Committee for Russian Economic Freedom

The World Economic Forum in Davos wrapped up late last week, with the head of the Russian delegation making some startling admissions about the ineptitude of his country’s political system, writes Anatoly Medetsky in the Moscow Times.

Deputy P.M. Shuvalov

At a meeting hosted by state-controlled Sberbank, First Deputy Prime Minister Igor Shuvalov said the way the state functions in Russia is “backward” and “one-dimensional” and that “Russia deserves a different political system.”

Adding insult to injury, Arkady Dvorkovich, a Kremlin economic aide, stated his belief that the state plays an excessively large role in the economy.

Meanwhile, former Finance Minister Alexei Kudrin, who fell out of the Kremlin’s favor last fall and is considering mounting an opposition campaign of his own, said he thinks businesses should have the right to finance political parties. “Only then,” he added, “will there be [political] competition.”

Read the full article here.

P.M. Putin

In the meantime, Putin was out with a 6,000-word article in Vedomosti (also excerpted in the Financial Times) making the case for why he should be elected for a third term as Russian president.

In it, he acknowledges a number of pervasive problems in the Russian economy and espouses a program of modernization. Yet to tackle Russia’s economic problems and implement an earnest modernization program would compel him to sacrifice the power system that has been in place since 2000.

He may say he wants modernization but it’s clear that any true actions in this direction would inevitably lead to self-destruction.

He’s stuck between an (alleged) $40 billion fortune and a hard place.

Prime Minister Putin

Michael Bohm writes in the Moscow Times that the only way for Prime Minister Vladimir Putin to ensure his continued economic prosperity – not to mention his freedom – is to stay in power, as the once-and-future Russian president could be subject to “possible corruption and other criminal charges” should he leave office.

Bohm explains:

As long as Putin remains in control, Western leaders will continue to do business as usual with him and his administration, and they will ignore or downplay allegations of corruption at the very top.

Should an opposition leader rise to power, a Putin trial – over the theft of Yukos, or over “corruption […] at Gazprom, VTB, Transneft, Russian Technologies, National Media Group, Gunvor, the Rotenberg brothers’ enterprises, Bank Rossia, arms trader Rosoboronexport and dozens of other companies that make up Putin’s ‘Russia, Inc.’” – would soon follow.

Bohm writes that Western leaders have shown in the last decade they have no trouble turning on a former dictatorial ally (Mubarak) or to go from tolerating a dictator to actively seeking his removal from power (Gadhafi).

“A similar fate could await Putin,” Bohn concludes, unless, of course, after two more presidential terms a 72-year-old Putin flees to friendly Belarus – or finds a way to stay in power into his sunset years.

Read the full article here.

Prokhorov

Kudrin

As tens of thousands of Russians demonstrated across the country this weekend, protesting the rigged Duma elections of Dec. 4, two prominent figures, billionaire industrialist Mikhail Prokhorov (also known as the owner of the New Jersey Nets) and former finance minister Aleksei Kudrin have announced their intentions to run for president against Prime Minister Vladimir Putin in March.

More on this development here.

The cover story in the Russian Weekly New Times gives a well-constructed overview of how Prime Minister Vladimir Putin and his cronies have “divided up the country” to create an all-powerful “Russia, Inc.” that controls 10 to 15 percent of the nation’s annual GDP. Yevgeniya Albats and Anatoliy Yermolin write that the process begun after the arrest of Mikhail Khodorkovsky in 2003 has continued through a series of hostile takeovers, questionable auctions and security service intimidations, as huge industries have returned to state control.

Essentially, a vertically integrated holding company has been created in the country’s expanses – it has its own credit organizations that provide working capital, its own cash factories that pump oil and gas from the land, its own pipeline systems, its own transport of all possible kinds, its own structures that ensure security and weapons for it, its own communications, its own social amenities, its own services, including media services, and its own instruments of political control.

Vladimir Putin

Putin’s strategy was to completely control the political process, remove Yeltsin-era elites from government and replace them with loyalists and audit to death the private companies created in the aftermath of the fall of Soviet Union.

With the Yeltsin-era business leaders out of the picture and his own cronies in place, wresting control of major industries – finance, energy, military and infrastructure – became possible.

The full article, in Russian, is available here.

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).

We previously wrote about record capital flight out of Russia due to political uncertainty. Both the New York Times and the Washington Post have articles covering this topic. While Kathy Lally at the Post relies on Olga Kryshtanovskaya, a member of Putin’s United Russia party, for her main assertions that there is no competition and it is all a show, Ellen Barry at the Times reports that something more substantive is in progress. Barry refers to a Churchill Winston remark that refers to the Kremlin transfer of power as bulldogs fighting under a carpet,

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.

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.

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.

Russia Profile reported on Medvedev’s speech at Davos to convince world and business leaders that Russia is ready to do business again. However, Tai Adelaja notes that

Despite the horrendous terrorist attacks, experts say the only bug in the president’s ointment is the case of Mikhail Khodorkovsky, the jailed former billionaire head of Yukos Oil, which continues to cast a shadow on the rule of law and leave a negative impact on Russia’s reputation abroad.

Adelaja describes Medvedev’s top ten reasons to invest in Russia. Here are some reasons to disagree.

Number one: Russia has slashed the number of its strategic companies fivefold. It is no secret that Russia experienced record capital outflows in 2010 and despite rising oil prices faces huge budget gaps. The Kremlin as its self interest in mind when it sheds strategic assets. Putin’s government has a history of opening up businesses to investments to allow others to turnaround the company only to come in at the end to take the company away through trumped up taxes and other phantom violations.

Number two: Russia is set to embark on a large-scale sell-off of state assets in efforts to modernize its country. The Russian government is expected to sell $32 billion in assets by 2013. Foreign investors should remember that some of those state assets were acquired by the state through expropriation. Rosneft’s major assets came after the dismantling of Yukos; now Russian officials are asking investors to risk their capital in Russia again.

Number three: President Medvedev said is poised to create a “special sovereign fund” to attract foreign capital. This was written about in an earlier post. With corruption at all levels in Russia continuing to climb, it was a contributor to the attack at the Domodedovo airport on January 24, Russia is now the lowest ranked developing country in Transparency International’s Corruption Perception Index. Out of 178 countries, Russia is ranked 154th. With capital leakage out of the Russian economy at all levels, it is clear that the special sovereign fund will be a tool for foreign investors to give money to Russian officials. Prime Minister Putin, the leader of the power tandem, has built himself a $1 billion palace with money milked from the power vertical he created. Below are some pictures, provided by RuLeaks, Russia’s version of WikiLeaks.

For more pictures click on photo.

Reason four: Medvedev reiterated that Russia will refrain from imposing a special tax on banks and the financial sector in an effort to attract addtional capital into the country. Russia needs to do all it can to attract foreign investment. In 2010, $38 billion in capital flight was from not only foreign investors but Russian ones as well seeking higher returns for their investment. The Russian stock market, despite being in the so-called BRIC powerhouse and overweighted in emerging markets indices, has lagged the other countries in performance and carries a 30% discount in valuations from other emerging economies.

Reason five: the Kremlin is pressing ahead with efforts to transform Moscow into one of the top-ten global financial centers as part of a drive to diversify the economy away from energy exports. President Medvedev announed in May 2010 that Alexander Voloshin, chairman of Russia’s metals giant Norilsk Nickel, will be the newest member of a presidential council on financial reform and lead the conversion of Moscow into a global financial powerhouse. As we mentioned in an earlier post, Russia is not yet a member of  International Organization of Securities Commissions (IOSCO), which is a minimum requirement for international financial centers. Of greater concern is why financial centers appear and grow, to efficiently allocate capital. But with even Russian investors shunning their exchange for London, New York or Hong Kong and capital outflows reaching record numbers, it is difficult to see how Moscow can differentiate itself and maintain international market standards.

Reason six: Medvedev reaffirmed Russia’s ambition to join the World Trade Organization (WTO) and the Organization for Economic Cooperation and Development (OECD). President Medevedev has proven himself to be ambitious in words but lacking in execution. From his anti-corruption commission to fighting the terrorists who attacked the Moscow airport, Medvedev is the more articulate of the leadership tandem, but he is not the one who holds the power. Medevedev recently admitted that there has been no progress in the country’s anti-corruption progress.

Reason seven: Medvedev vowed to continue the implementation of energy efficiency programs, stressing that the state would also enourage more partnerships in the energy sector. Rosneft, the 75% state owned oil producer recently announced partnerships with BP and Exxon Mobil. BP seemed to have learned from their previous scuffles with Russian authorities that political power trumps business ones. So it has decided to leave its long-time Russia partner TNK and $990 million in dividends to join forces with Putin and Igor Sechin at Rosneft.

Reason eight: Russia is presently developing a mechanism that would help it share technology – especially military technology – with other nations.  This seems to be another tactic for selling state assets as the Kremlin tries to find additional sources of capital, even as the price of oil moves past $90 a barrel.

Reason nine: Russia continues to invest heavily in its human resources, including trying to educate future businessmen and officials abroad.  President Medvedev said at Davos, “Our task is to make Russia more attractive to foreign experts to work in.” Expat workers need to remember Yukos and its audit firm, PWC. During the politically motivated second trial of Mikhail Khodorkovsky, PWC officials were pressured by Kremlin officials to rescind their audit certification of oil giant Yukos to prove the prosecutor’s case. 

Reason ten: Russia is also pushing to interest investors in projects related to the development of sports and large athletic events in preparation for the Olympic Games. Russia is hosting the 2014 Winter Games and corruption is roaring its head as the Sochi Winter Games in 2014 is already the most expensive by far. Just today, the constructiion chief for the Sochi Olympics, Taimuraz Bolloyev stepped down as President Medvedev announced fraud investigations.