Wednesday, January 26, 2011

Russia Needs Our Money Now, But For How Long? Medvedev in Davos

Dimity Medvedev’s Davos charm offensive was cut short by the suicide bombing at Domodedova airport. He could not afford to be seen mingling with “Davos Men” as victims of the tragedy lay dying. Vladimir Putin learned this PR lesson when he continued his vacation as the Kursk submarine sailors suffocated under water. Medvedev returned today to Davos, his agenda reduced to two events: meeting with world business leaders and delivering a keynote address. In both events, he will deliver the same message: Russia is open for business. His listeners will be told that state companies are being spruced up for sale. Only a few will remain off limit to foreigners. Goldman Sachs has been gearing up, beefing up its presence in Moscow. Goldman and other venerable investment houses will lend an air of credibility to the undertaking.

There is no mystery why Russia is again open to foreign investment. The state budget receives half its revenues from oil and gas, whose prices are no longer soaring and whose outputs are stagnant. The Russian economy has been in a funk for a few years, and tax revenues are down. The vaunted rainy-day fund from the halcyon days of the energy boom is almost exhausted. In a word, the Russian state badly needs money.

Putin and company will be actually interested in selling state companies at high prices this time around. Previous “privatizations” have brought precious little into state coffers. The most lucrative state companies have already been sold (or resold) to the Kremlin’s friends at bargain basement prices. None remain under the control of unreliable oligarchs to be confiscated as was Khodorkovsky’s Yukos. Not that much remains to be sold. Rossneft, now owned ten percent by BP, is the big prize, so to speak. Other companies on the auction bloc are less appealing, such as RusHydro and Sovcomflot.

Medvedev’s invitation is not the first, nor will it be the last. Mikhail Gorbachev counted on a huge influx of foreign investment when he liberalized rules in 1986, but no one came. The Yeltsin administration courted foreign investment, but few ventured in. There were still no laws and rules. Willing foreign investors were subjected to endless waits for finalized versions of production sharing agreements and the underlying “normative acts.” Putin came to power on a platform of offering stability and a rule of law. BP, Exxon, and Shell took the bait to be bloodied by arbitrary tax police, environmental agencies, and local oligarchs. The passive foreign investors in Russia’s best-run oil company, Yukos, saw their investments fall to zero as Putin’s tax police and courts dismembered Yukos on phony charges.

We are now assured by Medvedev that this time it will be different. Russia is truly open for business as a reliable partner. It is said that Putin himself stands behind such deals. Medvedev’s economic team is spreading further good news at Davos, such as the government’s intent to streamline rules and lower taxes. Are such siren songs to be believed?

Recent history warns that foreign buyers should be wary for a number of reasons:

First, it matters little whether Putin and Medvedev both stand behind these deals. Putin, or whoever else is in charge in the future, can always change their minds, as BP, ExxonMobil and Shell can attest. In the absence of a rule of law, whatever those in power say is the law is the law. And there are number of ways to break agreements without violating the words written in the contract.

Second, the state will likely remain the major shareholder; minority shareholders would have to search the world for a worse partner. The Russian state will continue to use companies in which it has controlling shares as instruments of state power without much real interest in creating shareholder value.

Third, potential foreign investors should be aware that, despite the participation of the world’s leading investment bankers and accounting firms, they will have to buy a “pig in a poke.” As far as I know, there has been no real audit of any substantial Russian company, despite the respected accounting firms whose names are listed in the prospectuses. A real audit cannot be conducted because it would reveal the web of corruption and related party transaction that lie buried beneath the surface of each of these companies.

The most likely outcome is that foreign money will indeed flood in (the unknown is the price, of course). Putin, Medvedev and the Russian state will behave as long as they need access to world capital markets. With the money safe in its coffers (either in Russia or Switzerland), Russia will again at some point put the screws to hapless foreign partners when the price of oil soars or some other serendipitous event occurs.

Any foreign investor considering investing in Russia for the long run must consider two metrics: Russia currently ranks 154 out of 178 countries in corruption, equal to Tajikistan, Cambodia, and Laos, lower than Pakistan. In terms of political risk, it ranks 186 out of 196. These miserable numbers are not made up. They reflect the reality of what it has been like to do business in Russia.

How Western investors accept the Medvedev-Putin invitation is yet another test for world capital markets. If bids are low enough to reflect the reality of Russian risks and corruption, it will have done its job, and Russian public finances will not be bailed out by naïve foreign investors. If foreign investors pay prices that ignore this reality, they are again like Charlie Brown rushing forward to kick the football that Lucy will snatch away at the last moment.

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