An outsider only hears the growling, and when he sees the bones fly out from beneath, it is obvious who won.

Barry doesn’t try to predict the winner but Prime Minister Putin has been in the headlines by reprimanding Russian trade officials who were seeking to comply with World Trade Organization’s rule before ascension. James Bacchus, a former chief judge for the World Trade Organization wrote,

Putin’s Russia is something considerably less than an open society. There is evidence aplenty of his decided disdain for the rule of law. A commitment to uphold the rule of law is implicit in signing the WTO treaty. Although not mandated in so many words by the treaty, conscientious allegiance to the rule of law is inherent to a national commitment to comply consistently with WTO rules.

Putin has likened the prolonged WTO accession process to an “ambush” of Russian economic interests. Evidently, he wants Russia to be able to enjoy the benefits without bearing the burdens of being in the WTO. He seeks the tariff concessions and the safeguards against trade discrimination that come with WTO membership, but he does not seem to want WTO commitments to impede unduly on his continued ability to impose the whims of what often seems an arbitrary rule.

Despite Putin’s omnipresence in Russian politics and economy, he was uncharacteristically quiet in the BP-Rosneft deal. BP trying to regain its footing after the Gulf Oil spill entered into a deal with Rosneft while ignoring their existing partners in Russia, Alfa-Access-Renova (AAR). After legal contests in London, AAR has won a major concession, Arctic exploration.

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.

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.

First, Vladimir Putin, the prime minister, likened western military action in Libya to the crusades, before Dmitry Medvedev, the president, told him, in essence, to hold his tongue.

Then, last week, Mr Medvedev ordered ministers to leave the boards of state-controlled companies. That struck at the heart of “Kremlin Inc” – the intertwined political and economic system Mr Putin created. Putin loyalists were affected, including Igor Sechin, a close ally for two decades and linchpin of a planned alliance between Rosneft, the oil company he chairs, and Britain’s BP.

Deep in the corridors of the Kremlin, it is clear the starting gun has been fired for presidential elections just under a year from now. Less clear, with Mr Putin expected to decide which man will be the presidential candidate – and to remain Russia’s most powerful figure, whatever position he holds – is what the dogfights are really about.

They may be an attempt to stimulate interest among Russians who are wearying of tightly controlled politics: Russians are unlikely to erupt into Middle East-style unrest. But a sense of popular disillusionment is adding to nervousness in business and political elites over the looming election, which is stifling domestic investment and contributed to $21bn of capital flight in the first quarter of 2011, despite a buoyant economy.

The jostling may be an attempt to prevent either figure becoming a lame duck. Mr Medvedev’s assertiveness could be a pitch to keep his job or it could be another feint. The Kremlin spent much of 2007, before the last elections, building up the conservative Sergei Ivanov as presidential heir apparent – until Mr Putin chose Mr Medvedev.

Neither side wants to be outdone. Mr Medvedev has positioned himself as the “modernisation” candidate, calling for Russia to develop high-tech industries to reduce reliance on oil. A liberal think-tank, the Institute for Contemporary Development, whose trustees Mr Medvedev chairs, has urged radical reform, including more democracy.

Mr Putin has formed his own task force of freethinking economists, including Vladimir Mau, an academic who worked with post-Soviet reformers Yegor Gaidar and Anatoly Chubais. Their conclusions resemble those presented to the president, minus democratic reform, an area people involved say was kept outside their remit.

Yet the worry for the powers that be is that voters seem jaded. Russian media have reported young professionals emigrating, fleeing the prospect of the same figures remaining in power for years to come.

Opinion polls show support for both men, still high by western standards, has fallen to its lowest for years. The dominant pro-Kremlin United Russia party performed comparatively poorly in regional elections last month.

Pollsters suggest support is waning, above all, among the growing urban middle class, perhaps 15 per cent of the electorate. Blog-reading, property-owning Russians are finally demanding a system responsive to theiraspirations.

A think-tank originally set up by German Gref, Mr Putin’s first economy minister, warned last week of a looming crisis because of the “fast-growing delegitimisation” of today’s leadership among many Russians. The only solution was to introduce more competition and new faces into the system.

The Kremlin has reacted in typical fashion, by toying with turning the shell of a 1990s-era party into a “tame” liberal group that could enter the ossified parliament in elections in December and champion middle-class interests. Talks have reportedly been held with liberal-leaning officials including Igor Shuvalov, a deputy prime minister, about leading the party.

Fringe pro-democracy politicians, outside the Kremlin-approved system, suggest this savvy new middle class would never fall for another “fake” party. They are targeting this electorate themselves.

One leading intellectual, echoing Russians at all levels, agrees that rampant corruption, now at the level of a “kleptocracy”, is a central issue. High natural resource revenues may see the leadership through the next elections, and buy support for a while yet. But within five or six years, he says, “change must come. If it doesn’t come from the top, it will come from below.”

The Financial Times Limited 2011

The dreams of a global financial powerhouse in Russia is running up against the realities of its limits. Weafer explains the mismatched expectations this way:

Valuation remains both the key and the difficulty, a fact clearly illustrated when three of the four IPOs offered in February failed. Investors want a deep discount to reflect market risk and liquidity risk. Issuers still retain ambitions for premium ratings. Issues that offer exposure outside of extractive industries will fare better than more-of-the-same investments in extractive industries. Issues that raise money for expansion and debt reduction will fare better than those simply cashing out an existing owner.

Despite three out of four Russian IPOs failing to launch in the first quarter of 2011, there are more on the way including RusAgro in April.

Some investor wariness might have to do with the political risk in Russia. Since the UN sanctioned strikes against Libya, fissures between Prime Minister Putin and President Medvedev have become more public creating more uncertainty around the 2012 presidential election.

Russia has not proven to be a place where Western private equity investors can have the returns and realize the profits commensurate with the risks they’ve had to take.

One reason the Russian government is trying to perk up foreign investment of all kinds is that capital outflows continue in 2011. The central bank’s first deputy chairman Alexei Ulyukayev explained that the outflow by Russian corporates investing abroad, as well as by some investor caution towards global emerging market risk.

Finance Minister Alexei Kudrin chalked it up to political risk:

Whenever there are elections in a country such as ours, in which a lot depends on the leader, there are higher risks, so investors are hedging their risks.

Russian businessmen are familiar with these political risks and have chosen to invest outside of Russia. That leaves the leadership tandem to think of new ways to get foreign investors back in the Russian investment groove. President Medvedev announced the creation of “special sovereign funds” at Davos in January a month ago. It is unclear if the private equity firms would be investing in these funds or something different all together.

With oil approaching two year highs, the Russian government is still facing budget shortfalls and looks to foreign investors to shore up the budget. One drain on the economy is Russia’s pension system. With parliamentary elections coming up in 2011 and presidential elections in 2012, Putin needs to increase pension payments to maintain his hold on power much like the authoritarian Middle East regimes looking to prevent political change.

The risk of losing one’s business in Russia today is real. But it is not the greatest risk investors face. Investors in Russia risk losing their lives.

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,

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 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.