Committee for Russian Economic Freedom

Russian Productivity Lags as Alcohol Consumption Soars

Russian President Dmitry Medvedev, PHOTO: AFP

Along with the corruption and red tape, Western corporations mulling risk premiums on investments in Russia have long discounted the impact excessive alcohol consumption has had on plummeting worker productivity. But despite decades of sobriety campaigns, the Kremlin now estimates that Russians consume 32 pints of pure alcohol per capita per year, more than double the World Health Organization’s recommended maximum. Andrew Osborn of the Telegraph reports that an estimated 500,000 people die for alcohol-related reasons in Russia every year, something President Dmitry Medvedev has dubbed “a national disaster.”

So along with battling bribery, modernizing operations, simplifying regulations and creating reliable infrastructure, add reducing the number of alcohol-related “sick days” to President Medvedev’s daunting to-do list as he fights to lure crucial outside investment.

Russia's Finance Minister Aleksei Kudrin

On Wednesday Prime Minister Vladimir Putin, the unspoken leader of the power tandem in Russia, met with leading economic experts to discuss Russia’s socio-economic development for 2020. According to Russia Profile:

The need for diversification of its resource-based economy has weakened the government’s tight control over the country’s vast resources…Putin, who has used such control in the past to provide a semblance of economic and political stability, now wants experts to put a more modern and efficient strategy in place.

And then in a speech today at the Krasnoyarsk Economic Forum, Russia’s finance minister Aleksei L. Kudrin said that executive management of the government has been “very weak” and said that economic change is not possible without political change. “Just and fair” elections being essential in reestablishing trust with the investment and business communities. 

While avoiding the word corruption, Kudrin describes Russia’s economic policies as being determined by relationships, not the rule of law. He goes on saying,

Arkadi Gontmakher, the owner of Global Fishing Inc., based in Bellevue, Washington, was the largest importer of the Russian crab in the United States. Gontmakher was arrested in Moscow in 2007 when he was arrested and charged with poaching, money laundering and organizing a criminal organization. After being acquitted in December 2010, he was rearrested and charged with the same charges again. The Washington Post describes his situation this way:

Gontmakher was caught up in a criminal justice system that makes doing business here a high-risk enterprise – one in which those in power, or with access to power, routinely use the police and courts to crush their commercial rivals, and in which being tried twice for the same crime is a matter of course, if that’s what it takes to keep someone out of circulation. 

This hand’s on approach to managing the economy is also shown through the capital markets. The Russian leadership of Vladimir Putin, Dmitry Medvedev and Igor Sechin have all called for increased foreign investment and strategic asset sales to boost the economy. Of the four companies that announced IPOs to close last week, only one, VTB, the state-owned bank came to the market. The other three, all private sector companies, Severstal, Chelpipe and HMS all abandoned their IPOs due to poor market conditions.

Here is the Financial Times’s assesment of Russia’s capital markets:

Russia’s private entrepreneurs have to take their chances when they know the Kremlin is in the market. The fact that three non-state issues were pulled reflects badly on the sellers and their advisers – the prices they sought were clearly too high. But the Kremlin should be concerned about the damage done to Russia’s reputation in the market.

Russia Profile reported on Medvedev’s speech at Davos to convince world and business leaders that Russia is ready to do business again. However, Tai Adelaja notes that

Despite the horrendous terrorist attacks, experts say the only bug in the president’s ointment is the case of Mikhail Khodorkovsky, the jailed former billionaire head of Yukos Oil, which continues to cast a shadow on the rule of law and leave a negative impact on Russia’s reputation abroad.

Adelaja describes Medvedev’s top ten reasons to invest in Russia. Here are some reasons to disagree.

Number one: Russia has slashed the number of its strategic companies fivefold. It is no secret that Russia experienced record capital outflows in 2010 and despite rising oil prices faces huge budget gaps. The Kremlin as its self interest in mind when it sheds strategic assets. Putin’s government has a history of opening up businesses to investments to allow others to turnaround the company only to come in at the end to take the company away through trumped up taxes and other phantom violations.

Number two: Russia is set to embark on a large-scale sell-off of state assets in efforts to modernize its country. The Russian government is expected to sell $32 billion in assets by 2013. Foreign investors should remember that some of those state assets were acquired by the state through expropriation. Rosneft’s major assets came after the dismantling of Yukos; now Russian officials are asking investors to risk their capital in Russia again.

Number three: President Medvedev said is poised to create a “special sovereign fund” to attract foreign capital. This was written about in an earlier post. With corruption at all levels in Russia continuing to climb, it was a contributor to the attack at the Domodedovo airport on January 24, Russia is now the lowest ranked developing country in Transparency International’s Corruption Perception Index. Out of 178 countries, Russia is ranked 154th. With capital leakage out of the Russian economy at all levels, it is clear that the special sovereign fund will be a tool for foreign investors to give money to Russian officials. Prime Minister Putin, the leader of the power tandem, has built himself a $1 billion palace with money milked from the power vertical he created. Below are some pictures, provided by RuLeaks, Russia’s version of WikiLeaks.

For more pictures click on photo.

Reason four: Medvedev reiterated that Russia will refrain from imposing a special tax on banks and the financial sector in an effort to attract addtional capital into the country. Russia needs to do all it can to attract foreign investment. In 2010, $38 billion in capital flight was from not only foreign investors but Russian ones as well seeking higher returns for their investment. The Russian stock market, despite being in the so-called BRIC powerhouse and overweighted in emerging markets indices, has lagged the other countries in performance and carries a 30% discount in valuations from other emerging economies.

Reason five: the Kremlin is pressing ahead with efforts to transform Moscow into one of the top-ten global financial centers as part of a drive to diversify the economy away from energy exports. President Medvedev announed in May 2010 that Alexander Voloshin, chairman of Russia’s metals giant Norilsk Nickel, will be the newest member of a presidential council on financial reform and lead the conversion of Moscow into a global financial powerhouse. As we mentioned in an earlier post, Russia is not yet a member of  International Organization of Securities Commissions (IOSCO), which is a minimum requirement for international financial centers. Of greater concern is why financial centers appear and grow, to efficiently allocate capital. But with even Russian investors shunning their exchange for London, New York or Hong Kong and capital outflows reaching record numbers, it is difficult to see how Moscow can differentiate itself and maintain international market standards.

Reason six: Medvedev reaffirmed Russia’s ambition to join the World Trade Organization (WTO) and the Organization for Economic Cooperation and Development (OECD). President Medevedev has proven himself to be ambitious in words but lacking in execution. From his anti-corruption commission to fighting the terrorists who attacked the Moscow airport, Medvedev is the more articulate of the leadership tandem, but he is not the one who holds the power. Medevedev recently admitted that there has been no progress in the country’s anti-corruption progress.

Reason seven: Medvedev vowed to continue the implementation of energy efficiency programs, stressing that the state would also enourage more partnerships in the energy sector. Rosneft, the 75% state owned oil producer recently announced partnerships with BP and Exxon Mobil. BP seemed to have learned from their previous scuffles with Russian authorities that political power trumps business ones. So it has decided to leave its long-time Russia partner TNK and $990 million in dividends to join forces with Putin and Igor Sechin at Rosneft.

Reason eight: Russia is presently developing a mechanism that would help it share technology – especially military technology – with other nations.  This seems to be another tactic for selling state assets as the Kremlin tries to find additional sources of capital, even as the price of oil moves past $90 a barrel.

Reason nine: Russia continues to invest heavily in its human resources, including trying to educate future businessmen and officials abroad.  President Medvedev said at Davos, “Our task is to make Russia more attractive to foreign experts to work in.” Expat workers need to remember Yukos and its audit firm, PWC. During the politically motivated second trial of Mikhail Khodorkovsky, PWC officials were pressured by Kremlin officials to rescind their audit certification of oil giant Yukos to prove the prosecutor’s case. 

Reason ten: Russia is also pushing to interest investors in projects related to the development of sports and large athletic events in preparation for the Olympic Games. Russia is hosting the 2014 Winter Games and corruption is roaring its head as the Sochi Winter Games in 2014 is already the most expensive by far. Just today, the constructiion chief for the Sochi Olympics, Taimuraz Bolloyev stepped down as President Medvedev announced fraud investigations.

Davos 2011

News out of Davos that the Moscow regime has struck mega mega oil and gas deals with BP and Exxon Mobil has heightened a sense among other potential investors that Russia may not be worth the risk. In their agreement with Igor Sechin’s state-controlled Rosneft, BP even turned its back on long-time Russian partners TNK, which took action yesterday in a London court to protect its interests.

Exxon Mobil also doesn’t seem to have a problem in doing business with Sechin and others who built Rosneft by stealing the assets of Yukos and sending its chairman Mikhail Khodorkovsky to a Siberian prison.

Despite an attempt by President Medvedev at Davos to promote investing in Russia, the corruption tax on investment flows directly to the Kremlin. As these two deals demonstrate, the Kremlin orchestrates deals to enrich themselves, adding resonance to Medvedev’s own words to Russian business leaders on December 29 that the country’s investment climate is “very bad.”

As Mikhail Khodorkovsky recently said to the International Herald Tribune and others,

It is obvious that those who can truly be called “oligarchs” – those who have combined state power and big business in one individual – were created by none other than Vladimir Putin and are his comrade-in-arms. The rest of the “Forbes faces” – and indeed a significant part of small business as well – have agreed to pay tribute to the bureaucracy in one form or another…Russia is a sovereign state, but to support deception to demonstrate respect for its corrupt officials, is amoral.

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

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.”

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?

President Dmitri A. Medvedev, in a Soviet-built luxury car, with Gov. Arnold Schwarzenegger.

As a counterpoint to President Dmitry Medvedev’s visit to Silicon Valley back in June, California Governor Arnold Schwartzenegger was invited to visit the Skolkovo, the new business school started by Medvedev to encourage high tech innovation with ambitious Silicon Valley aspirations. Despite intense support by the Russian political and business elite, incubating entrepreneurs in Russia face bureaucratic hurdles to success.

As part of Medvedev’s push to diversify the economy, he has launched an anti-corruption campaign but the results have demonstrated the systemic nature of corruption in Russian society. Recently, Yury Chaika the Prosecutor General has announced that the average bribe increased 30% from last year from 30,500 rubles ($1,015) to 23,100 rubles. At a meeting of the heads of the law enforcement agencies, Chaika exhorted his colleagues, “In 2008 and 2009, we saw a significant revival of work in this area, but the results of the activities of law enforcement agencies in the first half of this year confirm complacency and a decrease of effectiveness and quality of work.”

At the capital markets level, a disappointing IPO market this year reflects the lack of progress in strengthening the rule of law, scaling back government intervention in business and allowing greater political expression. So far, the Russian IPO market has totaled only $3 billion this year, of which $2.2 billion is made up of the Rusal IPO on the Hong Kong Stock Exchange in March. This is only a tenth of the $20 billion IPO market predicted earlier this year by sell-side analysts.

Although markets have been volatile, the Russian stock market has posted a 5% gain this month along with gains by other emerging markets powerhouses China and India. However valuations on the RTS Index are trading at an average multiple of 7 times 2010 earnings where other emerging markets are seeing an average of 13 times earnings. This is the inherent risk premium for businesses doing business in Russia as investors seek safer harbors for their assets.

Transparency International’s 2011 Corruption Perception Index is to be released next Monday, October 25 and it will be telling whether Russia improves or inches ever closer to the likes of Sierra Leone and Zimbabwe.

Jailed Russian businessman Mikhail Khodorkovsky and Hermitage Capital’s Bill Browder know all about doing business in Russia and how successful businesses can be run aground by the capricious whims of government officials. Khodorkovsky’s second trial is approaching its end and despite the trappings of a functioning judicial system, the ultimate decision maker of his fate rests within the Kremlin.

Investors should also heed the fate of Sergey Magnitsky, Hermitage Capital’s attorney who refused to give in to corrupt tax officials only to pay with his life. Recently, both US houses of Congress introduced the “Justice for Sergei Magnitsky Act of 2010”, which is not only symbolic but hits his perpetrators in their pocketbooks. The bill prevents Russian officials implicated in Sergey’s murder from entering the United States and freezes their assets here.

When introducing the bill, US Senator Benjamin Cardin said,

“Nearly a year after Sergei’s death, the leading figures in this scheme remain in power in Russia. It has become clear that if we expect any measure of justice in this case, we must act in the United States…At the least we can and should block these corrupt individuals from traveling and investing their ill-gotten money in our country.”

Although Russia is a tempting place to invest in new business with their highly educated population and large reserves, you should take caution to the promises offered by President Medvedev. He has promised much but delivered little during his term and with the 2012 presidential elections coming up, the winds are blowing against his direction and even his meager declarations of modernization, transparency and accountability may come to an end.