Committee for Russian Economic Freedom

A trial against popular opposition leader of a new generation, Alexei Navalny, continues in Kirov. Four years ago a company of Navalny’s acquaintance bought a medium lot of wood and then sold it with a 7% margin. According to the state prosecutor, Navalny and his friend “have stolen all the wood”. This is only one of five investigations against the opposition leader.

Navalny case will determine the investment climate in Russia for many years

Politically motivated persecution of Mr. Navalny will further undermine Russia’s unwelcoming investment climate. Any businessman could be accused of embezzling all his revenue and locked into prison for many years. According to Alexei Kudrin, Putin’s Minister of Finance in 2000-2011, this trial puts at risk the foundations of the market economy in Russia, including the freedom to sell and buy goods and services. Any verdict will influence the willingness to start new and invest in existing ventures, continues one of the most trusted Putin’s allies.

The Navalny case resembles the campaign against YUKOS, when the largest and most efficient Russian oil company was ruined in several months. Ten years ago, pro-Putin liberals hoped that the prosecution of Khodorkovsky would be an exception. However, the conviction of YUKOS owners and management opened the Pandora box of unlawful expropriation. “Siloviki” employed the technology from the YUKOS case to acquire thousands of large and small companies. Thousands entrepreneurs were imprisoned or squeezed out the country by Russian legal system.

The charges against Navalny reproduce the logic of the second Khodorkovsky’s trial, in which former tycoon, his partners and managers were accused in embezzlement of all oil produced by YUKOS. Two processes also share similar politically motivated goals. Nobody in Russia doubts that Kremlin will lock Navalny out of the legal political process. Khodorkovsky’s case ten years ago harmed Russia’s investment climate a lot, but high oil prices, Kudrin’s macroeconomic stabilization and the effect of Yeltsin’s market reforms cushioned all the negative impact. Now Russian economy approaches stagnation and after the government convicts the freedom of entrepreneurship one more time, it may well head to a hopeless recession. Siloviki and state-owned companies will be the only entrepreneurs left in the country.

The New York Review of Books

The Guardian (UK) reports that Barclays is retreating from the retail banking business in Russia.

Jill Treanor writes that Britain’s third largest bank may recoup just 10 percent of the purchase price for Expobank, the Russian lender it bought for £373 million in March 2008. Barclays is now soliciting bids, at what would be a 90 percent loss, mostly from large Russian banks.

Barclays is one of a growing number of international firms pulling out of consumer banking in Russia. The company’s new CEO, Bob Diamond, made the decision to sell off unprofitable businesses shortly after taking over last year, and Expobank is one division he says needs to go.

Foreign banks have recently had great difficulty finding success in Russian consumer banking . You may recall that HSBC announced in April that it was pulling out of Russia (selling their retail arm to Citi) after just two years. Banco Santander of Spain sold its retail banking business to a firm based in southeastern Russia this past January. This follows the failure of the BP-Rosneft deal and many other failed international business partnerships of the last year. Kremlin observers have mused that as long as the state manipulates the rules of the game — whether by clamping down on entrepreneurs like Khodorkovsky or on the opposition like the People’s Freedom Party — foreign entities should be wary of active participation in Russia’s economy.

At the same time foreign banks are leaving, Russia itself is consolidating its power in the banking sector. State-owned VTB Bank is in the process of fully buying out the Bank of Moscow, though the bad debt on BofM’s balance sheet has forced the Central Bank to bail it out, to the tune of $14.2 billion. But, of course, VTB “does not expect any negative impact on its financial performance to result from this acquisition,” according to a company statement.

In reality, the BofM takeover shows how corrupt and well-connected managers, like those at VTB, can force a hostile takeover of the nation’s fifth largest bank – using state funds and in conflict with state interests. That the VTB takeover story has become a footnote on European financial pages shows, sadly, that we have all just come to expect this behavior from the state.

Time magazine’s Simon Shuster today posted an article about young Russian entrepreneurs fleeing the country. The piece features a 22-year-old tech guru named Alexei Terentev, whose web hosting company, NKVD.pro, is now valued in the millions of dollars. But thanks to a business climate marked by fraud and fear, the economic activity Terentev’s company is to produce will not be benefitting his homeland: Alexei left Moscow for the Czech Republic to develop his business and hasn’t looked back:

The reasons for his move, as well as his haste, are the typical worries of the young entrepreneurs […]: corruption and bureaucracy, the forces that are driving the biggest exodus since the fall of the Soviet Union. […] Now the country is stable and the cities are thriving. But small-business owners seem to feel less safe than ever.

Shuster cites data that shows Russians paid nearly $600 million in bribes to authorities for “security provisions,” in 2010 – 13 times more than in 2005 – and then describes the calamity that befalls business owners if bribes aren’t paid: visits from inspectors, auditors or the police until the company is overwhelmed. If that doesn’t work, expect a corporate or government raid to follow, as was the case in 2000 for NTV television or in 2003 for Yukos Oil.

Earlier this year, Agava, one of Russia’s leading web hosting companies was raided by police, its server farm raided just weeks later. And this is happening , Shuster writes, while the Russian government is trying to enlist businesses to move to Skolkovo, Russia’s notional version of Silicon Valley. But the businesses that have signed on for Skolkovo are, not surprisingly, having trouble recruiting talent.

To drive the point home, Shuster quotes a California venture capitalist, Alexandra Johnson, who advises Russian businesses. “You need an entire ecosystem to support innovation,” she says. “You need incubators, entrepreneurship, managers to run the businesses. You need the rule of law. Many elements of this ecosystem are still missing in Russia.”

Read Shuster’s full article here.

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.

Paul Gregory

In Paul Gregory’s latest analysis, “The Khodorkovsky Ruling: Something Fishy in Strasbourg?” he takes a closer look at the Court’s decision on Khodorkovsky’s claim that his 2003 arrest was an incidence of Article 18. Despite ruling that the arrest was illegal and Khodorkovsky was kept in inhumane conditions, the Court didn’t review the facts of the case to come to this decision. As Gregory writes,

Notably, the Strasbourg court did not review the facts of the case. It punted the football by basing its decision on fear of setting a precedent for others is a position similar to Khodorkovsky…It seems that Strasbourg declined to examine the facts for fear of a rash of other complaints concerning Russia, asserting political motivation. Their docket is already bursting at the seams.

The Court when making the determination about Article 18 stated,

While Mr. Khodorkovsky’s case might raise some suspicion as to what the real intent of the Russian authorities might have been for prosecuting him, claims of political motivation behind prosecution required incontestable proof, which had not been presented.”

Gregory suggests that “incontestable proof” is an “impossible standard” and concludes,

It seems as if Putin and his power ministry gang can rest easily. So far, the European Court of Human Rights has proven itself as paper tiger. Such a court might work for countries that have a reasonable rule of law, but it is citizens of the Zimbabwes, Russias, and Chinas of this world that require the protection of such an international court.”

Paul Gregory, a Hoover Institution research fellow, holds an endowed professorship in the Department of Economics at the University of Houston, Texas, and is a research professor at the German Institute for Economic Research in Berlin. His most recent book is Politics, Murder, and Love in Stalin’s Kremlin: The Story of Nikolai Bukharin and Anna Larina (Hoover Institution Press, 2010).

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.”

Reuters

Pavel Ivlev, founder and chairman of the Committee for Russian Economic Freedom, condemned today’s verdict by the Moscow City Court upholding the false conviction of Mikhail Khodorkovsky, former Yukos CEO and Russia’s most well-known political prisoner, saying the result compounds investment risk in Russia.

Putin’s regime today put its own greed ahead of the interests of ordinary Russians who are starved for the capital they need to bolster their economy, create jobs and modernize the country,” Ivlev said. “The court’s decision mocks the rule of law and reconfirms the wide-held belief that it’s unsafe both physically and financially to invest in Russia.

Khodorkovsky and his business partner and co-defendant Platon L. Lebedev were found guilty by a lower court in Dec. 2010 on a second round of trumped up charges stemming from bizarre allegations that they embezzled the entire production of the Yukos Oil Company from 1998 to 2003. Today, the Moscow City Court upheld the verdict. Both men, who have been in jail since 2003, now face prison camp terms through at least 2016.

Years after Russia began its so-called modernization, the country still looks very much as it did two or three decades ago, where individuals can be locked up indefinitely based on little or no evidence,” Ivlev said. “Investors should be wary of putting their money in a country where the judiciary fails to follow the rule of law and where the rulers pick the market’s winners and losers.”

Khodorkovsky, who entered the Moscow courtroom to applause, spoke about the Dec. 2010 verdict, saying,

In what dusty cellar did they dig up that poisonous Stalinist spider who wrote this drivel? What kind of long-term investments can one talk about with such justice? No modernization will succeed without a purging of these cellars.”

“There is no way to correct this verdict,” Khodorkovsky continued. “Either overturn and terminate this shamefulness, or join ranks with the criminals, who spit on the law. I have nothing to talk about with criminals, even those in a judge’s robe. And indeed there is no reason for me to. I do not need mercy from criminals.”

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.

Peter Pomerantsev’s look into Russia’s growing television industry reveals the challenges of doing business in Russia. Among the unique features of working in Russia include diversion tactics for tax collectors seeking bribes, strategies for avoid kickbacks or otkat for broadcasters and overcoming societal indifference to rules of the game.

Pomerantsev starts his diary with the production company Potemkim Productions itself, the elaboate set up of gruff security men and rooms behind rooms are a ruse to persuade tax collectors that the company was small and warranted smaller levies.

No entrepreneuer paid their taxes in full: it wouldn’t occur to them. Taxes, he said, were just a way for bureaucrats to buy themselves holidays in Thailand…Ivan haggled with the tax police to keep down the size of the pay-off…then Ivan would bring out the fake accounts from the front office to support his case and they would sit down together to negotiate, with tea and biscuits as if this were the most normal of business deals. And in Russia it was.

Pomerantsev was hired to produce reality tv shows like the ones in the West, but those mainly flopped. The Russian version of The Apprentice closely followed the aspirational themes of those in the West, with someone succeeding after hard work, perserverence and some panache. The problem was:

…no one in Russia believed in the rules. The usual way to get jobs in Russia is not by impressing at an interview, but buy what is known as blat – “connections”. Russian society isn’t much interested in the hard-working, brilliant young business mind. Everyone knows where that type ends up: in jail like Mikhail Khodorkovsky, or in exile like the mobile phone billionaire Yevgeny Chichvarkin. Today’s Russia rewards the man who operates from the shadows, the grey apparatchik, the master of the politique de couloir – the man like Putin…The shows that did work were based on a quite different set of principles. By far the biggest success was Posledny Geroi (“The Last Her0″), a version of Survivor, a show based on humiliation and hardship. this chimed in Russia – a country where being bullied by the authorities is the norm.

The structural and cultural obstacles to aspiration and innovation are reflected Russia’s low ranking in Transparency International’s Corruption Transparency Index where it is the most corrupt major economy. Bloomberg reported on a Freedom House report that

Russia risks turning into an autocracy that resembles authoritarian regimes in the Middle East if Prime Minister Vladimir Putin prolongs his rule in 2012 elections…As venal Middle Eastern authoritarians give way to popular pressure for democratic change, Russia’s systemic corruption is becoming especially conspicuous.

The political risk in Russia remains higher than other emerging markets and for that reason the US private equity firm Blackstone doesn’t invest there. Could concerns with complying with US Foreign Corrupt Practices Act be a resaon too?