Special Economic Zones in Russia

The collaboration between the SEZs and the state-funded technology centres, regional industrial/innovation parks, and universities is much below potential. A National Innovation System (NIS) can be a step towards a right direction, as long as the state minimises its own role, since less bureaucracy means more results. The integration of the activities of the Russian Nanotechnology Corporation with some SEZs might give some boost to creating a high-tech network in Russia. The experience and outstanding leadership skills of the corporation's director general, Anatoly Chubais, are without a doubt major assets for the future development of Russian nanotechnology.

Closer collaboration with the world’s leading high-tech countries and the global R&D corporations would benefit the SEZs. Finland’s experience in particular could be useful for the Saint Petersburg SEZ and the Kaliningrad SEZ.

Threats

Most of the SEZs are to be closed in the mid-2020's, or even earlier, if Russia decides to cancel the SEZ laws due to the weak performance of the zones. The fixed tenure reduces the attraction to invest in the zones since the tenure of the privileged period becomes shorter day by day.

Even if Russia’s accession to the WTO has progressed very slowly, Russia’s possible membership in the WTO might force Russia to close the SEZs, and compensate losses to the SEZ residents. The compensation from the Russian Government does not necessarily cover all the costs incurred by a SEZ resident. In this context, one should stress that Russia's WTO membership is everything but certain.

The role of the military-industrial complex in innovation building distracts both the Russian private companies and foreign firms8. There is a substantial risk that some innovation-related industries become restricted, and therefore, natural competition weakens. As the competition forces organisations to innovate, restricted innovation sectors could be damaging for Russia’s goal to diversify its economy. The military-led innovation system would mean that competition would be replaced with control and secrecy. If the most advanced parts of the Russian innovation sector will become restricted or closed, it will push foreign innovation-related companies to invest in some Asian countries, where they will find experts with lower salaries (Liuhto 2008).

The Russian SEZs should not neglect foreign investments for at least six reasons.

First, foreign firms bring additional R&D capital into Russia9. Second, foreign firms bring advanced technology and introduce best practices, which are even more important than the finance per se, since money can buy the technology but not its effective use. Third, without the participation of the leading foreign R&D companies, the Russian innovation network will focus on domestic needs instead of the global opportunities. Fourth, the foreign firms accelerate competition, i.e. they bring dynamism into Russia's stagnant innovation sector. Fifth, the leading foreign innovators have a better view of future innovation development than even best-informed bureaucrats. Sixth, foreign high-tech companies' investment in Russia is a more cost-efficient way to diversify Russia from a raw material producer towards a high-tech country than the acquisition of foreign high-tech companies and bringing their knowledge to Russia.

I recommend that the Russian SEZs would focus on inviting a couple of leading foreign innovators in the zones. Foreign innovation leaders would bring their own foreign clients into the zones, as internationalisation often occurs via business networks (follow-your-client strategy). Since foreign innovation companies cannot act by themselves in Russia, the subcontracting agreements would be a natural way for Russian firms to join the global innovation networks without going abroad. Although the aforementioned recipe sounds easy, one should not assume that the SEZs alone would be a sufficient attraction to bring foreign innovators into Russia. Therefore, Russia should improve its investment climate and upgrade its innovation system to be able to succeed in a high-tech revolution.

The current financial crisis slows down the development of the SEZs, since the regions and the companies have to focus on securing their core operations instead of developing innovations.

As the new law on SEZs was passed relatively recently, it is understandable that the results of new SEZs are very modest. In other words, the results of today do fully describe the potential of tomorrow, and therefore, it is highly advisable that the follow-up of the SEZ analysis would be conducted in three-five years from now.

2.2. Saint Petersburg SEZ

The Saint Petersburg SEZ offers practically the same tax privileges as its three sister zones specialised in innovations. What makes the Saint Petersburg SEZ unique is its geographical location, i.e. this SEZ may develop into Russia's innovation window towards the West, if it manages to attract the leading foreign innovation-oriented companies. So far, the results are meagre.

Less than 30 companies has been registered in the Saint Petersburg SEZ. None of these companies can be classified as a globally recognised innovation company. In fact, they are rather unknown companies outside Russia, and even inside the country. For a closer description of these companies, visit the website of the Saint Petersburg SEZ (www.spb.rosoez.ru).

The zone has not fully started its operations, i.e. the construction process has not been finalised in either Neudorf (the southern part of the SEZ) or Novo-Orlovsk (the northern part of the SEZ). The international financial crisis may slow down the launching of the zone further, since some of the key financiers of the zone have encountered severe financial difficulties.

The Saint Petersburg SEZ has expressed its interest to focus on the production of software, ICT, consumer electronic devices, and military and civil aviation. Software production might be a challenging field since India, for instance, offers qualified experts with lower salary levels, and software production is not dependent on geographical proximity. ICT collaboration with the Nordic companies would be natural, and the close distance may create an additional competitive advantage, if the Nordic companies are not afraid of taking the risks involved regarding Russia's poor respect of immaterial rights. The SEZ's focus on consumer electronics is slightly strange, since the Kaliningrad SEZ is not located far away from St. Petersburg and the Kaliningrad SEZ is considered to be Russia's leading zone on producing consumer electronics, TV sets and vacuum cleaners in particular. The specialisation on aviation offers little, if anything, for foreign firms, since military aviation has been labelled as a strategic sector with a restricted access to foreigners.

As it is not constructive to analyse the plans, promises and hopes of the bureaucrats, one can only conclude that "no progress" means a relative weakening of the competitive position of the SEZ, since their competitors have not been idle for the past four years. To put it differently, Russia's stand-still means that the innovation gap between Russia and the rest of the world widens, as the surrounding world goes ahead, whilst Russia stays relatively unchanged.

Even if the progress in Saint Petersburg is not impressive, one should not forget that the Saint Petersburg SEZ may have a trump card up its sleeves, since Anatoly Chubais, Director General of Russian Nanotechnology Corporation (Rusnano), originates from St. Petersburg. It remains to be seen what will be the extent of the future collaboration between Rusnano and the Saint Petersburg SEZ10. In this context, one should not forget that Rusnano possesses USD 5 billion funds to be allocated to the development of nanotechnology investments.

Another trump card of the Saint Petersburg SEZ is its western neighbour Finland.

Finland is one of the world's leading high-tech countries, and innovation collaboration between Finland and St. Petersburg would be very natural. In order to facilitate this co¬operation, some Finnish innovation facilitators have already entered St. Petersburg.

Technopolis, formerly Oulu Technology Park, operates a technology park and an innovation centre in St. Petersburg. Pulkovo Technology Park will be designed as a platform for Finnish and international companies interested in starting their operations in Russia, and vice versa, for Russian companies interested in internationalisation. Similarly, the innovation centre has been founded to serve those Finnish innovation-oriented firms, which need support in their expansion into Russia11. Although the concept of Technopolis seems extremely good, it is too early to estimate the future of Technopolis' technopark and innovation centre since there is little evidence with regard to Finnish firms' interest in starting their innovation activity in Russia, where respect for immaterial rights is weak. The forthcoming report of the Pan-European Institute may bring empirical evidence on how the Finnish high-tech firms see the opportunities of St. Petersburg (Kaartemo et al. 2009).

In addition to the Saint Petersburg SEZ and the Finnish actors, there are several other high-tech facilitating organisations in St. Petersburg, such as Bonch-Bruevich Technology Park and the university-based innovation units. For a closer description of these units, see Kaartemo et al. (2009).

It remains to be seen how co-existence among several innovation facilitators proceeds. Hopefully, the city administration does not interfere in the competition but allows natural competitiveness to emerge, or alternatively, it has to be prepared to considerably subsidise the public units. Free competition is the best way to avoid costly overlapping between the innovation facilitators, and to create a truly sustainable and globally competitive innovation cluster in St. Petersburg.

Even if St. Petersburg would turn into a high-tech window of Russia (e.g. Matvienko 2007), one should not forget that foreign investors are not just interested in the window but in the whole house, and therefore, Russia should build their country's innovation system and investment climate as a whole. Particularly, Russia should improve their respect for immaterial rights and support free competition.

If the military-industrial complex will take over Russia's innovation industry, it might well be that foreign investors will see only the frames of the window, while the building itself has disappeared during the renovation process. As Russia cannot rely eternally on its current budget revenue generators - oil, gas, and metals, the failure in Russia's innovation policy would bring dramatic consequences for the future wellbeing of all Russians, and therefore, the possible adaptation of the military-led innovation system is a genuine threat to the Russian living standard, since the military-led innovation systems are by nature expensive, inefficient, and corrupt due to their secrecy, bureaucracy and noncompetitive nature.

2.3.              Kaliningrad SEZ(s)

The Kaliningrad region is a special place due to its geographical location, and therefore, the federal government has always fed the region with administrative privileges. Kaliningrad was granted a free economic zone (Yantar Free Economic Zone) as far back as in 1990-1991. However, already in 1995 this free economic zone was terminated.

A year later a special economic zone was established. This SEZ is based on duty free imports. If a company is able to add 30% onto the value in the imported product and the product's customs classification code changes, the company can sell this product to the Russian mainland without paying import duties. Hence, Kaliningrad has become a backdoor for a company which wants to legally avoid Russian customs duties. The Magadan SEZ in the Russian Far East follows the same operational model, though slight differences in the legislation exist (Lapin 2006; Liuhto 2007).

The most visible impact of the Kaliningrad SEZ is the increase in the imports of the Kaliningrad region. Currently, the total imports of the Kaliningrad region exceed nearly 10 times the level of the mid-1990's. As the citizens of Kaliningrad consume only a fraction of the imports, the majority of the imported goods serve industrial assembly in the region, and hence, assembly has vigorously supported the regional GDP growth (BRE 2009).

The aforementioned SEZ in Kaliningrad is to be closed in 2016. The same will happen with the Magadan SEZ a few years earlier. It is interesting to note that the Kaliningrad region will face another blow to its budget, when the oil field D-6 located in the proximity of Kaliningrad is to become depleted in 10-15 years from now.

As the old SEZ is to pass away in seven years from now, another SEZ law was adopted in 2006. This SEZ allows companies, both the Russian and foreign ones, to have a tax holiday for the first 6 years and a 50%-reduction of the taxes during the years 7-12.

In consumer electronics only 15% of value added is required.

In order to earn these privileges, a company has to invest at least RUR 150 million (some € 4 million) over a three-year-period. The new SEZ is to be terminated in 203113.

When one analyses the FDI inflow to the Kaliningrad region, one can easily observe that FDI inflow has picked up. In 2005, the annual FDI inflow to Kaliningrad was just € 15 million, whereas two years later it was already close to € 120 million (BRE 2009). In the beginning of last year, the number of the residents in the Kaliningrad SEZ was 55. Even if there is some hot air in the pledged investments, one should note that the investment commitments of these companies exceeded € 600 million. The largest investments were pledged to be placed in soybean processing, plastics production and logistics-related projects. These three projects alone cover more than a third of the investment commitments. At first glance, the share of foreign investments among the SEZ residents does not seem to be particularly large.

Besides the SEZ of the mid-1990's and the new SEZ, Kaliningrad has two additional zones i.e. the tourism zone and the gambling zone.

The tourism zone was founded in 2007, and it has been located on the Curonian Spit. This zone focuses on ecological and recreational tourism. Even if the tourism zone has been placed in a wonderful location, one can hardly expect a major tourism inflow. In this context, one should not forget that the number of Russian visitors in 2006 was no more than 275,000 and foreign tourists some 80,000. Germans made up one half of the foreign tourism inflow and visitors from the Baltic States and Poland together formed another 30% (Liuhto et al. 2007).

The fate of the gambling zone in Kaliningrad is even less bright, since the construction work of the zone has not even started yet though the zone should already begin its operations in July 2009. Kaliningrad would definitely benefit from gambling activities, but it is rather uncertain whether such a zone will be created. On the other hand, one does not need a gambling zone to open a casino in Kaliningrad i.e. a casino could be established in the Kaliningrad region even if the gambling zone were not opened. However, no rational company management opens any casino in Russia until the gambling law has been abolished for good.

To summarise, Kaliningrad offers truly attractive tax conditions for investors planning to place more than RUR 150 million in the region. Similarly, the region's proximity to Central Europe is a major advantage for those producers who do not meet the EU's customs barriers. On the other hand, higher logistical costs involved in transporting goods to the Russian mainland are one of the drawbacks of the region. In addition, the region's relatively narrow labour base does not allow the region to compete with low salaries for long.

Should Kaliningrad truly become Russia's leisure centre on the Baltic Sea, it is self-evident that high-quality construction companies from the West, including those from Finland, may find additional demand for their goods and services. A need for wooden summer houses is definitely growing in the region, when the current financial crisis is over. Furthermore, if Kaliningrad is serious about its nuclear power plant project, some Finnish construction companies recently involved in building the fifth nuclear unit in Finland might find the project in Kaliningrad worth studying in more detail.

In innovation competition the Kaliningrad region cannot beat St. Petersburg with its numerous top level universities and research centres. Similarly, the manufacturing base of Kaliningrad is non-competitive compared with St. Petersburg. As the electronics industry14 in Kaliningrad will decline along with the closure of the old SEZ in 2016 and the oil income will stop a few years later, Kaliningrad is not left with many options for developing its regional economy. Tourism and services related to it might not seem to be a lottery win for Kaliningrad, but the region does not have so many alternatives (e.g. Boos 2006).

3.              What do the Russian SEZs offer for foreign firms?

One could conclude the progress of the Russian SEZs with a proverb "Much ado about nothing". At the moment, the Russian SEZs still offer very little for foreign firms. Even if the SEZs offer certain financial privileges and the Russian researchers are generally very qualified, Russia's poor reputation on immaterial rights, weak innovation system, the low-tech image of the country, a lack of R&D-related finance, and administrative inertia downplay the advantages offered by the zones.

Therefore, it is not surprising to note that foreign firms are a rarity in the zones. In fact, only a few domestic companies have been founded in the Russian zones, since the majority of the zones have not started their operations as initially planned.

The Kaliningrad SEZ is by far the most attractive zone for foreign investors, which are ready to invest at least RUR 150 million (approximately € 4 mn) in the region. The reason for Kaliningrad's success is the fact that the zone offers better financial benefits than the zones elsewhere in Russia. On the other hand, Kaliningrad's enclave location decreases the competitive advantages the SEZ offers to a company, which targets the Russian mainland.

There are no major Finnish companies operating in any of Russia's SEZs for the time being, though one company with a Finnish name has been registered in the Saint Petersburg SEZ.

Although the Kaliningrad region is unfamiliar to most Finnish investors, I advise that Finnish companies considering an investment exceeding EUR 4 million in Russia should make a feasibility study on the investment possibilities in Kaliningrad. Besides tax benefits, the administration of the Kaliningrad SEZ has a good reputation for being investor-friendly, and furthermore, Kaliningrad is close to Central European markets. If the region starts to attract more tourists, one could estimate that Finnish construction companies might find additional demand for their high- quality goods and services. Though Kaliningrad offers the best financial benefits, it can be predicted that the Finnish companies follow the development of the Saint Petersburg SEZ more closely than that of Kaliningrad or any other Russian region.

If the Russian SEZs do not produce any tangible macroeconomic results by the middle of the next decade, their existence can be questioned, since already by 2025 many of the SEZs are to be terminated.

To sum up, although the results of these zones are meagre, I recommend the implementation of a follow-up study on the Russian SEZs and innovation-related activities in 3-5 years from now.