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. Last Updated: 07/27/2016

Hong Kong On the Baltic?

KALININGRAD -- When KIA Motors Corp., South Korea's second largest auto manufacturer, made a $1 billion, five-year promise last month to produce light vehicles, it was hailed as a victory for Russia's only true free economic zone: the tiny region of Kaliningrad.

The KIA deal was just the sort of thing the zone was designed to achieve. It will convert the ailing Yantar military shipyard in Kaliningrad into a modern car assembly plant, creating 20,000 jobs and raining an initial investment of $180 million into the region.

Local Kaliningrad officials, who see their city turning into a sort of Russian version of Hong Kong or Singapore or China's Shenzhen special economic zone, are hoping the deal will lead to a string of commitments by manufacturers to throw down a beachhead in the region via Kaliningrad.

Volkswagen AG says it is looking seriously at the area, which was part of Germany before World War II.

Maxim Litvin, representative for LG International, KIA's office in Moscow, said Kaliningrad's special economic status in Russia played a key role in choosing to locate there.

"Kaliningrad is a real free economic zone, the status of which is supported by the government. Kaliningrad has stability and, secondly, it's located near the center of Russia and the large Russian republics like the Ukraine, the richest parts of the former Soviet Union, where our products are most likely to be sold."

Kaliningrad was chosen as a free economic zone largely because it is an enclave cut off from the rest of Russia, a situation which gives it unique opportunities and also unique problems.

Its 750,000 citizens live 500 kilometers from the rest of Russia, separated by the territory of Belarus, Latvia and Lithuania. With more than half the residents in military-related work, the region has suffered worse than most from the collapse of Russia's military budget. The idea behind the creation of a free economic zone was that unless the region was opened to international trade, it would simply die out.

In January this year, parliament and President Boris Yeltsin signed a law giving Kaliningrad a host of extraordinary customs duty and other privileges.

Under the Jan. 12 law, hard currency laws have been softened, so that there is now no requirement to repatriate hard currency earnings from exports. Transport costs of goods through the territory are exempt from value-added tax.

Most importantly, the law offers major exemptions from Russia's high import taxes. All imports into the zone are generally duty-free.

The law also provides a substantial incentive for companies using Kaliningrad as a manufacturing center for Russia. Providing local factories add more than 15 percent to 30 percent to the value of their imported inputs, they are exempt from VAT and import taxes.

Kia believes this will play a crucial role in its plans. "There are no problems with customs," said LG International's Litvin.

Down on Kaliningrad's Portovaya Ulitsa, which leads down to the port where mothballed tankers and rusting passenger ships drift silently on their moorings, there is the rare example of one company that is already using the special rules.

Raisa Kostyuk's workers are sorting through huge piles of scrap, filling her three ships with metal for customers in Holland, Spain, Scandinavia and other points.

Director of RVC & Co., which buys and carves up scrap metal for resale on the international market, Kostyuk is capitalizing on her duty-free privileges. "Of course the free economic zone is beneficial to me," said Kostyuk.

The free economic zone helps her because it cuts out VAT on all transport which is the single biggest cost in her business.

About 10 different middlemen firms scour a huge area of the northwestern regions, as far away as Arkhangelsk on the Arctic Ocean, looking for factory equipment, excavators and ships, some old but some relatively new, lying unused. About 8 percent of the company's total volume is military mat?riel, much of it from the Kaliningrad region.

Employed and trained first by a German company which later left Kaliningrad, Kostyuk set up her own private company. Her volume of scrap metal in 1995 totaled 50,000 tons, about 3,000 to 5,000 tons per month, a pace she sees growing this year. But success stories like the KIA announcement and Kostyuk's are rare. The free economic zone has so far attracted little in the way of foreign or Russian investment.

In the past, uncertainty over the status of the free economic zone and its privileges held up investment. Last year, investment per capita in Kaliningrad's next-door neighbors amounted to $200 in Poland and $100 in Lithuania -- compared to $15 in Kaliningrad.

"That's a bit higher on the whole than in Russia -- at $10 -- but, for everyone, a bit weak for comfort," wrote Kaliningrad's popularly elected governor, Yury Matochkin, in an overview of the oblast's economy, published by Kaliningradskaya Pravda newspaper. Direct private foreign investment in Kaliningrad was just $5.2 million, he added.

Part of the reason for the poor performance so far is that talk of a free economic zone has been in the air for years, but despite a swarm of decrees and regulations, little practical progress was made.

Privileges were first granted in 1992 but weren't legally clear and were finally revoked in early 1995, largely because of concerns that the free economic zone was turning into a free-for-all for smugglers. Russian exports and imports were passing through the zone unsupervised.

Local officials admit that this track record of confusion works against Kaliningrad. "We understand there is skepticism, but we have to start somewhere," said Marina Melekhova of Committee for the Development of the Yantar Free Trade Zone.

"It's true that before there was no stability in those privileges," such as freedom from customs duties, she said. "They were afraid that, say, somewhere between Poland and Kaliningrad there would be a new law and the privileges would go away. But not anymore," she added quickly.

Although the new law does appear to resolve many of these problems, the devil might be in the details. Tomas Doms, head attorney of a German law firm in Kaliningrad, says, "The problem is that we have a secure base, starting with the law, but existing laws need to be brought to life."

One other big question mark hanging over Kaliningrad's plans is its transport infrastructure. Kaliningrad was primarily a military port until the dissolution of the Soviet Union in 1991, and it remains one of Russia's few warm-water ports.

The city has a commercial sea port but also a fishing port and a river port which handle trade cargo. The sea port is joined with the Baltic Sea by a 35 kilometer-long navigational channel and handles general cargo, bulk and liquid cargo and roll-on/roll-off cargo -- large-capacity containers and rolling trailers.

However, the port requires serious modernization. For one thing, it's not deep enough for bigger ships and dredging the key areas requires money. Sea port officials have asked the federal government for a $200 million upgrade, but that is unlikely.

Road and rail transport links outside the port are also a problem. To the west, the local government has built a stretch of highway leading to the Polish border, part of a planned link with Warsaw and Berlin. Unfortunately, the road ends at the border and the Polish government is not interested in building on its side.

To the east, the problem is clouded by politics as must as physical infrastructure. Kaliningrad is an island of Russian control among the newly independent Baltic nations, torn between building political-economic bridges to the West while remaining Russia's western-most military outpost.

Once a Soviet military garrison supporting an average of 250,000 troops, Kaliningrad boasted strategic importance as an ice-free Baltic port and political bulwark against NATO.

Although Kaliningrad has ambitions to be an entrep™t for the region, Russia has problematic relations with Lithuania and Latvia, which only received independence from the Soviet Union in 1991 and still remember their struggle for freedom with resentment.

This and the usual bureaucratic confusion have meant that border crossings are cumbersome and slow. This is especially a problem for trade between Kaliningrad and the rest of Russia, to which two or three borders must be crossed.

Such has been the experience of the Swedish company AGA, a leading producer of technical and medical gases and one of the main foreign investors in the region to date, having bought a 99 percent stake in a Kaliningrad acetylene and oxygen plant.

AGA bought back the plant in 1993, which it had owned in pre-World War II Kaliningrad, and invested over $2 million to modernize the plant to ship to counties like Lithuania, Latvia, Belarus and Russia.

The plant does benefit from the free economic zone, especially from duty-free imports of gas tanks which are a major cost input. But, along with high energy prices and the usual Russian problems of legal instability, AGA has faced acute border problems in shipping its production.

"Truck transport is very complex, and there's been no decision between Lithuania and Russia, so we have to pay transit customs on every side," said Stella Shulepova, director of AGA KAZ, the local subsidiary.

Take a shipment from Kaliningrad through Lithuania to Latvia, for example. AGA KAZ's head of logistics, Alexander Dovnar, describes the byzantine customs demands for a truckload of gas cylinder cargo worth roughly $27,000.

At customs, his drivers pay $57 just for filling out the declaration, then 0.15 percent ($40) for customs into Lithuania. Once at the customs warehouse in Lithuania, they pay $30 for a stamp, $40 to arrange the papers at the border, then a $700 refundable insurance deposit just in case the cargo is dropped in Lithuania instead. Then they pay $58 for a stamping of the deposit documents.

He doesn't think the insurance deposit method is safe, however, so the company pays an insurance company $60 for each trip, as well as $15 fee for the insurance of the vehicle through Lithuanian territory.

Now on to Latvia. Declarations costs $60, insurance of the vehicle another $30 and the official document stamp, another $15.

Were the shipment destined for Russia from Kaliningrad, AGA would only pay customs through Lithuania. Drivers pass free through Belarus, and then at the Russian border, they pay $19 to enter. "There's potential there," said an executive with one Western shipping company, "but there are still certain things that need to be done. Part of the problem also is that to reach Russia, purely from the strategic point of view of border arrangements, do you know how many customs formalities it's necessary to deal with?"

"If it was done in a way that's user-friendly to carriers like us, that would be one thing. But it's much easier to come in through one transit border or a Russian port of entry. You always have to be thinking about customs flow," the executive said.

Local officials have called for a lifeline -- a conceptual "trade corridor" smoothing customs procedures through Lithuania, Poland, and Belarus -- but given the complicated political situation, this is unlikely.

"There is no corridor," conceded Melekhova of the Yantar Committee.

One concrete problem is ongoing complaints from Russia that Lithuania is discriminating against shipments by rail to Kaliningrad across Lithuanian territory, charging a higher freight tariff.

As a solution, President Boris Yeltsin proposed a "priority road" bypassing Lithuania by cutting down through Poland and then through Belarus. The Poles had never heard of the idea and, not surprisingly, were nonplussed. Moscow Carnegie Center associate Irina Kobrinskaya wrote recently, "creating a corridor ... uniting Belarus with Kaliningrad through Polish territory has already provoked a sharp response from Warsaw."

Many would say that dreams of Kaliningrad as a Hong Kong on the Baltic have foundered so far because Kaliningrad is in Russia and not in Asia, and attitudes to business and getting things done are just different.

"Kaliningrad could have been a Hong Kong or Singapore, but no place in Russia could do any better within the difficult administrative and constitutional situation," said one high-level official with an international development agency.

"So the fact that Kaliningrad borders Europe and is a port city does not overcome the fact that it's still a part of Russia."