Political risk looms over Russian IT sector

Political risk looms over Russian IT sector

Information technology is a rare example of a globally competitive, non-natural resources sector in the Russian economy. Yet, government attention to this industry has led to clumsy regulations and higher political risks both for local and foreign companies.

The collapse of the Soviet Union coincided with an acceleration in global IT development. In the 1990s, highly educated people in post-Soviet countries actively joined the new industry. Private initiative and entrepreneurship created strong national IT champions with global aspirations, and the ability to compete with foreign companies as equals.

Completely disregarded by Russia’s state bodies, IT grew from non-existent to RUB 2.8 trln in 2013 (c. $87 bln, including communications). According to McKinsey, IT-dependent industries accounted for 17% of GDP in 2011 and were growing 3.6% faster than the broader Russian economy.

The local software market alone was estimated at $5 bln, while the export of IT services by Russian companies accounted for $5.4 bln. In 2014, total turnover of Russian e-commerce companies reached RUB 920 bln (c. $24 bln).

According to IAOP’s 2014 Global Outsourcing 100, a list of leading IT outsourcing companies, Russia was represented by 6 companies: Luxoft, MAYKOR, EPAM Systems, MERA, Auriga и Reksoft. Furthermore, Russia is one of a few countries with its own national Internet-search provider (Yandex), which dominates the regional market and successfully competes with Google.

Volume of software export by Russian companies, $ bln.

Source: Russoft

A symbolic moment for the Russian IT industry came in May 2011 when Yandex proceeded with an IPO and started trading its shares on the NASDAQ stock exchange. Market capitalization of the company peaked at $14.4 bln in late 2013, but is currently down 66% to $4.9 bln.

President Vladimir Putin added to the downward pressure by calling the Internet a “CIA project” that has “evolved in this manner. He also criticized Yandex for being registered in the Netherlands, “not only for the taxation purposes but for other reasons, as well.” Following Putin’s remarks, Yandex shares plummeted by 5%.

 Performance of Yandex shares vs Russian stock market (RTS – USD-denominated index), %

Source: Bloomberg

Although share price dynamics reflect a myriad of factors, including sharp ruble depreciation, investor disaffection with the Russian IT sector largely revolves around one factor: growing state intervention.

The first obvious move was internet censorship, which followed a global government trend. Those in power are increasingly attempting to control social media, in order to counteract its potential for protest activity and coordination of social unrest.

Russian authorities went one step further, introducing wide information bans and creating a new regulatory body, Roskomnadzor, which can block web-sites without court rulings. Roskomnadzor, translated as the “Federal Service for Supervision of Communications, Information Technology and Mass Media,” has proven to be a steady provider of operational disruptions for Russian IT companies.

The regulator lacks technical expertise and equipment, so it usually blocks entire web resources in case any aspect contains “forbidden information”. For instance, in December 2014, access to popular software and coding platform GitHub was blocked after it was found to host comic content related to suicide. This incident caused an outcry from Russian developers and backlash in the form of a hacker attack on Roskomnadzor’s servers.

Additionally, Russia’s Parliament passed a law limiting transactions via online payments accounts without submitting personal data, and banning cross-border payments. This legislation was presented as a counter-terrorism and anti-money-laundering measure, but is also well suited for hampering political crowd funding (the practice was pioneered in Russian politics by well-known opposition leader Alexey Navalny). On the day Parliament unveiled the draft law, shares of Qiwi, a Russian electronic-payment operator, sank by 17%.

Even the state’s supportive efforts (e.g. import substitution in IT) turned out to be a source of constant risk for local companies, due to the Russian government’s inclination towards centralization and control. For example, the Ministry of Communications bluntly tried to levy the cost of its ideas on domestic companies by introducing a special tax to finance development of national operating systems and other software. The aim was to compete with MS Windows and Linux, but after a wave of criticism, the Ministry dropped its proposal.

However, current versions of the import substitution program still carry the risk of additional dues and fees for private IT companies. The cash-stretched government is considering raising funds by lifting tax relief on VAT for the IT industry, which will effectively increase the VAT rate from zero to 10-18%. The likely beneficiary of the program is Rostech, a state-controlled conglomerate, which will lead the “collective” development of national software in order to “protect information sovereignty”.

In the vein of sovereignty, Russia’s Security Council recently discussed the high vulnerability of the Russian internet to an external “internet kill switch”. Later, rumors spread that the Ministry of Communications proposed to solve its cyber security issues by gaining control over critical IT infrastructure and installing traffic monitoring equipment. It also proposed to forbid private companies from using their own uncontrolled cross-border communication lines.

Foreign companies face increasing pressure as well. One of the most disruptive initiatives is the “Law on personal data protection,” which requires companies to store personal data on Russian citizens locally in Russia. The significant business impact of the law was further aggravated by Russian lawmakers who added tough deadlines of September 2015, instead of September 2016.

For this reason, many foreign internet companies had to hastily adopt the new, complex operations. With the deadline closer, many businesses are still unsure how to correctly comply with the new regulation. Due to ambiguity and strict deadlines, it is likely that Roskomnadzor will be compelled to go softer on non-compliant companies, but it also means arbitrary and selective enforcement. Even the Ministry of Communications admits that the wording of the new law is “not ideal”.

Another trend is increased tensions within the business community, as local IT companies try to compensate for damages from government intervention by embracing new tactics.

For instance, major Russian e-commerce companies lobbied change in customs duties so that purchases over 150 euros from foreign online-stores would be taxed at 30%. However, the tax free limit was later increased to 500 euros. It was then again delayed, until 2016, due to unpopularity among Russian consumers, ruble devaluation, and slow adoption of Eurasian Union’s common trade policies.

Finally, following the local sentiment and European trend, Yandex filed an antitrust complaint against Google regarding pre-installation of search engines on mobile devices. Currently, the investigation continues.

As a result of a deteriorating regulatory environment and growing hostility, a number of companies chose to leave the country or partly move their operations. Google relocated its Russian engineering office to Poland; Adobe liquidated all its Russian subsidiaries; Microsoft shut down its Moscow development office. IT companies are the most mobile in terms moving their operations abroad. If the situation worsens, we may see a bigger wave of tech exodus.

Thus, after decades of fruitful disregard, the Russian government has distorted the IT industry both for local and foreign companies. State intervention has increased unconventional risks, creating business tensions and constraining the operational environment. Ineffective state support goes hand in hand with tighter control, unpredictable regulation, and redistribution of resources at the expense of private sector.

State intervention may be lucrative for some well-connected or state-controlled companies with heavy local sales, but “IT nationalism” trends negative for innovation, creation of new companies, and development of competitive technologies in a globalized, fast-changing industry.

In 2011, Yandex stated in its IPO prospectus that “high-profile businesses in Russia, such as ours, can be particularly vulnerable to politically motivated actions” and “may be subject to aggressive application of contradictory or ambiguous laws or regulations”. In recent years, IT companies in Russia faced exactly these kinds of risks.

Categories: Economics, Europe

About Author

Alexey Kobylyanskiy

Alexey Kobylyanskiy currently works for a leading Russian mining company. He previously worked for the political risk insurance arm of the World Bank. He also has experience working for Russian regional government bodies and as an international election observer during the 2010 presidential elections in Ukraine. Alexey holds an MA in International Political Economy from Fordham University and an MA in International Relations from St. Petersburg State University, Russia.