Committee for Russian Economic Freedom

Police general Alexander Bokov was arrested in a $46 million fraud case involving Volgotanker, the former shipping giant linked to Yukos. Bokov along with accomplices Mikhail Kreimer and Sergei Stepanov, tried to get businessman Alexei Chegodayev to give them $46 million in exchange for a controlling stake in Volgotanker.

How did a police general get control of the world’s largest river tanker company?

Former Volgotanker executive Ilya Katsnelson testified in front of the US Helsinki Commission in 2009 to describe how the company was illegaly taken over by corrupt Russian law enforcement from its managers and shareholders in the shadow of Kremlin’s orchestrated attack on Yukos. Volgotanker, like Yukos before it, was crushed by a bankruptcy process based on invented tax claims.

However,  the money-making business of the Ministry of the Interior, same organization which denied attorney Sergei Magnitsky medical attention that led to his death, never stops. So once Bokov had Volgotanker under control, he tried to sell it to Chegodayev. Something went awry in the transaction as Chegodayev never got the business he paid for and now the FSB (successor to the KGB) is persecuting the generals. Most probably, the FSB have their own perspective purchaser for the same asset. 

At Davos, President Dmitry Medvedev announced the creation of a special sovereign fund to attract foreign capital. This fund would allow foreigner to invest in state property; it is unclear if that means Rosneft or other strategic assets. Russia has the third largest reserves in the world but it is quickly shrinking due to capital leaking out of the system through corruption and expropriation.  The Reserve Fund, which is used to cushion budget gaps decreased by 58% to $25.4 billion last year.

As Russian officials continue to divide up the economic pie among themselves, they are seeking newer sources of capital from foreign investors. But investors should remember the fates of Yukos and Volgotanker and the corrupion tax on any potential returns.

Helsinki Commission Katsnelson Remarks 2009

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?

Russia started 2011 in the shadow of the Khodorkovsky trial. Judge Danilkin delivered a guilty verdict and the maximum sentence requested by the prosecutors, signalling to investors that Prime Minister Putin’s power vertical remained as strong as ever. Despite recovering from the lows of 2009, First Deputy Chairman of the Central Bank of Russia Alexei Ulyukayev recently told the press that total capital outflors will be in the $25-30 billion range. Russian investors took Putin’s retention of power seriously and looked for safer places to invest.

According to Russia analyst James Beadle:

[Russia's] economic development is the innocent victim in this domestic power play. Russia’s business leaders may understand this message but international investors don’t. They observe a distrubing dichotomy between words and actions. Putin has demonstrated that his arbitrary word is the law and that Russia’s legal system remains feudal…Russia’s popularity as a target for investment of all forms will be hindered by insecure political structures. Foreign direct investment will be the biggest victim.

Russia also faces pressure to reduce corrpution and President Medvedev has put that at the top of his agenda. Despite Medvedev’s efforts at combating corruption, Russia continues to fail to comply with the Council of Europe’s Group of Statees Against Corruption (GRECO). Out of 26 recommendations made, Russia completed only a third. Accoring to Alexei Volkov, head of the State Duma’s commission on anti-corruption legislation, change in the area of corruption requires “deep” analysis to see if “they will work in Russia taking into account our culture and tradions.” Would that be the culture of corruption Mikhail Khodorkovsky mentioned in 2010?

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.”

Russian President’s chief economic advisor Arkady Dvorkovich acknowledged in a BBC interview that his country is having a perception issue. He also suggested that 1,000 years of corruption is a hard habit to kick but the authorities are looking into violations of the rule of law. Acceptance is the first step to change and Russia is in need of much change. In the latest Transparency International  survey, Russia declined in ranking again this year to 154 out of 178 countries.

Perception is based on reality and a whistleblower came out today to implicate Prime Minister Putin at the top of an elaborate multiyear scheme to extract contributions from Russian businessmen. Sergei Kolesnikov, a business associate of Putin, has offered the most detailed description of how Putin has engaged in a combination of corruption, bribery and theft to amass his own personal wealth. Read the letter here.

In the open letter to President Medvedev, Kolesnikov reveals Putin’s secret funding network. This letter was delivered Tuesday to the Russian U.N. mission in New York. Two or three times a year Kolesnikov regularly briefed Putin on his personal wealth accumulated through contributions by businessmen. Washington Post columnist David Ignatius wrote today that “it’s one of the most detailed allegations I’ve seen of the links between Putin and Russia’s “crony capitalism.”

Additional reporting by Ellen Barry at the New York Times show how corruption and politics prevent uncovering the truth about the death of Sergei Magnitsky. Contradictory official statements and lack of oversight have prevented the truth to be known. President Medvedev established the Public Oversight Commission to look into the case but after an initial thoughtful review was hijacked by security forces.

These same Federal Security Service (FSB) forces also known as the siloviki are the subject of an article in the New York Review of Books which refers to them as the New Nobility in Russia. In the assessment the FSB runs the country with Putin at the top.

…the FSB focuses its efforts on protecting the Kremlin’s vast economic interests, suppressing legitimate political opposition, and ensuring the Kremlin’s control over the press and television through intimidation and violence.

Alrosa, world’s second largest diamond producer, is considering a stock market flotation in 2012. Currently majority-owned by the Russian government, Alrosa is closed to outside equity investors. Despite some optimism that greater foreign investment would translate to better corporate governance, Alrosa is preparing for their float by restricting the ownership structure. This is standard operating procedure at Kremlin Inc. As we have noted before, the Russian government keeps tabs on its investments even as it looks for fresh sources of capital outside its border by restricting percentage of shares a Russian company can list abroad.

With state capitalism firmly entrenched in Russia, Alrosa maintained its production volume even as other diamond producers have scaled back. Alrosa sells its excess diamonds to the Russian government, which owns a $1 billion diamond stockpile. This indicates that Kremlin officials might have other uses for Alrosa besides the float on a foreign exchange, as another channel for top-level corruption.

The verdict for the Khodorkovsky trial has been postponed until next Monday, December 27th and it looks like the market has already priced in his continued conviction. Russian stocks remain at a 30% discount to other emerging market stocks based on forward price/earnings multiples. That the government or oligarchs own 44% of Russian equities may indicate a not just a strong government influence in business but also a lack of enthusiasm among foreign investors for Russian companies. And since 2005 the 24 stock offerings of Russian companies have returned 13%, but remove gas producer Novatek and the return falls to less than 1%. No wonder investors are in no hurry to allocate capital to Russia.

Alexey Navalny released a new video on his research into Transneft and other large scale projects underway. According to official documents provided by the Russian Federal Audit Chamber, the government has already spent over $15 billion in the Eastern Siberia-Pacific Ocean Pipeline with billions embezzled during the construction.

Sergei Ignatyev, Russia’s central banker, announced on Tuesday that capital outflows have reached over $22 billion in the first 10 months of 2010. Compare this with the other BRIC nations that are seeing capital inflows and the overall emerging markets expect to take in $825 billion in private capital inflows this year.

In Seeking Alpha, Craig Pirrong writes

The net capital outflows reflects two things: (a) Relatively little money flowing into Russia, and (b) a lot flowing out. The former is readily understood, given the very weak investor protections, and the horrible experiences of many foreign investors (Shell, BP, Telenor, Ikea, and on and on). The latter is very revealing too, though. The distribution of wealth is highly concentrated in Russia, so net wealth outflows mean that even the extremely wealthy–those that have investible wealth and the ability to move it overseas–perceive that the risks of investing in Russia are extreme. Even given the vaunted discounts in Russian equity prices, they put a lot of their money overseas. They realize that they have their wealth at the whim of Putin and the siloviki. Better to get it (and in many cases, their families) in a place where it’s harder for the state and the power structures to get at it. They have more influence in the system than foreigners, but “more” doesn’t mean “a lot.”

The lack of effective law enforcement in Russia is reflected in the low prices of stocks on the Russian stock exchange as well as the concentrated management of Russian firms. Without say in the management or direction of the company, investors are not inclined to invest a lot of money.

Which leads us to, where are investors going with their money?

Emerging markets are still where investors are taking their money and BRIC companies make up a large part of those investments. The $48 billion MSCI Emerging Markets Index Fund has a portfolio that has half of the companies in BRIC countries. In the first 10 months of this year, investors have added $75 billion to emerging markets equity mutual funds compared with $15 billion in US large equity funds.

But seeing Russia’s issues with corruption and capricious governance, investors are turning towards Indonesia to replace Russia in the marquee emerging market acronym.

For plenty of money managers and economists, however, the Russo euphoria is all but gone. From Nouriel Roubini to Morgan Stanley, they are calling either for Russia to be ousted from the BRICs altogether in favor of Indonesia or, at the least, for Indonesia to join the other four. They are put off by the policymaking drift in the Kremlin, Russia’s demographic atrophy, and endemic corruption. Indonesia’s fiscal prudence, economic growth—6 percent this year, according to the International Monetary Fund—and strengthening social and political institutions have far more appeal. Twice-elected President Susilo Bambang Yudhoyono has directed funding toward schools and health care, and Indonesia’s coffers are full enough to put the onetime IMF bailout case on the brink of an investment-grade credit rating.

Despite President Medvedev’s roadshow to Silicon Valley and Washington DC, the continued uncertainty over the 2012 presidential elections adds another layer of uncertainty to any investment in Russia. Even wealthy Russians are taking their money and going elsewhere. Should you?

Boris Nemtsov at an event hosted by Columbia University's Harriman Institute and the Institute of Modern Russia

On November 17, 2010, Boris Nemtsov, a leader of the Russian democratic opposition and a former Deputy Prime Minister of Russia, spoke at Columbia University’s Harriman Institute on the current political situation in Russia and his perspective for its future. Echoing his thoughts and research in his recently published pamphlet, “PUTIN: What 10 Years of Putin Have Brought,” Mr. Nemtsov equated Prime Minister Vladimir Putin’s economic policy with Russia’s corrupted state. “If you break corruption, you will break Putin,” Mr. Nemtsov said.

The symbol of corruption in Russia remains the imprisonment of Mikhail Khodorkovsky. Mr. Nemtsov speaks in this video at length about how Khodorkovsky’s imprisonment is an impediment to foreign direct investment and perhaps even more importantly, how freeing Khodorkovsky allows President Dmitry Medvedev the opportunity to break free of Putin’s vertical power chain.

Allegations of corruption on a grand scale continue to dog the Kremlin. Transneft was accused by minority shareholder Alexey Navalny of embezzeling $4 billion during the construction of the East Siberia-Pacific Ocean pipeline. Some of the materials that support his allegations come from mid-level civil servants in the Audit Chamber, perhaps implying that vertical power is most profitable at the top.

Although much is written about the corruption in Russia, estimated by Russian authorities to be between $200 and $300 billion annually, the main indicator for investors is their return on investment.

There was another call today, to remove Russia from the group of emerging market powerhouses, BRIC and replace it with Indonesia. Although a fabricated group of emerging market countries, the allure of BRICs remain and companies from BRIC companies dominate indexes. Indonesia has a younger, growing population, maturing social and political institutions and commitment to education and public health and make it more attractive to foriegn investors. Above all, investors seek growth on their investment, as long as the Kremlin continues to siphon off working capital to grease their vertical power structure, Russia will only continue to be less productive and become less attractive to investors.

PUTIN: What Ten Years of Putin Have Brought

Pavel Khodorkovsky and Mikhail Kasyanov

On Friday, October 22, former Russian Prime Minister Mikhail Kasyanov spoke about the potential for political change in Russia at Columbia University’s Harriman Institute. Some issues he mentioned included the need for political opposition, rule of law and greater foreign investment in Russia. Kasyanov also mentioned the need for Russia to have an active political opposition, something Russia currently lacks. Over 100 people came to listen to the potential 2012 presidential candidate as he described a Russia that leads through example and cooperation, not words and intimidation.

Foreign investors are finicky and there are a lot of options. Last week, Transparency International released their latest Corruption Perception Index and Russia dropped to 154th out of 178 countries, making it the most corruption country in the G20.