But, as opposed to Saudi Arabia's or Venezuela's, Russia's b_Russian Roulette: Russia's Economy in Putin's Era

Russian Roulette

Russia's Economy

In Putin's Era

1st EDITION

Sam Vaknin, Ph.D.

Editing and Design:

Lidija Rangelovska

A Narcissus Publications Imprint, Skopje 2003

First published by United Press International - UPI

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Created by: LIDIJA RANGELOVSKA

REPUBLIC OF MACEDONIA

C O N T E N T S

I. The Security Apparatus

II. The Energy Sector

III. Financial Services

IV. The Russian Devolution - The Regions

V. Agriculture

VI. Russia as a Creditor

VII. Russia's Space Industry

VIII. Russia's Vodka Wars

IX. Let My People Go

X. Fimaco Wouldn't Die

XI. The Chechen Theatre Ticket

XII. Russia's Israeli Oil Bond

XIII. Russia's Idled Spies

XIV. Russia's Middle Class

XV. Russia in 2003

XVI. Russia Straddles the Euro-Atlantic Divide

XVII. Russia's Stealth Diplomacy

XVIII. Russia's Second Empire

XIX. The Author

XX. About "After the Rain"

The Security Apparatus

Shabtai Kalmanovich vanished from London in late 1980's. He resurfaced

in Israel to face trial for espionage. He was convicted and spent years

in an Israeli jail before being repatriated to Russia. He was described

by his captors as a mastermind, in charge of an African KGB station.

In the early 1970's he even served as advisor (on Russian immigration)

to Israel's Iron Lady, Golda Meir. He then moved to do flourishing

business in Africa, in Botswana and then in Sierra Leone, where his

company, LIAT, owned the only bus operator in Freetown. He traded

diamonds, globetrotted flamboyantly with an entourage of dozens of

African chieftains and their mistresses, and fraternized with the

corrupt elite, President Momoh included. In 1986-7 he even collaborated

with IPE, a London based outfit, rumored to have been owned by former

members of the Mossad and other paragons of the Israeli defense

establishment (including virtually all the Israelis implicated in the

ill-fated Iran-Contras affair).

Being a KGB officer was always a lucrative and liberating proposition.

Access to Western goods, travel to exotic destinations, making new (and

influential) friends, mastering foreign languages, and doing some

business on the side (often with one's official "enemies" and

unsupervised slush funds) - were all standard perks even in the 1970's

and 1980's. Thus, when communism was replaced by criminal anarchy, KGB

personnel (as well as mobsters) were the best suited to act as

entrepreneurs in the new environment.

They were well traveled, well connected, well capitalized, polyglot,

possessed of management skills, disciplined, armed to the teeth, and

ruthless. Far from being sidetracked, the security services rode the

gravy train. But never more so than now.

January 2002. Putin's dour gaze pierces from every wall in every

office. His obese ministers often discover a sudden sycophantic

propensity for skiing (a favorite pastime of the athletic President).

The praise heaped on him by the servile media (Putin made sure that no

other kind of media survives) comes uncomfortably close to a Central

Asian personality cult. Yet, Putin is not in control of the machinery

that brought him to the pinnacle of power, under-qualified as he was.

This penumbral apparatus revolves around two pivots: the increasingly

fractured and warlord controlled military and, ever more importantly,

the KGB's successors, mainly the FSB.

A. The Military

Two weeks ago, Russia announced yet another plan to reform its bloated,

inefficient, impoverished, demoralized and corrupt military. Close to

200,000 troops are to go immediately and the same number in the next 3

years. The draft is to be abolished and the army professionalized. At

its current size (officially, 1.2 million servicemen), the armed forces

are severely under-funded. Cases of hunger are not uncommon. Ill (and

late) paid soldiers sometimes beg for cigarettes, or food.

Conscripts, in what resembles slave labour, are "rented out" by their

commanders to economic enterprises (especially in the provinces).

A host of such "trading" companies owned by bureaucrats in the Ministry

of Defense was shut down last June by the incoming Minister of Defense

(Sergei Ivanov), a close pal of Putin. But if restructuring is to

proceed apace, the successful absorption of former soldiers in the

economy (requiring pensions, housing, start up capital, employment) -

if necessary with the help of foreign capital - is bound to become a

priority sooner or later.

But this may be too late and too little - the much truncated and

disorientated armed forces have been "privatized" and commandeered for

personal gain by regional bosses in cahoots with the command structure

and with organized crime. Ex-soldiers feature prominently in extortion,

protection, and other anti-private sector rackets.

The war in Chechnya is another long standing pecuniary bonanza - and a

vested interest of many generals. Senior Russian Interior Ministry

field commanders trade (often in partnership with Chechen "rebels") in

stolen petroleum products, food, and munitions.

Putin is trying to reverse these pernicious trends by enlisting the

(rank and file) army (one of his natural constituencies) in his battles

against secessionist Chechens, influential oligarchs, venal governors,

and bureaucrats beyond redemption.

As well as the army, the defense industry - with its 2 million

employees - is also being brutally disabused of its

centralist-nationalistic ideals.

Orders placed with Russia's defense manufacturers by the destitute

Russian armed forces are down to a trickle. Though the procurement

budget was increased by 50% last year, to c. $2.2 billion (or 4% of the

USA's) and further increased this year to 79 billion rubles ($2.7

billion) - whatever money is available goes towards R&D, arms

modernization, and maintaining the inflated nuclear arsenal and the

personal gear of front line soldiers in the interminable Chechen war.

The Russian daily "Kommersant" quotes Former Armed Forces weapons

chief, General Anatoly Sitnov, as claiming that $16 billion should be

allocated for arms purchases if all the existing needs are to be

satisfied.

Having lost their major domestic client (defense constituted 75% of

Russian industrial production at one time) - exports of Russian arms

have soared to more than $4.4 billion annually (not including

"sensitive" materiel). Old markets in the likes of Iran, Iraq, Syria,

Algeria, Eritrea, Ethiopia, China, India, and Libya have revived.

Decision makers in Latin America and East Asia (including Malaysia and

Vietnam) are being avidly courted. Bribes change hands, off-shore

accounts are open and shut, export proceeds mysteriously evaporate.

Many a Russian are wealthier due to this export cornucopia.

The reputation of Russia's weapons manufacturers is dismal (no spare

parts, after sales service, maintenance, or quality control). But

Russian weapons (often Cold War surplus) come cheap and the list of

Russian firms and institutions blacklisted by the USA for selling

weapons (from handguns to missile equipped destroyers) to "rogue

states" grows by the day.

Less than one quarter of 2500 defense-related firms are subject to (the

amorphous and inapt) Russian Federal supervision. Gradually, Russia's

most advanced weaponry is being made available through these outfits.

Close to 4000 R&D programs and defense conversion projects (many

financed by the West) have failed abysmally to transform Russia's

"military-industrial complex". Following a much derided "privatization"

(in which the state lost control over hundreds of defense firms to

assorted autochthonous tycoons and foreign manufacturers) - the

enterprises are still being abused and looted by politicians on all

levels, including the regional and provincial ones. The Russian

Federation, for instance, has controlling stakes in only 7 of c. 250

privatized air defense contractors. Manufacturing and R&D co-operation

with Ukraine and other former Soviet republics is on the ascendant,

often flying in the face of official policies and national security.

Despite the surge in exports, overproduction of unwanted goods leads to

persistent accumulation of inventory. Even so, capacity utilization is

said to be 25% in many factories. Lack of maintenance renders many

plant facilities obsolete and non-competitive. The Russian government's

new emphasis on R&D is wise - Russia must replenish its catalog with

hi-tech gadgets if it wishes to continue to export to prime clients.

Still, the Russian Duma's prescription of a return to state ownership,

central planning, and subsidies, if implemented, is likely to prove to

be the coup de grace rather than a graceful coup.

B. The FSB (the main successor to the KGB)

Note:

The KGB was succeeded by a host of agencies. The FSB inherited its

internal security directorates. The SVR inherited the KGB's foreign

intelligence directorates.

With the ascendance of the Vladimir Putin and his coterie (all former

KGB or FSB officers), the security services revealed their hand - they

are in control of Russia and always have been. They number now twice as

many as the KGB at its apex. Only a few days ago, the FSB had

indirectly made known its enduring objections to a long mooted (and

government approved) railway reform (a purely economic matter).

President Putin made December 20 (the day the murderous Checka, the

KGB's ancestor, was established in 1917) a national holiday.

But the most significant tectonic shift has been the implosion of the

unholy alliance between Russian organized crime and its security

forces. The Russian mob served as the KGB's long arm until 1998. The

KGB often recruited and trained criminals (a task it took over from the

Interior Ministry, the MVD). "Former" (reserve) and active agents

joined international or domestic racketeering gangs, sometimes as their

leaders.

After 1986 (and more so after 1991), many KGB members were moved from

its bloated First (SVR) and Third Directorates to its Economic

Department. They were instructed to dabble in business and banking

(sometimes in joint ventures with foreigners). Inevitably, they crossed

paths - and then collaborated - with the Russian mafia which, like the

FSB, owns shares in privatized firms, residential property, banks, and

money laundering facilities.

The co-operation with crime lords against corrupt (read:

unco-operative) bureaucrats became institutional and all-pervasive

under Yeltsin. The KGB is alleged to have spun off a series of "ghost"

departments to deal with global drug dealing, weapons smuggling and

sales, white slavery, money counterfeiting, and nuclear material.

In a desperate effort at self-preservation, other KGB departments are

said to have conducted the illicit sales of raw materials (including

tons of precious metals) for hard currency, and the laundering of the

proceeds through financial institutions in the West (in Cyprus, Israel,

Greece, the USA, Switzerland, and Austria). Specially established

corporate shells and "banks" were used to launder money, mainly on

behalf of the party nomenklatura. All said, the emerging KGB-crime

cartel has been estimated to own or control c. 40% of Russian GDP as

early as 1994, having absconded with c. $100 billion of state assets.

Under the dual pretexts of "crime busting" and "fighting terrorism",

the Interior Ministry and FSB used this period to construct massive,

parallel, armies - better equipped and better trained than the official

one.

Many genuinely retired KGB personnel found work as programmers,

entrepreneurs, and computer engineers in the Russian private sector

(and, later, in the West) - often financed by the KGB itself. The KGB

thus came to spawn and dominate the nascent Information Technology and

telecommunications industries in Russia. Add to this former (but on

reserve duty) KGB personnel in banks, hi-tech corporations, security

firms, consultancies, and media in the West as well as in joint

ventures with foreign firms in Russia - and the security services'

latter day role (and next big fount of revenue) becomes clear:

industrial and economic espionage. Russian scholars are already ordered

(as of last May) to submit written reports about all their encounters

with foreign colleagues.

This is where the FSB began to part ways with crime, albeit hitherto

only haltingly.

The FSB has established itself both within Russian power structures and

in business. What it needs now more than money and clout - are

respectability and the access it brings to Western capital markets,

intellectual property (proprietary technology), and management. Having

co-opted criminal organizations for its own purposes (and having acted

criminally themselves) - the alphabet soup of security agencies now

wish to consolidate their gains and transform themselves into

legitimate, globe-spanning, business concerns.

The robbers' most fervent wish is to become barons. Their erstwhile,

less exalted, criminal friends are on the way. Expect a bloodbath, a

genuine mafia gangland war over territory and spoils. The result is by

no means guaranteed.

The Energy Sector

The pension fund of the Russian oil giant, Lukoil, a minority

shareholder in TV-6 (owned by a discredited and self-exiled Yeltsin-era

oligarch, Boris Berezovsky), this week forced the closure of this

television station on legal grounds. Gazprom (Russia's natural gas

monopoly) has done the same to another television station, NTV, last

year (and then proceeded to expropriate it from its owner, Vladimir

Gusinsky).

Gazprom is forced to sell natural gas to Russian consumers at 10% the

world price and to turn a blind eye to debts owed it by Kremlin

favorites.

Both Lukoil and Gazprom are, therefore, used by the Kremlin as

instruments of domestic policy.

But Russian energy companies are also used as instruments of foreign

policy.

A few examples:

Russia has resumed oil drilling and exploration in war ravaged

Chechnya. About 230 million rubles have been transferred to the federal

Ministry of Energy. A new refinery is in the works.

Russia lately signed a production agreement to develop oilfields in

central Sudan in return for Sudanese arms purchases.

Armenia owes Itera, a Florida based, Gazprom related, oil concern, $35

million. Itera has agreed to postpone its planned reduction in gas

supplies to the struggling republic to February 11.

Last month, President Putin called for the establishment of a "Eurasian

alliance of gas producers" - probably to counter growing American

presence, both economic and military, in Central Asia and the much

disputed oil rich Caspian basin. The countries of Central Asia have

done their best to construct alternative oil pipelines (through China,

Turkey, or Iran) in order to reduce their dependence on Russian oil

transportation infrastructure. These efforts largely failed (a new $4

billion pipeline from Kazakhstan to the Black Sea through Russian

territory has just been inaugurated) and Russia is now on a charm

offensive.

Its PR efforts are characteristically coupled with extortion. Gazprom

owns the pipelines. Russia exports 7 trillion cubic feet of gas a year

- six times the combined output of all other regional producers put

together. Gazprom actually competes with its own clients, the

pipelines' users, in export markets. It is owed money by all these

countries and is not above leveraging it to political or economic gain.

Lukoil is heavily invested in exploration for new oil fields in Iraq,

Algeria, Sudan, and Libya.

Russian debts to the Czech Republic, worth $2.5 billion in face value,

have just been bought by UES, the Russian electricity monopoly, for a

fraction of their value and through an offshore intermediary. UES then

transferred the notes to the Russian government against the writing off

of $1.35 billion in UES debts to the federal budget. The Russians claim

that Paris Club rules have ruled out a direct transaction between

Russia (a member of the Club) and the Czech Republic (not a member).

In the last decade, Russia has been transformed from an industrial and

military power into a developing country with an overwhelming

dependence on a single category of commodities: energy products.

Russia's energy monopolies - whether state owned or private - serve as

potent long arms of the Kremlin and the security services and implement

their policies faithfully.

The Kremlin (and, indirectly, the security services) maintain a tight

grip over the energy sector by selectively applying Russia's tangle of

hopelessly arcane laws. In the last week alone, the Prosecutor

General's office charged the president and vice president of Sibur (a

Gazprom subsidiary) with embezzlement. They are currently being

detained for "abuse of office".

Another oil giant, Yukos, was forced to disclose documents regarding

its (real) ownership structure and activities to the State Property

Fund in connection with an investigation regarding asset stripping

through a series of offshore entities and a Siberian subsidiary.

Intermittently, questions are raised about the curious relationship

between Gazprom's directors and Itera, upon which they shower contracts

with Gazprom and what amounts to multi-million dollar gifts (in the

from of ridiculously priced Gazprom assets) incessantly.

Gazprom is now run by a Putin political appointee, its former chairman,

the oligarch Vyakhirev, ousted in a Kremlin-instigated boardroom coup.

Foreign (including portfolio) investors seem to be happy. Putin's

pervasive micromanagement of the energy titans assures them of

(relative) stability and predictability and of a reformist,

businesslike, mindset. Following a phase of shameless robbery by their

new owners, Russian oil firms now seem to be leading Russia - albeit

haltingly - into a new age of good governance, respect for property

rights, efficacious management, and access to Western capital markets.

The patently dubious UES foray into sovereign debt speculation, for

instance, drew surprisingly little criticism from foreign shareholders

and board members. "Capital Group", an international portfolio manager,

is rumored to have invested close to $700 million in accumulating 10%

of Lukoil, probably for some of its clients. Sibneft has successfully

floated a $250 million Eurobond (redeemable in 2007 with a lenient

coupon of 11.5%). The issue was oversubscribed.

The (probably temporary) warming of Russia's relationship with the USA

and Russia's acceptance (however belated and reluctant) of its

technological and financial dependence on the West - have transformed

the Russian market into an attractive target. Commercial activity is

more focused and often channeled through American diplomatic missions.

The U.S. Consul General in Vladivostok and the Senior Commercial

Officer in Moscow have announced that they will "lead an oil and gas

equipment and services and related construction sectors trade mission

to Sakhalin, Russia from March 11-13, 2002." The oil and gas fields in

Sakhalin attract 25% of all FDI in Russia and more than $35 billion in

additional investments is expected. Other regions of interest are the

Arctic and Eastern Siberia. Americans compete here with Japanese,

Korean, Royal Dutch/Shell, French, and Canadian firms, among others.

Even oil multinationals scorched in Russia's pre-Putin incarnation -

like British Petroleum which lost $200 million in Sidanco in 11 months

in 1997-8 - are back.

Takeovers of major Russian players (with their proven reserves) by

foreign oil firms are in the pipeline. Russian firms are seriously

undervalued - their shares being priced at one third to one tenth their

Western counterparts'. Some Russian oil firms (like Yukos and Sibneft)

have growth rates among the highest and production costs among the

lowest in the industry. The boards of the likes of Lukoil are packed

with American fund managers and British investment bankers.

The forthcoming liberalization of the natural gas market (the outcome

of an oft-heralded and much needed Gazprom divestiture) is a major

opportunity for new - possibly foreign - players.

This gold rush is the result of Russia's prominence as an oil producer,

second only to Saudi Arabia. Russia dumps on the world markets c. 4.5

million barrels daily (about 10% of the global trade in oil). It is the

world's largest exporter of natural gas (and has the largest known

natural gas reserves). It is also the world's second largest energy

consumer. In 1992, it produced 8 million bpd and consumed half as much.

In 2001, it produced 7 million bpd and consumed 2 million bpd.

Russia has c. 50 billion oil barrels in proven reserves but decrepit

exploration and extraction equipment, and a crumbling oil transport

infrastructure is in need of total replacement. More than 5% of oil

produced in Russia is stolen by tapping the leaking pipelines. An

unknown quantity is lost in oil spills and leakage. Transneft, the

state's oil pipelines monopoly, is committed to an ambitious plan to

construct new export pipelines to the Baltic and to China. The market

potential for Western equipment manufacturers, building contractors,

and oil firms is evidently there.

But this serendipity may be a curse in disguise. Russia is chronically

suffering from an oil glut induced by over-production, excess refining

capacity, and subsidized domestic prices (oil sold inside Russia costs

one third to one half the world price). Russian oil companies are

planning to increase production even further.

Rosneft, the eighth largest, plans to double its crude output. Yukos

(Russia's second largest oil firm) intends to increase output by 20%

this year. Surgut will raise its production by 14%.

Last week, Russia halved export duties on fuel oil. Export duties on

lighter energy products, including gas, were cut in January. As opposed

to previous years, no new export quotas were set. Clearly, Russia is

worried about its surplus and wishes to amortize it through enhanced

exports.

Russia also squandered its oil windfall and used it to postpone the

much needed restructuring of other sectors in the economy - notably the

wasteful industrial sector and the corrupt and archaic financial

system. Even the much vaunted plans to break apart the venal and

inefficient natural gas and electricity monopolies and to come up with

a new production sharing regime have gone nowhere (though some pipeline

capacity has been made available to Gazprom's competitors).

Both Russia's tax revenues and its export proceeds (and hence its

foreign exchange reserves and its ability to service its monstrous and

oft-rescheduled $158 billion in foreign debt) are heavily dependent on

income from the sale of energy products in global markets. More than

40% of all its tax intake is energy-related (compared to double this

figure in Saudi Arabia). Gazprom alone accounts for 25% of all federal

tax revenues. Almost 40% of Russia's exports are energy products as are

13% of its GDP. Domestically refined oil is also smuggled and otherwise

sold unofficially, "off the books".

But, as opposed to Saudi Arabia's or Venezuela's, Russia's budget is

based on a far more realistic price range of $14-18 per barrel. Hence

Russia's frequent clashes with OPEC (of which it is not a member) and

its decision to cut oil production by only 150,000 bpd in the first

quarter of 2002 (having increased it by more than 400,000 bpd in 2001).

It cannot afford a larger cut and it can increase its production to

compensate for almost any price drop.

Russia's energy minister told the Federation Council, Russia's upper

house of parliament, that Russia "should switch from cutting oil output

to boosting it considerably to dominate world markets and push out Arab

competitors". The Prime Minister told the US-Russia Business Council

that Russia should "increase oil production and its presence in the

international marketplace."

It may even be that Russia is spoiling for a bloodbath which it hopes

to survive as a near monopoly in the energy markets. Russia already

supplies more than 25% of all natural gas consumed by Europe and is

building or considering to construct pipelines to Turkey, China, and

Ukraine. Russia also has sizable coal and electricity exports, mainly

to CIS and NIS countries. Should it succeed in its quest to

dramatically increase its market share, it will be in the position to

tackle the USA and the EU as an equal, a major foreign policy priority

of both Putin and all his predecessors alike.

Financial Services

An expatriate relocation Web site, settler-international.com, has this

to say about Russian banks: "Do not open a bank account in a Russian

bank : you might not see your deposit again." Russia's Central Bank,

aware of the dismal lack of professionalism, the venality, and the

criminal predilections of Russian "bankers" (and their Western

accomplices) - is offering "complementary vocational training" in the

framework of its Banking School. It is somewhat ironic that the

institution suspected of abusing billions of US dollars in IMF funds by

"parking" them in obscure off-shore havens - seeks to better the

corrupt banking system in Russia.

I. The Banks

On paper, Russia has more than 1,300 banks. Yet, with the exception of

the 20-odd (two new ones were added last year) state-owned (and,

implicitly, state-guaranteed) outfits - e.g., the mammoth Sberbank (the

savings bank, 61% owned by the Central Bank) - very few provide minimal

services, such as corporate finance and retail banking. The surviving

part of the private banking sector ("Alfa Bank", "MDM Bank") is

composed of dwarfish entities with limited offerings. They are unable

to compete with the statal behemoths in a market tilted in the latters'

favor by both regulation and habit.

The Agency for the Reconstruction of Credit Organizations (ARCO) -

established after the seismic shock of 1998 - did little to restructure

the sector and did nothing to prevent asset stripping. More than one

third of the banks are insolvent - but were never bankrupted. The

presence of a few foreign banks and the emergence of non-bank financing

(e.g., insurance) are rays of hope in an otherwise soporific scene.

Despite the fact that most medium and large corporations in Russia own

licensed "banks" (really, outsourced treasury operations) - more than

90% of corporate finance in 2000-2001 was in the form of equity

finance, corporate bonds, and (mainly) reinvested retained earnings.

Some corporate bond issues are as large as $100 million (with 18-months

maturity) and the corporate bond market may quintuple to $10 billion in

a year or two, reports "The Economist", quoting Renaissance Capital, a

Russian investment bank.

Still, that bank credits are not available to small and medium

enterprises retards growth, as Stanley Fischer pointed out in his

speech to the Higher School of Economics in Moscow, in June 2001, when

he was still the First Deputy Managing Director of the IMF. Last week,

the OECD warned Russia that its economic growth may suffer without

reforms to the banking sector.

Russian banks are undercapitalized and poorly audited. Most of them are

exposed to one or two major borrowers, sectors, or commodities. Margins

have declined (though to a still high by Western standards 14%). Costs

have increased. The vast majority of these fledglings have less than $1

million in capital. This is because shareholders (and, for that matter,

depositors) - having been fleeced in the 1998 meltdown - are leery of

throwing good money after very bad. The golden opportunity to

consolidate and rationalize following the 1998 crisis was clearly

missed.

The government's (frail) attempts to reform the sector by overhauling

bank supervision and by passing laws which deal with anti-money

laundering, deposit insurance, minimum capital and bankruptcy

regulations, and mandatory risk evaluation models - did little to erase

the memory of its collusion in the all-pervasive, massive, and

suspiciously orchestrated defaults of 1998-1999. Russia is notoriously

strong on legislation and short on its enforcement.

Moreover, the opaque, overly-bureaucratic, and oligarch-friendly

Central Bank is at loggerheads with would be reformers and gets its way

more often than not. It supports a minimum capital requirement of less

than $5 million. Government sources have gone as high as $200 million.

The government retaliates with thinly-veiled threats in the form of

inane proposals to replace the Bank with newly-created "independent"

institutions.

Viktor Gerashchenko - the current, old-school, Governor - is set to

leave on September 2002. He will likely be replaced by someone more

Kremlin-friendly. As long as the Kreml is the bastion of reform, these

are good news. But a weak Central Bank will remove one of the last

checks and balances in Russia. Moreover, a hasty process of

consolidation coupled with draconian regulation may decimate private

sector Russian banking for good. This, perhaps, is what the Kremlin

wants. After all, he who controls the purse strings - rules Russia.

II. The Stock Exchange

The theory of financial markets calls for robust capital markets where

banks are lacking and dysfunctional. Equity financing and corporate

debt outstrip bank lending as sources of corporate finance even in the

West.

But Russia's stock market - the worst performer among emerging markets

in 1998, the best one in 2001 - is often cornered and manipulated, prey

to insider trading and worse. It is less liquid that the Tel-Aviv Stock

Exchange, though the market capitalization of RTS, Russia's main

marketplace, is up 430% since 1998 (80% last year alone). Bonds climbed

500% in the same period and a flourishing corporate bonds markets has

erupted on the scene. Many regard this surge as a speculative bubble

inflated by the high level of oil prices.

Others (mostly Western brokerage houses) swear that the market is

undervalued, having fallen by more than 90% in 1998. Russia is

different - they say - it is better managed, sports budget and trade

surpluses, is less indebted (and re-pays its debts on time, for a

change), and the economy is expanding. The same pundits talked the RTS

up 180% in 1997 only to see it shrivel in an egregious case of Asian

contagion. The connection between Russia's macro and micro is less than

straightforward.

Whatever the truth, investors are clearly more discriminating. Both the

New York Times and The Economist cite the example of Yukos Oil (up

190%) versus Lukoil (up a mere 30%). The former is investor friendly

and publishes internationally audited accounts. The latter has no

investor relations to speak of and is disclosure-averse. Still, both

firms - as do a few pioneering others - seek to access Western capital

markets.

The intrepid investor can partake by purchasing mutual funds dedicated,

wholly or partially, to Russia - or by trading ADR's of Russian firms

on NYSE (10-20 times the US dollar volume of the RTS). ADR's of smaller

firms are traded OTC and, according to the New York Times, one can

short sell Russian securities through offshore vehicles. The latter are

also used to speculate in the shares of defunct Russian firms

("shells") traded in the West.

III. Debt Markets

Perhaps the best judges of Russia's officially minuscule economy

(smaller than the Netherlands' and less than three times Israel's) -

are the Russians. When the author of this article suggested that

Russia's 1998 chaos was serendipitous (in "Argumenti i Fakti" dated

October 28, 1998), he was derided by Western analysts but supported by

Russian ones. In hindsight, the Russians were right. They may be right

today as well when they claim that Russia has never been better.

The ruble devaluation (which made Russian goods competitive) and rising

oil prices yielded a trade surplus of more than $50 billion last year.

For the first time in its modern and turbulent history, Russia was able

to prepay both foreign (IMF) and domestic debts (it redeemed state

bonds ahead of maturity). It is no longer the IMF's largest debtor. Its

Central Bank boasts $40 billion in foreign exchange reserves. Exactly

a year ago, Russia tried to extort a partial debt write-off from its

creditors (as it has done numerous times in its post-Communist decade).

But Russia's oft-abused creditors and investors seem to have

surprisingly short memories and an unsurpassed capacity for masochistic

self-delusion.

Stratfor.com reports ("Russia Buys Financial Maneuverability" dated

January 31, 2002) that "Deutsche Bank Jan. 30 granted Vneshekonombank a

$100 million loan, the largest private loan to a Russian bank since the

1998 ruble crisis. As Russia works to reintegrate into the global

financial network, the cost of domestic borrowing should drop.

That should spur a fresh wave of domestically financed development,

which is essential considering Russia's dearth of foreign investment."

The strategic forecasting firm also predicts the emergence of a

thriving mortgage finance market (there is almost none now). One of the

reasons is a belated November 2001 pension reform which allows the

investment of retirement funds in debt instruments - such as mortgages.

A similar virtuous cycle transpired in Kazakhstan. Last year the

Central Bank allowed individuals to invest up to $75,000 outside Russia.

IV. The Bandits

In August 1999, a year and four days after Moscow's $40 billion

default, the New York Times reported a $15 billion money laundering

operation which involved, inter alia, the Bank of New York and Russia's

first Representative to the IMF.

The Russian Central Bank invested billions of dollars (through an

offshore entity) in the infamous Russian GKO (dollar-denominated bonds)

market, thus helping to drive yields to a vertiginous 290%.

Staff members and collaborators of the now dismantled brainchild of

Prof. Jeffrey Sachs, HIID (Harvard Institute of International

Development) - the architect of Russian "privatization" - were caught

in potentially criminal conflicts of interest.

Are we to believe that such gargantuan transgressions have been

transformed into new-found market discipline and virtuous dealings?

Putin doesn't. Last year, riding the tidal wave of the fight against

terror, he formed the Financial Monitoring Committee (KFM). Ostensibly,

its role is to fight money laundering and other financial crimes, aided

by brand new laws and a small army of trained and tenacious accountants

under the aegis of the Ministry of Finance.

Really, it is intended to circumvent irredeemably compromised extant

structures in the Ministry of Interior and the FSB and to stem capital

flight (if possible, by reversing the annual hemorrhage of $15-20

billion). Non-cooperative banks may lose their licenses. Banks have

been transferring 5 daily Mb of encoded reports regarding suspicious

financial dealings (and all transactions above 600,000 rubles - equal

to $20,000) since February 1 - when the KFM opened for business. So

much for Russian bank secrecy ("Did we really have it?" - mused

President Putin a few weeks ago).

Last month, Mikhail Fradkov, the Federal Tax Police Chief confirmed to

Interfax the financial sector's continued involvement in bleeding

Russia white: "...fly-by-night firms usually play a key role in illegal

money transfers abroad. Fradkov recalled that 20 Moscow banks inspected

by the tax police alone transferred about $5 billion abroad through

such firms." ITAR-TASS, the Russian news agency, reports a drop of 60%

in the cash flow of Russian banks since anti-money laundering measures

took effect, a fortnight ago.

V. The Foreign Exchange Market

Russians, the skeptics that they are, still keep most of their savings

(c. $40-50 billion) in foreign exchange (predominantly US dollars),

stuffed in mattresses and other exotic places. Prices are often quoted

in dollars and ATM's spew forth both dollars and rubles. This

predilection for the greenback was aided greatly by the Central Bank's

panicky advice (reported by Moscow Times) to ditch all European

currencies prior to January 1, 2002. The result is a cautious and

hitherto minor diversification to euros. Banks are reporting increased

demand for the new currency - a multiple of the demand for all former

European currencies combined. But this is still a drop in the dollar

ocean.

The exchange rate is determined by the Central Bank - by far the

decisive player in the thin and illiquid market. Lately, it has opted

for a creeping devaluation of the ruble, in line with inflation.

Foreign exchange is traded in eight exchanges across Russia but many

exporters sell their export earnings directly to the Central Bank.

Permits are required for all major foreign exchange transactions,

including currency repatriation by foreign firms. Currency risk is

absolute as a 1998 court ruling rendered ruble forwards contracts

useless ("unenforceable bets").

VI. The International Financial Institutions (IFI's)

Of the World Bank's $12 billion allocated to 51 projects in Russia

since 1992, only $0.6 billion went to the financial sector (compared to

8 times as much wasted on "Economic Planning").

Its private sector arm, the International Finance Corporation (IFC)

refrained from lending to or investing in the financial sector from

March 1999 to June 2001. It has approved (or is considering) six

projects since then: a loan of $20 million to DeltaCredit, a smallish

project and residential finance, USAID backed, fund; a Russian

pre-export financing facility (with the German bank, WestLB); Two

million US dollars each to the Russian-owned Baltiskii Leasing and

Center Invest (a regional bank); $2.5 million to another regional bank

(NBD) - and a partial guarantee for a $15 million bond issued by

Russian Standard Bank. There is also $5 million loan to Probusiness

Bank.

Another active player is the EBRD. Having suffered a humiliating

deterioration in the quality of its Russian assets portfolio in

1998-2000, it is active there again. By midyear last year, it had

invested c. $300 million and lent another $700 million to Russian

banks, equity and mutual funds, insurance companies, and pension funds.

This amounts to almost 30% of its total involvement in the Russian

Federation. Judging by this commitment, the EBRD - a bank - seems to be

regarding the Russian financial system as either an extremely

attractive investment - or a menace to Russia's future stability.

VII. So, What's Next?

No modern country, however self-deluded and backward, can survive

without a banking system. The Central Bank's pernicious and

overwhelming presence virtually guarantees a repeat of 1998. Russia -

like Japan - is living on time borrowed against its oil collateral.

Should oil prices wither - what remains of the banking system may

collapse, Russian securities will be dumped, Russian debts "deferred".

The Central Bank may emerge either more strengthened by the devastation

- or weakened to the point of actual reform.

In the eventuality of a confluence between this financial Armageddon

and Russia's entry to the WTO - the crisis is bound to become more

ominous. Russia is on the verge of opening itself to real competition

from the West - including (perhaps especially so) in the financial

sector. It is revamping its law books - but does not have the

administrative mechanism it takes to implement them. It has a rich

tradition of obstructionism, venality, political interference, and

patronage.

Foreign competition is the equivalent of an economic crisis in a

country like Russia. Should this be coupled with domestic financial

mayhem - Russia may be transformed to the worse. Expect interesting

times ahead.

The Russian Devolution

The Regions

Russia's history is a chaotic battle between centrifugal and

centripetal forces - between its 50 oblasts (regions), 2 cities (Moscow

and St. Petersburg), 6 krais (territories), 21 republics, and 10 okrugs

(departments) - and the often cash-strapped and graft-ridden

paternalistic center. The vast land mass that is the Russian Federation

(constituted officially in 1993) is a patchwork of fictitious homelands

(the Jewish oblast), rebellious republics (Chechnya), and disaffected

districts - all intermittently connected with decrepit lines of

transport and communications.

The republics - national homelands to Russia's numerous minorities -

have their own constitutions and elected presidents (since 1991).

Oblasts and krais are run by elected governors (a novelty - governors

have been appointed by Yeltsin until 1997). They are patchy fiefdoms

composed of autonomous okrugs. "The Economist" observes that the okrugs

(often populated with members of an ethnic minority) are either very

rich (e.g., Yamal-Nenets in Tyumen, with 53% of Russia's oil reserves)

- or very poor and, thus, dependent on Federal handouts.

In Russia it is often "Moscow proposes - but the governor disposes" -

but decades of central planning and industrial policy encouraged

capital accumulation is some regions while ignoring others, thus

irreversibly eroding any sense of residual solidarity. In an IMF

working paper ("Regional Disparities and Transfer Policies in Russia"

by Dabla-Norris and Weber), the authors note that the ten wealthiest

regions produce more than 40% of Russia's GDP (and contribute more than

50% of its tax revenues) - thus heavily subsidizing their poorer

brethren. Output contracted by 90% in some regions - and only by 15% in

others. Moscow receives more than 20% of all federal funds - with less

than 7% of the population. In the Tuva republic - three quarters of the

denizens are poor - compared to less than one fifth in Moscow. Moscow

lavishes on each of its residents 30 times the amount per capita spent

by the poorest region.

Nadezhda Bikalova of the IMF notes ("Intergovernmental Fiscal Relations

in Russia") that when the USSR imploded, the ratio of budgetary income

per person between the richest and the poorest region was 11.6. It has

since climbed to 30. All the regions were put in charge of implementing

social policies as early as 1994 - but only a few (the net "donors" to

the federal budget, or food exporters to other regions) were granted

taxing privileges.

As Kathryn Stoner-Weiss has observed in her book, "Local Heroes: The

Political Economy of Russian Regional Governance", not all regions

performed equally well (or equally dismally) during the transition from

communism to (rabid) capitalism. Political figures in the (relatively)

prosperous Nizhny-Novgorod and Tyumen regions emphasized stability and

consensus (i.e., centralization and co-operation). Both the economic

resources and the political levers in prosperous regions are in the

hands of a few businessmen and "their" politicians. In some regions,

the movers and shakers are oligarch-tycoons - but in others,

businessmen formed enterprise associations, akin to special interest

lobbying groups in the West.

Inevitably such incestuous relationships promotes corruption, imposes

conformity, inhibits market mechanisms, and fosters detachment from the

centre. But they also prevent internecine fighting and open,

economically devastating, investor-deterring, conflicts. Economic

policy in such parts of Russia tend to be coherent and efficiently

implemented. Such business-political complexes reached their apex in

1992-1998 in Moscow (ranked #1 in creditworthiness), Samara, Tyumen,

Sverdlovsk, Tatarstan, Perm, Nizhny-Novgorod, Irkutsk, Krasnoyarsk, and

St. Petersburg (Putin's lair). As a result, by early 1997, Moscow

attracted over 50% of all FDI and domestic investment and St.

Petersburg - another 10%.

These growing economic disparities between the regions almost tore

Russia asunder. A clunky and venal tax administration impoverished the

Kremlin and reduced its influence (i.e., powers of patronage)

commensurately. Regional authorities throughout the vast Federation

attracted their own investors, passed their own laws (often in defiance

of legislation by the centre), appointed their own officials, levied

their own taxes (only a fraction of which reached Moscow), and provided

or withheld their own public services (roads, security, housing,

heating, healthcare, schools, and public transport).

Yeltsin's reliance on local political bosses for his 1996 re-election

only exacerbated this trend. He lost his right to appoint governors in

1997 - and with it the last vestiges of ostensible central authority.

In a humiliating - and well-publicized defeat - Yeltsin failed to sack

the spectacularly sleazy and incompetent governor of Primorsky krai,

Yevgeni Nazdratenko (later "persuaded" by Putin to resign his position

and chair the State Fisheries Committee instead).

The regions took advantage of Yeltsin's frail condition to extract

economic concessions: a bigger share of the tax pie, the right to

purchase a portion of the raw materials mined in the region at "cost"

(Sakha), the right to borrow independently (though the issuance of

promissory notes was banned in 1997) and to spend "off-budget" - and

even the right to issue Eurobonds (there were three such issues in

1997). Many regions cut red tape, introduced transparent bookkeeping,

lured foreign investors with tax breaks, and liberalized land

ownership.

Bikalova (IMF) identifies three major problems in the fiscal

relationship between centre and regions in the Yeltsin era:

"(1) the absence of an objective normative basis for allocating budget

revenues, (2) the lack of interest shown by local and regional

governments in developing their own revenues and cutting their

expenditures, and (3) the federal government's practice of making

transfer payments to federation members without taking account of the

other state subsidies and grants they receive."

Then came Russia's financial meltdown in August 1998, followed by

Putin's disorientating ascendance. A redistribution of power in

Moscow's favor seemed imminent. But it was not to be.

The recommendations of a committee, composed of representatives of the

government, the Federation Council, and the Duma, were incorporated in

a series of laws and in the 1999 budget, which re-defined the fiscal

give and take between regions and centre.

Federal taxes include the enterprise profit tax, the value-added tax

(VAT), excise, the personal income tax (all of it returned to the

regions), the minerals extraction tax, customs and duties, and other

"contributions" . This legislation was further augmented in April-May

2001 (by the "Federalism Development Program 2001-2005").

The regions are allowed to tax the property of organizations, sales,

real estate, roads, transportation, and gambling enterprises, and

regional license fees (all tax rates are set by the center, though).

Municipal taxes include the land tax, individual property, inheritance,

and gift taxes, advertising tax, and license fees.