To Russia, with greenback

Eleven years ago, I reported on a conference in New Zealand of the fast-rising Asian nations. It was a high-powered meeting attended by just about everybody who mattered in the region including president Clinton, the Chinese prime minister and other heads of state and, surprisingly, a big contingent from Russia.

During the final session, a leading Russian economist got to his feet to discuss the state of his nation which was then in some turmoil as a new breed of oligarchs fought for the spoils of the old Soviet economy from oil fields to banks. Surprisingly candid, he started by bemoaning how Russia was always in the headlines for the wrong reasons – kidnappings and assassinations, social instability, gyrations of the rouble and a variety of other horror stories in a nation that had turned into something of an economic wild west.

“What we need is for Russia to be boring,” he said. “Much more boring.”

After another decade, has much changed? As Russia enters its second great round of privatisations of state-owned companies, the turmoil has certainly subsided, the political environment is much more stable and foreign investment, although lumpy, has been growing. Yet Russia doesn’t look nearly boring enough.

Banks and airlines
Russia wants – and needs – a steady flow of western, MidEast and Asian capital of at least $100bn a year to renew its many obsolete factories and its general infrastructure. But the government also wants to turn all that infrastructure into roubles. Thus in October prime minister Vladimir Putin announced the biggest sale of state-owned assets since the anarchic privatisation process that followed the collapse of the Soviet Union.

In round figures the Kremlin is looking to raise around $59bn as banks such as VTB Bank – the Citibank of Russia, and nationwide savings institution Sberbank go on the auction block along with factories, transport companies, airlines, airports and much else. The government isn’t confident enough to sell 100 percent of its state-owned silverware and wants to retain control of many of these assets. For instance, among other minority shareholdings on offer to bidders will be 15 percent of oil giant Rosneft, 25 percent of Russian Railways, a monopoly, and an unnamed slice of Aeroflot.

Also, it’s a highly political process where the heavy hand of state management is apparent. We’ve already seen the addition and/or removal from the list of certain companies such as oil pipeline-owner Transneft in the general horse-trading leading up to the compilation of the list.

Still, while it’s not quite “everything must go”, the list adds up to a comprehensive clearance of stock. Altogether no less than 900 state-owned firms will go up for sale, or parts thereof.

Nor is it going to happen overnight. In what all observers see as a stern and extended test of Russia’s ability to conduct a proper privatisation process along transparent, international lines free of political interference, the bidding will start this year and run for another three to five years.

It’s likely nothing quite like it will happen again and there’s hardly a significant international investor, especially the cash-rich sovereign wealth funds, that isn’t investigating the assets in the shop window. But, just as importantly, they’re scrutinising the protection that potential investors can expect from a country whose legal systems are, by common consent, a work in progress.

A very particular market
Yet as this commercial revolution unfolds, there are serious doubts whether the administration of Vladimir Putin has done enough in the last decade to attract the required avalanche of fresh capital. As Andrey Goltsblat of Goltsblat BLP, Moscow-based international law firm, wrote recently in Global Treasury News, Russia promises potentially lucrative opportunities and good economic prospects, particularly in comparison with the highly indebted doldrum economies of western Europe as they recover from the financial crisis.

However, he warns: “The Russian market has a particular legal, regulatory and business landscape for potential bidders to navigate and investors will need to tread carefully.” In short, a minefield. 

Russia experts, particularly those who live there, make no bones about the risks in buying into state-owned companies where municipal or other authorities have long exercised control and are unwilling to cede it. All too often, many such authorities continue to regard a new owner as simply another shareholder with few, if any, of the rights that proprietorship confers in the west. And as a number of international firms have found to their cost, their investment may not be protected by the courts, which have routinely repudiated contracts or allowed them to be rewritten on the emergence of “new evidence”.

“Russian corporate law is rapidly developing and operates differently to international legal systems,” summarises Goltsblat.

However many investors are unhappy with the direction in which the law is – or isn’t – developing. This is why western sources of capital are often forced to fall back on courts outside Russia to settle any disputes, particularly the London Court of International Arbitration whose rulings are enforceable in Russia.

Ominously, few details have been released so far about how the public auction process in the privatisation programme will work. As for the courts, they have little experience of adjudicating a fully transparent, international privatisation programme with its inevitable points of dispute.

The Kremlin’s oligarchs
Although there are certainly successful cases of foreign direct investment in Russia, generally in privately-owned, retail businesses, there are too many nightmare stories where oligarchs, often working in concert with the authorities and/or the Kremlin, manage to wrest control from original investors.

The list of globally significant companies that have fallen foul of the system grows almost by the month. Motorola has retreated from Russia after its local supplier was charged with corruption (he had reportedly refused to pay bribes). Ikea has been in Russia for a decade, but has routinely stopped investing there in protest at spontaneous charges of corruption among other issues. (Local authorities switched off Ikea’s power on its big opening day.) Health and hygiene group Kimberly-Clark has twice lost court cases over previously approved boundaries of its factory and has both times had to relocate the factory, but it’s far from alone. Norwegian communications group Telenor, Royal Dutch Shell and BP: All have nightmare stories about doing business in Russia. 

Oil and gas ventures are a particular problem. Infamously, BP lost operational control of its 50:50 TNK-BP venture to oligarchs associated with the Kremlin, ostensibly over a variety of accusations that the UK-based company vehemently denied. TNK-BP’s then manager, Bob Dudley, had to flee the country in 2008 and briefly run the business from a secret location.

Likewise many of Russia’s leading businessmen have fled the country after getting on the wrong side of the Kremlin for one reason or another. Indeed it’s safe to say that no other country is pursuing so much of the wealth of so many of its voluntarily exiled businessmen. Just one of these is UK-based Boris Berezovsky who was sentenced in absentia to 19 years in prison on charges he describes as a “farce”.

Meantime the plight of Mikhail Khordorkovsky, the former chief of oil giant Yukos, is hardly doing the privatisation programme much good. He’s already spent eight years in a Siberian jail for allegedly stealing $27bn of Yukos oil – the exact amount the state happened to claim in back tax taxes. Since the government had already frozen all of Yukos’ assets, it naturally couldn’t pay up. Eventually, in 2006, a Russian court declared Yukos bankrupt and most of the firm’s assets were sold at rock-bottom prices to oil companies owned by the government.

The unfortunate Khordorkovsky is now facing another six years in jail on what are widely claimed as trumped-up embezzlement charges. The Parliamentary Council of Europe has condemned the government’s campaign against Yukos and its owners as “a violation of human rights.”

The sacking in September of long-serving Moscow mayor Yuri Luzkhov triggered further allegations of corporate cronyism in the Kremlin. He was shown the door by Medvedev after months of simmering tensions between them over the latter’s frustration with the mayor’s handling of the summer bush fires that led to wholesale evacuations. Ever since Luzkhov has complained publicly that Kremlin-linked oligarchs are intriguing to break up the construction empire of his wife Elena Baturina, Russia’s richest woman with $1.4bn in assets, and divide it up among themselves. In turn Luzkhov has long been accused of steering fat city contracts into the hands of companies in the control of his wife.

A founding member of Putin’s United Russia party, Luzkhov clearly feels betrayed and warns that Russia is reverting to “a collective authoritarian state.” By way of precaution against kidnapping, he has relocated the couple’s two daughters to London.

Transparent as Zimbabwe
The collective impact of these events has done nothing for Russia’s commercial reputation. Its rating for commercial transparency was already appalling, with Transparency International putting Russia in 146th place in its corruption perception index, equal with Zimbabwe and Sierra Leone. Needless to say, neither of those last two nations is planning a massive privatisation programme.

Unless it quickly improves its game, Russia could be walking a tightrope in foreign investment, warns Washington-based Frontier Strategy Group, a corporate advisory firm specialising in emerging markets. The group points out that as recently as five years ago companies with ambitions in Eastern Europe generally made a start in Russia because of its enormous market of 142 million people and, with that beachhead established, moved on to develop the business in other former Soviet nations.

However that trend is reversing rapidly for two reasons. The first is that Russia’s relations with border nations deteriorated markedly under Putin’s presidency and have not improved greatly despite Medvedev’s best efforts. The second is that these former Soviet Union countries are so anxious for foreign investment that they are trying harder than Russia to adopt best practice.

Not only does Russia need western and Asian capital, it also needs outside management skills. “There are so many uncompetitive factories, what do we do with them?” asks Yuri Novozhilov, president of state-owned Trans Kredit Bank. Competing factories in China generally run on a quarter of the operating costs. Potential investors, manufacturers in particular, are wising up. Many now make sure to select a range of sites for their factories before making a final decision about where to locate them. In this way they are able to apply pressure on local authorities to provide the essential services with a minimum of bureaucratic delays and bribes. According to the Financial Times, agricultural equipment giant John Deere got a factory going in seven months from start to finish, apparently an all-time record, by doing its homework first. It made sure to select an area run by a progressive local council with which it could work. But generally it costs twice as much and takes 70 percent longer to establish a comparable factory than it does in China.

Putin is pivotal
In all this the role of Putin is considered central. A former KGB spy, he served two terms as president before compulsorily kicking himself downstairs to become prime minister. Judged by his own remarks, it seems Putin wants to stand again for the presidency, probably up against his former protégé Dmitri Medvedev, a leading international and commercial lawyer before he became a key member of the former KGB man’s team.

Right from the start of his presidency, many saw Medvedev as a stop-gap replacement. In the last few years, a clear split has developed between the two men over economic direction and levels of official corruption. While Putin insists the economy is healthy and well on the way to being the energy superpower which he believes is Russia’s future, Medvedev says reform is long overdue and Russia’s dependence on oil is “primitive”. Putin is also seen as highly ambivalent on corruption while Medvedev has gone so far as to deplore Russia’s “legal nihilism”.

Although Russia hasn’t got the levels of debt of several western nations, nor has it the economic robustness and diversity required to raise domestically the funds it needs to expand further. The budget deficit is running at around $60bn a year – three percent of GDP – and Russia relies on high oil prices to restore it to good order. As economic commentators point out, Russia is so dependent on its raw energy that the budget cannot balance unless the price of Urals blend, Russia’s equivalent of Brent crude, hits more than $100 a barrel.

By themselves, domestic debt markets cannot possibly raise $60bn a year. Thus the success of the privatisation programme is crucial. The state of the stock markets is hardly conducive to the great privatisation. As Russian investors largely keep their hands in their pockets, current valuations languish in the doldrums, stuck at roughly the same levels as they did in 1999. Valuations are a long way behind other Bric nations. For instance, Russian companies trade at around seven times earnings, roughly half the ratio prevailing in developed economies and a long way behind Brazil (13 times earnings), China (15 times) and runaway India (20 times).

The banking industry is a relatively bright spot. It weathered the financial crisis of 2008-2010 safely enough, albeit with a lot of help from the central bank that dug into its reserves to pump liquidity into ailing institutions. Transparency not exactly being a way of life in Russian banking, as in commerce generally, the precise figures have never been released and probably never will be.

In what remains largely a command economy, the financial sector is hedged by a thicket of laws designed to protect the rouble. For instance, say bankers, transfers of the currency from resident to non-resident accounts must navigate multiple currency-control regulations. Acting as agents of the central bank, retail institutions must check all commercial payments over the modest amount of $5,000.

There are signs that the privatisation may stir Russia into adopting more orthodox and international standards in the courts and elsewhere. For instance, the finance ministry has sought advice from various foreign and domestic institutions about how best to proceed, and it was told to engage more openly with the international economy. For a start, it should join such pivotal global organisations as the World Trade Organisation.

But clearly the most important reforms must be made in the areas of corruption, central and local, and in transparency. When Russia’s commercial practices are more boring and predictable, foreign investment will pour into what is, after all, a country of exciting potential.