Special Report on Russia: The long arm of the state

RUSSIA

The long arm of the state

Nov 27th 2008
From The Economist print edition

The financial crisis may lead to renationalisation by stealth

EVEN to someone who has never been to Yekaterinburg, a large industrial city in the Urals, the changes are obvious. Shiny towers of metal and glass have shot up everywhere without order or design, pushing aside historic buildings and making the Soviet-era apartment blocks look even grimmer. At night cranes are lit up like Christmas trees. At eight in the morning heavy traffic, mostly of foreign-made cars, chokes streets that still bear Soviet names. The city’s ultra-modern airport makes Moscow’s look shabby.

Yekaterinburg, traditionally the centre of the mining and metal-bashing industry, is a microcosm of Russia’s economy. Until recently it has been flush with money, mostly from natural resources and cheap credit, spent in sprawling supermarkets, restaurants and car dealerships. Oil, gas and metals make up around 80% of Russia’s exports, and until recently their prices were rising fast. For the past five years the economy has been growing at about 7% a year. Measured in dollars the rise has been much faster. Some of this money has been stashed away into a stabilisation fund, but a large portion has been fuelling an unprecedented consumer boom. Real incomes have more than doubled since 1999 and the growth in retailing has averaged 12% a year.

In a country so long starved of good restaurants, hotels and shops, it was natural that consumers should take a lead role, says Andrei Illarionov, a former economic adviser to Vladimir Putin and now one of his fiercest critics. Besides, there is so much uncertainty around that most people would rather spend than save.

But there has been plenty of capital investment too, though mostly in extractive industries. Fixed investment last year rose by a record 21% on the year before, although it remains relatively low.

Private initiative, freed up by the market reforms of the 1990s, became the main force behind Russia’s economic recovery after the 1998 crisis. Growth was particularly strong in sectors that were not weighed down by any Soviet legacy, such as mobile telecoms. But private ownership was also transforming Soviet-era behemoths.

Proud to be private
One example is Uralelectromed, a large copper producer in the Urals, which is partly owned by Andrei Kozitsyn. In the past five years the company’s revenues have tripled. It has used the money to install a new production line, along with the latest American equipment. To add value, it has begun to produce high-quality wire, which it exports to Europe. “We had to be competitive, otherwise we were meaningless,” says Mr Kozitsyn. Having started as a worker in the factory, he rose to the top because he wanted to be in business. But these days, he says, young people prefer bureaucratic careers.

Tax revenues from his industry provide about 40% of the Ural region’s budget. But the government has used the money to pay higher salaries to its employees, recruit more of them and renovate offices rather than build new roads and railway lines, which companies like Uralelectromed badly need.

Crucially, the government failed to use the good times to diversify the economy, clean up its banking system, reform capital markets, strengthen property rights and establish the rule of law. As long as the oil price was going up, nothing that Russia did—from the overt expropriation of Yukos, a giant Russian oil company, to forcing foreign oil companies out of production-sharing agreements—seemed to stop the flow of money into the Russian stockmarket. The job of raising capital was outsourced to foreign banks and capital markets. They lent money to state companies such as Gazprom and Rosneft whose debts were implicitly backed by the government.

This uncontrolled corporate borrowing undid the government’s success at repaying state debt, building up foreign-exchange reserves and setting up a stabilisation fund in which to accumulate some of the oil revenues. At the end of June Russia’s total external debt was $527 billion. Its total reserves in November were $475 billion.

Mr Putin boasted that the net inflow of capital had reached $80 billion last year and total foreign investment had risen to 9% of Russia’s GDP. But only a quarter of this was foreign direct investment; the rest came in the form of loans and portfolio investments. As Kirill Rogov of the Institute of Economy in Transition, a think-tank, explains, this reflected the strength of Russia’s reserves and the weakness of its investment climate. Whereas other emerging economies were fighting tooth and nail for direct investment, Russia was borrowing cheaply instead, he says.

When the world economy started to wobble, the government increased its spending by 40% to boost consumption, says Evgeny Gavrilenkov, chief economist at Troika Dialog, an investment bank. With demand outpacing supply, the Russian economy started to overheat. Inflation topped 15% during the summer. Held back by red tape, the strong rouble and weak property rights, Russian industrial production grew by 5.4% in the first nine months of this year and imports in the same period shot up by 42%. Yekaterinburg is full of department stores, but hardly anything that is sold in them is produced around there. What is made locally is tanks, exports of which did go up last year.

Even as the Russian stockmarket went into a nosedive, Mr Putin insisted that Russia had escaped the financial crisis. On September 13th, in an interview with France’s Le Figaro, he gloated: “We did not have a crisis of liquidity; we did not have a mortgage crisis [like America or Europe]. We did not have it, we escaped it.”

When the music stopped
But when the oil price started to fall, foreign banks stopped lending and money began to flow out of Russia, it became clear that the economy was more vulnerable and more highly leveraged than many investors had wanted to believe. The cranes in Yekaterinburg, and in many other Russian cities, are now standing idle. Production lines have ground to a halt and metal companies and carmakers have begun to sack workers.

The fall in the stockmarket mattered because Russian firms had borrowed heavily against their shares and faced margin calls from their foreign creditors. Mr Illarionov says this is a “standard” credit and liquidity crisis rather than a budget crisis. Compared with many other countries Russia still has plenty of cash, even if its reserves are dwindling at a worrying rate. Leaving aside the recent spending spree, the country’s overall macroeconomic policy has been sensible. For the past eight years the government has been running budget and current-account surpluses. If growth were to slow down to 3% next year, as some analysts predict, that would still be more than in most countries.

Eyevine

All quiet now in YekaterinburgIgor Shuvalov, the first deputy prime minister, puts a brave face on it: “High oil prices corrupted us, inflated our expenditure and distorted our economy. If this crisis had not happened now, by 2011 the quality of credit portfolios would have been much worse. So it is a blessing. Now we can start the real project, to develop domestic industry and the financial sector.”

In essence Russia’s problems are political, not economic. “We have come to this crisis well prepared,” says Yegor Gaidar, a former prime minister and architect of Russia’s post-Soviet economy. “But now we need to stop nationalising companies and cut down on populism. You can make any argument for nationalisation, but when Russia started to nationalise its oil industry production stopped growing.”

Russia may also need to devalue the rouble. The central bank recently allowed it to depreciate slightly against a basket of currencies, but it still intervenes in the market to defend it. Politically a strong rouble has become a proxy for a resurging Russia and devaluing it or letting it float would hurt Mr Putin’s reputation.

As Mr Rogov explains, it would do no harm if Russia’s highly leveraged oligarchs were to hand over their stakes to foreign creditors, but the Kremlin would not allow this. The risk is that instead of clearing the system and promoting the most efficient firms, the crisis is helping the least efficient. The government is already introducing protectionist measures.

“The crisis itself is less grave than the potential consequences of the government’s actions in solving it,” says Andrei Sharonov, a former deputy economics minister who now works in the private sector. The government has earmarked a total of more than $200 billion for various rescue measures, which as a proportion of GDP is almost three times what the Americans are spending. But in contrast to America, there is little public scrutiny of what the money goes on. The first victims to be rescued by the government were two banks said to be closely linked to senior government officials.

To unblock the banking system, the government deposited $50 billion in three banks, two of which are state-linked. The third used to be controlled by Gazprom and is now owned mostly by private individuals. The idea was that the banks would inject liquidity into the system, but in the event they did not lend the money on to other banks, so now the government decides whom they should lend to.

Another $50 billion of the rescue money was earmarked for bailing out “strategic” companies. At the front of the queue were Russia’s largest oil and gas companies, including the state-controlled Gazprom and Rosneft. Igor Sechin, the powerful deputy prime minister in charge of energy, seems to have promised $9 billion of government money to energy companies. Half of it will go to Rosneft, which has a debt of $20 billion that goes back to its controversial takeover of the Yukos oil company. Mr Sechin is also the chairman of Rosneft and, says Mikhail Khodorkovsky, the former boss of Yukos (and now in jail), the man who destroyed his company.

Next came electricity companies, carmakers and anyone else who could think of a good reason to ask for help. As one Russian oligarch observed, a lot of people in the Kremlin would like to take back the companies that were privatised in the 1990s. Back then the oligarchs lent money to the cash-strapped state and got assets at knock-down prices in return. Now it is the companies that are in debt, whereas the state is cash-rich and can buy the assets back cheaply. To make them even cheaper, government officials publicly threaten companies or dig out old charges against them, as Mr Sechin has recently done with one of Russia’s largest fertiliser producers.

The crisis has also changed the behaviour of private firms. In the past the market pushed them to improve their governance, but now they are encouraged to look towards the state, says Roland Nash of Renaissance Capital.

Mr Shuvalov admits that some private assets might end up in state hands, but he insists that the government does not intend to keep them. The question is how, and to whom, these assets will be sold. Nationalising businesses is risky in any country, but in Russia, with its weak institutions and powerful Kremlin clans, it is almost certain to lead to a redistribution of property to the ruling elite, mainly past and present members of the security services, collectively known as siloviki, or hard men.

Neither one thing nor the other
The new entities that could emerge from the crisis may be neither state nor private, says Mr Rogov, but the worst of both worlds: opaque, quasi-state firms run by people affiliated with the Kremlin. One model for this form of ownership is a privately controlled subsidiary of a state-controlled company. Another is something called a “state corporation”.

One example is Russian Technologies, run by Sergei Chemezov, a former KGB officer and a friend of Mr Putin’s from the 1980s when the two served together in East Germany. Until last year Mr Chemezov was in charge of a state arms-trading monopoly, which did not stop him from taking over a successful private titanium business and a car factory. This year his empire, now under the umbrella of Russian Technologies, has grown even further. State corporations’ assets, Mr Chemezov once said, “are neither state not private”; they are “state commerce”.

He has successfully lobbied for the inclusion in Russian Technologies of some 420 mostly state-controlled companies, some of which—such as airlines or property—seem to have little to do with the corporation’s declared aim of promoting technology. Alexei Kudrin, Russia’s finance minister, noted that giving Russian Technologies all these assets would amount to “a covert privatisation and the loss of control over how the proceeds are spent”. But his words fell on deaf ears.

Another state corporation is based on Vneshekonombank (VEB), which is meant to be bailing out Russian firms that need to refinance their foreign debt. The committee that decides on the bail-outs is chaired by Mr Putin himself. VEB has recently lent $4.5 billion, well above its supposed limit, to Rusal, a company controlled by Oleg Deripaska, a Russian aluminium tycoon, so he could repay a foreign loan backed by 25% of Norilsk Nickel, the world’s largest nickel producer. In return VEB will include government officials in the company’s management and board. But even before the crisis Norilsk Nickel’s controlling shareholder, Vladimir Potanin, one of the most politically savvy oligarchs, had put a former KGB officer in charge of the company—to be on the safe side.

The projection of KGB power in Russia’s politics and economy has been a guiding principle of Mr Putin’s period in office. In the past the siloviki often had to rely on tax inspectors or the Federal Security Service (FSB) to get hold of assets. Now the crisis is creating new opportunities for what Mr Illarionov calls the “KGB-isation of the economy”. The result, he explains, could be a new, highly monopolistic system, based on a peculiar state-private partnership in which the profits are privatised by Kremlin friends and debts are nationalised. This will not take Russia back to a state-run economy, but it is likely to shift it further towards a corporatist state.