Committee for Russian Economic Freedom

Swedish Tele2 sells its Russian arm to VTB, a state-controlled bank, for $3.55 billion while consortium of Vimpelcom and MTS, two leading mobile networks in Russia, offers up to $4.25 billion for the asset.

In a free market economy, sellers maximize price by organizing transparent auctions between potential buyers. Through the auction procedure, buyers improve their offers and a seller gets the highest possible price for his asset while shareholders control the process and push company to shop for the best proposal.

Andrei Kostin is famous on serving Kremlin's special interests

Things are different in Russia. Transparent, competitive procedures are rarely observed in the Russian market. In many cases sellers have no other choice but to sell their assets, and do it urgently. The only possible acquirer is usually known beforehand. The sum of the deal often depends on the goodwill of a buyer and “merits” of a seller. Those, who risk stepping in with a counter offer, are ignored or severely punished.

The acquisition of Tele2 Russia, the fourth largest cellular network in Russia, fits well into a pattern of a typical Russian deal. Two largest Russian telecom companies complain that they have not been allowed to participate in negotiations with Tele2. According to VTB, the parties already signed a legally binding agreement and the deal can’t be reversed. Head of VTB Andrei Kostin makes no secret of the bank’s intentions to sell Tele2 Russia in the nearest future. Most likely, the assets will be used to form a larger company with state-controlled Rostelecom or/and Megafon, the third largest mobile network provider.

Tele2 sells its Russian assets because the company’s further development has been effectively blocked by the Russian government. In the telecommunications industry regulator can easily kill a company as happened many times in the Russian wireless market. The Swedish company was allowed neither to build 4G network nor to use its 2G network for LTE.

The economic impact of the deal will be mainly negative. The effective government control over the economy will increase as well as the capital outflow from Russia. The real beneficiaries of the acquisition will be revealed pretty soon. Non-transparent, non-competitive deal procedure demonstrates Russia’s unfavorable investment climate. Investors don’t receive fair price for their assets while the growth of non-government controlled companies depends on the relationships of their owners with the Putin’s team.

FT

September’s research of Gaidar Institute for Economic Policy analyses the rebound of Russian economy after 2008-2009 crisis. The institute concludes that the economic growth model of 2011-2012 doesn’t work anymore and warns of the threat of a new banking crisis.

Central Bank Chairman Sergei Ignatiev needs to choose between supporting economic growth and preventing banking crisis

Consumer spending was the major contributor to the economic growth in Russia during the last two years. More than quarter of household consumption was financed by consumer credit. However, banks don’t have resources for further expansion. Their clients prefer buying dollars and transferring them abroad instead of depositing money in Russian banks. The Bank of Russia became the major provider of liquidity, but recently it tightened its monetary policy.

The inevitable contraction of consumer credit will lead to the economic slowdown. Furthermore, several indicators point to the mounting risk of a full-scale banking crisis. The share of liquid assets in total banks assets has dropped below the level of September 2008, when a previous banking crisis happened. At the same time the “credit deficit” – the difference between banks’ loans and deposits – almost equals the amount of liquid assets. In sum, Russian banking system is ill prepared for the worsening of economic conditions.

Banks will be one more time bailed out with the government’s funding and boost of liquidity from central bank. However, the loose monetary and fiscal policies won’t trigger the much-needed growth of investments, but will fuel inflation. To speed up the economic growth, the government should commit to structural and institutional reforms, restoring the private property rights and guaranteeing fair competition to all economic agents.

Gaidar Institute

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.

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.

Reason One: Chances are you and your clients will lose money.

Russia is “one of the world’s riskiest locations for business to invest in,” according to a survey of 196 nations by U.K risk-assessment company Maplecroft. Russia is the 10th-riskiest country for investors, sliding from 15th last year to place between Pakistan and the Central African Republic, concluded Maplecroft’s annual Political Risk Atlas released in December 2010.  Brazil, India and China, which along with Russia make up the so-called BRIC group of leading emerging-market economies, are ranked 94th, 26th and 62nd, respectively. Russia’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,” Maplecroft said.

Reason Two: Russia is the world’s most corrupt major economy.

Little surprise that Russia is also the world’s most corrupt major economy, according to Transparency International’s 2010 Corruption Perceptions Index issued in October, sliding to the 154th spot of 178 countries and placing it alongside Tajikistan and Kenya.

Reason Three: Even President Medvedev says conditions are “very bad.”

Following the conviction of former Yukos CEO Mikhail Khodorkovsky on a second round of trumped up charges in December 2010, President Dmitry Medvedev noted that only 14 companies went public on his country’s market in 2010. “This is nothing to be proud of,” Medvedev told business leaders. “Part of the problem is, of course, is our investment climate, which is bad. Very bad.”

Reason Four: It’s not worth the hassle and you could wind up in jail or worse

The conviction of former Yukos Chairman Mikhail Khodorkovsky’s on a second round of trumped up charges in December 2010 may have “unintended repercussions” for business in Russia, state-controlled VTB Capital said Dec. 31.The “most disturbing detail” was the court’s rationale for the verdict, VTB said. Charges based on Yukos’s use of internal transfer pricing, which redistributes cash flows among units of a holding company, creates a precedent that leaves other businesses open “to attack.” Meanwhile, lawyers in the U.S. are racking up massive billable hours representing corporation and their board members fearing prosecution under tougher Foreign Corrupt Practice Act enforcement. Moreover, CEOs are feeling pressure from board members and shareholder groups to avoid the financial and legal nightmare associated with getting entangled in corruption scandals in Russia and elsewhere. And anyone thinking about investing in Russia ought to remember what happened to corporate counsel Sergey Magnitsky when he tried to defend investor rights in Russia – he died under brutal conditions in a Moscow jail.

Reason Five: Small investors lose, too

Only the the bravest, or most foolhardy, of small investors would consider wading into the Russian swamp, Brian Milner wrote in the Globe and Mail, citing Peter Zeihan of Stratfor, a global intelligence firm based in Austin, Tex. “Russian law, when it comes to portfolio investments, is at best inconsistent,” Zeihan said. “I don’t think we’re ever going to see a rebound of activity to the levels we saw in 2006-07. Too many people have been burned.” Russia, Zeihan said, “is not a global player economically in any way, with the exception of energy sales to Europe. That’s all they’ve got. I don’t mean to say it’s small, but it’s certainly narrow. And the Europeans, to be perfectly blunt, are pretty sick of the Russians. So any time there’s a decrease in demand in Europe, the first importer that gets cut is Russia.” The country, he says, is “in a long, slow twilight. They’re going to have a couple of great years while the Europeans are in a mess. And they have relative strength because the Americans are distracted in the Middle East. But they realize that they’re on borrowed time.”

Reason Six: The Russian equity market’s bad reputation is priced in

There is little doubt that Russia has a poor image and this is probably why its stock market is one of the most lowly-rated of the emerging economies, with an average price-to-earnings ratio of about seven or eight times, the Moscow Times reported.

Reason Seven: Putin’s vendettas hurt the economy and scare away investors

Arkady Dvorkovich, the Duke University-educated aid to Medvedev, said that “a significant part of the international community will have serious questions” about the Khodorkovsky case and that “the assessment of the risks of working in Russia will increase.” Moreover, Roland Nash, co-founder of Verno Capital and a 16-year veteran of doing business in Moscow, told journalist Chrystia Freeland that the Khodorkovsky case had exacted a real, quantifiable economic cost. “The Russian equity market would be worth several hundred billion dollars more if it weren’t for the critical Western perception of Russia, and the Khodorkovsky case is the principal example of that perception,” Nash said. “Within Russia, everyone who matters understands exactly what the Kremlin is trying to say: that there is no one above the rule of the Kremlin.”

Reason Eight: The smart money is going out, the dumb money is going in.

The unreasonably harsh punishment of unbreakable Khodorkovsky and Lebedev shows that this system has grown so thoroughly corrupt that by trying to prove its power it actually destroys its credibility

analyst Pavel K. Baev argues. This disappointment translates into re-evaluation of business and investment prospects in the country of self-serving bureaucracy – and into capital flight that increased sharply in the last months of 2010. In 2010, total captial outflows from Russia amounted to $38 billion. President Medvedev quite possibly doesn’t understand that the Khodorkovsky case is not a minor setback for the markets, as it was five years ago, but the irrefutable verdict for his ‘modernization’ agenda.

Reason Nine: Russia is a sucker’s bet

According to Peter Cohan, president of Peter S. Cohan & Associates, a management consulting and venture capital firm:

Russia is under the illusion that it can use PR spin to dissipate investors’ concerns about its past abuses of capital providers and convince new suckers to invest there. The fate of Khodorkovsky is one particularly unpleasant example. Three cases of Russia’s hostility to outside investors:

• How Russia used its legal system to kick out BP executives, including Bob Dudley (now BP CEO), from an energy joint venture
• How Russia offered the founder of Hermitage Capital, an investment firm that had placed capital in Russia, the option of his life or his money
• How Sawyer Research, a small Cleveland, Ohio, company, lost its $8 million investment in a Russian quartz plant to “creeping expropriation”

The simple reality is that investors may get seduced into a country by high growth rates, but if that growth should slow, the country’s bones will poke through.

Reason 10: Russia will remain backward as long as Putin thwarts modernization

Putin has used the second Khodorkovsky show trial to make clear that he is unwilling to ease his informal authoritarian style, even as Russia seeks a path toward modernization, according to James Beadle, an independent investment consultant and a founding partner of the financial blog Market Melange wrote in an op-ed:

Economic development is the innocent victim in this domestic power play. Russia’s business leaders may understand the message, but international investors don’t. They observe a disturbing dichotomy between words and actions. Putin has demonstrated that his arbitrary word is the law and that Russia’s legal system remains feudal. But once again, 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. Learning from Yukos, as well as Shell, BP and many others, companies will be hesitant to invest in long-term fixed assets as long as the government’s word is the only guarantee that their rights and property will be respected.

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?

Our recent participation in the Global Macro Investing and Geopolitical Risk Forum in New York helped us focus attention on the challenges and potential rewards of investing in Russia. We are asking supporters of free markets, free ideas and free people to show support for the rule of law, transparency and secure profits by requesting a symbolic share in Russian Economic Freedom today.

By becoming a shareholder in Economic Freedom you will send a message to Russia’s leaders that direct foreign investment will increase only if they stem corruption, increase transparency and enhance corporate governance. Owning a share will cost you nothing more than the courage of your own convictions, yet it will yield tremendous social and financial rewards for asset managers and the Russian people alike. Hedge your position – short Russia’s current regime and go long Russia’s economic future.

As you know, hope for an improved investment climate in Russia surged after President Dmitry Medvedev’s tour of Silicon Valley in June and California Governor Arnold Schwarzenegger’s October visit to Skolkovo, the new business and research hub started by Medvedev to encourage high tech innovation. Despite intense words of support by the Russian political and business elite, it’s become even more apparent that incubating entrepreneurs in Russia face massive bureaucratic hurdles to success.

As part of President 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. The Prosecutor General Yury Chaika announced that the average bribe increased 30 percent to 30,500 rubles ($1,015) from 23,100 rubles last year. 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 performance for Russian IPOs this year reflects the lack of progress in strengthening enforceable contracts, 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.

The Russian stock market is posting gains along with increases by other emerging powerhouses China and India. However, volatility reigns as valuations on the RTS Index are trading at an average multiple of seven times 2010 earnings while other emerging markets are changing hands at an average of 13 times earnings. This represents an inherent risk premium for Russian businesses as investors seek safer harbors for their assets.

Transparency International’s recently released 2010 Corruption Perceptions Index ranked Russia as the world’s most corrupt major economy, falling to 154th of 178 countries. (Russia placed 146th in the 2009 index of 180 countries.) Russians now pay bribes totaling $300 billion a year, equivalent to almost a quarter of the nation’s GDP, according to Kirill Kabanov, head of the National Anti-Corruption Committee.

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.

“A guilty verdict would damage President Medvedev’s reputation and his drive for modernization,” Mark Urnov, a political scientist at the Higher School of Economics in Moscow, told Bloomberg News. “Though Medvedev has never said that he’d like Khodorkovsky to be freed, his acquittal would be seen by many as Medvedev’s achievement.”

James Beadle, a U.K.-based consultant for investors in Russia, echoed that “a negative outcome for Khodorkovsky is likely to reinforce investor skepticism toward the fairness of the Russian business climate … I don’t think that any foreign company is under any illusions that things have changed; they remain hesitant.”

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 be cautious about the exhortations 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.

Email info@russianeconomicfreedom.org and become a shareholder of Russian Economic Freedom.

San Jose Mercury News
By Jamison Firestone
Special to the Mercury News
Posted: 06/23/2010 08:00:00 PM PDT

Russian President Dmitry Medvedev visited Silicon Valley this week in hopes of wooing executives to invest in Russia. But as high-tech leaders think through the pitch, they might want to consider what could happen when their Russian investments are up and running.

I am a member of the New York Bar who’s served on the board of directors of the American Chamber of Commerce in Russia for the past six years and managed a law firm in Moscow for 17 years. My firm represented the largest foreign investor in Russia, Hermitage Fund, which once had more than $4 billion invested there.

In 2007, officials from the Moscow Interior Ministry raided my offices and my client’s offices and took all of Hermitage Fund’s statutory documents and seals. Even the Russian government now concedes in Moscow court filings that those documents and seals were then used to fraudulently re-register the companies into the name of a convicted killer. A criminal group subsequently applied for a refund of the $230 million of taxes that the Hermitage Fund paid in 2006. The payment was granted in one day, no questions asked. It was the largest tax refund in the history of Russia, a country where even the smallest refunds take months, if not years.

Hermitage hired five law firms to report the thefts and recover the stolen companies. In the two years that followed, I personally witnessed Russian officials implicated in the crimes attempting to arrest every lawyer who was involved in the investigation or reporting of the thefts. In a classic case of Kafkaesque absurdity, two of Russia’s most famous and respected lawyers were criminally prosecuted for reporting the theft. They fled the country.

third respected corporate lawyer, my partner Sergei Magnitsky, refused to flee Russia because he thought the law would protect him. He testified against the corrupt officials. One month after his testimony, he was arrested by the very officials he testified against. The next day, they tried to arrest three more lawyers, all of whom fled Russia.

Magnitsky was kept in pre-trial detention for 12 months and was tortured to get him to withdraw his testimony, but he refused. On Nov. 16, 2009, Magnitsky died as a result of torture at the age of 37, leaving a wife and two young boys.

Since then, it became public that the same group of officers and criminals had been accused of similar crimes in the past. It was also discovered that immediately after the thefts were reported, the officers’ families acquired millions of dollars in assets.

Like many people, I find Medvedev confusing. He speaks about fighting corruption, building rule of law and fostering investment, but Russia’s level of corruption continues to increase. Silicon Valley may see him as the first Russian leader to surf the Web and use e-mail, but television news still is under state control, and independent journalists, human rights activists, businessmen and now their lawyers are arrested and killed with impunity.

I would like to believe that Medvedev is sincere. But he has done nothing to bring Sergei’s killers to justice, to find the stolen government money, to help my client recover its companies or to stop the attacks on lawyers.

What happened to my client can happen to anyone doing business in Russia, and no law firm in the world can defend you in a land without law. Large companies that were sure they would have government support, like Shell, BP, Carrefour, Telenor and Ikea, were left to the wolves. In each case, the Kremlin either attacked or allowed corrupt officials to attack foreign investors that bought into the same pitch you just heard.

Caveat emptor.

JAMISON FIRESTONE is managing partner of Firestone Duncan, Moscow. He wrote this article for this newspaper.

Los Angeles Times
The government is building a Russian version of Silicon Valley. But the Kremlin’s Big Brother approach, along with lawlessness and corruption, leaves entrepreneurs wary of taking risks.
Leon Aron
June 23, 2010

Having survived — barely — an 8% contraction in its gross domestic product (the worst among the G-20 countries), Russia’s prospects for the next few years are iffy at best. Unless oil shoots back up to more than $100 a barrel, the country’s economy may grow only slightly — or stagnate for the next few years.

In response to its economic woes, the Kremlin has decided that what Russia needs is the equivalent of a Silicon Valley. And so the government is building “Innovation City” in Skolkovo, just outside Moscow. The project is envisioned as a kind of free entrepreneurial zone, aimed at attracting the best and the brightest from Russia and abroad. The Kremlin has appropriated $3.5 billion to build the “technopolis” — a gated community surrounded by guards

This is hardly a new strategy. Importing ideas and technology from the West has been a key element in Russia’s “modernizations” since at least Peter the Great in the early 18th century. For two centuries, Russian leaders followed in the czar’s footsteps, including when Stalin implemented his five-year plans. But Russia has tightly controlled what it imported. Machines and engineers, yes. A spirit of free inquiry, a commitment to innovation free from bureaucratic “guidance” and, most importantly, encouragement of brave, even brash, entrepreneurs who can be confident they will own the results of their work — most certainly no.

Peter and his successors sought to produce fruit without cultivating the roots. During the 17th and 18th centuries, this approach could be seen in the Nemetskaya sloboda (German district), where foreign craftsmen lived but Russians were not allowed lest they be tainted by foreign influences.

When national economies were defined by the amount of pig iron, steel and coal they produced, a serf or a worker with no rights would do. They could cast Peter’s cannons and pour concrete for the plants of Stalin’s industrialization. But only a man or woman free from fear and overseers can build a Silicon Valley.

And such men and women are harder and harder to come by in Russia today. Disgusted and scared by the lawlessness and rampant corruption, they tend to shy away from ambitious plans and avoid taking risks.

To be fair, President Dmitry Medvedev, who will visit California’s Silicon Valley this week, is aware of the problems and says all the right things about the need for liberty, private property and a spirit of unfettered innovation. He speaks of the importance of the rule of law. But after two years in power, he is losing credibility, and his words are wearing thin. “How are things, really?” I recently asked a top Russian entrepreneur, having made sure that no one could hear us. “Poka ne trogayut,” he answered. “They are not after me yet.” Hardly an environment for an innovation-driven business model.

Paralyzed with fear and uncertainty, Russian entrepreneurs are investing very little in their country beyond their immediate production needs. Up to 80% of investment in Russia today comes from the government. Capital flight is rampant. Worse yet, according to recent research, some of the most successful Russian entrepreneurs, not satisfied with merely sending their children to live and study in the West, increasingly think of selling their businesses and leaving themselves. At the very least, almost all are building their lives and business around the “two-home” model: one in Russia, one in the West.

Today’s atmosphere is a far cry from the end of the 1990s and first few years of this century. Then, with the worst of the rough-and-tumble, raw and crude capitalism behind it, Russia seemed as if it would soon be capable of forging its silicon valleys. State power seemed to be finally detaching itself from property, and top Russian entrepreneurs, newly confident of their property rights, began to invest billions of dollars to create companies every bit as modern, efficient and open as the leading Western conglomerates. With their profits, they donated millions to charity, promoted computer literacy and Internet availability and invested in a “knowledge-based” economy.

One company and its entrepreneurial leader stood as symbols of the new business environment: the oil company Yukos and its chief executive and principal owner Mikhail Khodorkovsky. Today, the company is no more. It was taken over by the state for alleged nonpayment of taxes, broken up and sold at rigged actions to the state-owned Rosneft. Convicted by a kangaroo court on charges of fraud and sentenced to eight years in prison after his 2005 trial, Khodorkovsky today is in the middle of another farce of a trial, accused of stealing 350 million tons of oil from Yukos’ subsidiaries.

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.

Leon Aron is director of Russian studies at the American Enterprise Institute.