Committee for Russian Economic Freedom

Neil Buckley, the Eastern Europe editor of the Financial Times, writes on the Valdai Club website today about the IPO shortfall in Russia, summarizing the dismal first half of 2011 for Russian companies looking to go public:

Analysts originally forecast private companies could raise more than $25bn in 2011 from so-called initial public offerings of their shares, up from only $5.5bn last year. In fact, only $3.9bn was raised in the first half of the year from a mere six deals.

Seven other planned Russian IPOs were postponed in the same period, he notes, prompting:

…more soul-searching about Russia’s lack of attractiveness to international investors, even as president Dmitry Medvedev has announced measures to try to improve the investment environment. It comes as domestic investors also seem reluctant to invest in Russia ahead of parliamentary elections in December and next March’s presidential poll – leading to billions of dollars of net capital outflows in recent months.

Mikhail Khodorkovsky

While IPOs the world over have underperformed, Russia’s case is especially gloomy, as investors have been burned by Russian IPOs not materializing and poor performance with those that did, at least in the traditional extracting industries like metals and mining. (Search engine Yandex is the successful exception mentioned here.)

Buckley concludes by citing the political discount, often called the “Khodorkovsky discount” after the imprisoned former chief of Yukos whose case represents many of the challenges faced by Russian entrepreneurs today, that keeps Russian markets undervalued:

It is difficult to achieve top valuations for Russian IPOs when its whole market remains undervalued largely because of the political “discount” investors apply to the country [due to] perennial concerns over corruption and weak rule of law, [which] seem to reflect uncertainty over the outcome of the presidential election, and whether Russia will be able to conduct reforms needed to boost its flagging economic growth.

Half  of all Russian businesspeople and students want to flee the country, according to the Levada Center, an independent, non-governmental Russian polling and research organization, and as reported in France’s daily financial newspaper, Les Echoes.

Almost a quarter of the entire Russian population would like to emigrate, according to the poll. The principal reasons: the high cost of living (67 percent); corruption (49 percent); and criminal activity (48 percent).  As it is, more than 100,000 Russian are leaving the country each year, according to a number of sources.

Meanwhile, Charles Clover writes in today’s Financial Times about “ascent and dissent,” how with rising wage disparity in Russia comes rising dissatisfaction with the economic status quo, where the children of civil servants are more likely to score high paying jobs than more qualified, less well-connected individuals. That inequality only feeds on itself, as those locked out of the upper echelon have little chance of breaking in:

While income distribution in Russia creeps towards Latin American levels of inequality, having widened notably since the turn of the millennium, the state has incubated an ever more entrenched and inaccessible elite that now controls government and business, and jealously guards its privileged domain.

Washington Post reports that massive and unprecedented outflows from Russia signify deep uncertainty about Russia’s future and its ability to provide a stable platform for economic growth. Russia has well-known domestic infrastructure needs and President Dmitry Medvedev has made modernizing and diversifying the economy as a central issue in his presidency. But with $30 billion leaving the country in the first four months of 2011, the loss of confidence in the Russian government to make infrastructure changes and support the rule of law is evident in both domestic and foreign investors.

Russia’s currency reserves are buffered by the high price of oil, but that usually meant a stem in capital outflows. Not so this year. Evsey Gurvich, head of the Economic Expert Group in Moscow cites political uncertainty in the 2012 presidential elections as one of the reasons for capital flight,

In our country, personal guarantees, personal relations, are still more important for big businesses than laws and rules and formal regulation.”

Another reason he cited was the “weak business environment” in Russia due to the pervasive corruption and expropriation of private business by government officials.

That is another way of talking about corruption, bureaucratic capriciousness and courts that take their orders from on high.

The reaffirmation this week of the conviction of Mikhail B. Khodorkovsky, the onetime oil tycoon who lost his company and his freedom after he challenged Putin, probably translates into “several more billion dollars on the run from Russia,” Gontmakher said.

Domodedovo Airport, the only privately owned airport in Moscow, has come under relentless pressure publicly from the authorities, and that, [Yevgeny] Gontmakher, [deputy director of the Institute of Contemporary Development in Moscow] said, sets a very visible and “awful” example.”

“Trust, but verify” – “doveryai, no proveryai” or “Доверяй, но проверяй” – was President Ronald Reagan’s catchphrase in pressing Soviet leaders for weapons inspections. Now nearly a quarter-century later, trust between the US and Russia is in short supply as President Obama and Russian President Medvedev were unable to show progress on missile defense. Tension levels were already edging higher after the U.S. State Department raised concerns over a Moscow appeals court’s decision to uphold a guilty verdict for former Yukos CEO Mikhail Khodorkovsky on a second round of politically motivated charges, spurring capital flight from Russia amid investors fear that Prime Minister Putin will elbow Medvedev from power.

Pavel Ivlev, CREF’s chairman remarked,

The US and the Western world shall not forget what President Reagan said. “Trust, but verify” is very much applicable to Medvedev today, who is known of saying right words, but very weak on delivery.

We previously wrote about record capital flight out of Russia due to political uncertainty. Both the New York Times and the Washington Post have articles covering this topic. While Kathy Lally at the Post relies on Olga Kryshtanovskaya, a member of Putin’s United Russia party, for her main assertions that there is no competition and it is all a show, Ellen Barry at the Times reports that something more substantive is in progress. Barry refers to a Churchill Winston remark that refers to the Kremlin transfer of power as bulldogs fighting under a carpet,

An outsider only hears the growling, and when he sees the bones fly out from beneath, it is obvious who won.

Barry doesn’t try to predict the winner but Prime Minister Putin has been in the headlines by reprimanding Russian trade officials who were seeking to comply with World Trade Organization’s rule before ascension. James Bacchus, a former chief judge for the World Trade Organization wrote,

Putin’s Russia is something considerably less than an open society. There is evidence aplenty of his decided disdain for the rule of law. A commitment to uphold the rule of law is implicit in signing the WTO treaty. Although not mandated in so many words by the treaty, conscientious allegiance to the rule of law is inherent to a national commitment to comply consistently with WTO rules.

Putin has likened the prolonged WTO accession process to an “ambush” of Russian economic interests. Evidently, he wants Russia to be able to enjoy the benefits without bearing the burdens of being in the WTO. He seeks the tariff concessions and the safeguards against trade discrimination that come with WTO membership, but he does not seem to want WTO commitments to impede unduly on his continued ability to impose the whims of what often seems an arbitrary rule.

Despite Putin’s omnipresence in Russian politics and economy, he was uncharacteristically quiet in the BP-Rosneft deal. BP trying to regain its footing after the Gulf Oil spill entered into a deal with Rosneft while ignoring their existing partners in Russia, Alfa-Access-Renova (AAR). After legal contests in London, AAR has won a major concession, Arctic exploration.

Source: UNCTAD

Financial Times reports of $26.3 billion in capital flight leaving Russia through April of this year. Arkady Dvorkovich, President Medvedev’s top economic advisor said,

The assessment by the president is that we did not have real progress in improving the investment climate. We need progress now in the short term. Investment is very low and capital flight is very high.

Conventional wisdom says uncertainty with the 2012 presidential election is making investors, both foreign and domestic skittish. But with little substantive difference between the tandem leadership, investors seem to reacting to Russia’s infrastructure.

Chris Barter, co-chief executive of Goldman Sachs in Russia, insists

Some kind of enduring reform of the financial and judicial system is needed because currently the rate of capital outflows is unsustainable.

Over the past week the plug seemed to be pulled on the BP-Rosneft deal, only to have the Kremlin step in and resuscitated it with a deadline extension to the middle of May. Despite government meddling in this case, there have been other signs that President Medvedev has moved further away from Putin’s managed democracy and the rule of law are taking hold.

Pavel Felgenhauer writes in the the Eurasia Daily Monitor

Russia’s tandem rulers – President Dmitry Medvedev and former president and current Prime Minister Vladimir Putin – continue to profess their friendship, but these statements are increasingly unconvincing as the presidential elections that will install a new head of state for six years come closer. In Russia elections are shamelessly rigged and results prearranged by a corrupt bureaucracy, so the nomination of an official candidate is indeed the election per se, while the casting of the popular vote is a public relations exercise, mostly intended to appease foreigners and gain international legitimacy. The present tandem arrangement with Putin as the all-powerful prime minister officially sitting in the backseat with Medvedev performing the role of a largely figurehead president cannot continue much longer, certainly not for another six years, as it is already beginning to visibly crack.

Last year, President Medvedev signed into law that those charged with economic crimes should not have to face severe pre-trial detention, however, Russia’s best known political prisoner Mikhail Khodorkovsky has been in pre-trial detention since the start of his second trial. In an appearance before Russia’s Supreme Court, Khodorkovsky won his detention appeal.

The decision was a moral victory for Khodorkovsky, who was sentenced to remain in prison until 2017 in a December ruling condemned by Western governments and rights groups, but it will not lead to his release.

Are these signs that Medvedev’s power is ascending? Ordering top government officials to step down from their directorships of large Russian owned companies has not drawn comment from Putin, who set up the system. Perhaps this is a glimpse of modernization in action, Medvedev-style.

In London, an injunction prohibiting the share-swap agreement between BP and Rosneft was issued indefinitely. The group Alfa Access Renova (AAR) had an agreement with BP as their investment partner in Russia. BP, still reeling from the Gulf Oil disaster looked to the deal with Rosneft to expand their exploration into the Arctic Circle. BP’s shares have gained 2.6 percent so far this year but still trade well below their value of before the Gulf Oil Spill. The injunction is likely to give AAR more leverage, and money, from any resulting BP-Rosneft deal.

WSJ’s Heard on the Street urged potential investors in Russia to study Kremlinology, the study of the murky underbelly of the Russian government. When BP made the deal with Rosneft, it no doubt received strong support from the Russian government since Igor Sechin is both chairman of Rosneft, deputy prime minister and close confidante of Prime Minister Vladimir Putin. Despite these close ties, the Kremlin has not used its muscle to lean on AAR to forgo their legal battles against BP and Igor Sechin is about to lose his chairmanship at Rosneft.

Despite these and other efforts by President Dmitry Medvedev to make Russia more enticing to foreign investors, critical factors remain:

The country needs to attract more foreign direct investment: It fell 13% to $13.8 billion last year, half the level in 2007. Gross domestic product growth could fall to 2.5% to 3% per year in the next 10 years, compared with 6% to 7% in the last decade unless annual foreign direct investment is ramped up toward $75 billion, investment bank Uralsib forecasts. The government wants foreign investors to participate in a planned $35 billion of state-owned company flotations in the next three years. Industries from farming to oil and gas also need foreign expertise to develop.

…so long as former Yukos boss Mikhail Khodorkovsky languishes in jail, many will be sceptical Russia’s legal system is truly independent. Political risk is the reason Russian equities trade at 9.1 times expected 2011 earnings, a 20% discount to their emerging market peers. It would take a brave Kremlinologist to bet on that gap closing.

Russian politics, Churchill said, is like watching two dogs fighting under a carpet. Lately, however, Russia’s top political dogs have shed the rug and are nipping openly at each other’s heels.

First, Vladimir Putin, the prime minister, likened western military action in Libya to the crusades, before Dmitry Medvedev, the president, told him, in essence, to hold his tongue.

Then, last week, Mr Medvedev ordered ministers to leave the boards of state-controlled companies. That struck at the heart of “Kremlin Inc” – the intertwined political and economic system Mr Putin created. Putin loyalists were affected, including Igor Sechin, a close ally for two decades and linchpin of a planned alliance between Rosneft, the oil company he chairs, and Britain’s BP.

Deep in the corridors of the Kremlin, it is clear the starting gun has been fired for presidential elections just under a year from now. Less clear, with Mr Putin expected to decide which man will be the presidential candidate – and to remain Russia’s most powerful figure, whatever position he holds – is what the dogfights are really about.

They may be an attempt to stimulate interest among Russians who are wearying of tightly controlled politics: Russians are unlikely to erupt into Middle East-style unrest. But a sense of popular disillusionment is adding to nervousness in business and political elites over the looming election, which is stifling domestic investment and contributed to $21bn of capital flight in the first quarter of 2011, despite a buoyant economy.

The jostling may be an attempt to prevent either figure becoming a lame duck. Mr Medvedev’s assertiveness could be a pitch to keep his job or it could be another feint. The Kremlin spent much of 2007, before the last elections, building up the conservative Sergei Ivanov as presidential heir apparent – until Mr Putin chose Mr Medvedev.

Neither side wants to be outdone. Mr Medvedev has positioned himself as the “modernisation” candidate, calling for Russia to develop high-tech industries to reduce reliance on oil. A liberal think-tank, the Institute for Contemporary Development, whose trustees Mr Medvedev chairs, has urged radical reform, including more democracy.

Mr Putin has formed his own task force of freethinking economists, including Vladimir Mau, an academic who worked with post-Soviet reformers Yegor Gaidar and Anatoly Chubais. Their conclusions resemble those presented to the president, minus democratic reform, an area people involved say was kept outside their remit.

Yet the worry for the powers that be is that voters seem jaded. Russian media have reported young professionals emigrating, fleeing the prospect of the same figures remaining in power for years to come.

Opinion polls show support for both men, still high by western standards, has fallen to its lowest for years. The dominant pro-Kremlin United Russia party performed comparatively poorly in regional elections last month.

Pollsters suggest support is waning, above all, among the growing urban middle class, perhaps 15 per cent of the electorate. Blog-reading, property-owning Russians are finally demanding a system responsive to theiraspirations.

A think-tank originally set up by German Gref, Mr Putin’s first economy minister, warned last week of a looming crisis because of the “fast-growing delegitimisation” of today’s leadership among many Russians. The only solution was to introduce more competition and new faces into the system.

The Kremlin has reacted in typical fashion, by toying with turning the shell of a 1990s-era party into a “tame” liberal group that could enter the ossified parliament in elections in December and champion middle-class interests. Talks have reportedly been held with liberal-leaning officials including Igor Shuvalov, a deputy prime minister, about leading the party.

Fringe pro-democracy politicians, outside the Kremlin-approved system, suggest this savvy new middle class would never fall for another “fake” party. They are targeting this electorate themselves.

One leading intellectual, echoing Russians at all levels, agrees that rampant corruption, now at the level of a “kleptocracy”, is a central issue. High natural resource revenues may see the leadership through the next elections, and buy support for a while yet. But within five or six years, he says, “change must come. If it doesn’t come from the top, it will come from below.”

The Financial Times Limited 2011

Chris Weafer, Chief Strategist at Uralsib and frequent Russia analyst, commented on the slower than expected Russian IPO market. Despite analysts estimates of Russian issuance market at $20-30 billion, he surmises the revised estimate for all of 2011 to be in the $5-10 billion range. The government would like to move forward with a $30 billion three-year privatization program, but Weafer cautions total investments of only $6 billion.

The dreams of a global financial powerhouse in Russia is running up against the realities of its limits. Weafer explains the mismatched expectations this way:

Valuation remains both the key and the difficulty, a fact clearly illustrated when three of the four IPOs offered in February failed. Investors want a deep discount to reflect market risk and liquidity risk. Issuers still retain ambitions for premium ratings. Issues that offer exposure outside of extractive industries will fare better than more-of-the-same investments in extractive industries. Issues that raise money for expansion and debt reduction will fare better than those simply cashing out an existing owner.

Despite three out of four Russian IPOs failing to launch in the first quarter of 2011, there are more on the way including RusAgro in April.

Some investor wariness might have to do with the political risk in Russia. Since the UN sanctioned strikes against Libya, fissures between Prime Minister Putin and President Medvedev have become more public creating more uncertainty around the 2012 presidential election.