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Toni Schönfelder
A lifetime of innovation

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Toni Schönfelder
A lifetime of innovation

Tuesday, Jul. 16, 2002.

Putins 8-Year Plan

An increasing share of economic activity in Russia is moving under the control of fewer and more powerful oligarchs, as current economic growth is ever more dependent on commodities, in particular oil.

The government therefore has a problem in that it has to find a way to boost very significantly investment capital flows into the noncommodity parts of the economy to achieve higher annual GDP growth rates that can be sustained in order to create a more diversified economy -- both in terms of activity and ownership -- by the end of the decade.

If it fails to do so then Russia will end up as little more than a Venezuela writ large, with a "boom to bust" commodity dependent economy. Far from realizing the proclaimed goal of integration into the global economy as an equal partner, Russia will be held hostage to the commodity price cycle and a few very powerful individuals and companies.

It has also been made very clear by President Vladimir Putin that a very significant element of the solution to this problem lies in the hands of the oligarchs. He has clearly set out the terms of the carrot that will be given for cooperation -- an amnesty for repatriated flight capital and a continued forgiving attitude toward how state assets were acquired -- and he has hinted strongly at what sticks might be deployed if the oligarchs choose not to participate voluntarily in the next phase of the administrations growth plan.

This stick would surely come in the form of much more aggressive scrutiny of corporate activities, capital flight and tax audits, which in many instances could result in prosecutions, heavy fines and even confiscation of assets.

In an address to the oligarchs just after being elected president two years ago, Putin made it clear that they had a two-year window to clean up their acts and to start behaving as good corporate citizens. That period has now come to an end.

Defenders of the oligarch system in Russia liken the development to that of the robber barons in the United States and elsewhere, and therefore view it not just as inevitable but as necessary. This line of argument naively glosses over some very fundamental differences. In no other country did the oligarchs (or their equivalent) not simply sit close to the heart of government but largely displace and usurp it at a time when the largest privatization of state assets in the history of the planet was taking place.

For example, there is no historical counterpart to the loans-for-shares scheme that transformed mere millionaires into oligarch billionaires in the mid-1990s

The result of the endgame that we are now entering will either see the emergence of a Korean- or Japanese-style "Chaebol" system if the carrot is accepted, with all of the long-term economic risks that this entails, or a period of increased political and investment risk if the government ends up wielding the stick.

A good way to look at the governments plan for economic reform is to break Putins likely two terms in office into four two-year periods, with each having a specific objective and each having specific implications for investment and risk.

The theme of the first period can best be described as the removal of obstacles to future growth and the changing of attitude toward investment. Some of the obstacles removed were economic; e.g. tax reform has clearly broadened the tax paying base and permanently increased revenues, while pushing for growth in oil production and exports has created an additional safety zone in the budget and reduced vulnerability to oil price weakness. Other obstacles were people, the removal of Central Bank Chairman Viktor Gerashchenko and Gazprom CEO Rem Vyakhirev being the most high-profile examples. Over this period investors were rewarded with strongly rising asset prices. For example, over the three years to the end of June, the RTS gained 188 percent compared to a loss of 24 percent for the average emerging market and a loss of 44 percent for Nasdaq.

The theme of the next two-year period can be described as one of preparation for future growth. Key obstacles have been removed but the economy is not yet ready to grow at the 6 percent to 8 percent annual rate being called for. That is still two years away in the third of the two-year periods, and in order for the objectives of that period to be achieved a sound investment infrastructure has to be put in place. This chiefly means reforming the banking system to create the infrastructure for capital flows, pension reform to create a local source of long-term investment capital, and judicial reform to protect investors and their investments.

The theme of the third two-year period is seen as implementation, as capital flows increase through the newly created investment infrastructure. Like Putins first two years in office, this third period is shaping up to have the same high-risk, high-reward characteristics. If successful, then the last of the four periods, covering Putins final two years in office, should see Russia become more closely integrated into the global economy with significant benefits in the form of substantial long-term investment flows.

However, it is the achievement of the objectives of the next phase of the economic plan and the future of the oligarchs that are closely linked. More than 50 percent of industrial capital investment is directed towards the fuel sector, and most of this is used to grow production and exports ever faster. So far this suits the government objective of lessening exposure to oil price weakness, but rather than wishing to become the new Saudi Arabia (a scenario that several of the oil oligarchs have publicly endorsed), it is clear that the governments objective is for a one-off structural change that will see oil exports raised to between 4.5 million and 5 million barrels per day and then a substantial shift in capital investment into developing other sectors of the economy.

A substantial amount of the estimated $160 billion of Russian capital held in foreign bank accounts is under the control of commodity exporters and oligarchs.

Investment spending in the noncommodity parts of the economy is today at a negligible level and success in increasing this to desired levels will depend on how successful the government is in either persuading, or forcing, the owners and controllers of that capital to take it out of safe foreign bank accounts and to significantly slow down oil-related capital expenditures.

If the scenario involving four two-year plans is correct then we should expect there to be increasing debate on the deployment of Russian-owned capital, in parallel with the building of the domestic investment infrastructure, between now and the March 2004 presidential election.

After that, those in the Kremlin who still harbor ambitions to finally extract a fair price for state assets sold far too cheaply in the early and mid-1990s may yet be given an opportunity to realize those ambitions. The phrase "hydrocarbon windfall tax" might now only be mentioned in hushed tones in government circles, but nonetheless it cannot have failed to come to the attention of certain oligarchs.

Whether they choose to heed the warnings will be the subject of intense scrutiny during this next phase of the economic development plan.

Chris Weafer, head of research at Troika Dialog Investment Bank, contributed this comment to The Moscow Times.

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