In the 1990s, analysts heralded the rise of Russia’s Far East as the next Asian tiger, destined for exponential economic growth as seen in Japan, South Korea and China. Post-Soviet liberalisation created an air of expectation in the investment community like a 19th-century gold rush.

Tony Meleca, then owner of a small Los Angeles-based translation firm, was one of them. “With our major target translations being in Russian, Japanese and Korean, and multinationals going in, we thought it was the perfect opportunity,” he says.

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Investors large and small rushed to the region seeking their fortune – and with good reason. The Russian Far East has it all: the vast mineral resources of Chita on the eastern border of Siberia, gold and diamonds in Sakha, forestry in Amur, Khabarovsk and Primorye, and petroleum and gas in Sakhalin.

To make it even more appealing, this plethora of potential is packaged within a short trip from the dynamic north-east Asian region. Vladivostok is a morning train trip from Dalian, China, an afternoon flight from Seoul, Beijing or Tokyo, or an overnight ferry from South Korea or Japan.

Harsh reality

Such was the enthusiasm for the Russian Far East that by 1994 it accounted for 20% of venture partnerships between Russian private companies and foreign investors, despite accounting for only 5% of gross national product. But for small and medium-sized enterprises in particular, the gold rush expectations of the 1990s did not match the harsh reality on the ground.

“As soon as I arrived I knew I had made a mistake,” says Mr Meleca. “People started coming at us from all directions, looking for money.”

For some, it was the delay in train departures, or the inexplicable cancellation of afternoon flights. For others it was the overnight ferries, which were heavily listing rust buckets with engine troubles that routinely took long and dark detours along the North Korean coast to avoid bad weather. But for most, it was the endless general graft, bureaucratic hassle and incompetence one encountered before even leaving customs control at the terminal.

“You can definitely say that corruption in Russia and Vladivostok flourished,” says Alyona Sokolova, editor of Vladivostok’s English language daily VladNews. She is privy to what many SME investors wish they had known in the 1990s: “If you want business to go smoothly, one should pay ‘fees’ to the right people to have fire inspection done, to have sanitary inspection done, to have tax inspection done, to have any kind of inspection done, and the list never ends.”

Power vacuum

The post-Soviet power vacuum not only allowed corruption to flourish, but also resulted in a substantial increase in organised crime. During the 1990s, organised criminal syndicates intimidated the Far East region with kidnappings, car bombings and extortion of all kinds. Corruption and crime in Russia came to be epitomised by the notorious situation there. In the western media, the region quickly became known for its ‘Wild West frontier’ atmosphere.

The investors left as fast as they came. Mr Meleca left after being persuaded by what he calls “uncouth thugs” to give up bidding for a translation contract. Crime and corruption drove out the SME investors and the benefits they brought to local economies, leaving only the large multinationals.

New enthusiasm

Today, expectation is back. Not pie-in-the-sky, gold-rush-fever expectation, but expectation based on cold, hard, rational business decisions. The potential for profit remains but this time it is being approached with caution, tenacity and, above all else, cognisance of the ongoing risk.

Fuelling these new-found expectations is the commodities boom and the rising price of oil. Chinese demand has created a sellers’ market for just about every raw material that can be pulled out of the ground in the Russian Far East. Iron ore, coal, petroleum and natural gas serve as stunning examples of why expectation has returned.

Iron ore in demand

In the past three years, iron ore prices have more than doubled on the back of Chinese demand. China is now the world’s largest importer of iron ore, ahead of Japan and South Korea. Together, these three countries account for 60% of world iron ore imports. Russia is already the fourth largest producer of iron ore, after Australia, Brazil and China (where demand far outweighs domestic supply). The Russian Far East could not be in a better position to supply the three Asian giants.

Importers of iron ore need energy to use it. Coal and gas prices have risen commensurate with rising demand for ore. Russia is the fifth largest producer of coal in the world. With domestic demand accounting for all but 10% of production, exports would not seem to play a large role. However, smaller deposits being exploited in proximity to China are beginning to play a greater role as the cost of shipping coal from distant sources such as Australia and South Africa increases.

If petroleum and natural gas are the jewels of the Russian Far East, then Sakhalin is the crown. Conservative estimates of oil deposits off the coast of Sakhalin match and even surpass the known reserves of Saudi Arabia. Mitsui, Mitsubishi, Marubeni and Shell are among the big players that have committed themselves to Sakhalin’s energy resources.

There are even plans for natural gas from Sakhalin to be used in electricity generation for the entire north-east Asian region. The plans for the Unified Power Grid of Russia envisage the construction of two large-scale power production plants on Sakhalin Island with a combined output of 24 billion kWh, and the amalgamation of power grid systems in the Russian Far East, Japan, China, North Korea and, ultimately, South Korea.

On the back of these massive projects ride the SMEs. Smaller firms are returning to undertake sub-contracts in environmental monitoring, human resources, education, accommodation, business services, maintenance – and translation. Tony Meleca is one of them. “I think the environment has changed enough, but I’ll still be wary,” he says.

Moscow’s role

It is not only the commodities boom and rising oil prices that are reigniting interest in the Russian Far East. The scales of administrative power have begun to tip in favour of Moscow. The government of President Vladimir Putin came to power on a platform of restoring Moscow’s control over the regions, most notably the Chechen Republic, but the Far East was also firmly in his sights. This culminated in a now-infamous telephone conversation between Mr Putin and allegedly corrupt Primorye governor Yevgeny Nazdratenko, convincing the latter to resign. For SME investors, this potentially means less discrepancy between federal and regional regulations and possibly less corruption.

Another promising light on the horizon is Russia’s entry to the World Trade Organization. While little will change immediately, the transparent, predictable and non-discriminatory rules-based trading environment will influence commercial relations in Russia in the longer term. Similarly, Russia’s presidency of the Group of Eight industrialised nations in 2006 is inviting further external scrutiny of the economy and its administration.

Risks remain

There are inherent risks in the Russian Far East that investors, both large and small, need to monitor. Geopolitical issues remain important. Russia has good relations with both China and Japan, but unresolved issues stoked by nationalist tendencies threaten improvement in both the long and short term.

In the short term, nationalist sentiment on the domestic political scene prevents Russia from resolving territorial disputes with Japan regarding the future of the Kurile Islands. The Soviet Union occupied the Kurile Islands at the end of World War Two but failed to agree to terms for their return. While the post-Soviet Yeltsin government got close to settling the dispute in return for Japanese financial assistance, nationalist political interference prevented the conclusion of a deal. Failure to agree to a settlement prevents more substantial Japanese investment outside of the oil and gas sectors.

In the longer term, China presents both an opportunity and a threat. It is estimated that by 2010 the population of the Russian Far East will amount to about 6.7 million. In comparison, the population of north-east China will be about 120 million. Given such a difference in population and the even greater difference in population density, the Russian region could face social disruption and possibly even claims to territory formerly held by China.

Substantial increases in Chinese migration to the Amur, Khabarovsk and Primorye regions have already caused concern in the Far East region. The darker side of growing nationalist sentiment has been intermittently demonstrated with occasional racist attacks on people of Asian appearance.

Most locals know that the future of the region lies with China and Japan, but as Ms Sokolova says, interests from Moscow continue to dominate the local scene. “All ports and major plants are under Moscow management. Vladivostok could have developed in its own way commercially in the Asian direction if given a chance, but it has been exploited by Moscow,” she says.

Other risks remain but are slowly eroding. Corruption and crime are still issues. Russia continues to rank among the worst performers in Transparency International’s corruption perception index. The country’s 2005 corruption perception index score put it in the same group as Albania, Nigeria and Sierra Leone.

It would not be fair to say that nothing is being done, though. Efforts are under way to combat corruption. The federal and regional administrations are beginning to heed international concern over the level of corruption and crime in Russia, and in the Far East in particular.

Irina Besedina, chief of foreign relations for the Khabarovsk Krai (administrative region) government, says that administrative reform to combat corruption is well under way. “One of the major goals of the newly formed Foreign Investor Advisory Council is to prevent corruption,” she says.

Under direct control of the governor’s office, the councils co-ordinate responses of the regional authorities. “Any investor can refer corruption issues to these organisations, as well as to the Khabarovsk Krai Foreign Investment Promotion Agency,” assures Ms Besedina.

At the federal level, efforts are also under way to combat corruption. Appointees to law enforcement agencies from outside the region are being made to break the chain of corruption between law enforcement, judiciary and government.

Even more promising, the non-government sector is playing a bigger role in making crime and corruption less welcome. In 1997, the Law School of the Far East State University established the Vladivostok Centre for the Study of Organized Crime. The centre has since earned an international reputation for studies on corruption and money laundering in Russia.

Expropriation

Although the return to strength of the federal government has reduced crime and corruption in the Far East, it is also, ironically, a risk factor for foreign investors. Expropriation of assets by Moscow and its allies in regional administration has become a feature of Mr Putin’s Russia, as demonstrated by the 2003 government takeover of Yukos.

Moscow has stated its aim to nationalise specific strategic enterprises: it has negotiated control of energy company Sibneft and carmaker AvtoVAZ, and plans to create national champions in the vehicle, aeronautics and gas transport sectors. Although such moves may or may not represent a change in the privatisation trend, they do present an inherent risk to be considered prior to investment.

The Russian Far East holds potential for the (cautious) small and large investor alike. As Ms Besedina states demurely: “Do not be scared to invest in Russia. The investment climate here is much more favourable than it often appears from foreign publications.”