Committee for Russian Economic Freedom

James Beadle

Source: PRIME-TASS
Contributed by James Beadle, a private investment consultant

MOSCOW, Jun 23 (PRIME-TASS) — Since 2003 former Yukos executives Mikhail Khodorkovsky and Platon Lebedev have been incarcerated in Russia on charges of tax evasion. At present, as their eight year stint enters its final stages, the two are on trial once more, charged with stealing millions of tonnes of oil (reputedly the same oil that they didn’t pay taxes on).

The Yukos case has always been of fundamental significance to Russia investors. The original arrests marked the end of what might be called the “liberal progressive” period of Vladimir Putin’s presidency. As Yukos was transferred to the state through a series of corrupted political interventions, so Putin’s policies became increasingly harsh.

His efforts to placate investors by offering up Gazprom delivered huge profits to a minority, but had little structural impact. And although the Russian market soared from 2004-2008, the costs and implications of the Yukos case also lingered and stacked up. Russia became increasingly corrupted as the judiciary ceased any pretence of impartiality and the bureaucracy found its powers rejuvenated. The one-party system rebounded from 15 years in the wilderness.

Today, Russia faces a new set of challenges. Although it has not acknowledged the costs of nationalist policies and political risk, unleashed by the prosecution of the nation’s former richest man, it publicly recognises that dependence on oil and gas revenues is a limited and dangerous strategy.

As Khodorkovsky and Lebedev labour their way through their second show-trial, Russia’s new president is seeking to demonstrate that the nation is changing, that business risks are on the decline and that foreign investors are welcome, wanted even.

If the facts of the Yukos case were clean cut, or even uncertain, then the trial would be of limited importance; but the scale of the farce taking place in the Moscow courtroom is rapidly becoming a political embarrassment. Few Russia specialists, this one included, expect a fair hearing, or an honest outcome. But, as the evidence stacks up against the prosecution, so the case gains importance as a litmus test of how much has changed since Medvedev came to power on a promise to end corruption and clean up the judiciary.

In recent court sessions, Khodorkovsky has cross examined a series of high profile politicians from the Putin era: former central banker Viktor Gerashenko, former Prime Minster Mikhail Kasyanov (now an embattled opposition leader), former Economics Minster German Gref (now head of Sberbank) and incumbent Industry and Trade Minister Viktor Khristenko.

All have, to a greater or lesser extent, come out against the prosecution, stating variously that no oil was stolen, that transfer pricing was legal and normal practise or that they were not aware of any theft.

The cynical argument would be to say that this new freedom of speech – which would have been inconceivable just a few years ago – is an effort to make the trial look fair before putting the pair away again. The reality is that something has shifted in Russia.

Not to say that we should expect an honest or open result. Yukos investors are currently prosecuting the government for $100 bln in the European Court of Human Rights. (Note that there was no sign of contingency for this case in the pricing of Russia’s recent Eurobond.) A victory for the defendants would certainly increase the risk of Russia being put on the hook for an extremely large sum in this related case.

More important, it would also discredit the entire Putin era, undermining much of the power vertical that has been so meticulously constructed.

The sad fact is that Khodorkovsky and Lebedev are likely to be kept in jail for a long time yet. Many senior investors will talk about why this is justified. The truth is that it will continue to sustain the risk premium Russia faces as an investment destination. (The true cost of the policies that began with the prosecution of Yukos – in terms of reputation, investor risk premium and lost opportunity – are unmeasurable, but certainly higher than the $100 bln being sought by Yukos shareholders.)

Freeing Khodorkovsky and Lebedev would be a bold move implying that things are really on the mend in Russia. It would boost investor interest and bring a difficult transitional chapter to a close. Unfortunately, with so many of the victors of that chapter still in power (is it a coincidence that there is a lengthy article about Igor Sechin in the FT this week?) such an outcome is unlikely.

At last week’s St Petersburg Economic forum, President Medvedev announced the elimination of capital gains tax on long-term fixed investment projects. It is pertinent that Russia is doing what it can to sustain high returns as economic growth has slowed and risk remains high.

Witnesses at the Khodorkovsky trial have proven that things are changing in Russia. But freedom of speech is one thing, independent judiciary is quite another.

The case is likely to confirm my 2010 outlook that the changes under-way fall short of what is needed for Russia to embark on an optimal development path, but we should never forget that in Russia the unexpected is always possible.

End

Russia 2H10

The 2010 St. Petersburg International Economic Forum will start next week on June 17. This is a key capital markets event for investors, business people and policymakers and supported by the Russian Federation. Talk about the economy and banking is everywhere. This neatly dovetails into Russia’s own focus on economics as the main engagement point with other countries, especially those in the G20. Below is a letter from CREF’s Chairman Pavel Ivlev to forum attendees.

CREF Chairman’s Letter to St. Petersburg Economic Forum Attendees

Zuma Press - Gazprom company worker places a Russian flag on the Nord Stream pipeline last month. The pipeline will run from Russia to Europe.

With the arrival of Ian Bremmer’s new book, “The End of the Free Market: Who Wins the War Between States and Corporations?” the future of the global economy has been set up as an epic battle between state capitalists like China and Russia and free-market capitalists like the US, EU, Japan and Canada.

State capitalists are defined by their domination of strategic assets and creation of wealth that is used to maintain and enrich the political leadership. State capitalists also tilt the marketplace in favor of state-owned companies and put multi-national corporations at a disadvantage through laws and regulations. An example of this from Ian Bremmer in the Wall Street Journal:

In December 2006, the Russian government informed Shell, Mitsubishi and Mitsui that it had revoked their environmental permits as project managers for the $22 billion Sakhalin 2 project, forcing them to halve their respective holdings and give Gazprom, Russia’s natural gas monopoly, a majority stake. This instantly wiped out 2.5% of Shell’s global reserves.

Russia is a model state capitalist as the Kremlin consolidates control over the country’s vast oil and gas reserves and increasingly pressure multi-nationals to sell their companies to state-owned entities. This recently happened with one of BP’s investments in Russia, RUSIA Petroleum.

BP purchased the Kovykta natural gas field back in the early 1990s because of its proximity to China and its enormous reserves. It created a joint venture with local businessmen to create TNK-BP. Before they could make any money, TNK-BP invested hundreds of millions of dollars to develop the infrastructure and pipelines needed to get the Kovykta gas to China.

As the project developed more Russian officials took notice and in 2007 TNK-BP was pressured to sell RUSIA Petroleum to Gazprom, Russia’s state-owned oil and gas company. That same year, the Kremlin passed a law prohibiting private gas exports from Russia, institutionalizing Gazprom’s monopolistic position.

With Gazprom the only buyer of RUSIA Petroleum and government officials dictating not only the pipeline start date but also insisting on a northern, circuitous route, RUSIA Petroleum could not get natural gas to consumers and fell behind on its loan repayments. TNK-BP, which was a creditholder to RUSIA Petroleum, is trying to recoup some of its losses by filing for bankruptcy. It will be seen whether the officials of Russia’s state government give some of TNK-BP’s money back.

Situations such as these make President Dmitry Medvedev’s goal of transforming Moscow into a global financial center and the next Silicon Valley even less likely. Matt Marshall, the only US reporter on a recent venture capitalist tour, was invited to visit Russia as part of the Kremlin’s plan to encourage more foreign direct investment. His critical assessment of Russia’s investment potential is probably not the press the Kremlin was hoping for:

Russia is the sixth-largest economy in the world, but it’s also a country relatively untouched by foreign investors, especially investors in technology. Could Russia potentially be the home of the next massive tech boom?

The short answer is: No way. At least not anytime soon. That’s the conclusion I’ve come to after a week in Moscow, a week in which I took part in the first ever delegation of US venture capital investors to visit Russia.

Now, of course, I’d be delighted if I could report that this Russia is the next India, China or Israel — all places that have seen massive foreign investment in recent years. Russia has among the highest per capita number of students in the world, boasts high levels of mathematics and science education, and being in desperate need of modernization, you’d think Russia would be a gold mine for investors. President Medvedev greeted the delegation, and made clear that technology is needed to diversify from Russian oil, gas and metals — which make up 80 percent of Russia’s total exports. That legacy industry is highly influenced by a group of about 22 so-called oligarchs — many of them exerting their power behind the scenes through corruption. Technology entrepreneurship, if it is fostered, will lead to positive change — there is no question. Everyone agrees.

But investing in Russia can be “insanity.”

The more time I spent in Russia, the more complex the story became (and I’m not the first to say that about Russia). The more I learned — about corruption, the abuses of the courts, the terribly archaic educational system, the choked up traffic, the lack of investment in infrastructure, the cultural penchant for Hobbesian brute leaders, the lack of a truly independent media, and the assassination of journalists when they do show independence — the harder it is for me see a positive short-term future for U.S.-style tech investment for this country.

Musings continue about the Foreign Ministry’s leaked policy document on engaging with the West to help Russia modernize. This new leaked policy seeks to import Western techonology and expertise to improve Russia’s infrastructure and jump start its techonolgy sector.

While Deripaska looks towards East for future initial public offerings of his other companies, notably EN+ Group, Rusal’s holding company, and OAO EuroSibEnergo, a power utility company. Rusal is the trailblazer Russian IPO on the Hong Kong Stock Exchange, but with it’s dismal performnace its first six months, it could leave a bad taste for other Asian investors. Additionally, institutional money managers are wary of Russian companies with opaque management rules and only promises of profits.

Investors both from the West and from Asia need to see commitment from the Russian government and the Russian business elite that they are serious about developing the technology and financial sectors in Russia. Russian businessman routinely top Forbes list of the world’s wealthiest; they clearly have the means to invest in domestic techonology firms. Russia’s political system as it has concentrated power to the executive branch has the political will to end corruption and strengthen the rule of law and improve its perception among foreign investors. But so far Russian businesman prefer to use their money on overseas investments while Russian politicans strengthen their own power at the expense of the country’s economic development.

Reuters recently released an article outlining three key risks in Russia: the variable price of oil, political shake up in the Kremlin and further insurgency attacks. Though the world’s largest energy producer, Russia’s manufacturing, construction and retail industries continues to contract as domestic consumption and foreign investment continues to lag, increasing the economy’s dependence on oil prices for growth.

Prime Minister Vladimir Putin remains popular and the driver behind the co-governance team with President Dmitry Medvedev. Despite highlighting their differences and indicating Medvedev’s intentions of political and judicial reform, Reuters notes that Russian markets would rebound only if Putin remained in place. The maintenance of the status quo despite Russia’s world renown for government corruption and weak rule of law seems curious. With foreign investors, such as IKEA, Hermitage Capital, and now HBK investments scaling back or pulling out of Russia due to corruption and extortion, why would the markets value Russian companies more if the status quo remained?

And how does the continued expropriation of private business by government officials add to Russia’s economic capital?

The extraction of Russia’s economic and natural resources by the politically connected few leads to only self-enrichment. Perhaps this self-enrichment would be tolerable if the proceeds were reinvested in Russia and the Russian people, but this is rarely the case. What Russia needs is investment to update oil and pipeline infrastructure, capital to encourage innovation and a stronger rule of law to benefit all Russian people.

Russia’s most famous political prisoner, Mikhail Khodorkovsky began his spirited defense yesterday against his Kafka-esque second trial. The government charged Khodorkovsky and his business partner Platon Lebedev with stealing 2.5 billion barrels of YUKOS’s crude oil or a third of the United States’ entire annual consumption of oil.

The trial is also viewed domestically and abroad as a test of Medvedev’s commitment to ending “legal nihilism” and his power and control within the Kremlin. Medvedev even started a national anti-corruption drive this March. According the Associated Press,

The trial is considered a test of whether President Dmitry Medvedev, himself a lawyer, is serious about reforming Russia’s judicial system. In other cases, judges have come forward to complain they face political pressure.

Only time will tell if Medvedev makes good on his words.

Despite a recent article linking Russian Medvedev’s liberalization efforts as gloss on Putin’s authoritarianism, there remains a way for political outsiders, Russians and foreign investors to effect change in Russia, and that is through company ownership. With no political opposition and cronies heading up the country’s largest companies, the current political structure is in place to maintain Russia as an ATM for the political elite. According to Transparency International Russia,

Since Putin came to office in 2000, Russian officials are estimated to have skimmed some $200 to $300 billion a year from the economy.

The most important job of the Russian government is to ensure that all the stolen money remains hidden and that the system aiding and abetting the pilfering of national assets remains in place. So, even though 93% of Russians believe that the government is not doing enough to combat corruption, Medvedev will not enact meaningful reform and rock the boat he helped build with Putin.

One of the only ways to make Russian political and business elite to take notice, is shareholder activism. By using his minority ownership of state-run companies, Alexei Navalny has shone the spotlight on the mismanagement and embezzlement by government officials. Foreign investors in Russia can do the same by demanding a greater percentage of ownership and management input from Russian companies that seek to tap into international capital markets. From this ownership position, accountability and transparency can start to take root in the Russian economy.

Recently Bill Browder, CEO of Hermitage Capital Management was on CNBC with Maria Bartiromo discussing the risks and rewards of investing in Russia. In this segment he describes the reality of investing in Russia and lengths authorities there go to expropriate private property for personal gain.

Moscow Times reports today that even though Russia is one of the top five places for foreign direct investment (FDI) it is not expected to return to pre-crisis levels until 2013. Russia’s economy shrink by 7.9 percent in 2009 and is expected to grow to 3.1 percent in 2010, according to analysts reports.

According to Capital Economics analysts:

[Russia] may not return to its pre-crisis levels until 2012. By contrast, the Chinese and Indian economies are expected to grow by more than 25 percent over the same period. So for now at least, Russia seems destined to remain the fourth BRIC.

At the September 2009 Committee for Russian Economic Freedome event, Jamison Firestone spoke about the need for greater respect and adherence to the rule of law in Russia and how institutional corruption worked to seize Hermitage Capital’s assets.

IKEA, the global furniture giant, recently fired their two executives who turned a blind eye on government bribes, but only to move their expansion project forward. Mikael Ohlsson, the chief executive and president for the Ikea Group, Ikea’s largest franchisee, which includes the Russian operation, said in a statement, “Corruption is totally unacceptable for Ikea.”

Corruption is a serious issue in Russia and it is routinely discussed by President Medvedev as a top priority for his government, however, not much as changed. The investment environment in Russia remains toxic and Russia is now falling behind economically and academically its BRIC rivals Brazil, India and China. In a recent Financial Times article, a large pension fund manager asked this question,

Russia defaulted in ‘91, restructured in ‘95, defaulted in ‘98, took assets away from Yukos, from Shell from BP. If you cmplain, you get expelled from the country and then if you continue to complain you may die in London from polonium poisoning, or die in pre-trial detention in Russia. Now tell me why I should invest in Russia?