in Table 2 can only be taken as a general indication
of the stock of investment activity identified with a given
country. This does not represent an accumulated stock of direct
investment because these figures include portfolio and "other"
investment and do not reflect any withdrawal of funds or
decreases in value of assets. Although the U.S. fell behind the
Netherlands and Cyprus in terms of direct investment in 2004 and
2005, this is largely due to Royal Dutch/Shell's USD 11 billion
investment in Sakhalin and returning Russian capital from Cyprus.
Note that although Germany continues to show a larger stock of
total investment than the U.S., a large proportion of German
investment consists of "other" investment, primarily trade
credits.

Table 2: Top Investors - Accumulated Basis (Amounts in USD
Million)

Country Jan.-Sept. 2004 Jan.-Sept. 2005
Total FDI Total FDI

Cyprus 9,580 5,545 17,576 12,682
Luxembourg 10,560 280 16,101 399
Netherlands 10,678 7,858 15,586 12,085
UK 7,422 1,460 9,642 1,802
Germany 9,378 2,410 9,321 2,587
USA 6,670 4,207 7,157 4,361
France 4,206 364 3,483 424
Switzerland 1,608 738 2,179 1,015
Virginia Islands (UK) 1,611 873 2,151
1,382
The Bahamas N/A N/A 1,801 639
Japan N/A N/A N/A N/A
Austria 1,140 262 N/A N/A
All Others 10,576 5,772 11,477 5,954
Total 73,429 29,769 96,474 43,330

Source: Federal Service for State Statistics (FSSS)

Table 3 shows foreign investment by region over the first nine
months of 2005, compared to the same period in 2004. Moscow city
attracted the largest volume of investments, mainly due to
concentration of companies' headquarters that guarantees
attraction of investments. Moscow also has the largest
concentration of consumers with high purchasing power.

Table 3 - Foreign Investment - Top Regions

Jan-Sep 2004 Jan-Sep 2005
Amount % Rank Amount % Rank
Moscow (city) 11,796 40.5% 1 11,438 42.6% 1
Sakhalin 2,774 9.5% 3 3,743 14.0% 2
Moscow Region 1,292 4.4% 4 1,772 6.6% 3
Omsk Region 811 2.8% 7 1,620 6.0% 4
Sverdlovsk Region 427 1.5% 11 967 3.6% 5
St. Petersburg 651 2.2% 8 899 3.4% 6
Chelyabinsk Region 210 0.7% 12 647 2.4% 7
Republic of Sakha (Yakutiya) 520 1.8% 10 596 2.2% 8
Samara Region 592 2.0% 9 483 1.8% 9
Arkhangelsk Region - - - 577 1.8% 10
Vologda Region 1,054 3.6% 5 419 1.6% 11
Kemerovo Region - - - 416 1.6% 12
Krasnoyarsk Region 921 3.2% 6 376 1.4% 13
Khanty-Mansiisk region-Ugra 3,899 13.4% 2 66 0.2% -

Others 4,187 14.4% 3,354 12.5%
Total 29,135 100.0% 26,829 100.0%

Source: Federal Service for State Statistics (FSSS) (Note:
Includes direct, portfolio and other investment.)

Tables 4a and 4b show investment by sector over the first nine
months of 2005. Investment in trade and catering continued to
lead all sectors as of September 2005.

As of January 1, 2005, Goskomstat has changed its methodology for
calculating industry-related statistics. It no longer breaks the
data down by sector; rather it groups it into three categories:
(1) extraction of raw materials, (2) manufacturing, and (3)
production and distribution of electricity, gas and water. While
the new standard conforms to EU methodology and makes cross-
country comparisons more relevant, it makes comparisons to the
prior year more difficult.

Table 4a: Foreign Investment: Top Sectors - 2004 (Amounts in USD
Millions)

Jan-Sep 2004
% Amount

Trade/Catering 32.8% 9,557
Fuel Industry 24.2% 7,055
Non-Ferrous Metallurgy 6.9% 2,003
Ferrous Metallurgy 5.1% 1,478
CASM 3.9% 1,133
Food Industry 3.5% 1,019
Communications 3.4% 1,003
Machine Building 2.6% 771
Lumber Industry 2.4% 705
Finance 2.4% 691
Chemical and Petrochemical 2.1% 605
Transport 1.7% 486
All Others 9.0% 2,629
Total 100.0% 29,135

Table 4b: Foreign Investment: Top Sectors - 2005 (in USD)

Jan-Sep 2005
% Amount
Trade/Catering 32.2% 8,634
Extraction of Fuel 14.4% 3,856
Metallurgy 9.2% 2,471
Communications 7.1% 1,892
Real Estate and Related Services 6.8% 1,823
Finance 5.1% 1,376
Chemical Industry 3.0% 804
Food Industry 3.0% 801
Lumber Industry 1.9% 517
Equipment and Finished Metal Goods 1.9% 509
Transport 1.3% 361
All Others 46.3% 12,419
Total 100.0% 26,829


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