Committee for Russian Economic Freedom

News of corruption-related crimes involving top government officials and large bribes increasing 100% in 2010 year-on-year in Russia comes as studies in geopolitical risk and economic opportunities reiterate Russia’s decline. Two notable studies on business risk came out this week, Heritage Foundation’s Index of Economic Freedom and Maplecroft’s Political Risk Atlas.

In the Heritage Foundation report, Russia remains in the bottom quintile and is only 0.6 points away from being in the “repressed” category of the index.

Russia scores very low in the categories Freedom from Corruption, Investment Freedom and Property Rights. From the summary report

Economic freedom is severely challenged in Russia. While strong returns from hydrocarbons have buoyed its economy, prospects for sustained, long-term diversification and growth remain dim…Pervasive corruption and limited respect for property rights hinder the development of economic activity that is free from government control or influence. Macroeconomic instability is a drag on economic growth.

In the Maplecroft report, the focus is widened to include political risks as well as emergins risk areas, notably structural risk affecting long-term infrastructure stability. Widening the scope of the survey seems to dampen Russia’s prospects further as Russia moved into the “extreme risk” category of their study for the first time. Russia is ranked 10th most risky country, sandwiched between Pakistan at number 9 and the Central African Republic at 11.

Political Risk Index 2011 (Dynamic) © Maplecroft, 2011

Russia’s extreme risk rating is exacerbated by the increased activity of militant Islamist separatists in the North Caucasus region. In 2010, terrorist attacks in this area doubled. Additionally, the business and investment environment in Russia is under a lot of pressure from the government. The Maplecroft study summarizes Russia’s business climate this way,

The country’s poor performance is compounded by its “extreme risk” ratings for its business environment, corporate governance and the endemic nature of corruption, which is prevalent throughout all tiers of government.

Challenges for companies operating in Russia also stem from an ineffective legal and regulatory system, which includes a lack of judicial independence from the government. This was most recently in the politicised case agained jailedYukos oil tycoon Mikhail Khodorkovsky, which most commentators dubbed a show trial.

Maplecroft also sees worsening stuctural issues for the BRIC countries and particulary Russia. In Ariel Cohen’s analysis of the Khodorkovsky verdict, he sees a “telephone” law at work where “a system in which punishments are triggered by phone calls from higher ups”

Given all this evidence, why risk Russia?

Tony Avelar/Bloomberg News

News that Goldman Sachs engineered a major stake in Facebook, the world’s most popular social networking website, by Moscow-based investment firm DST Global offers more evidence to support Mikhail Khodorkovsky’s observation in the Washington Post last year that corruption ranks as a leading Russian export.

“The source of the funds used to make the Facebook investment merits further investigation,” said Pavel Ivlev, chairman of the Committee for Russian Economic Freedom. “It’s increasingly clear that money stolen by corrupt Russian officials is being spirited out of the country and invested in legitimate Western businesses.”

Created in 2005, DST is owned by oligarch Alisher Usmanov and Yuri Milner, founder of Russia’s most successful Internet ventures, including Mail.ru.

Usmanov, a native of Uzbekistan, spent six years in an Uzbek prison on a conviction of fraud and embezzlement in the 1980s, charges he says were politically inspired. A Soviet court later dismissed the charges and Usmanov eventually made billions of dollars in the post-Soviet era by managing steel mill subsidiaries for Gazprom before they were spun off as his own businesses.

The record shows that Usmanov’s relationship with Vladimir Putin and other Kremlin leaders has made him one of Russia’s wealthiest men. From his lead role at Gazprom, the state-controlled energy giant that absorbed assets stolen from Khodorkovsky’s Yukos in 2003-2004, to his current company Metalloinvest, Usmanov has made the money he used to invest in Facebook by capitalizing on what former Prime Minister Mikhail Kasyanov calls “Putin’s capitalism for friends.”

Milner got his start in business working for Khodorkovsky’s bank Menatep, setting up a brokerage and investment arm before leaving in 1997, the Financial Times reported. Officials aligned with the regime later prosecuted former Menatap financial executives and tried to force them to testify falsely against Khodorkovsky. But not Milner, who shifted into investing in the Internet with the backing of Usmanov and others tied to Putin.

Following Khodorkovsky’s conviction last month a second round of trumped up charges, Russian Foreign Ministry spokesman Andrei Nesterenko dismissed protests from leaders in Washington and EU capitals, saying “we expect everyone to mind their own business, both at home and in the international arena.”

Investors in Russia have done just that, “minding their own business” by pulling assets out of the country at an accelerated pace, according to Pavel K. Baev in a post-verdict analysis.

The conviction of Khodorkovsky proves that Prime Minister Putin and not President Medvedev controls Russia and “translates into a re-evaluation of business and personal prospects in a country of self-serving bureaucracy – and into capital flight that increased sharply in the last months of 2010 and is set to reach $25 billion to $30 billion,” Baev wrote.

“Medvedev tries to explain away this worrisome trend by emphasizing the need to improve the investment climate, which in his view “leaves something to be desired; it is bad.” Medvedev has also initiated a package of reforms in economic legislation that should take effect in 2011-12, and quite probably he simply does not understand that the Khodorkovsky case is not a minor setback for the markets, as it was five years ago, but the irrefutable verdict on his “modernization” strategy.” Yet the verdict renders hollow Medvedev’s statements supporting the rule of law and enforceable contracts in Russia.

“Investors in PepsiCo, Morgan Stanley, Facebook should closely question their board members about the prudence of those companies risking capital with the Putin regime given the growing list of major Western companies that have been defrauded by corrupt Russian officials,” Ivlev said. “But more telling are the latest statistics which show that Russian businesses that have benefited from the regime are now eschewing further investments in the country given the lawlessness that they themselves helped promote.”

The 2010 St. Petersburg International Economic Forum will start next week on June 17. This is a key capital markets event for investors, business people and policymakers and supported by the Russian Federation. Talk about the economy and banking is everywhere. This neatly dovetails into Russia’s own focus on economics as the main engagement point with other countries, especially those in the G20. Below is a letter from CREF’s Chairman Pavel Ivlev to forum attendees.

CREF Chairman’s Letter to St. Petersburg Economic Forum Attendees

Reuters recently released an article outlining three key risks in Russia: the variable price of oil, political shake up in the Kremlin and further insurgency attacks. Though the world’s largest energy producer, Russia’s manufacturing, construction and retail industries continues to contract as domestic consumption and foreign investment continues to lag, increasing the economy’s dependence on oil prices for growth.

Prime Minister Vladimir Putin remains popular and the driver behind the co-governance team with President Dmitry Medvedev. Despite highlighting their differences and indicating Medvedev’s intentions of political and judicial reform, Reuters notes that Russian markets would rebound only if Putin remained in place. The maintenance of the status quo despite Russia’s world renown for government corruption and weak rule of law seems curious. With foreign investors, such as IKEA, Hermitage Capital, and now HBK investments scaling back or pulling out of Russia due to corruption and extortion, why would the markets value Russian companies more if the status quo remained?

And how does the continued expropriation of private business by government officials add to Russia’s economic capital?

The extraction of Russia’s economic and natural resources by the politically connected few leads to only self-enrichment. Perhaps this self-enrichment would be tolerable if the proceeds were reinvested in Russia and the Russian people, but this is rarely the case. What Russia needs is investment to update oil and pipeline infrastructure, capital to encourage innovation and a stronger rule of law to benefit all Russian people.

Russia’s most famous political prisoner, Mikhail Khodorkovsky began his spirited defense yesterday against his Kafka-esque second trial. The government charged Khodorkovsky and his business partner Platon Lebedev with stealing 2.5 billion barrels of YUKOS’s crude oil or a third of the United States’ entire annual consumption of oil.

The trial is also viewed domestically and abroad as a test of Medvedev’s commitment to ending “legal nihilism” and his power and control within the Kremlin. Medvedev even started a national anti-corruption drive this March. According the Associated Press,

The trial is considered a test of whether President Dmitry Medvedev, himself a lawyer, is serious about reforming Russia’s judicial system. In other cases, judges have come forward to complain they face political pressure.

Only time will tell if Medvedev makes good on his words.

Despite a recent article linking Russian Medvedev’s liberalization efforts as gloss on Putin’s authoritarianism, there remains a way for political outsiders, Russians and foreign investors to effect change in Russia, and that is through company ownership. With no political opposition and cronies heading up the country’s largest companies, the current political structure is in place to maintain Russia as an ATM for the political elite. According to Transparency International Russia,

Since Putin came to office in 2000, Russian officials are estimated to have skimmed some $200 to $300 billion a year from the economy.

The most important job of the Russian government is to ensure that all the stolen money remains hidden and that the system aiding and abetting the pilfering of national assets remains in place. So, even though 93% of Russians believe that the government is not doing enough to combat corruption, Medvedev will not enact meaningful reform and rock the boat he helped build with Putin.

One of the only ways to make Russian political and business elite to take notice, is shareholder activism. By using his minority ownership of state-run companies, Alexei Navalny has shone the spotlight on the mismanagement and embezzlement by government officials. Foreign investors in Russia can do the same by demanding a greater percentage of ownership and management input from Russian companies that seek to tap into international capital markets. From this ownership position, accountability and transparency can start to take root in the Russian economy.

Ian Bremmer and Alexander Kliment published an interesting article in the World Politics Review today called, “State Capitalism and the Future of Globalization.” In it they argue that the assumption that globalization and capitalism will lead to free markets and free ideas must be reconsidered.

Far from blossoming into the pro-Western, market-oriented democracy that the 1990s shock therapists dreamed of, the successor to the Soviet Union has developed into a quasi-authoritarian petro-state, strongly committed to a form of tightly managed oligopolistic capitalism, in which elements of free market ideology coexist with strict government control over sectors that the Kremlin considers vital to Russia’s economy and security.

In Russia today, Bremmer and Kliment point out that Prime Minister Vladimir Putin has crafted a public policy that puts the interests of the state and its officials above the interests of investors, domestic or foreign. These state capitalists have codified their behavior by passing the “strategic sectors law” of 2008, where foreign investors must receive special governmental approval to obtain large stakes in Russian companies in the 42 sectors deemed of national strategic importance.

As an example of this state control, Bremmer and Kliment point to the energy sector where the state now controls 50% of Russia’s oil output, up from 10% when Putin initially come to power. Part of this was accomplished by

jailing in 2003 of Mikhail Khodorkovsky and the state takeover of his Yukos oil company. [And] several years later, the state pressured the Shell-led consortium at the Sakhalin-2 oil and gas project to cede a controlling interest to Gazprom for below-market value.

Interestingly, the 13 largest energy companies on Earth are owned and operated by governments and these state-owned companies now control nearly 80% of global crude oil reserves. As Russia and China take the lead to dominate sectors domestically, they are also funneling the wealth from these state organizations into sovereign wealth funds, maximizing not only their investment returns but also international political influence.