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Liberalization and Privatization Reforms
in Russian Telecommunications
 

Strategy for Quantum Investment Fund

Vladimir Gololobov

M.A. Project
Monterey Institute of International Studies

Table of contents

Scenario
Executive Summary
Background Analysis

Sectoral Overview
Monopolization Issues of the Sector
International and WTO Regulations on Telecommunications

Analysis of Policy Issues in the Russian Telecommunications Sector

Policy and Principles of Quantum Fund and George Soros
Disruptive Monopoly Tactics

  • Cross-subsidization
  • Interconnection
  • Skimming

Unemployment
Independent Regulator

Analysis of Commercial Issues

Commercial Goals and Benefits of Quantum Fund

  • Impact of the reforms on the revenues
  • Impact of the reforms on returns on investments
  • Strategies for market development

Projections of Svyazinvest Revenues, Profits, and Investments

  • Profits will rise from privatization and liberalization
  • Projections based on Chile’s experience
  • Reform’s impact on employment

Analysis of Economic Issues

Overall Macroeconomic Consequences of Reform
Economic Effects of Privatization
Economic Effects of Liberalization

Regulatory and Legal Analysis

Proposed Amendments to the Law "On Communications"
Development in Privatization Legislation

Political Analysis of Stakeholders

Stakeholders

  • Quantum Fund and Mustcom Limited
  • Presidential administration
  • Ministry of Communications and Information Technology
  • Regional authorities
  • Svyazinvest
  • Ministry of Trade and Economic Development
  • Ministry on Anti-Trust Policy
  • Ministry of State Property
  • Ministry of Agriculture
  • Citizens
  • State Duma

Recommendations and Strategy

Primary Objectives of Quantum Fund’s Strategy
Directions of the Strategy

  •  Cooperative and coalition building efforts
  • Strategy for the Executive branch
  • Strategies for the Legislative Branch
  • Media and Public Relations Strategy
  • Grassroots Strategy
  • International Strategy

Exhibits
Questions and Answers
Sample Media Advisory
Sample Press Statement
Time Frame
Budget Estimates
Chart of Interest Groups
Sample Testimony
Sample Letter to the Congressman
Sample Letter to the Editor
Sample Op-ed
Sample White Paper
 

Tables
Table 1. Svyazinvest Consolidation
Table 2. Employment in Telecom Sector
Table 3. Investments in the Russian Telecommunications Sector
Table 4. Financial Indicators of Largest Svyazinvest Companies
 

Charts
Chart 1. Internet Users in Russia
Chart 2. Svyazinvest’s Profits: Projections Based on Deutsche Telekom and CTC
Chart 3. Svyazinvest Revenues and Expenses: Projections Based on Deutsche Telekom
Chart 4. Svyazinvest Revenues and Expenses: Projections Based on CTC
Chart 5. Russian Employment in the Telecom Sector: Projection Based on CTC
Chart 6. Sectoral Investments: Projections Based on Chile
Chart 7. Mustcom Shares Distribution

Bibliography


SCENARIO  

In my Masters’ project, I assume the role of consultant to George Soros’ Quantum Fund. Quantum Fund helped initiate the privatization of the Russian telecommunications holding company “Svyazinvest.”  The management of Quantum Fund requested that I prepare a strategy to convince Russian authorities to promote the privatization and restructuring of Svyazinvest. These moves would be part of a larger process of liberalizing the telecommunications sector, and would help economically integrate Russia with the world.  
 


EXECUTIVE SUMMARY  

Quantum Fund is owned and managed by George Soros, a businessman and philanthropist committed to free market reforms. Quantum Fund owns 53%[1] of Mustcom Consortium, which owns 25% of Svyazinvest, the state-run Russian telecommunications holding company. The Russian government owns 75% of Svyazinvest, and is considering selling a 25% stake. By supporting further privatization of Svyazinvest, Quantum Fund would protect its original $1 billion investment. Political reality dictates that sufficient privatization will only occur concurrently with liberal market reforms in the telecom sector. Thus, Quantum should advocate both privatization and liberalization simultaneously.  

From a commercial standpoint, Quantum Fund should support liberalization reforms in the Russian telecommunications sector to increase competition, transparency, and predictability, and promote a level playing field for private, foreign, and state companies. The current telecom regime and government control over Svyazinvest’s subsidiaries constrain the company’s market potential. Quantum Fund can achieve better long-term profitability in a free market environment, where profits are determined by market forces rather than arbitrary non-transparent regulatory decisions. These reforms will meet WTO provisions on cross-subsidization, interconnection, and monopolistic regulations. Conforming to these provisions will accelerate Russia’s accession to the WTO.  

Privatization and liberalization in Germany and Chile expanded the telecom market, and increased profits of dominant providers. [2] Financial projections show that Svyazinvest profits will increase to $1.7 billion in 10 years, making it possible for Quantum Fund to recuperate its investments entirely in 8 years, as opposed to 25 years under the current regime. Quantum Fund is convinced that reforms will result in higher profits, and will increase the value of Quantum’s shares in Svyazinvest. Privatization will protect Quantum’s existing investment, increase its share of ownership and control, and attract more operating capital.[3] Liberalization will allow Svyazinvest to compete under free trade where prices are determined by market forces.[4] Reforms will remove heavy social obligations from Svyazinvest subsidiaries. As a result of reform, Svyazinvest subsidiaries will be able to expand their market shares to data transmission, Internet, and mobile services. Quantum Fund’s manager, George Soros, is committed to both privatization and liberalization in spreading free market reforms in emerging markets. Mr. Soros would not seek privatization alone, simply buying into a monopoly, and relying on continued monopoly protection.  

The government sale of 25% of Svyazinvest, along with telecom liberalization, will ensure the continuity of reforms both in the telecommunications sector and in Russian industry as a whole. The Russian government should proceed with the next bidding contest as soon as possible. By giving private companies a larger stake in Svyazinvest, the government will attract private and foreign capital, investments, and credits. Privatization will help cure the underdevelopment of telecommunications, and the financial demise of the regional Svyazinvest subsidiaries.  

The government will be reluctant to privatize Svyazinvest and open Russia to foreign telecom companies unless liberalization also takes place. Liberalization will increase competition and transparency, create a level playing field among foreign and domestic companies, and encourage new entrants into the market. Experience in such countries as Germany and Chile demonstrates that telecom market reforms attract foreign and domestic capital, and improve telecommunications infrastructure.  

Telecom liberalization is closely related to the issue of sectoral monopolization. In Russia, regional telecommunication providers obtain control over local line networks. However, their small size and scales of operation are responsible for a low rate of capitalization. Low capitalization dissuades needed investments, which are essential for expansion to the more lucrative and value added services. This results in monopolization of fixed line services, and of mobile phone service in some regions.  

Often the government uses its control over Svyazinvest to achieve social objectives at the expense of the company’s profits. Pricing regulations imposed by the federal body reinforce the monopolization of the sector, since cross-subsidization is not prosecuted, and reasonable interconnection rates are hard to enforce. Cross-subsidization occurs when monopolies cover losses in local calls by increasing fees for long distance calls. Enforcement of an adequate pricing policy is hampered by local authorities, and by the difficulty in controlling the large number of telecommunications providers. Cross-subsidization helps preserve a state run monopoly in Russia. All of these practices are outlawed under the WTO provisions; therefore they will raise serious concerns of Russia’s partners at the accession negotiations. Russia will be required to comply with WTO provisions on regulation in telecommunications. These provisions correspond with interests of potential investors and service providers, and with Russia’s long-term interests.  

An effective pro-competitive policy in the Russian telecommunications sector is crucial for the country’s overall economic development, and for Russia’s successful completion of WTO accession procedures. To ensure that such policy is implemented, the country must revise some regulatory aspects of its legal framework and launch a comprehensive sectoral reform of telecom regulations. This reform will attempt to make the legal and regulatory framework more transparent and secure for investors, and provide the public with better service at a reasonable price. New regulations should be compatible with the WTO principles outlined in the General Agreement on Trade in Services.  

Specifically the reform should include the following components:  

  • A transparent regulatory regime for licensing to promote foreign and domestic investments efficiently and expediently
  • A viable competitive environment through consolidation of local telecommunication monopolies  
  • Protection and promotion of consumer interests  
  • Enhanced management of telecommunications through sectoral privatization
  • Harmonization of domestic regulations with internationally accepted standards in telecom policy, bringing the country’s laws in compliance with the WTO provisions  
  • A presidential veto of the bill “On the Protection of the Economic Interests of the Russian Federation…” and Duma’s version of the bill “On Privatization”. These bills would severely hamper foreign investments in telecommunications companies.  

The following legal reforms should be proposed in a package:  

  • Amendments to the existing federal law “On Communications” to comply with the WTO GATS Agreement, and Agreement on Basic Telecommunications Services  

  • Adoption of the “Federal Budget Law” for the Year 2002, including provisions on the sale of 25% shares of Svyazinvest  

  • Legislation for the education and retraining of workers unemployed from the telecom industry, to reduce negative social impacts of the reforms 

  • An ordinance to complete the consolidation of smaller local telecommunications carriers 

  • A decree to establish an independent regulator in the telecommunications sector 

  • Simplification of licensing regulations in telecommunications. 

Despite advantages to investors, common citizens, and key Russian sectors as a whole, reform implementation will face the following obstacles:  

  • Bad publicity of previous privatization attempts, whose results were invalidated by major players and media outlets due to lack of transparency 

  • Opposition of conservative parties and politicians to liberalization and privatization in any sector of the economy, especially involving foreign investments 

  • Ignorance and apathy of the general public.  

Although the demand for high quality telecom services is high, liberalization and privatization in telecommunications is of little public interest. Many are wary of the economic liberalization of the last decade, and are prejudiced against further liberalization efforts. The public needs to be convinced of the advantages of liberalization and privatization.  

Regarding the legal aspect of privatization, Quantum Fund and its allies must address a new federal bill on a dispute between the State Duma and the government. The State Duma is attempting to control the privatization of large state-run enterprises significant to the Russian economy. The dispute is an obstacle to privatization and may delay the bidding contest on Svyazinvest.  

Since Quantum Fund is a foreign company, it should base its strategy on telecom reforms to build a coalition of like-minded Russian interest groups that favor free market reforms in telecommunications. The proposed organization, the Coalition for Reforms in Russian Telecommunications (CRRT), should include the Interros Group, a group of Russian companies with extensive private holdings in media and manufacturing. Interros owns 10.7% of Mustcom, and shares Quantum’s interest in Telecom privatization for increased control of the telecom sector. Interros has developed extensive relations with politicians, the executive branch, and legislators. Together with Interros and the Quantum Fund, the CRRT should implement the following comprehensive strategy:  

  • Strategy for the executive branch will ensure the support of Russian Ministries and the Presidential Administration of privatization and liberalization of telecommunications. Once the support is confirmed the Coalition must ensure that the issue remains at the top of the agenda.  
     

  • Strategy for the legislative branch will focus on building support for the reforms by the majority in the State Duma and Federal Assembly. The Coalition needs to communicate the advantages of reform to the constituents of every senator and congressman, and ensure that proposed bills are put to a vote as soon as possible.  
     

  • Media and public relations strategy will emphasize the need for broad public support for the reforms. Along with local efforts, this will comprise the core of the grassroots strategy. The benefits of reform can be trumpeted through statements, testimonies, press releases, articles, advertisements, and other means of media.  
     

  •   International strategy of the Fund will be built on Russia’s aspiration to join the WTO and integrate into the world economy. Countries interested in investing in the Russian telecommunications sector must raise the issue of Russia’s accession to the WTO. Media and public relations efforts on the international level should inform interested parties abroad about reforms in Russia, and how the reforms will benefit foreign businesses. The campaign will encourage telecom providers abroad to be proactive and lobby their governments to work for early implementation of Russian telecom reforms.  
      


BACKGROUND ANALYSIS  

Quantum Fund and its Mustcom partners own 25% of Svyazinvest. The remaining 75% of shares are in government possession. Svyazinvest subsidiaries control over 90% of the Russian telecom sector, which is largely underdeveloped due to monopolization and lack of transparency. Low phone line penetration and poor service quality stall business transactions, and create a significant barrier to trade development. The current non-transparent regime and weak legal regulations create opportunities for corrupt practices, posing an obstacle to Russia’s WTO accession.  
   

History of the Privatization and Restructuring Process

Until 1993, the Russian telecommunication network was fully controlled by the Russian Ministry of Telecommunications. In 1993, local network operators were privatized so that each region received at least one telecommunication provider, and more than 80 companies were established. A Russian telecommunication holding company “Svyazinvest” was formed in September 1995. The main objective of the company is to attract investments to develop the regional telecommunications networks, and improve the competitiveness of local providers. Svyazinvest controls 89 regional telecommunication providers (“electrosvyaz” companies), 3 municipal networks, 3 long distance and international telecommunication providers, telegraph companies, and the international telecommunication provider “Rostelecom”. This makes Svyazinvest the largest shareholder of one of the largest telecommunication networks in the world. In the first round of telecom privatization, the Russian government is supposed to keep 50% of the Svyazinvest shares, with the remaining shares intended for sale at the auctions.              

Despite Svyazinvest being presumably an independent company, the government, as the largest shareholder, has great influence on its policy, decision-making, and management strategy. In July 1997, the government sold 25% shares of the Svyazinvest holding for $1.875 billion. The tender was won by the Cyprus based consortium, Mustcom, which included George Soros’ Quantum Fund, Russian Uneximbank (owned by Interros Group), MFK, the Renaissance Capital Investment Fund, Deutsche Morgan Grenfell, and Morgan Stanley. The money raised went almost entirely to the government budget, with Svyazinvest retaining only $95 million.            

In June 1998, the Russian government announced a decision to sell another 25% (minus two shares) of Svyazinvest stock. The government would retain controlling interest, owning slightly over 50%. The Commission hoped to sell it for $1.1 billion and attached investment obligations of $400 million, making the total price of $1.5 billion. At that moment, Svyazinvest was among the most profitable Russian companies, with a net profit of $1.2 billion in 1997. However, as a result of the August 1998 financial crisis in Russia, the tender was cancelled. Telecommunication providers’ debts were increasing, and the fall in the dollar/rouble rates resulted in a major devaluation. Russian carriers were not solvent to pay foreign producers for imported equipment. At the end of 1998, 35 of 89 Svyazinvest companies finished the year in the red. 

Quantum Fund presently owns 53% of Mustcom. Quantum Fund has been increasing its share of Mustcom by buying shares from partners, most recently in August 2001. This demonstrates Quantum’s commitment to the Russian telecommunications market, and confidence in liberalization and privatization reform. Mustcom presently owns only 25% of Svyazinvest, making it a minority shareholder dominated by the 75% share of the government. However, if the government agrees to sell an additional 25% (minus two shares), Mustcom will attempt to buy them. In that case Mustcom, while not having controlling interest, would be a near equal partner, with an investment that yields significant influence.[5]  
   

Sectoral Overview  

The telecommunications infrastructure of Russia is not sufficient to handle the demands of the country’s population. Over 6 million Russians are currently on the waiting list to receive phone lines. By the year 2005, the list will rise to 8 million[6]. The telecom infrastructure is characterized by inadequate capacity, low penetration (21.3%), poor call completion rates (56% of long-distance calls are incomplete)[7], and a lack of modern communications services. The Russian economy has inherited a telecommunications infrastructure in urgent need of modernization.  
   

Inadequate Capacity

Prior to 1992, a mere 0.15%[8] of GNP was devoted to telecom infrastructure investment. The network has weak intercity, interregional and international connectivity, trunk line bottlenecks, and limited regional interconnectivity.  
   

Low Penetration and Call Completion Rates

Main line penetration is low throughout Russia, and telephone densities are considerably lower than those of most other European countries. The basic network has roughly 22 million telephone lines and 34,000 switching stations. The national penetration rate is about 21.3 lines per 100 people. Only 2.5 million lines have digital switches, the rest are served by outdated crossbar technology.[9] The network is still poorly prepared to serve the needs of the general population or the emerging business community.  
   

Lack of Modern Communication Services

Until recently, the Russian public network had only one significant international exchange in Moscow. Although access can now be made through one of three gateway switches, they are insufficient to handle the current load of 110 million calls per year[10]. Businesses used to enjoy many international service options, and many companies used to hold licenses from the Ministry of Telecommunications for international communications in European Russia. Unfortunately, the Ministry of Telecommunications has recently dictated that this service can only be provided via Rostelecom, the Russian long distance carrier.  

The long-distance network for calls within Russia is a mixture of radio relay, cable and satellite. Of the 1.2 billion long-distance calls made annually, only about 44 percent of domestic calls are successfully completed. In Moscow, the city network (MGTS) and intercity telephone network (MMT) have long been inadequate for international business. This condition is changing with the introduction of newer technological equipment and foreign investment. However, these changes are slowed by investment risks associated with non-transparent and arbitrary policy in telecom.  

Initially, foreign joint venture participants in Russia were mainly European (British, Belgian, Scandinavian). However, such American providers as Direct Net Telecommunications, Americom Business Centers, and Global TeleSystems Group have also attempted joint ventures. AT&T and Sprint offer calling card and E-mail/Internet services. The Moscow market is clearly more competitive, with rates leveling. Outside of Moscow, the situation is quite different. While some larger cities are following Moscow’s footsteps, most of the country has difficulty communicating with Moscow and other Russian cities. Areas outside Russia are virtually inaccessible.  

To improve the situation, new telecom technologies, such as VSATs (small stand-alone satellite trans-receivers) could be used to provide private telecom services to offices, factories, and areas unreachable via existing networks. These technologies require significant investment, which the Svyazinvest subsidiaries lack.  
   

Recent Introduction of Western Technology

The first cellular system appeared in the early ’90s. The lifting of COCOM restrictions initiated these changes. Recently, such new technologies as fiber optic and radio relay transmission, high-speed digital switching, and communication privacy have become available to support the development of the Russian telecommunications infrastructure.  

The development of the telecommunications network is directly linked to overall economic and societal development in Russia, and Russia’s integration into the world economy. Fast development of telecommunications increases national welfare and security, encourages GDP growth, and promotes progress in science, health care, culture, and industry. As a result, Russia could easily become one of the largest world markets for telecommunications goods and services.



[1] Svyazinvest’s Annual Report 2001.

[2] See profit projections on p. 35.

[3] See p. 28.

[4] See p. 43.

[5] Ingram, R., Accounting: Information for Decisions, 2nd edition, South- 
Western College Publishing, 2001, p.415.

[6] Svyazinvest’s Annual Report 2000.

[7] Report on Indicators of Service Quality 1995-2000. Ministry of 
Communications. www.minsvyaz.ru

[8] Neuman, W., The Future of Russia's Telecommunications Infrastructure:  
Toward an Open Communications Environment. Research Program on 
Telecommunications Policy, Massachusetts Institute of Technology, June 1995.

[9] Neuman, W., The Future of Russia's Telecommunications Infrastructure: 
Toward an Open Communications Environment. Research Program on 
Telecommunications Policy, Massachusetts Institute of Technology, June 1995.

[10] Kazachkov, Mikhail, On Certain Problems in the Russian Communications 
Sector, 14 May 1998.

 

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