What End to the Endgame?

By Christopher Weafer

Twelve months after the arrest of Mikhail Khodorkovsky triggered an escalation in the investigation of Yukos by the Tax Ministry and the launching of several criminal cases against Menatep shareholders, there is still no clear understanding of how or when they will end.

Uncertainty surrounding the likely resolution of the Yukos/Menatep case continues to be the major cause of stock market volatility and is regarded by many as the true reason why several credit rating agencies continue to withhold investment-grade status for Russian sovereign debt. More broadly, the case has also provoked a lively debate as to the residual effect it will have on the credibility of Russia as an "attractive investment location," an ideal that President Vladimir Putin has frequently made reference to over the past few years. This has been a crucial element of his declared strategy to eventually create a more diversified economic base with greater wealth distribution across the population.

The evidence from the stock market and the recent price trend of Russian debt suggests that investors are bored with the issue and now simply want the uncertainty to end so that an assumed major obstacle to increased local and foreign institutional portfolio investment in Russia can be removed. The optimistic perspective is supported by the fact that, despite well-publicized concerns over the legal protection of property rights, major multinational groups, such as Total and Conoco, are continuing to make investment commitments to Russia.

There is plenty of evidence to support the view that the actions against Yukos and its controlling shareholder, Menatep, are a "one-off" and therefore will not be repeated -- or, at least, not in such an aggressive way -- against other business groups.

This case could actually be considered a necessary part of the Kremlin's strategy for regaining control over the strategically important oil industry, as well as economic planning generally.

Putin has made it very clear that he regards the breakdown of the former Soviet control structure in the 1990s as the main reason for almost all of the problems that he inherited from Boris Yeltsin in early 2000, and while restoring strong political control has been an obvious priority during his first term, he also made it clear that his vision of a "state-private enterprise partnership" is one where the state sets the broad directional growth parameters and private enterprise is expected to adjust investment strategies to help achieve the state's goals.

The Yukos/Menatep case presented a very neat opportunity for Putin both to recover a big slice of the state's former control in the country's main strategic industry and also to teach a lesson to in the consequences of challenging the state's declared economic priorities the business community. In early 2003, Mikhail Khodorkovsky lobbied very actively to try to force the government to change its declared strategy of creating a three-year gap in adding new oil export capacity, so as to allow the Finance Ministry the opportunity to increase the tax take from the oil companies to fund budgetary mechanisms that would help boost growth in manufacturing industries.

Such a window was also considered necessary to help mobilize political and public support behind the proposed reform package. That did not suit Khodorkovsky's ambitions for increased exports to the United States and China, and he tried to force a change in government policy.

On a practical level, one of the immediate consequences of this action has been a significant broadening of the tax base in Russia and a sizable increase in the amount of tax raised. Tax collection over the first half of this year, for example, showed an increase equal to 1.1 percent of GDP over the same period in 2003.

Eventually this case will have to end and when it does, there will be a strong relief rally on the stock market -- the abundance of liquidity in the hands of local investors will ensure that. This whole case has dragged on for far too long, and often aggressive or inconsistent actions on the part of the state agencies involved suggests that while the decision to pursue this case must have been made at a senior government level, there was no thought given to the mechanisms for realizing it in practice. This is something that we have seen in other important areas, such as in the slow progress on reforms, and raises concerns among long-term investors that while Putin may remain committed to the ideal of an "attractive investment case" and the broad economic and structural reform program, he simply does not have the administrative support infrastructure to realize them. The Yukos affair highlights the apparent inability of government agencies to complete the relatively simple task of quickly raising a tax bill to approximately the net valuation of the targeted asset.

Without progress in advancing the reform package, investment growth will likely remain narrowly based, raising concerns that inward investment will either be directed toward natural resources or more speculative areas such as real estate. While that strategy will likely sustain growth over the medium term, the economy will ultimately become even more dependent on the commodity price cycle.

That leads us to the next concern which is that should headline growth slow due to a decline in commodity prices, the government might become even more interventionist and embark on another "one-off" like the Yukos/Menatep case?

On the other hand, with the country's foreign exchange reserves recently topping $100 billion and the stabilization fund rapidly heading toward $20 billion, Russia has effectively zero net foreign debt. Russia also has considerable potential to increase oil and gas production and exports. Those simple facts will be enough to allow the Yukos/Menatep case to be conveniently swept aside by the stock market and some strategic investors. The potential to make money is simply too good to dwell on the negative implications of the case.

As for the endgame, there can no longer be any doubt that, at the very least, the government intends to gain control of Yukos' largest production unit, Yuganskneftegaz. The only question is whether it will proceed to confiscate the remaining production units as well, effectively destroying Yukos. The key to that is what happens to Menatep's controlling stake in the oil major. There is no way that Putin will allow Khodorkovsky to walk out of jail with any residual holding in Yukos. If Menatep's equity stake is successfully confiscated by court action or voluntarily handed over as part of some plea bargaining, then Putin will not need to destroy Yukos.

It would then effectively become a state-controlled company and eventually be absorbed into Russia's version of Saudi Arabia's Aramco -- which most probably will be centered around Gazprom.


Christopher Weafer, chief strategist at Alfa Bank, contributed this comment to The Moscow Times.

(From The Moscow Times, 26.10.2004)
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Mmm... Chief strategist at Alfa Bank... Remembering the last declarations of his boss Fridman... Anyway, he is rather interested in showing that is all is safe for Alfa business partners. The show must go on...