Committee for Russian Economic Freedom

Shockwaves rolled through the Russian investment community today with news that masked policemen stormed Deutsche Bank’s main Moscow office grilling bankers and frightening employees. The raid, reportedly tied to a probe of investments by a political foe of Putin, Inc., comes just days after President Medvedev unveiled a plan to establish Moscow as an international financial center akin to Hong Kong and Singapore.

The New York Times reported today:

Whatever the legal or political missteps of such clients, foreign bankers in Moscow have for years implored the government to refrain from conducting such jarring raids on bank offices. Sometimes, police wielding guns force stock analysts and economists onto the floors of their offices.

That’s not the way to boost investor confidence.

Russian President Dmitry Medvedev looks through 3D glasses at an exhibition at the economic forum in St. Petersburg, Russia, Saturday, June 19, 2010. (AP Photo/Dmitry Lovetsky)

Just a few weeks ago Putin was front and center with his visits to Istanbul and Paris, negotiating foreign policy disputes over UN sanctions against Iran. He even made comments about his tandem leadership with Medvedev that Kremlinologist have interpreted to mean that Putin as no choice but take over the reins in 2012, lest Medvedev actually execute his modernization plans by reducing 160,000 bureaucrats and nearly 300,000 policemen. Of course not all of these government employees have profited from Putin’s rein at the helm but they benefit from the existing “old” system (“budget inefficiency and a resource-based economy” as Arkady Dvorkovich, Medvedev’s top economic advisor put it.)

What a difference a few weeks make.

This week President Medvedev is visiting Silicon Valley to drum up support for a Russian Silicon Valley in Skolkovo outside Moscow. Despite a more promising outlook for Russia’s growth this year, in order for Medvedev’s modernization to be realized, laws must be enacted and enforced.

Another hinderance to Medvedev’s efforts is widespread corruption in the country, equivalent to a third of the country’s GDP annually. The death of Sergey Magnitsky while in pre-trial detention hangs like a cloud. Today, Magnitsky’s business partner Jamison Firestone released a video documenting what the government officials who are responsible for Magnitsky’s death are doing with their ill-gotten fortunes.

Beyond the Magnitsky tragedy the Khodorkovsky trial is a symbol of the lack of property rights in Russia and is costing Russian companies a risk premium as foreign investors demand greater compensation for this political risk.

Leon Aron, director of Russian studies at the American Enterprise Institute wrote in the Los Angeles Times that:

The road to a Russian Silicon Valley starts not in California, Mr. President. It begins with unlocking the door to Mikhail Khodorkovsky’s jail cell.

This is a critical time for Russia’s development as an emerging market. It remains to be seen if Medvedev’s modernization initiatives will be allowed to proceed and allow Russia to develop in an ever crowded global economic playing field or will the presidential election of 2012 reaffirm the Kremlinologists prediction that Putin will rein in liberalizing efforts and lead Russia down the path of increased centralization in government and government oversight of business and trade.

Field of Dreams

In late 2008 President Medvedev discussed the need to create a global financial center in Moscow and recently has accelerated the process by appointing through executive decree on May 18, 2010 that Alexander Voloshin, chairman of Russia’s metals giant Norilsk Nickel, will be the newest member of a presidential council on financial reform. This group will set out a five year plan to make Moscow a financial powerhouse rivaling Shanghai, Dubai and Mumbai.

Global financial centers are based on basic economics, efficient allocation of capital from investors to businesses. A recent Moscow Times op-ed noted the challenges Moscow faces in creating such a center in five years. One such issue is attracting capital and creating an infrastructure of investment domestically. A main reason Russian companies list on foreign exchanges is that it provides a gateway toward more investors and capital. If Russian companies shun their local exchange, there is little motivation for foreign companies to invest the money required to list in a foreign country through understanding of its rules and regulations.

The four components of successful financial centers include:

1. Communications infrastructure, including solid and uninterrupted international links and modern IT capabilities.
2. Legal certainty through clear commitment to the rule of law, protecting property rights and efficient legal processes. Fiscal structures and policies must also be clear and predictable.
3. Fair treatment. Markets must be better regulated so that local insiders are unable to exploit their position. Standards of governance of corporations and institutions must ensure disclosure and the fair treatment of minority shareholders through adequate and consistent disclosure.
4. Availability of skills at all levels either locally or through the free admission of foreign staff.

Of these four issues, international standards of corporate governance may be the hardest for Russia to achieve. At Russia’s annual Securities Market Regulation Conference, Dmitry Ananyev, chairman of the Russian Financial Markets Council conceded that, “We have an additional task of overcoming the non-competitive financial system, which we have inherited from the Soviet era.”

Help may come from abroad.

New financial reforms are sprouting in all countries as the global economic crisis deepens on sovereign concerns that extend beyond Greece to Spain and Ireland and some assert may adversely impact the United Kingdom and the United States.

The London Stock Exchange (LSE) remains the favorite listing exchange for Russian companies, but with Rusal’s recent listing on the Hong Kong Stock Exchange (HKSE) more companies are also looking East. The implications o f HKSE’s more lax listing requirements are disputed by Hong Kong officials, but LSE has begun to require that non-UK companies seeking a premium listing on the LSE to comply with the UK’s Combined Code on Corporate Governance, not just the corporate governance requirements in their home country. Maybe this is the impetus Russian companies need to strengthen their own corporate governance even as the Russian government stalls.

The Russian government’s efforts to limit the percentage of shares a Russian company can list abroad is restricting an important source of capital for Russian companies to expand and refinance debt which puts them at a global disadvantage from other companies.

Russia views entry into the International Organization of Securities Commissions (IOSCO) an important milestone in establishing a global financial center. But as the Moscow Times notes, a financial center is built not with only steel and glass, a vital Moscow financial center needs international investors and transparent laws and regulations. In order for President Medvedev to realize his vision, he needs to change the strict top-down management mentality at the Kremlin and allow capital to flow without government interference. And then, foreign investors may come.