Putin returns to state control to go forward

TWO WEEKS AFTER Yukos boss Mikhail Khodorkovsky was arrested, a company official spoke out. “The relationship between government and big business has changed,” said Yukos CFO Bruce Misamore, standing at the back of a press conference held early last November. “The way that Yukos is run now depends on the way that Russia is run,” he predicted.

The press conference had been called to celebrate the first meeting of the joint board of YukosSibneft as the merger between oil majors Yukos and Sibneft neared completion. But at the start of December the merger was abruptly called off by Sibneft owner Roman Abramovich on what is widely believed to be Kremlin orders.

Since the arrest of Khodorkovsky by the federal security services the Kremlin has increased its grip on the country and the relations between big business and government have been put on a new basis, with business definitely on the back foot.

President Vladimir Putin effectively carried out a mini coup d’état at the end of last year and rapidly consolidated his position. The same day that Russia’s richest man was arrested, Alexander Voloshin, a powerful big business ally at the heart of government, quit his job as head of the presidential administration and was replaced by two Putin loyalists.

A little over a month later, Putin’s victory was complete when the pro-Kremlin forces routed the opposition and took a super-majority in the country’s fourth Duma elections. With a majority in the legislature, Putin now has the power to change the constitution at will if he chooses.

Whether all these events were connected or pre-planned is a matter of speculation, but the result is that a new phase in Russia’s turbulent development has opened. The empowered state was already flexing its muscles and looks poised to play a more assertive role in industrial policy over the four years that will follow Putin’s near certain victory in the March presidential elections.

The Yukos affair has shaken markets and rattled investors’ confidence. Some observers speculate that Russia is on the cusp of a new authoritarian era and the rolling back of free-market reforms. However, over the past four years Putin has been consistent in promoting a reform agenda and at the height of the scandal repeatedly asserted that the attack on Yukos was specific and not the start of a general campaign. Still, the relationship between government and big business will now change.

Famous encounter The transformation is epitomized by Putin’s two meetings with Russia’s big business – his famous encounter with the oligarchs in July 2000 a few months after taking office, and the meeting at the end of November 2003 when he renewed his deal with Russia’s richest men and added some new conditions.

At the first meeting Putin told the oligarchs: “You can keep your companies – just stop stealing from the state.” He backed this up with the threat of banishment; oligarchs Boris Berezovsky and media mogul Vladimir Gusinsky had been driven into exile and lost control of their companies in the months before.

The stealing did stop, but the oligarchs continued to interfere in politics through what is politely referred to in Russia as lobbying. Khodorkovsky’s offence was not that he was actively backing opposition parties – all big business backs most of the parties – but that he was actively trying to push the country in a direction that was at odds with Putin’s own view of what Russia Inc should be doing.

Despite Russia’s being the second-largest producer of oil in the world after the Middle East region (and the fourth-largest oil producing country), oil makes up only a third of its GDP. Although oil is an important source of budget revenue, Putin has been pushing hard to diversify the economy and create more jobs for the country’s 145 million citizens.

Strength for strength’s sake To do this he wants to recreate a strong state – a force that was almost completely destroyed after the collapse of the Soviet Union. Mike McFaul, a political science professor at Stanford University, argues that this goes further: because of his KGB background, Putin wants a strong state for the sake of having a strong state, in the style of Mahathir Mohamad’s Malaysia.

Over the past year, Khodorkovsky had been pushing hard for new pipelines that would open up the burgeoning Chinese and US markets to Russian oil exports. A nasty row was raging all year. The oil companies said they were willing to pay for construction and could have the pipelines up and running by 2006; the state preferred to put the project in the hands of state-pipeline monopoly Transneft, which will only complete its feasibility study in 2006.

Building these pipelines quickly would make more money for the already super-rich oil companies and take Russia towards the Venezuelan model – a poor country dependent on oil exports. It would also have bolstered an already outspoken and independent Khodorkovsky’s position on the world stage.

On the face of it, Putin’s first Faustian deal with the oligarchs has been a big success, with all the leading companies investing heavily in production and priming the pump that led to Russia’s first strong economic growth in three decades.

Charles Ryan, CEO and chairman of United Financial Group, was among a group of bankers called in to meet Putin shortly after Khodorkovsky was arrested.

“Putin opened the meeting by quoting the latest fixed investment numbers, which have grown by a strong 12% in November,” Ryan says. “He went on to say that he understood that his biggest success has been to ensure the stability that led to this investment and intimated that he wouldn’t do anything to undo that achievement. In the short term Khodorkovsky’s arrest will hurt sentiment, but he said that in the long term business had to understand that they have to follow the law.”

Stunning growth For all the stunning headline economic growth, business has continued to infiltrate government and push its own agenda. Between a quarter and a third of deputies in the Federation Council, the upper house of parliament, are connected to one of the big companies, and the Moscow Times estimates that one in five Duma candidates were bankrolled by companies. The spat over pipelines was only the most public disagreement between business and government over Russia’s future. Did the country’s biggest businesses and taxpayers feel that they could take control of its political institutions and dictate industrial policy to the president and people?

Having bided its time the Kremlin felt compelled to act with the Duma elections approaching. Extra political capital could be made by populist and public oligarchbashing on the eve of the vote.

At the second oligarch meeting in November, Putin re-emphasized that there should be a “clear line” between government and business but also called on the oligarchs to take more social responsibility.

“I think the business community could also put some effort into developing a system of new social guarantees for the population that is more in keeping with the demands of the times,” Putin told members of the Russian Union of Entrepreneurs and Industrialists (RSPP in Russian).

What does Putin mean by “social guarantees”? That businesses should build more hospitals or fund education programmes? Ironically, Yukos was the only big Russian company that has been systematically funding non-government organizations.

Nearly all analysts agree a new deal is being offered, but few agree on what the terms are. What should investors think?

“It’s a flash in the pan,” says Peter Boone, the head of research at Brunswick UBS Warburg. “If the government destroys Yukos then it will be a bigger flash in the pan, but nothing the government has done has changed the basic structure of the economy and Russia remains a very profitable place for business at the moment.”

Others are more pessimistic. “There is a new deal in Russia,” says Steven Deshevsky, head of research at Aton. “All the oligarchs got their companies for free and although those companies will not be nationalized, the government will take more of their money as they think it belongs to the people. The crackdown on the oligarchs is not designed to help small and medium-size enterprises, it is a mission in its own right.”

Roland Nash, chief strategist at Renaissance Capital, suggests that there is a “third way” between these extremes. “Putin seems to be moving towards creating a closer ‘partnership’ between the state and the private economy,” he says, “with the commanding heights of the economy having less independence from the state, although still being owned and managed by the private sector.”

Russia’s big business is probably at the peak of its power. The top eight industrial corporations have increased their share of GDP to about 22%, according to a study by Brunswick UBS Warburg. In the mid-1990s it was between 11% and 14%, when Berezovsky first claimed that the seven leading oligarchs owned half the economy.

This share will ultimately be diluted by the growth of small and medium-sized enterprises (SMEs) as big business is not interested in the high-volume/low-margin manufacturing businesses that usually make up the bulk of an economy.

Heavy tax “The relations between government and big business are changing, but those with the SMEs have remained the same. They represent a big share of GDP but they could never make government listen to them,” says Steven Deshevsky, head of research at Aton. “The real change in government policy is not so much helping SMEs by coming down on big business but the decision to tax big business more heavily is a mission in its own right. The government has become stronger and it has become less reliant on big business.”

The Kremlin wants to speed this process up by imposing a more assertive industrial policy. It has conceded that private management is vastly superior to public, but intends to direct economic activity through taxes and its control over major infrastructure such as pipelines.

“The government has conceded that private management is better than state and so won’t dictate to companies, but it does intend to direct companies by retaining control over the infrastructure,” says Chris Weafer, the head of strategy at Alfa Bank. “Reforms could now go much faster in the new year.”

Fears that Putin would abandon his economic reforms are already receding and it seems likely that if anything they will accelerate now that the oligarchs have been completely removed from the Kremlin. Since he took over, Putin, through economic development and trade minister German Gref, has been remarkably consistent on the need for reform.

“Gref usually blurts out the plan about a year before anything happens, then follows a year of haggling before a compromise is thrashed out through the practical political process and the plan, in its final form, is put into effect,” says Weafer. Now, though, the amount of haggling that the Kremlin has to do has been drastically reduced. Its victory in the Duma elections swept away the last constraints on the executive’s hold on power.

Putin has made no secret of his attempts to build up a system of vertical power and he has built up a parallel government, the presidential administration, which is where the real authority and policymaking lies in Russia.

New deal If Nash is right and Putin’s new deal is that the oligarchs can maintain ownership of industrial assets while his administration directs overall industrial policy, how will this work in practice?

The Kremlin has said little about its policy for the next four years, but it seems clear that if the first four years were about “removing the obstacles to growth” then the next will be about “implementation and society”.

The only hint has been from Igor Shuvalov, a deputy in the presidential administration, who laid out the main directions for Putin’s second term in October. These would, he said, include development of the mortgage market, improvements in education, military reform, modernization of the health service, and the creation of special economic zones. Only the last item is an economic reform.

Likewise, at Putin’s first public address after the Duma elections he called on the new deputies to put cuts in social taxes and a reform of the bureaucracy at the top of its agenda.

Business will not be ignored, but the relations with government have changed in three ways.

First, there will be strenuous attempts to make sure existing laws are applied. As the voters went to the polls, government officials were promising crackdowns. In December the Central Bank of Russia began checking the ownership of banks and it promises to go over all the banks applying for membership of the deposit insurance scheme, the cornerstone of banking reform, which should come into effect this year.

Typically a bank will issue loans to shell companies that then buy shares in the bank and so artificially inflate the bank’s capital. It is a widely used scam and bankers estimate that a fifth of all registered banking capital is virtual money that increases bank sector risks, since reported capital determines a bank’s reserves against bad debts.

Likewise the economic development and trade ministry announced new laws to crack down on fake bankruptcies. Another favourite scam, one-day companies, involves the accumulation of VAT payments in business transactions that are then liquidated along with the tax bill.

Secondly, the government will impose an increasing tax burden on the country’s big companies.

Putin blasted the oil companies for aggressively using tax loopholes to reduce their payments to the government. Yukos has wrangled its profit tax down to about 13% compared with the flat-rate corporate tax of 24%, and in 2003 Sibneft paid an effective rate of 5% over the first half of the year.

The Audit Commission, a government watchdog, noted that this was “ethically not pretty, but legal”.

Inevitable increase Vyacheslav Nikonov, the president of the Politika Foundation, says: “The increase of tax on oil companies is inevitable. The debate is now only over the numbers. Sergei Glaziyev, the head of Rodina [the pro-Putin party now dominating the Duma], has called for $10 billion tax a year, while [Alexander] Zhukov, who is head of the Duma budget commission and probably closer to Putin’s own position, has suggested a more modest $2 billion to $3 billion.”

A survey conducted by the natural resources ministry in December also concluded that oil companies are underpaying profit taxes by just over $3 billion a year.

There has been talk of imposing a royalty tax on oil companies. United Financial Group estimates that some sort of tax increase is likely to knock 13% to 25% off oil companies’ bottom line next year. Existing tax loopholes are rapidly being closed. The loophole that Sibneft used – employing disabled workers – has already been closed and regional exemptions – Mordovia for Yukos, Chukotka for Sibneft and Kalmykia for TNK – were also ended early last month.

The new deal is not limited to private companies. The Kremlin has already demanded bigger dividend payments from state-owned companies.

Deputy property minister Alexander Braverman said in November that state-owned companies could greatly increase their dividend payments.

In the case of some, such as pipeline operator Transneft, the increase could be seven-fold.

Gazprom in particular has come under the spotlight and the government is investigating its profit tax payments. It turned in between $30 million and $60 million in the first half of 2003, “an insignificant sum” says Karen Oganyan, head of the tax ministry’s profit tax department.

Russia’s economy is changing shape. Four years ago the oil and gas sector dominated everything and the only other companies putting in strong growth were those catering directly to rising consumer demand. These two bread-and-butter sectors sandwiched a filling of unattractive middle weight and unreformed Soviet-era industries.

However, over the past four years competition in the growth sectors has become stiff, encouraging domestic entrepreneurs to eat into the meat of this Soviet sandwich.

The star sectors over the first 10 months of last year were machinery and equipment, which grew up to 10.3% year on year, and construction material, up 8.5%. Both sectors were growing as a result of a surprisingly strong 12% gain in fixed investment over the same period.

“The oil story is over,” says Greg Thain, the chairman of IMS, a leading market research company that released a “hot 100” list of potential IPO candidates earlier this year. “All the action is going to be in the nuts and bolts of Russia – the machine makers, the food processors, the tyre manufacturers.”

The Kremlin will start fine-tuning the system to promote non-natural resources sectors, something the economic development and trade industry was attempting to do in the summer of 2002 until the government got bogged down in infighting. Preparations for this shift have been going on since the end of last summer when the government set up seven new committees to plan future sector reforms.

Reversal of policy The most obvious example is the inclusion of special economic zones (SEZs) on Shuvalov’s list. It represents a reversal to tax reform policy – so far tax rates have been slashed to the bone and the rules made black and white in an effort to bring companies back into the regular economy. SEZs mean the government feels strong enough to reintroduce special tax rates and exemptions that were widely abused in the past.

So far the only sector to receive tax concessions has been the SMEs. Putin personally intervened in December 2001 to push through measures that cut taxes and reduced paperwork. This has resulted in the SMEs subsequently doubling their share of GDP.

The Kremlin is hoping to apply the same logic to boosting the fortunes of about 10 regions this year, according to the economic development and trade ministry’s plans.

“Russia is now entering the critical phase in its economic transition,” says Alfa’s Weafer. “Putin’s plan is to take the enormous risk of deliberately suppressing growth in the most efficient sectors of the economy, probably for two years, in order to try to seed growth in what are currently inefficient areas of the economy. Pushing reforms is an important part of that formula, but ultimately he will only have a chance of success by also sharply reducing bureaucracy and corruption and restoring the ‘attractive investment climate’ that briefly led to a reversal of capital flight before the start of the Yukos investigations.”

Gref had revised his blueprint for economic reform in 2002 and two-thirds of the new plan was dedicated to boosting manufacturing sectors. But the attempts to make a start died as the government got bogged down in fighting with big business over such issues as new pipelines. Now that the Kremlin is fully in control these efforts will be restarted. Akardy Dvorkovich, Gref’s deputy, said in November that the introduction of SEZs was an attempt to speed economic growth as the existing plans would not deliver enough growth to meet Putin’s target of doubling GDP by the end of the decade.

How this plan will go down with the rest of the world remains to be seen.

United Financial Group’s Ryan says that Putin’s overriding goal is to rebuild the country so that it can sit at the top table with other members of the G8.

Aton’s Deshevsky argues that investors will not be perturbed as they do not insist on democracy but do insist on stability, which is at the core of Putin’s programme. The president himself remains pragmatic and will do whatever he thinks will work.

When asked about the role of democracy by a US journalist last autumn he said: “If by democracy one means the dissolution of the state, then we do not need such democracy. Why is democracy needed? To make people’s lives better, to make them free. I don’t think that there are people in the world who want democracy that would lead to chaos.”

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