[lbo-talk] From shock therapy to consumer cure: Russia's middle class starts spending

Chris Doss lookoverhere1 at yahoo.com
Tue Oct 31 08:33:04 PST 2006


Financial Times October 31, 2006
>From shock therapy to consumer cure: Russia's middle
class starts spending By Neil Buckley

Just off Revolution Avenue in the Russian city of Voronezh 15 years ago stood a state-owned pelmennaya, a grubby cafe where surly matrons slopped greydumplings into chipped bowls. Today, it is a franchise of Mango, the Spanish fashion chain - all smoked mirrors, halogen spotlights and low-rise jeans.

"The prices are still quite high for us," muses Vera Cherkasova, a lawyer with a property company, admiring a tailored woollen cardigan. "But Russian women are prepared to spend a bit on looking nice."

Next door, the former Niva food store, which in the Soviet Union's dying days sold little beyond tinned fish and lumps of lard, is now an Adidas franchise. The once-dowdy Rossiya department store nearby is a mini-mall with franchises of Benetton and Diesel. Grocery shoppers can choose from numerous modern supermarkets, two Russian-owned hypermarkets and a cash-and-carry run by Germany's Metro. Little by little, cappuccino bars and mobile phone stores, McDonald's outlets and Irish pubs are transforming this 1m-strong regional capital - even though the roads and other government services are worse than ever.

What is happening in Voronezh, 300 miles south of Moscow, is a powerful new phenomenon. Western-style retailing and international brands, largely confined a decade ago to metropolitan Moscow and St Petersburg, are spreading to cities across Russia. After the hardships of the 1990s, Russia is finally witnessing the rise of a prosperous post-Soviet middle class.

Politically and economically, this has become one of the most important, and least talked-about, trends in Russia today. While international attention has focused on President Vladimir Putin's increasingly authoritarian approach, that tends to obscure what many Russians believe to be his main legacy - the extent to which they have, materially, become better off under his presidency.

Some international observers feel, moreover, that if democracy, press freedom and the rule of law are to flourish in Russia, that may depend on an assertive middle class pushing for such rights.

Those economic conditions are being created. Although the country is known abroad primarily as an exporter of raw materials, companies from carmakers to cosmetics giants now list Russia alongside China and India among their most dynamic consumer markets.

"What's happening here is very exciting. We're running to keep up," says A G Lafley, chairman of Procter & Gamble, who was in Moscow last month to celebrate the consumer group's 15th anniversary in Russia. Richard Smyth, general manager in Russia for Mars, echoes this, pointing to new production lines at a $200m (£105m, €157m) chocolate factory south of the capital. "Basically", he says, "we can't build it fast enough".

The consumer boom is the fruit of nearly eight years of economic growth averaging 6.6 per cent - thanks in part to record oil and natural gas prices - since Russia's debt default and financial crisis in 1998. Real wages and consumer spending are growing twice as fast. The average monthly wage was up 13.6 per cent year-on-year in September to $415 - still low, but four times what it was when Mr Putin became president in 2000.

Low housing and utility costs mean a relatively high proportion of Russians' wages goes straight into disposable income. A lingering suspicion of banks, born of the 1998 crisis, also means spare cash is more likely to go into flat-screen television sets or washing machines than into savings accounts.

Russians are less wary of borrowing, however. Consumer credit has mushroomed from zero a few years ago to about $40bn - though at barely 5 per cent of gross domestic product, one-tenth of western European levels, there is plenty of room for growth.

Yet despite the progress, yawning inequalities exist - and overall trends are not wholly encouraging. Tatyana Maleva, a sociologist at Moscow's Independent Institute for Social Policy, led a study in 2000-01 of Russia's social structure. Analysing salaries and factors such as savings and property ownership, she classed fewer than 1 per cent of Russians as a super-rich elite. At the other extreme, 10 per cent of the 144m population lived in real poverty.

In between, 20 per cent formed a more-or-less comfortable middle class; just under 70 per cent were lower middle class - struggling, but able to afford a few consumer luxuries.

The picture already differed sharply from Soviet times. Then, too, says Ms Maleva, there was a privileged elite and poor underclass. But 80-90 per cent of Russians formed a middle layer where modest income differences were partly smoothed out by the Soviet command economy's inability to produce goods for people to buy. (Many Russians amassed big rouble savings, only to see them wiped out by hyper-inflation triggered by the 1990s "shock therapy" reforms.)

Six years after her study, Ms Maleva says the overall picture has not changed. Russia's middle class is still around 20 per cent, but has got richer - because it includes those in thriving economic sectors such as natural resources and banking. The poor class has shrunk a little, thanks partly to government social programmes. But few of the 70 per cent lower middle class have made the jump to the next rung, its members working largely in the public sector or less successful parts of the economy.

"While incomes have been rising, there are those who have been winners and those who received much less," says Ms Maleva.

But with tens of millions of Russians now having at least a foot in the door of the consumer society, foreign and domestic investors are starting to look beyond oil and gas. Apart from a few big energy and metals deals, acquisitions by Coca-Cola and Heineken and a big domestic retail merger have been among the largest transactions of the past 18 months.

Russia's "oligarchs" have spotted the consumer market as a growth opportunity largely free of the political risk and state interference now associated with energy. Mikhail Fridman, head of the Alfa Group conglomerate, is a big shareholder in the TNK-BP oil joint venture but has consumer exposure through Alfa Bank and a stake in Vimpelcom, a mobile phone group.

In his biggest consumer venture yet, Mr Fridman in April merged his Perekryostok supermarket chain with Pyaterochka, a St Petersburg-based discounter, to create Russia's biggest grocery retailer with nearly 900 stores and a target of $6bn annual sales by 2008.

"We believe retailing generally, and especially food retailing, will develop very fast here. And we are at the leading edge," says Mr Fridman.

Even $6bn sales would give the chain only a few percentage points of a large but unconsolidated food retail market, which the Economist Intelligence Unit forecasts will grow from $113bn last year to $203bn in 2010. It expects total retail sales will double in the same period from $245bn to $526bn - taking Russia from 12th- to ninth-biggest retail market in the world.

With "modern" formats - rather than markets, street kiosks or unrefurbished Soviet-era stores - accounting for less than one-third of the retail market, the opportunity is huge.

Strangely, perhaps, retailing's global giants have been slow to take up the challenge. Wal-Mart of the US, France's Carrefour and the UK's Tesco have so far stayed away, citing the risks and difficulties of operating in Russia. But Auchan of France, Germany's Rewe as well as Metro and Turkey's Migros Turk have all entered the Russian grocery market. France's Leroy Merlin, Germany's OBI and the UK-based Kingfisher are chasing consumers' roubles in the home improvement sector. Britain's Dixons last year acquired an option to buy Eldorado, a Russian electrical retailer, for $1.9bn by 2011.

Sweden's Ikea is playing a pioneering role by developing not just its own furniture stores but shopping malls alongside, housing partner retailers such as Auchan and OBI, multiplex cinemas and fast food courts. After three such Mega-Malls opened in Moscow since 2002 and one in Kazan, more are due to arrive over the next year in other 1m-plus cities - St Petersburg, Nizhny Novgorod, Yekaterinburg, Samara,Rostov-on-Don and Novosibirsk.

While other foreign retailers dither, budding Russian chains are scurrying to raise expansion capital before the competition arrives. Retailers are well represented among the flood of Russian initial public offerings on the London Stock Exchange.

In a headquarters surrounded by new shopping centres and apartments in a St Petersburg suburb, Oleg Zherebtsov, chief executive of Lenta, is one such retailer. He jokes that when his chain opened its first warehouse-style store in 1999, "we thought we had invented the concept". Now aware that it did not introduce hypermarket retailing to the world, Lenta still hopes to pioneer it in many Russian cities. It opened last month in Astrakhan and Novosibirsk, adding to nine existing St Petersburg hypermarkets with $700m annual sales.

Foreigners already dominate some consumer segments. Scottish & Newcastle and Carlsberg - which jointly own Baltika, the market leader - along with InBev and Heineken control much of a beer market that has doubled since 1999 to become the world's fifth biggest.

Similar changes are now expected in higher-value sectors. Sales of foreign cars grew 58 per cent last year to about 400,000, overtaking sales of local brands for the first time, and Boston Consulting Group forecasts they will reach 900,000 by 2010. That could put pressure on Avtovaz, maker of the Lada, which still churns out 70 per cent of all cars assembled in Russia.

Avtovaz is a rare case of state intervention in a consumer segment: Rosoboronexport, a state arms agency, seized control of the struggling Soviet-era behemoth last year and pledged huge investment. That may reflect the social and political importance of a manufacturer employing 120,000 and reckoned directly or indirectly to support up to half a million people.

But the government has encouraged foreign manufacturers to open assembly plants, provided they use some local components. Ford is adding more expensive models to lines that produce the Focus, Russia's best-selling foreign car. VW, Toyota, Nissan, General Motors and China's Great Wall are among 15 foreign manufacturers with existing or planned assembly lines, set to double the country's output to 2m cars a year within a few years.

As Russians get richer, entertainment and travel should also flourish. Restaurant menus are being translated into Russian in resorts across Europe, while Turkey and Egypt are becoming to Russians what Spain was for Britons in the 1970s. Mohamed Rachid, Egypt's trade minister, says 1m Russians visited last year, and the total could reach 1.5m in two years.

"Russian tourists coming to Egypt are the highest spenders," he adds. "They might take cheaper packages, but once there they spend more than all the other Europeans."

Could today's boom be followed by a 1998-style bust? With Russia's public coffers overflowing with petrodollars, and big efforts in recent years to reduce debts, a default looks a remote possibility. But dependence on energy and raw material exports makes the economy vulnerable to any correction in commodity prices. Even if the good times continue, growth in disposable incomes is expected to slow towards the level of overall GDP growth by about 2010.

One other big question remains: Why is Russia's Mango-clad, Ford-driving, Egypt-holidaying middle class not becoming more politically assertive? Some suggest Russians are too busy enjoying the comparative stability and prosperity the Putin years have brought to protest about the accompanying erosion of political and media freedom.

"In the early 1990s our people were paupers - and it's ridiculous to say they were free," Vladislav Surkov, a senior aide to Mr Putin seen as the Kremlin's chief ideologist, said recently. "When you have a car to ride in and things to buy - that's freedom."

A poll this month by the Levada Center, an independent pollster, showed how successful United Russia, the political party whose main credo is loyalty to Mr Putin, has been at capturing the support of the middle class (which Levada estimates at 15 per cent of the population rather than 20 per cent).

Middle-class support for United Russia was 55 per cent, against 48 per cent among the rest of the population. And support for the Communist party in the middle class was markedly lower than by others (8.5 per cent against 22 per cent). Support for the liberal Yabloko party - perhaps the closest Russia has to a western-style social democratic party - was a mere 5 per cent among the middle class and 3 per cent among the rest.

Stephen Jennings, chief executive of Renaissance Capital, a Moscow investment bank, believes pressure for change may grow out of more prosaic, but concrete, issues.

"You have a good job, you have money, you have a nice dacha, but you can't get there because the roads are so terrible," he says. "I think the next big wave of change will be more bottom-up. That's why this middle-class phenomenon is so powerful."

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