Putin misses a chance for economic reform

By Neil Buckley in Moscow

Financial Times

Published: April 15 2005

In London's Queen Elizabeth II conference centre there was standing room only. Some 3,000 delegates, including Russia's business elite, investors and Kremlin advisers, were packed in this week for the Russian Economic Forum, an investment showcase that should have been a chance to relaunch the case for putting money into Russia.

Two weeks earlier, Vladimir Putin, the president, had summoned the "oligarchs", the businessmen who made their fortunes in Russia's often murky privatisations of the 1990s, to the Kremlin. He told them he would change the law to make reviews of those privatisations impossible and rein in Russia's aggressive tax police. The message to domestic and international investors seemed clear: there would be no repeat of the Yukos affair, the attack by the authorities on what was previously Russia's most successful oil company and Mikhail Khodorkovsky, the man who built it.

Yet just hours after the conference started on Monday came a reminder of why Russia's investment reputation has been so dented. Word arrived from Moscow that a claim for back tax against TNK-BP, the oil joint venture that is the biggest foreign investment in Russia, had been increased sevenfold to nearly $1bn. Coming during an upbeat presentation by Viktor Vekselberg, an oligarch who is a big TNK-BP shareholder, it appeared timed to cause maximum embarrassment.

The timing now looks more likely to have been a bureaucratic bungle, and the increased tax claim a not unexpected development in a long-running case against the Russian arm of the venture ahead of an appeal hearing this week, rather than a politically motivated attack. But it was a serious setback to Russia's attempts to calm investors frightened by the imprisonment of Mr Khodorkovsky - who faces up to 10 years in a labour camp if found guilty this month of fraud and tax evasion - and the effective renationalisation of Yukos's main production arm in part payment of a $28bn back tax bill.

The Yukos affair, the contradictory messages, the rampaging tax police and a battle over economic policy between pro-market reformers and more interventionist elements in the government have all damaged investment. That, in turn, helped slow overall economic growth from 7.1 per cent last year to 4.4 per cent year-on-year in January and February. Capital flight increased fivefold last year to $9.5bn. Foreign investment remains paltry given Russia's size and its buoyant record of six years of economic growth averaging 6.7 per cent (see charts). Small businesses are finding local governments in some cases taking their cue from the central authorities and grabbing assets for themselves.

More importantly, a historic reform opportunity is being missed. With record oil prices bringing revenues gushing into the country, Mr Putin has a chance to modernise and diversify Russia's economy. He also has huge personal popularity on his side. But the president's failure to seize that chance was a recurring theme at this week's conference.

"In 1999, you had a well-intentioned government with massive problems," says John Litwack, lead economist in the World Bank's Moscow office. "Now the Kremlin has real power. There is a lot they can do if they want to, but they are not doing it."

That failure comes in spite of Mr Putin's commitment to liberal reforms during his first presidential term, and in spite of the fact that strong growth is crucial to the Kremlin's aim of getting a chosen successor to Mr Putin elected president in 2008 to continue his political project.

Recent signals suggest Mr Putin and his entourage have been rattled by the revolutions in neighbouring Ukraine, Kyrgyzstan and Georgia. At the same time, they have drawn a lesson that tinkering with the electoral system is dangerous. So, despite speculation that the Kremlin might alter the constitution to let Mr Putin serve a third term, the administration has concluded it must stick to existing rules. Mr Putin reiterated this week he had no plans to stand for president again in 2008.

Even with the advantages the Kremlin enjoys, such as effective control over television news, getting an anointed candidate elected means continuing to deliver the rise in living standards and real incomes that has underpinned Mr Putin's popularity. It also means keeping business on board.

A recent declaration by Mikhail Kasyanov, sacked as prime minister by Mr Putin last year, that he might stand for president in 2008 brought media comparisons with Viktor Yushchenko, the new Ukrainian president, that only heightened the Kremlin jitters. Many business leaders privately say they could rally around Mr Kasyanov. Oligarchs driven out of Russia during Mr Putin's first term - including Boris Berezovsky, the prominent 1990s financier, and Leonid Nevzlin, who now controls Yukos's holding company - have openly expressed support.

Dmitry Medvedev, the president's chief of staff, gave a glimpse of the jumpy Kremlin mood last week in a rare interview with Expert, a Russian magazine. In an implicit call to back the administration as a guarantor of stability and growth, Mr Medvedev warned that a Ukrainian - or Georgian-style change of power in a country as big and complex as Russia could lead to a break-up. The end of the Soviet Union "would look like a kindergarten party compared with the collapse of the state in modern Russia", he said.

Against that background, Mr Putin's message to the oligarchs last month looks like a subtle restatement of his famous bargain with them in 2000, when he said they could keep their gains if they paid their taxes and stayed out of politics. Now the message is that they can hold on to their empires if they invest in helping Mr Putin deliver on his economic promise. Rather than setting big business against him, Mr Putin is trying to co-opt it. "Putin had his back to the wall and he did the sensible thing," says Al Breach, an economist at Brunswick UBS in Moscow.

After a year-long battle over policy the outlines of the Kremlin's plan to achieve the economic growth that it wants are starting to emerge. The oligarchs have their part to play. But the Russian state is set to take a much bigger role than previously expected.

Mr Putin spent his first term re- establishing presidential power, wresting influence from the oligarchs and removing other vested interests that might block reforms. To help him, Mr Putin appointed to his personal staff several former members of the security services or military, known as siloviki, or "men of power". But he balanced their influence by including economic liberals, such as German Gref, economics minister, and Alexei Kudrin, finance minister, in the government.

After his overwhelming election victory a year ago, Mr Putin was widely expected to use his power and ballooning oil revenues to support a blueprint for economic diversification drawn up by Mr Gref. Instead, the siloviki, who favour a stronger state role in the economy, seem to have won out over the liberals.

Chris Weafer, chief strategist at Alfa Bank, believes that after several botched reforms - including benefits changes that provoked demonstrations by pensioners in January - the presidential administration decided the state bureaucracy was too weak or corrupt effectively to implement the measures envisaged by the Gref plan. Instead, those around Mr Putin would take control of key sectors - oil and gas, metals and minerals, and parts of defence and aerospace - and use these as motors of growth.

"What makes more sense to Mr Putin is to merge the control requirement with the economic priority," Mr Weafer says. While not returning to Soviet-style central planning, Russia is moving towards a model of state-controlled, or at least Russian-controlled, "champion" companies in sectors that are growing or where Russia has a competitive advantage, with a state-directed policy for each sector. It will encourage foreign companies to take minority stakes to import technology and expertise. But foreign control in strategic sectors, or even further 50-50 ventures such as TNK-BP, may be out.

The Gref reforms, Mr Weafer believes, will not be abandoned. But their implementation will be slowed and partly put off until after 2008.

The evidence supports his thesis. Russia has already moved towards centralising control over strategic economic sectors. It is not clear whether grabbing Yukos's assets was among the original motives for the attack on Mr Khodorkovsky, widely seen as punishment for using his wealth to get into politics. But the siloviki seized the opportunity to take back one of Russia's most lucrative oil assets - Yuganskneftegaz, the main production arm of Yukos. It ended up in the control of Rosneft, the state-owned oil company, after a controversial auction last December. Rosneft, meanwhile, is being merged into Gazprom, the world's biggest natural gas producer. The result will be a state-controlled energy giant that is being compared to Saudi Arabia's Aramco.

Mr Putin's entourage has also been taking a direct role in strategic state-owned companies. Mr Medvedev, Mr Putin's chief of staff, now chairs Gazprom. Igor Sechin, the powerful deputy chief of staff, chairs Rosneft. Three other deputy chiefs - Viktor Ivanov, Vladislav Surkov, and Sergei Prikhodko - between them chair Aeroflot, the national airline, Almaz-Antey, a missile consortium, Transnefteprodukt, the pipeline monopoly, and TVEL, Russia's sole nuclear fuel trader.

Russia is creating United Aircraft Corporation, a single state-controlled commercial aircraft manufacturer, and positioning state-owned Vneshtorgbank and Sberbank to dominate banking.

Other events in the past week have provided pointers to the future. Sual, the Russian aluminium group, ruled out a London stock market listing, saying foreign ownership would not be popular with the Kremlin. Russia blocked a bid by Germany's Siemens for Power Machines, a turbine maker with links to the defence industry, but did sign a deal for Siemens to supply 60 high-speed trains - technology that Russia lacks.

The wish to create national champions is not necessarily bad, says Eric Kraus, chief strategist at Sovlink Securities in Moscow. "If you build national companies to save sunset industries, it is going to be a disaster. If you do it to fund new technologies, capital-intensive businesses, that the private sector might not fund, it can work," he says, pointing out that successful economies such as South Korea, Taiwan and China all had massive capital allocation by the government.

But there are well-known pitfalls in building national champions through state ownership. State companies may compete unfairly with non-state groups, holding back their development. Bureaucrats tend to be poor managers. In Russia's case, wealth may continue to be concentrated in a small group of key industries, rather than more broadly spread as it would be through measures to foster small and medium-sized businesses. The economy may end up overly reliant on commodity prices, setting it up for a bigger fall when those prices eventually drop. And, as other countries, especially oil-rich ones, have found, state ownership can be a recipe for corrupt practices.

Mr Weafer says the risk is that, instead of looking like Chile, where strong state power pushed through liberal reforms, Russia could end up like Indonesia, where reliance on oil led to inefficiency and corruption.

Andrei Illarionov, who has held on to his job as Mr Putin's economic adviser despite outspoken criticism of the direction in which policy is moving, draws a different analogy. He told this week's London conference that Russia risked becoming like Venezuela, where strong growth in the oil industry when it was controlled by foreign investors was followed by decades of stagnation after it was nationalised.

Mr Illarionov's gloom may prove misplaced. Whether it does will depend, more than ever before, on Mr Putin and his inner circle.

A market mission marred by mishandling

At the end of 1999, when Vladimir Putin was still Russia’s prime minister, he set up a think-tank to draw up a 10-year blueprint for economic policy. It was headed by German Gref, a lawyer, whom Mr Putin knew from his days in the St Petersburg administration, and included a “dream team” of reform-minded economists. Its plan, published six months later, was hailed as the most market-oriented programme for Russia since the Soviet Union collapsed in 1991.

The goals were ambitious: cutting state intervention in the economy, minimising red tape, lowering the tax burden and boosting private business. Natural monopolies in electricity, gas and railways were to be reorganised. There were measures to improve property rights and corporate governance. Social benefits were to become more targeted, to narrow the gap between rich and poor. In a sign of his commitment to the plan, Mr Putin brought Mr Gref into government as economy minister - where he remains.

Five years on, the record is broadly positive. Economic growth, helped by high oil and gas prices, has beaten the average 5 per cent annual rate envisaged in the plan, putting Russia among the world’s fastest growing economies - although inflation last year exceeded the 10 per cent target. A centrepiece of the plan, moving to a flat rate of income tax of 13 per cent, has been implemented with success, helping restore public finances.

But changes to social welfare,replacing in-kind benefits such as free bus passes with direct payments to pensioners, were mishandled. As a result, the government’s commitment to the next stage, phasing out subsidies on housing, is in question. Electricity reform has been protracted while Gazprom, the gas monopoly, is set to remain a state-controlled monolith, strengthened by its merger with Rosneft, the oil producer.

Where Russia remains particularly weak is in promoting small and medium-sized enterprises. According to Opora, a small-business lobby group, in the 10 years to 2004 the number of SMEs increased by only 100,000 to reach 950,000, accounting for 13 per cent of gross domestic product compared with more than 50 per cent in many western economies. The true number may be higher, since many businesses try to avoid cumbersome registration procedures.

Small businesses still face a jumble of requirements to get licences, register with multiple state agencies and submit to inspections - all providing opportunities for officials to demand kickbacks. Measures to stimulate smaller businesses and high technology, and to cut bureaucracy and corruption, could be set back if the Kremlin focuses o n supporting national industrial champions.

Mr Gref, in a recent interview with the Financial Times, insisted his reform agenda was intact. Legislation on the way, including competition and state-aid rules and the planned privatisation of 1,500 more enterprises this year - among them Svyazinvest, the telecommunications holding company - would dispel any doubts about the commitment to continuing reform, he said.

“I’m convinced that we can only have a successful economic policy by providing maximum economic freedom to citizens. Any other policy is doomed to failure,” Mr Gref added. “And I wouldn’t have the strength, or the motivation, to carry out a policy that I knew was doomed to failure.”

Additional reporting by Arkady Ostrovsky

Sources for charts: Thomson Datastream; Consensus Economics; EIU; Unctad