Under the cover of law and order

Under the cover of law and order Andrew Jack asks whether President Putin is in danger of missing a historic opportunity for sweeping modernisation

19 October 2004 10:39
Strong growth may have been the backdrop for Russia in 2004, but two other words took centre-stage during the year: Beslan and Yukos. Both shook the country out of its new complacency and bode ill for the future.
President Vladimir Putin began his second term with everything in his favour: a compliant political system matched by popular support that is the envy of his counterparts in the west; and economic expansion exceeding that of most of his Asian neighbours to the east.

But then came Beslan, the school siege in the southern republic of North Ossetia last month which left more than 330 adults and children dead. It was a symbol of the failure of the Russian authorities to look after their own people, and the pretext for hotly-contested political reforms.

Meanwhile, Yukos, the oil company which had become synonymous with Russia's new-found oil largesse and emerging corporate governance, lurched towards dismemberment. The process involved some of the worst excesses of an arbitrary state as the government reasserted control over the natural resource sector.

The two events have overshadowed undoubted macro-economic strengths that are enriching the nation, and encouraging foreign investors to commit to a future in Russia. "I am very disappointed," says Yegor Gaidar, the economist, former deputy prime minister and periodic government adviser. "The first 100 days of Putin's first term were a splendid textbook example of how to promote extremely difficult reforms. The first 100 days of his second term were a textbook example of how to misuse the time."

During Mr Putin's first four years in the Kremlin, he consolidated power in a way that allowed him to maintain and extend a series of liberal economic reforms launched during the 1990s, led by simplification of the tax system. He restored public finances to health aided significantly by fast-growing commodity prices.

Alexei Kudrin, the finance minister, sees no sign that this pace is abating during the new presidential term. Negotiations on Russia's entry into the World Trade Organisation are proceeding apace. Full currency liberalisation is on track for 2006. Reforms to social charges and value added tax are under way. There is a strong budget surplus, foreign currency reserves are high, debt is being paid down, and a "stabilisation fund" comprising windfall oil tax revenues has been growing fast.

Mr Kudrin points to a new balance of funding and responsibilities between federal, regional and local authorities, and continued plans for reforms to Russia's natural monopolies. "The roots of economic reform are in place," he says. "The new government is defining its principles. There are several years of serious reforms ahead. Step by step, they will happen."

Jonathan Schiffer, a vice-president at Moody's, the rating agency which last autumn granted Russian government bonds investment grade and recently shifted it to "positive outlook", shares this optimism. "The macro figures and the key ratios are getting better and better. We see nothing to threaten the country's ability to pay," he says.

If there are few risks of default for investors in the coming years, there are also many profitable business opportunities.

The economy is set to grow by more than 7 per cent again this year, much of it driven by oil and gas as well as by the manufacturing and retail sectors. Foreign direct investment remains modest but is also increasing, with indications that it may reach record levels above Dollars 8bn this year. Big western energy groups led by Royal Dutch/Shell and ExxonMobil are already substantially advanced towards spending their respective budgets of Dollars 11bn and Dollars 12bn in the fields off Sakhalin island in Russia's far east.

"There's a respectable deal flow," says one western investment banker who predicts a new wave of purchases and investments in the metals and financial services sectors in the months ahead, as well as new initial public offerings by Russian companies. "The big difference today is that every CEO has to have a Russia strategy. It can be positive or negative, but it has to be thought through."

But like his peers, he concedes that Yukos has helped to create a new hesitancy about investment, causing at least temporary fluctuations in the fledgling stock market as many mainstream international institutions flinch at the potential risks.

Mikhail Khodorkovsky, Yukos' former chief executive and largest shareholder, has been charged with tax evasion and fraud. Whether he is guilty or innocent, there is little doubt that it was his political ambitions that triggered the authorities' legal action against him. To some degree, the Yukos attack has also yielded benefits. It has cowed Mr Khodorkovsky's fellow oligarchs, whose grip on politics was long a frustration for policy-makers, and whose monopolising influence on the economy was resented by smaller business. Many companies are now voluntarily paying more tax and becoming more sensitive to their social obligations.

Yet the heavy-handed approach of the authorities has been equally troubling. The legal system is being used to crush one of the country's most profitable companies, pushing it to the verge of bankruptcy and towards a fire sale of its key assets when it could rapidly raise the cash to pay off the back taxes now being claimed. The process has also highlighted the vulnerability of the tax authorities, the courts, the justice ministry, the public prosecutors to political pressure, and set back Mr Putin's early commitment to establishing a "dictatorship of law".

The damage around Yukos can still be limited. But at least in the short term, it has fuelled capital flight, and encouraged big Russian business to slow investment. "The integrity of private ownership is a massive question now," says one Moscow banker. "Clients are saying they will run their businesses on a cash flow, not a capitalisation, basis." For the business community, the Beslan tragedy may seem remote, aside from the growing threat of terrorism for all residents in Russia.

But in both its causes and in the remedial action proposed, the affair underlined problems of governance that may have a broader effect on the economy. Four years ago, Mr Putin could blame others for Beslan-style attacks. But now he must take responsibility for his hard line tactics in Chechnya and for the corruption and incompetence that permitted the security breaches leading up to the school siege.

Instead of shifting tactics, his response reflected more of the same: still greater funding for defence and security; and further centralisation of power through the abolition of direct elections for regional governors and of locally-selected candidates for parliament.

This all leaves little time, before the next electoral cycle kicks in, to tackle the complex challenges involved in restructuring natural monopolies, diversifying the economy, streamlining the bureaucracy, and boosting investment in education and health. If growth is maintained, this may not lead to a short-term crisis so much as a historic missed opportunity.

But if Mr Putin's greatest achievement during his first term was to create predictability after the chaos of the 1990s, the paradox is that his second term has begun with a return of destabilising uncertainty.

(From The Financial Times 19.10.2004)