“Russia,” commented financier George Soros last year, “is like a canoe in which seven men are fighting over a hoard of gold. They are too absorbed by this to recognize that they are heading towards a waterfall.” He was referring to what the Russian media often call the semibankirshchina or rule of the seven bankers, harking back to the semiboyarshchina – the brutal reign of Russia’s aristocratic officials and landowners during the 17th century.
Unlike Asia’s financial crisis, which followed decades of growth and vast infrastructural investment, Russia entered its crisis on the heels of a decade-long collapse, capital flight running into hundreds of billions of dollars and the kind of mass poverty not seen since the 1940s. Industrial production, according to one estimate, has dropped since 1991 by 80%, capital investment by nearly 90%.
By the time prime minister Sergei Kiriyenko announced a devaluation and default on August 17, the economy was already on its knees. “They were losing $2 billion a week in reserves,” says Richard Gray, head of emerging markets research at Bank of America. “They asked the G7 and the IMF for more help, were turned down and decided to go it alone.” A participant at the frantic talks between the government and the IMF in the days before the announcement describes them as akin to “a madman arguing with a deaf man”.
With debt servicing costs running at almost half of tax revenues and no prospect of new money from the IMF, the government had two options: print money to finance the deficit or default. It chose the latter – even in Russia printing enough money to redeem the outstanding GKOs was impossible. With hindsight the decision seems inevitable. “Bond yields were already priced for default,” says Alexander Pertsovsky, president of Moscow brokerage Rinaco Plus. Yields had risen above even those of October 1993 when the Duma was shelled, and of December 1991 when the Soviet Union collapsed.
Losses to foreigners from the default on GKOs could reach $40 billion, depending on the fate of the rouble. Commercial creditors, whose loans came under a 90-day debt moratorium, stand to lose up to $50 billion. Rating agency Fitch IBCA believes that Russia will be the largest single credit loss ever suffered by the international banking community. Private creditors are looking at losses of up to $100 billion.
This comes on top of the losses already incurred by equity investors. The capitalization of the Russian stock market had fallen from $120 billion in October of last year to around $20 billion by early September. In the month to September 7 the price of Lukoil common stock plunged 54% and other companies watched their shares lose more than 90% of their value.
The market is now totally illiquid. The bid for Surgut Holding common stock is $20; the offer is $60. One fund manager boasted wryly that his fund had outperformed the market, falling by only 73%, against 76% for the market as a whole.
In the build-up to the crisis, comment from western financiers in Moscow was marked by a stubborn refusal to confront its depth. A research report, from investment bank MFK Renaissance, dated May 29 and titled, “A strong rouble, GKO yields at under 30%: The dawn of a new era?” was full of talk of a “virtuous circle” of economic reform. Even four days before the government defaulted, Alex Knaster, until recently head of CSFB’s Moscow operation, said: “The sovereign financial situation is fine, the key is to hold the course and not panic”.
Remarkably, the government issued a 30-year Eurobond as late as June, racking up a total for the year of $4.8 billion. “Some of the Eurobond deals were piggy-backing on the expectation of more IMF money,” says Gray at Bank of America, “but anybody issuing or buying a Eurobond issue has his eyes wide open.”
The view from within the government in the build-up to the crisis was certainly bleak. “Kiriyenko’s government was from the beginning a hostage to old debt policies,” says former deputy prime minister and leading reformer, Boris Nemtsov. “His predecessor Chernomyrdin did not even bother to cut state spending. He used credits like a drug as a result of which the debts piled up. Sooner or later the country would have exploded or the financial system would have collapsed.”
Yet the multilaterals coughed up again in July to the tune of $22.6 billion. In the weeks leading up the bail-out announcement – fearing that the loan spigot might at last be turned off – president Boris Yeltsin warned that Russia was in imminent danger from extremist forces. The tactic of evoking political bogymen evidently worked.
So why did the IMF, the World Bank and western investors get it so wrong in Russia? “In Russia as well as in both the IMF and the World Bank,” says professor Grzegorz Kolodko, visiting fellow at the World Bank, and former deputy prime minister and finance minister in Poland, “people are having serious doubts about the inappropriate course taken by the transition in Russia. Advice was too often linked more with the interests of the advising countries, lobbies, organizations and individuals than with the interests of Russia.”
In the name of deregulation and liberalization, so the argument goes, Russia’s economy has been looted by a band of well-placed insiders, mostly Soviet apparatchiks. They now dominate the media and the state, and have moved as much as possible of their wealth abroad.
Seven bankers of the apocalypse
The identity of these insiders is well known though they escape publicity. Boris Berezovsky, a Rasputin-like figure in the Yeltsin court, declared a salary of $43,000 in 1997, but his personal assets have been valued at close to $3 billion. His interests include a car dealership and large stakes in the ORT television network, national airline Aeroflot and oil firm Sibneft. Vladimir Potanin, who beat Berezovsky in the auction for telecoms company Svyazinvest, controls Russia’s largest bank, Unexim, oil company Sidanco and the Norilsk Nickel company, largest corporate supplier of nickel in the world. Potanin also controls the newspapers Izvestiya and Komsomolskaya Pravda. The other five of the original oligarchs are Mikhail Khodorkovsky, chairman of Bank Menatep; Vladimir Gusinsky, chairman of Most-Bank; Alexander Smolensky, chairman of SBS-Agro Bank; Mikhail Fridman, chairman of Alfa-Bank; and Vagit Alekperov, chairman of Lukoil.
Vying with the original seven for the status of full-fledged oligarchs are three other men: Rem Vyakhirev, chairman of Russia’s largest energy conglomerate, Gazprom; Vitaly Malkin of the Rossiiskii Kredit Bank; and Vladimir Bogdanov, chairman of energy company Surgutneftegaz.
The multilaterals have staked not only money but their credibility on the Russian reform programme, which foundered on the opposition of these oligarchs and on endemic corruption in the state and private sectors.
The oligarchs seemed to have their backs to the wall as the government sought to implement the conditions of the IMF bail-out: lower state spending and higher corporate tax collection. In early August there was talk of company executives being arrested and accounts being frozen. “The game was up,” said Pertsovsky, president of Rinaco Plus.
The fight-back began when Russia’s leading energy firms released an open letter to Yeltsin, in which they accused the government of acting under pressure from “international financial organizations” and decried moves to increase taxes from oil.
Above all else, though, the oligarchs had their sights set on the rouble. In the days after the announcement of default and devaluation, stories began to appear in the Russian press of a meeting of Russian oligarchs in Nice, on the French Riviera, eight days earlier where the package was drafted before being handed to Yeltsin to enact as a fait accompli. Wherever it was conceived, default and devaluation were seen as a last-ditch effort by the oligarchs to save themselves and their holdings.
“The majority of oil companies have revenues in dollars but costs in roubles,” says Matthew Thomas, an economist with CA IB Investmentbank in Moscow. “There is an accurate perception in the market that oil companies will benefit across the board from devaluation.”
The machinations of the oligarchy came as a slap in the face for the IMF. “These things are not supposed to happen after the announcement of an IMF bail-out,” says the chief emerging markets economist at one western investment bank, who believes the IMF must carry its share of the blame for the crisis. “The IMF conditions were in large part proposed by the Russians,” he says. “The efforts to boost tax collection and the fact that they had been running a primary surplus throughout this year should have been lauded by the IMF.”
Some of the reforms instigated by the Kiriyenko government were spectacular by the standards of its predecessor: like applying tax legislation from Gazprom to the corner shop; the transfer of tax revenues from the regions to the federal government; and allowing the federal tax service and the tax police to act in unison. “The notion of the tax police raiding an oligarch’s dacha six months ago would have been unthinkable,” says Charles Ryan, CEO at United Financial Group. “Under Kiriyenko, the oligarchs really were running scared.”
The manner in which the IMF conditions of lower budget spending and increased tax collection were implemented did little to quell market disquiet. It took rule-by-decree in Russia, as IMF first deputy managing director Stanley Fischer proposed it would, for the Fund’s executive board to approve $11.2 billion in “financial support”, beyond previous loan commitments – part of the $22.6 billion two-year package, announced on July 13.
The IMF and the World Bank also come in for flak over their cavalier attitude to corruption in Russia. Corruption in Russia, within the state and the private sector, has assumed breathtaking proportions. Of $2.3 billion allocated by Moscow for the reconstruction of Chechnya, just over half was carelessly accounted for and the rest disappeared, says Venyamin Sokolov, head of Russia’s Chamber of Accounts. The rot extended as far as the central bank, whose reserves were regularly replenished by the IMF. “Some $2 billion disappeared without explanation from the central bank’s hard currency reserve accounts in 1995,” says Paul Saunders, director of the Nixon Center, a Washington-based think tank.
Things are little better in the private sector. Swiss federal prosecutor Carla del Ponte says that approximately 40% of the $40 billion kept by Russians in Swiss banks are of criminal origin. Figures provided by the US Federal Bureau of Investigation and confirmed by Russian law-enforcement sources suggest that half of the country’s 256 largest banks were linked last year to organized crime through extortion schemes and money laundering.
Corruption and theft clearly happened under the nose of the multilaterals. The World Bank has been working with Russia since 1993 to transform the grossly inefficient Soviet mining industry. It granted Russia a $500 million loan to help retrain miners, close unproductive mines and revamp the rest. At least $240 million of this has disappeared.
“There was never proper control,” says Vadim Voronin, deputy director of the World Bank’s Moscow office. “Unfortunately, some of the money was misused or mismanaged.”
Yet the multilaterals went on throwing money at Russia. “Each year, the amount of money lent by the IMF and the World Bank has been larger than the year before,” says Peter Reddaway, professor of political science at George Washington University. “And each year, bad things have followed the loans, in politics as well as economics. For example, three months after the IMF gave its second loan (of $1.5 billion) in 1993, President Boris Yeltsin used tanks to disperse the democratically elected parliament that had brought him to power. Then, in 1994, after getting another $1.5 billion, Yeltsin sent his tanks into Chechnya, launching a long war. Much of 1995’s loan of $6.8 billion went to finance the continuing bloodbath there.”
The last time the Fund extended a helping hand was in summer 1996, and most commentators agreed that its offer of an extended funds facility worth $10.2 billion was more-or-less a contribution to Boris Yeltsin’s re-election campaign. In the run-up to the election, the government ran-up huge deficits even under the watchful gaze of the IMF.
The Fund has failed to give a clear and coherent account of its strategy on Russia. And after the decision to default, the Fund has become more circumspect than ever. “We are basically reacting to the realities that are unfolding,” says John Boorman, the IMF’s director of policy development and review. The relationship between the government and the IMF was summed up by Nemtsov in an interview with the local press before August 17: “For the west it would be absolutely undesirable to have a financial collapse of Russia, a financial and political collapse. Of course, as they took the decision to help Russia, western leaders thought about the fact that this would preserve stability. I think they behaved absolutely predictably. We know them and they know us.”
When he was summarily sacked from the government with the re-appointment of Chernomyrdin as prime minister, Nemtsov spoke more frankly about the “market reforms” the IMF was drip-feeding: “It was too difficult to carry out any reforms … in the conditions of such an ugly market, where competition is non-existent, monopolies are rampant, where rules are few.”.
So will default and devaluation allow the oligarchs to survive? Boris Jordan, head of MFK Renaissance, is sceptical. “Listen, I just finished working on Sidanco’s problems,” he says. “I can tell you that devaluation is not going to save them. The oil industry has two problems. Firstly, taxes – this is where they needed to lobby the government, to get oil taxes changed. The government was trying to squeeze everything it could out of the oil sector in order to support the economy. Secondly, it’s an issue of oil prices. And for this, they have to change production patterns, they have to lay off 40-50% of their people. They have to stop the construction of mansions and amazing office buildings that is depleting their capital. Nor can they build gas stations in New York. They’ll have to reduce company spending.”
The meltdown of the banking sector will also hit the oligarchs hard, quite apart from ordinary Russians. Before the latest crisis, analysts took comfort from the fact that the real economy was insulated from the banking sector, because bank lending is only 20% of GDP, compared with over 100% in most industrialized countries. But the fate of the oligarchs’ “financial-industrial groups” (Figs), which account for 50% of the economy, is inextricably linked to the banking sector. The Figs have used future oil receipts as collateral for loans with their sister banks. For example, Menatep used oil production and shares in Yukos as collateral for borrowing. It was then faced with margin calls on shares at $1.20 each, when the share price had fallen to 20 cents. Other Figs are in similar dire trouble.
Before August 17, the prospect of some of these companies being forced into receivership to western banks became a real possibility. “We were prepared to initiate bankruptcy proceedings against some of Russia’s largest companies,” says Nemtsov. This was a bridge too far for the oligarchs and spurred them into the rearguard action which saw the currency devalued and a debt moratorium declared.
Against this background of negligible competition and seething corruption, it is little wonder that the economy stagnated after the collapse in output of the early reform years. “The privatization process was driven by political not economic imperatives,” says Neil Parison, the head of the EBRD’s Moscow office. State-owned industries were given away for a song to form a bulwark against any communist revival. The economy was privatized but not commercialized.
“Outside of the banking sector there are hardly any examples of rationalization or consolidation,” says Parison. The failure to restructure has gone hand in hand with the calamitous levels of capital flight – estimated at between $150 billion and $300 billion – and paltry levels of foreign direct investment. Last year, the country received $4.5 billion in FDI, or roughly 1% of GDP, and, only $10 billion in total since 1991. By contrast, last year alone Brazil received almost $18 billion (2.5% of GDP), and China more than $45 billion.
There are some grounds for optimism, however. “Russia is not melting down completely,” says Nicholas Sundstrom, chief Russia economist at Citibank. at Citibank. “There is a danger that we get too pessimistic. There is an irreversible trend towards capitalism. The problem is that markets have been temporarily erased. We are back to building debt and equity markets from scratch.”
Others hope that the crisis has delivered a much needed shock to the system. “Hopefully now it will be understood that one cannot have a healthy currency and financial system within the context of a sick economy and political system,” says Kolodko. “There is a need for comprehensive medium-term development program, where fiscal and monetary targets must serve as the means, not as the ends of policy.”
The stakes could hardly be any higher, given Russia’s nuclear might, however corroded it might be. In 1995, professor Alexander Yanov, author of After Yeltsin: A Weimar Russia, wrote: ”The history of the Weimar Republic was brief – just 15 years long. But it will forever remain a striking illustration of an implacable historical law: any attempt to reduce the giant task of democratic transformation of an imperial leviathan to the trivial problem of money and credits ends without fail in a world disaster.”
