Out of the Red: Investment and Capitalism in Russia

By John T. Connor and Lawrence P. Milford

Over the last fifteen years, Russia has become a larger part of the global economy—and in the years ahead, it will continue to grow in prominence. If you want to improve your investment endeavors in this market, you must first understand how it operates. With Out of the Red as your guide, you’ll become familiar with all the opportunities this country has to offer and learn how to make the most informed investing decision within this emerging arena.

• Language: English
• Publisher: Wiley
• Release date: Aug 10, 2011
• ISBN: 9781118160763

Book preview

Preface

At the end of the nineteenth century, Russia sported the world’s fastest-growing economy; business was flourishing. Then came the Red Revolution, and business disappeared. Looking at that nation’s financial statements, Stalin and the Soviet era leadership added substantial assets to the balance sheet—through forced industrialization. The Soviet Union’s income statement, by contrast, was characterized by inputs exceeding outputs. In short, Enterprise Soviet Russia operated at a loss (or in the red, some may say).

With the disintegration of the Eastern European Soviet empire in the early 1990s and the subsequent dismemberment of the Soviet Union itself, Russia was back and business reappeared. A modern constitution was adopted, patterned on that of France, and democratic institutions were created. From Boris Yeltsin leading the rise of Russian democracy to Vladimir Putin leading the rise of the Russian economy, the transformation of the Soviet Union into modern Russia has created a wealth of opportunities for business.

Americans continue to be fascinated with what is going on in Russia. After nearly a half century of living through the Cold War, watching the former bastion of communism emerge as a democratic nation is a story that resonates in the West. This book looks at Russia’s fast-growing and highly profitable business economy, and what it means for global markets.

Part One sets the stage for the investor or more general business/economics reader to understand Russia in terms of traditional risk/reward analytical categories, including recent historic developments informing these judgments.

When approaching the subject of business in Russia, it is hard not to address up front the overwhelming concern that the average reader evinces about crime and corruption and the rule of law in Russia, so Chapter 2 provides some further background.

Part Two discusses how conditions were ripe for business to flourish in the 1990s and focuses on the new businesses in Russia’s free market economy that have grown up over the last 15 years, as well as on the so-called oligarchs who are the first generation of owner-operators. Some businesses were built from the privatized bits and pieces of former Soviet ministries and some are purely private start-ups like the cell phone companies. Chapters 4 through 8 discuss the leading companies in the main sectors of the Russian economy today. Chapter 9 briefly steps away from the discussion of Russia to look at the countries of Ukraine and Kazakhstan and at a few companies there.

Part Three challenges the reader to move beyond the traditional misconceptions about modern-day Russia and look toward its future. Chapter 10, titled Discovering the Real Russia, highlights the evident negativity among U.S. elites toward many of these recent developments in Russia. Chapter 11 looks forward briefly toward possible future developments in Russia.

Earlier writings for the Third Millennium Russia Fund (TMRFX) focused more on the mechanics of investing in the Russian stock market, which are by now well understood. In fact, Russia has become mainstreamed, as most global financial firms are well represented in Moscow. So this book is an attempt to put investing in Russia in the broader context of the companies that have grown up, their leaders, and the macroeconomic and political developments that form the present-day environment for doing business in Russia.

The Third Millennium Russia Fund can be viewed on a daily basis at Yahoo! Finance and other Internet sites and at www.tmrussia.com. The Third Millennium Russia Fund is a series of The World Funds and can be reached at 1-800-527-9525. The Fund covers all the countries of the Commonwealth of Independent States (CIS). Now that Russia has entered a dramatic domestic growth phase, we hope its stock market will continue to outperform world stock markets, but past results are never an indicator of future performance.

The contents of this book pertaining to markets and specific companies come mainly from the research conducted by Third Millennium Russia Fund. This research has been aided by the research departments of various brokerage firms that cover Russia and the Commonwealth of Independent States (CIS). We would like to especially thank UBS for its extensive research resources for the region.

Part One

FREE MARKETS AND DEMOCRACY ARRIVE IN RUSSIA

Chapter 1

Today’s Russia

The Russians have endured generally abysmal leadership for long periods of time. In the nineteenth century, Tsar Alexander II freed the serfs, but Josef Stalin in effect again enslaved the population in the second quarter of the twentieth century. As a result, the Russians are long-suffering and more than a little cynical about their leaders. If you want to hear something unfavorable about Russia and its leaders, you do not have to go to Washington, D.C. Just ask a Russian and you will hear it at length. You do not have to read an American journalist; just pick up a Russian newspaper.

Russia has a tremendous number of daily newspapers, and readership continues to be among the highest in the world. The expression and range of opinions in the Russian media are very great. If it is favorable coverage you need for your business or political purposes, just buy it, it’s for sale. Broadcast media? That’s another story as it is under the Kremlin’s thumb.

Rebuilding Russia is now the challenge. For the past 15 years, the country has been depleting its Soviet-era legacy infrastructure: the roads, factories, proven oil reserves, and so forth. Now the era of inadequate new investment is over and a period of domestic growth and expansion has been launched, a la post–World War II Japan and the United States. Public–private partnerships, including toll roads, a new Priority National Projects program, and company-funded capital expenditures (capex) are all in prospect.

Russia’s Transformation into a Free Market Economy

Before assessing the risks and rewards of investing in Russia, let’s look at how the centrally planned, communist economy from the Soviet era became the free-market economy of today’s democratic Russian Federation.

Gorbachev, Yeltsin, and Putin: Three Transformational Leaders

Like its stock market, the recent history of Russia has been volatile. But net, Russia’s market has also been up over 1,000 percent¹ since the 1998 collapse of the economy (the Crisis). Mikhail Gorbachev, Boris Yeltsin, and Vladimir Putin have each been transformational leaders, contributing greatly to fast progress and positive change.

Mikhail Gorbachev, of course, presided over the ceding of an empire by letting go of Romania, Bulgaria, Poland, East Germany, the Czech Republic, and Hungary. Not one person died in the process. For this he is greatly esteemed outside of Russia, but not in Russia. If he had decreed Soviet tanks to roll into central Prague, people would have run for cover, as in the past. But he did not do so. He let it all unravel.

He was a true believer in communism, and still is. He thought he could give communism a new face, a renewed lease on life. But, as a product of the system, enjoying the confidence of the Politburo right up until it was too late for the ancient regime, he oversaw the dismantling of Russia’s international empire.

In the process, he sat down with President Ronald Reagan, who well appreciated the historic opportunity and who, it turned out, hated nuclear weapons and the threat they posed to humanity and negotiated the most substantial arms control agreements ever. This accomplishment alone assures Reagan of his place in history. Although he recognized the overall possibilities with Gorbachev and certainly sought to promote the end result (Mr. Gorbachev, tear down this Wall), his more triumphalist supporters want to give him sole credit for the end of the Evil Empire. (For more, please read Reagan and Gorbachev by former Ambassador Jack Matlock Jr., who assisted President Reagan at the Reykjavik Summit in Iceland.)

But Gorbechev, who dismantled the Eastern European Soviet empire, did not intend the disintegration of the Soviet Union itself, the former Russian empire. Boris Yeltsin (see Figure 1.1), not esteemed at present anywhere, stepped up on a tank and oversaw three historic developments:

1. Russian Independence

2. Democracy

3. Free Markets and Privatization

Figure 1.1 Boris Yeltsin, First President of the Russian Federation

Courtesy of Fotosearch.

Russia: Free at Last

As a Russian nationalist, Yeltsin understood that it would be an unnecessary burden for Russia to continue to carry the weight of the other generally resource-poor former Soviet republics. Great Russia itself is the largest country in Europe. When Siberia is added to the map, a region that has the same population as Canada, with its people also clinging to its southern border, even European Great Russia looks small.

It took only one meeting of the Communist Politburo for hands to wave in the air when Yeltsin asked for volunteers to lead each of the constituent Soviet republics into independence. In general, those Soviet-era leaders grabbed and held their presidencies long after each republic declared its independence. This process generally unfolded smoothly. As for Ukraine, though, there was particular chagrin. In the 1950s, Nikita Khrushchev, who was from The Ukraine, as it was then called, gave The Crimea, which had no particular historic tie to Ukraine, to that Soviet republic. The painful realization of the modern implications of that gratuitous decision are now apparent to Russia as it is currently fighting a legal battle with the government of independent Ukraine to ensure the Russian Navy’s continued access to its important warm-water port, a need Russia has pursued since the reign of Peter the Great.²

Most of us are familiar with the White House of Russia, the offices of the Supreme Soviet of the RSFSR (the Russian Republic, a constituent of the Soviet Union). This is the location of Boris Yeltsin’s famous mounting of the tank during the attempted coup against Gorbechev. And, later, it was the site of the brief hostilities when the Yeltsin forces shelled the White House and the recalcitrant Communist-led Supreme Soviet (the national legislature adopted the historic Duma name later with the new democratic constitution) was forced to surrender. Subsequently, a fine new democratic constitution was adopted to replace the Soviet-era constitution-in-name-only (the Communist Politburo had run the country dictatorially).

My office was just across the Moscow River from the White House and, during my years of living in Moscow, I watched its early stages of construction as the seat of government for the RSFSR, never dreaming that one day it would in fact house the government of the new, independent Russian Federation. Since, in typical Soviet construction style, it took 10 years to be completed, this transition in fact took place not long after its completion. Today, it is surrounded by a heavy, iron fence, so storming it would not be easy.

The Establishment of Democracy

As the first president of an independent Russia, Boris Yeltsin set up the institutions of democracy. He oversaw the drafting of a new constitution, based on that of the French Fifth Republic, which has well served France since 1958, and serves the Russian Federation today.

Boris Yeltsin was a genuine, backslapping, smiling, people-to-people politician. Americans are not the only voters who appreciate a leader possessing the common touch. Russians can also tell when a candidate likes people, enjoys being among them, and simply asks for their votes and support. This Yeltsin did admirably, moving around the country in two election cycles (1992 and 1996), and the Russian people responded. Unlike Putin, Yeltsin had always been a populist leader, well known to the public.

The 1996 Presidential election and the State Duma election were of course critical to the continued progress of Russia toward democracy and free markets. Although the threat of a Communist Duma has now receded to the point of being very unlikely, the Communists had been nothing but obstreperous in the early days of the new, independent Russia. They had a significant bloc in the State Duma, and from 1995 to 1999, they stopped tax reform and other necessary changes.³ In the 1996 election cycle it was the financial and organizational support of the oligarchs—who had profited so much from the privatization program—that saved the day for Yeltsin and helped contain the size of the Communist bloc in the Duma going forward so that tax and other reform programs could be enacted.

Free Markets and Privatization

Yeltsin’s third historic achievement, in January 1992, freed prices to fluctuate with the market under acting Prime Minister Igor Gaidar and shepherded by his brilliant young privatization director, Anatoly Chubais. Then shops, apartments, and enterprises were privatized to their occupants, workers, and managers.⁴ Russia’s business sector today is more private than that of Italy or France. Chubais’s animus was simply to get everything out of the hands of the government, which had made such a mess of it.

The tricky part was the privatization of clearly valuable companies, such as oil companies. No one had funds to pay market prices, so were they to be auctioned off to foreigners, or to Russians? Fifteen years later, even after the Yukos affair and the clawing back of assets by the state, the Russian oil industry is still about two-thirds privately owned as measured by output. Since government-owned oil companies are more fully valued in the market due to less perceived risk, on a market-cap basis the public/private ratio is closer to 50/50.⁵

It was during these pre-1998 years that the United States was of tremendous help to Russia. Laws, including securities laws, were enacted with U.S. assistance. Americans can take great pride in the material assistance we gave Russia; and the government of Russia eagerly sought and accepted that advice and assistance. It was during this period that the idea that our two countries were great friends and allies took hold. Now, many U.S. commentators, instead of building on the base of the many positive developments we engendered in Russia, seem intent only on hectoring and lecturing Russia on its many real and apparent shortcomings (more on this in Chapter 10).

Learning the Hard Lessons of Capitalism: The 1998 Crisis

The year 1998 brought with it events that have continued to shape Russian politics and economic policy. On the surface, the end of 1997 looked like it was going to be a turning point in the grand Russian free market experiment. The United States and the International Monetary Fund (IMF) were working closely with the Central Bank of Russia (CBR) to bring in foreign loans and assist in creating effective controls over the economy, and this assistance seemed to be working. The country was reporting its first annualized growth (0.8 percent) in gross domestic product (GDP) since the collapse of the Soviet Union.⁶ At the same time, Russian blue chip stocks were showing huge gains on the Russian Trading System (RTS), some stocks recording gains as high as 1,500 percent,⁷ as Western and Japanese investors flocked to the Russian market in search of the hefty gains that seemed a sure thing.

The price of oil, Russia’s primary export, was holding steady at then-record levels of around $23 per barrel, bringing in added revenues to the Russian economy and the Russian government. Thanks in part to the help of the IMF and the United States, this impressive turnaround came with a reduction in inflation, a number that reached a high of 2,600 percent in 1992, down to 11 percent in 1997. These improvements, though, seemed to convince most people involved that the Russian economy was sound and that the economic warning signs that were evident at the time could be ignored as merely, as then–World Bank head James Wolfensohn stated, a bump in the road.⁸

Although 1997 appeared to be a breakthrough year for the Russian economy, the underpinnings of economic disaster were already becoming evident. The first sign was the Asian currency crises of 1997 that began with the Thai baht crisis in Thailand, where currencies in many Asian countries, and their economies, were devastated by speculators betting huge sums of money on the potential of their currencies devaluing while their central banks spent huge sums of money to protect the value of those currencies.

The Asian currency crisis had a major impact on Russia’s exports, as it relied on many of these Asian markets as trading partners. This crisis also put pressure on the price of crude oil, which eventually fell to around $11 per barrel in 1998 on the potential for decreased demand. The financial pressure, along with poor government decision making, was taking its toll on the Russian economy. This is evidenced by the fact that by the end of 1997 only about 40 percent of Russian workers were being paid on time and in full.⁹

The