Financing aircraft construction in Russia

by Simon Pirani

In the air transport market, wallowing in post-11 September depression, Russia is awakening new interest. While leasing into Russia remains difficult, mainly because of punitive duties, the domestic market offers possibilities for the adventurous. And the leasing of two Tupolev-204s to the European cargo carrier TNT shows that, as Russia’s aircraft manufacturers struggle to get back on their feet, they may find an outlet for their cheap but reliable products beyond the traditional Soviet-era markets in Asia and Africa.

Western interest in leasing Russian aircraft

The one-year renewable wet lease of two Tu 204-120s to TNT, due to start this month [February], has been arranged by Sirocco Aerospace International of London, sales agent for the planes, which are designed by the Tupolev Design Bureau and manufactured by Aviastar of Ulyanovsk. A spokesman for TNT confirmed that it was taking delivery of the planes, which will be operated by HeavyLift Cargo Airlines from the TNT base at Liege, Belgium.

Sirocco hopes that the plane will soon complete certification by the European Joint Aviation Authorities, and that the TNT deal will be the lead-in to mature markets that Russia’s beleaguered aircraft manufacturers desperately need. In that respect Sirocco sees TNT, which has had one Tu-204 on lease from Air Rep of the UK for the last year, as an ideal customer. A banker close to the transaction said: “This deal is indicative. It shows that the Russian market is gradually sorting itself out and that Russian manufacturers have the capacity to export, as well as to sell to domestic airlines.”

The Tu 204-120 is a medium-range plane developed for both cargo and passenger markets, close in size to the Boeing 757, with engines from the Perm engine-building plant or Rolls Royce, and avionics from Honeywell. Sirocco, owned by Kato Aromatic of Egypt, was set up in 1996 to develop the Tu 204-120, and in 1998-99 delivered the first three Tu-204-120s (two passenger and one cargo) to Air Cairo.

Prior to the TNT deal, in September last year, Sirocco signed up with the China Aviation Supplies Import-Export Corporation to sell five Tu-204s, powered with Rolls Royce RB211-535E4 turbofan engines, to two Chinese airlines, with an option for a further ten. The deal was struck between Sirocco, the Russian aircraft export agency Aviaeksport, China North West Airlines and China South West Airlines during Chinese prime minister Zhu Rongji’s visit to St Petersburg, and deliveries are expected to start at the end of this year.

A UK export credit guarantee is being sought for the British content. John Cheffins, president of Rolls-Royce civil aerospace operations, described the Chinese sale as “an important breakthrough”.

As for Aviastar’s struggle for revival, Sirocco’s interest does not stop at leasing and sales. The factory recently severed links with its strategic partner Novoe Sodruzhestvo holding, which is controlled by Rostelmash, the engineering company. According to sources close to Aviastar, it is now being courted both by Sirocco, which says it is prepared to put $200 million into the factory, and the Lider group, a leasing company.

The Aviastar scenario says much about the difficulties of Russia’s aircraft builders. The post-Soviet slump, and the presence of huge numbers of not-yet-outworn Soviet aircraft and of a myriad of cash-strapped small airlines who are happy to make do with them, has slashed demand. Most of the factories are at a virtual standstill or producing at a fraction of capacity. The only Russian airlines that can easily afford new planes, the international carriers Aeroflot and Transaero, prefer foreign makes. And while the Russian government appears torn, wanting to do its best both by these services giants and by an important manufacturing sector, adventurous expats who can bring leasing techniques and financial experience are not unwelcome.

Sirocco is one example of that. Another is Phoenix Project Management, which together with Sibir, the second-largest domestic carrier after Aeroflot, is developing a scheme to take the Tu-154, the workhorse of Russian aviation, into the domestic secondary leasing market.

The plan is to establish an onshore leasing company in which Sibir will have a controlling stake, in exchange for providing 20 Tu-154s. Peter Smith, chief executive of Phoenix, told Trade Finance that the planes would require about $2 million each for refurbishment, and that commercial banks are being approached this month [February] with a view to raising debt finance.

Ernst & Young is acting as advisor to the project, which it described in a statement as “the first opportunity for international investors to invest in the first western style non-governmental aircraft leasing company in Russia”. Mark Jarvis, managing director of corporate finance at Ernst & Young, said in a recent interview in a Russian newspaper that the firm would be helping to “raise some debt finance, acquire aircraft and lease them back into the market to try to support the regional airlines and develop a leasing philosophy in Russia”. The project would “give the aviation industry another ten years to come up with new planes and not let regional airlines fail”.

State support for domestic leasing schemes

Another attempt to breathe life in to Russian aircraft leasing, and so aid manufacturers, is a state-supported scheme to finance the manufacture of planes for lease to domestic airlines. In a deal hammered out late last year, the state will put up $132.6 million for controlling stakes in two leasing companies, which in turn will finance the construction of ten Ilyushin-96s at the Voronezh aircraft plant and ten Tupolev-214s (a wider-bodied version of the 204) at the Kazan aircraft plant in the republic of Tatarstan.

On 24 December, prime minister Mikhail Kasyanov signed an order assigning 1 billion rubles ($36 million) from the 2001 budget to the scheme. A further 2.5 billion rubles is projected to come from the 2002 budget, and a final 400 million rubles either from revenues from the scheme or from the 2003 budget. A tender to manage the scheme was won in September by Ilyushin Finance, in which the state will take a 38% stake for $80 million, and the Financial Leasing Company (FLK), in which the state will take a 51% stake for $52.6 million.

The deal with Ilyushin Finance, whose major shareholders apart from the state are the Gazprom-allied National Reserve Bank, the state-controlled Vnesheconombank and the Ilyushin Aviation Complex, is to finance the construction at Voronezh of ten Il-96s – six for delivery to Aeroflot and four for Atlanta-Soyuz. Igor Medzhibovsky, deputy general director of Ilyushin Finance, told Trade Finance: “We have reached agreement with the government on state equity participation and received the first tranche of state aid in December.

“The construction of the ten Il-96s will be sufficient to run the Voronezh factory for two or three years, after which we hope to see demand for exports. During that time we expect the company at Voronezh to undertake a restructuring scheme and expand its international service and maintenance network, particularly in the regions where there is potential demand for Russian aircraft.”

Medzhibovsky said that Ilyushin Finance is also in the market to lease Il-114s manufactured in Tashkent, Uzbekistan, and Antonov-74s built at Kharkyv, Ukraine. The deal with FLK, whose shareholders include the Tatarstan government, Tatneft oil company, the Kazan aircraft works and Zenit bank, will finance the construction at Kazan of ten Tu-214s – six for Dalavia airline based in the Russian Far East, two for Tretyakovo airline and two for Versus Holding, an Aeroflot affiliate.

Yevgeny Zaritsky, general director of FLK, told Trade Finance that the company was “delighted” at the government’s support for the aircraft industry. “Aircraft construction is heavily subsidised all over the world, and support such as this is essential if the Russian industry is to become competitive.”

A pilot project – the construction and lease to Dalavia of two Tu-214s for use on routes between Moscow and Khabarovsk in the Far East – is “working smoothly”, Zaritsky said. The project, supported by the regional governments of Tatarstan, where the factory is located, and Khabarovsky krai, which is served by Dalavia, and the planes were delivered in May and September last year.

Zaritsky said that in addition to the Tu-214 leasing programme, FLK has entered into preliminary agreements to lease up to 30 other planes, and is in talks with Sibir about leasing to it new Tu-204s built by Aviastar of Ulyanovsk.

It is the financing of Aviastar, Russia’s largest aircraft builder, that industry observers consider to be the problem left unresolved by the state support scheme. A role is being played by the leasing group Lider, whose principle project is aimed at leasing Tu-204s into the domestic market. Lider’s president Igor Leiko and vice president Yury Berestnikov were elected onto the Aviastar board at an annual general meeting in November last year. At a Global Business Forum aircraft financing conference in Vienna in September Leiko outlined plans for a scheme to buy and lease up to 80 Tu-204s, with interest rate subsidies from the state.

Observers believe that the Ilyushin-FLK scheme’s main problem will be on the demand side. Yelena Sakhnova, transport analyst at the Aton investment group, said: “Market development is ultimately determined by supply and demand. The success of the scheme will depend on the readiness of airlines, who still have large fleets of Soviet-era planes that are not yet unusable, to lease new models. Similar schemes have been discussed for many years, and this is the first time the government has actually signed an agreement and come up with some money, and that is a good sign. But schemes for the secondary market, such as that devised by Sibir, may find more demand in the short and medium term.”

The trouble with Aeroflot

One of the contributory factors to the slump of Russian aircraft production is the lack of enthusiasm from the country’s leading international carriers, Aeroflot and Transaero, for leasing or buying Russian models.

In the mid-1990s, the two companies succeeded in lobbying for suspension of punitive 20% import duties and 20% VAT charges on foreign air transport equipment, and began leasing Boeings from Boeing’s own leasing arm Boeing Capital, International Leasing Finance Company of the US and others. Aeroflot’s fleet of 112 planes includes 28 foreign-built craft which account for about half its flight business; Transaero’s fleet of nine planes includes seven leased Boeing-737s.

The two airlines agreed, in return for the tax exemptions on foreign leased aircraft, to use domestic aircraft too. But in 2000 a pilot programme for the lease of further Il-96s to Aeroflot foundered amid mutual recriminations, and by late last year Aeroflot executives were saying that they intended to stop using Il-62s and Il-86s all together, and replace them with leased Boeing and Airbus models.

In October last year Aeroflot deputy general director Lev Koshlyakov stated that the company’s remaining 28 Ilyushins would be transferred to a special division for charter hire on the domestic market. In an interview with the business newspaper Vedomosti he also said the company intends to sell 11 cargo Il-76s and replace them with three leased DC-10s. The success of such a strategy will depend on the government’s attitude, which has yet to be clarified: the government is under pressure from domestic manufacturers and from politicians not to give further tax breaks for the lease of foreign craft while Russian aircraft factories are in the doldrums.

Transaero added to its fleet of Boeings not with Russian aircraft but with an Airbus. In December 2000 it took delivery of an A310-300 from Airbus’ own leasing arm, Airbus Asset Management Division, which it uses on its routes from Moscow to Tel Aviv, London, Frankfurt and Almaty.

Sakhnova at Aton said: “The government will not give tax breaks for leases from abroad to the extent they did in the past. But more than that it is difficult to determine its attitude. We understand that two draft laws have been drawn up on [prime minister] Kasyanov’s orders: one to extend support to the Russian leasing sector, and the other that provides for leasing equipment from abroad, albeit with a proviso that that will only apply to ‘equipment not available in Russia’. So they continue to look in two directions at once.”

Leasing into Russia

Opportunities for leasing into Russia will be limited in the medium term. Sakhnova believes that the main demand will be for small planes for regional players, and that the large-scale replacement of the Tu-154 on which passenger services depend will not start until at least 2005.

But external factors have driven foreign leasing companies and export financiers to look harder at the Russian market than they otherwise would have done. The widespread decline in passenger demand since 11 September, and the resulting financial crisis among international airlines, means that business in the mature markets is tougher than ever – and so Russia, which is doing so much better all-round than other emerging economies, is getting a second look. Tyco Capital of the US and Pembroke Group of Ireland, which is 50% owned by Rolls Royce, are among the lessors understood to be studying the Russian market carefully.

Andrew Muriel, a partner specialising in asset finance at Watson Farley & Williams, said: “The question in Russia is, which aircraft could usefully substitute for the Tu-154, and the answer includes the Airbus A-320 and the Boeing 737 family. Because western lessors have since 11 September been faced with defaults and the need to repossess, and because the market for such aircraft is so depressed, they are ready to look at Russian risk in a way they may not have been before. Russia is now on the ‘possible’ list.

“The lessors would look at leasing aircraft without paying duties, and while the first port of call would inevitably be Aeroflot and Transaero, they might look at smaller airlines too. Exemptions would have to be obtained, for which, presumably, the quid pro quo would be commitments to buy Russian aircraft.

“There is also a market for foreign lessors taking Russian equipment to lease outside Russia, in return for leasing foreign equipment into Russia. This would require political will and, specifically, a federal government decree to deal with customs issues.”

Among western engine builders, there is an acute awareness that the combination that attracted TNT to the Sirocco Tu-204s – Russian bodies with western engines and avionics – could be a winning one. While Rolls-Royce is supplying engines for the Tu-204, Pratt & Whitney has worked with Ilyushin on a version of the Il-96, work on which slowed last year, and has discussed a programme to reequip Il-76 cargo plane with PS-90A engines. Honeywell and Collins have sold avionics into Russia. Michael Blore, project executive (Russia sales and projects) at Rolls-Royce, said: “In terms of leasing, there are outstanding problems, particularly with leases to second-tier airlines. The status of retrieval rights has never really been tested. But we expect that attempts will be made. As a company we will support any leasing dealing going into Russia.”

As in other economic respects, Russia’s longer-term potential is limitless – and no political energy has been spared to make sure that Boeing and Airbus are among the beneficiaries. Last year Airbus was plugged by French president Jacques Chirac during a visit to Moscow in July, although analysts regard the figure of 30 planes touted in the press as “fanciful” in the short and medium term. In October, Thomas Pickering, Boeing’s senior vice president (international relations), joined a US trade mission to Moscow headed by Donald Evans, US secretary of commerce; among other things Boeing has formed an alliance with Sukhoi, Russia’s leading military aircraft manufacturer, to develop models for the civil aviation market.


For lessors going into Russia, a change in the import duty and VAT regime is crucial. Opportunities to challenge current restrictions legally may come about more quickly as a result of Russia being fast-tracked into the World Trade Organisation. Muriel of Watson, Farley & Williams said that overall, the legal environment for lessors is improving: the changes made to the Central Bank’s licencing regime in October last year, under which various categories of lease payments were exempted from licencing requirements, showed that the trend is towards deregulation. A remaining problem is the wealth of contradictions between leasing legislation, customs regulations and tax laws, which a new leasing law that has passed its second reading in parliament does not satisfactorily address.


Market participants believe that beyond such legal problems, the future of aircraft leasing, and the development of a real domestic leasing sector, depends on demand. Zaritsky of FLK believes that as the Soviet-built fleet, on which the Russian and other CIS domestic markets rely, becomes outworn, there will be demand for 250 Tu-214s between now and 2015. A Rolls Royce marketing study estimates demand for 100 of the planes equipped with RB 211-535 engines. Medzhibovsky of Ilyushin Finance says: “The next three or four years will be a period of consolidation in aircraft manufacturing and aviation, and only after that will the leasing market start to realise its potential.”

A version of this article appeared in Trade Finance magazine, February 2002
Posted April 2002; © 2002 Simon Pirani



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