Russia

For Richer, For Poorer

Lawrence S. Speidell

Nicholas-Applegate

Pensions 2000 Conference

Moscow

May 16, 2002

And the children shall lead them….

Arbat Street, Moscow

Russian/US relations sometimes resemble an Italian couple who fight often, throw things, break dishes and then make up. It is time to move forward to a more functional relationship for both sides.

Now, however, it is time for a change. Building a friendship between the US and Russia could be the most important feature of this century.

As John Morz, of the EastWest Institute, has said, “Putin’s turn to the West is the most important diplomatic event of the last 5 years, maybe 10.” The opportunity is for us to build on this foundation to shape a better world.

A Short History of Russia

Ü1917: Bolshevik revolution, Communism introduced

Ü1957: Sputnik

Ü1980: State control, long lines for consumers

Ü1990: Vouchers, “Capitalism” introduced

Ü1991: Coup, end of Soviet Union

Ü1995: Foreign investors and new “elite”

Ü1998: Devaluation, corruption, foreign investors disillusioned and disappointed

Ü2000: President Putin takes office

Ü July 2001 – Bush-Putin meeting: “Russia is not the enemy of the US”

Ü9/11/01: President Putin supports the West against terror

A short history of Russia begins with the fall of the Tsar in 1917 and the introduction of Communism. Through most of the 1980s, the state controlled everything, and the norm was shortages and long lines for consumers. Military expenditures were 50% of GDP at the height of the Russian/Afghan war in 1985 (versus 7% in the U.S.). In 1991 the GUM department store on Red Square was an empty barn with only a few old-style shops open. Clerks stood behind counters to separate customers from the merchandise. Quality was so low that the only lingerie appeared to be military issue. Most shelves were empty, but where goods were available, the lines of sullen customers were long. In the Soviet Union, automobile windshield wipers were in such short supply that drivers had to remove them when they parked lest they be stolen. Shortly thereafter, Gorbachev began reforming the country, and then the August 1991 coup led to the fall of the Soviet Union and the acceleration of change toward capitalism. Unfortunately, it was “crony” capitalism that took hold, with a few well-connected politicians and gangsters getting rich while standards of living and life expectancy fell for most Russians. The term, “island people” was coined for those bureaucrats and bankers who sought to make off with enough money that they could retire an move to an island…which they would buy. By 1998, over-eager foreign investors and ill-trained bankers had created a bubble that burst with the collapse of the ruble.

Yelsin’s turbulent regime ended with the election of President Putin, a former KGB officer, in early 2000. Early in his administration, Putin indicated his leaning toward the West. He went to Germany and addressed the Bundestag in impeccable German (it is also said that he spends an hour each day learning English). Since then, there have been additional positive developments. In July 2001, the EastWest Institute published a report, “Toward the Common Good”, by a blue ribbon task force, headed by former Senators Borin, Danforth and Simpson. Presented to President Putin and President Bush, the report recommended a new approach the U.S.-Russian relations founded on mutual respect and shared values. It urged: “The United States can afford to make a bet on continued positive change in Russia.” Shortly thereafter, in July 2001, President Bush met President Putin and declared, “Russia is not the enemy of the United States”[Broder]. Then in September 2001, following the terrorist attacks in New York, President Putin made a historic decision to support the West in the war against terror. His was the first call by a foreign leader to President Bush, and Putin immediately cancelled Russian military exercised to avoid a distraction to our government.

Russia’s cooperation in the war on terror has been substantial. In Afghanistan, they helped supply arms to the Northern Alliance, shared intelligence and acquiesced to our use our use of air bases in Tajikistan, Uzbekistan and Kyrgystan. They have also cooperated with international criminal justice institutions regarding terrorist networks in Russia. Also, Russia has permitted U.S. forces to train Georgian troops to restore order in the Pankisi Gorge on Russia’s southern border, where Al Qaida may be operating. Many of these concessions are controversial among the Russian elite, and it is important for Putin to show that there are offsetting benefits for Russia.

Economics

Russia is a resource rich country, with 40% of the world’s gas reserves, 6% of the world’s oil and 20% of its timber. Glen Waller of ExxonMobil has said that more oil will be produced in Russia than any other country in this century. The statistics above show the irregular progress of the Russian economy in recent years. GDP per capita dropped sharply following the 1998 ruble devaluation and remains a low level. There has, however, been an economic recovery since 1998 as Russia has now entered the fourth consecutive year of growth. Capacity utilization has risen for its aging plants, however, and there is fear that the low level of capital investment will limit future Real GNP growth to 3-4%. The unemployment rate remains high, at nearly 10%, and this figure is probably understated.

Exhibit 1

Source: Center for Strategic and International Studies

Population growth (or lack of it) is a major concern, as the population of 144 million is shrinking by 800,000 per year. The birthrate is only 1.1 children per family compared with a replacement rate of 2.2. Life expectancy for males plunged to 57 years in 1994, when Gorbachev’s high tax on vodka was discontinued. According to one survey, two thirds of men who died over the age of 55 were drunk at the time of death. A positive statistic is the inflation rate, which has dropped from 2650% in 1992 to an estimated 17% in 2002. As for foreign investment, it remains at a low level at $4 billion/year, less than half what Poland receives and one-tenth the amount that goes to China. Interestingly, the largest source of foreign direct investment (FDI) coming into Russia is from Cyprus, where money from Russia sometimes makes a round trip before returning home. The level FDI from the U.S. is actually lower than the amount the U.S. invests in Costa Rica.

Exhibit 2

Russian Trading System Index (RTX)

The stock market, measured by the Russian Trading System Index (RTX), peaked at 950 in 1997, plunged to 70 in the currency crisis of 1998 and has since recovered to 670. It is composed of 63 stocks, with a market capitalization of $125 billion, selling at a current Price/Earnings level of 8x.

For richer

In thinking about our relationship with Russia, there are many strong features. Among the most important is the commitment to the democratic process which Russia’s people and politicians have made. There was a 61.8% voter turnout in the 1999 election, a figure that puts most democratic nations in the world to shame. All major politicians are committed to the election process, and extremist parties have been marginalized. In the old days, it was said that both the U.S. and the Soviet Union has freedom of speech, the difference was that the U.S. also had freedom after speech. Today there are still problems with free speech and freedom of the press. Contract killings of reporters have occurred, and the government closed down TV6 over biased reporting. However, the U.S. is working with Russia to develop a truly free press that is not beholden to special political of criminal groups.

Exhibit 3

Among Russia’s powerful strengths is science including the areas of metallurgy and aerospace. The picture above was taken 10 years ago at the Krunichev rocket works in the southwestern Moscow, where Proton rocket boosters are built. This is the main driver of the Russian space program, which has a better reliability record than the American Atlas rocket. Another example of Russia’s strength in aeronautics is the Ruslan, shown in exhibit 4. This is the world’s largest cargo plane, designed in Russia and built at the Kiev Aircraft Production Association in Ukraine. When our P-3 Orion plane was forced down in Hainan Island, China, we called on the Russians to help us bring it back. When not carrying entire aircraft, the Ruslan has been used to transport heavy machinery and even America’s Cup sailboats.

Exhibit 4

More pedestrian manufacturing is also a strength of Russia, although investment in modern facilities is needed to capitalize on it. Caterpillar has recently opened a profitable plant that manufactures hydraulic equipment components for export to its European factories. This takes advantage of Russia’s abundance of low-cost energy and steel, as well as its well-educated labor force.

Exhibit 5

GUM Department Store in 1991… and in 2002

Two views of the GUM department store on Red Square in Moscow shows the many changes since the days of Communism. In the Spring of 2002 a Ford Focus automobile is on display next to the fountain to herald the opening of Ford’s first manufacturing plant in the country in July 2002. The Focus will sell for $13,900 compared with Russian Ladas at $5,000 and Volgas at $5-12,000, but the Focus will arrive fully equipped and with the quality that Russians appreciate.

For Poorer

On the negative side, Russia faces many challenges. Many of us who have fought Russia as our Cold War adversary think of the Russian military as a formidable foe, and it is, with 25,000 nuclear warheads. Today, however, the greater threat is not what Russia will do intentionally, but what might happen accidentally, either through another Chernnobyl disaster or through loss of control over weapons of mass destruction that might fall into the wrong hands. There are even nuclear powered radio beacons scattered around the country that could provide dangerous nuclear material for a “dirty” bomb it they fell into the wrong hands. With U.S. help, Russia is working toward better control of these devices.

Another immediate concern is the dilapidated state of Russian economic infrastructure. On a visit to Zelenograd, the “Green” City, in 1991, I observed the “clean” room of a semiconductor laboratory. While visitors wore hats and workers insider wore clean suits and masks, a ventilator duct in the ceiling displayed a six-inch plume of dust hanging down. A standing joke was that the Russians made the “fastest watches and the largest microprocessors in the world”. Today, conditions are not much better. The average age of plant and equipment is 17 years, three times that of the OECD countries; and each year there are 70 breakdowns per 100 kilometers of utility pipes and wiring compared with 10 in Europe. With 38% of enterprises unprofitable, it is not surprising that $160 billion of capital has fled the country, at an annual rate of $13 billion last year, compared with only $4 billion of Foreign Direct Investment.

Another obstacle to progress in Russia is the burdensome bureaucracy. Certification requirements forced Volkswagen to completely disassemble a car for the inspectors and then even fly them to Germany for a plant tour before they agreed that the cars were free of hazardous substances. Inspectors have even demanded testing of Swiss watches to make sure they are safe to come in contact with the skin.

Exhibit 6

One of the greatest problems in Russia is the sense that corruption pervades all aspects of life. Transparency International ranks the country at 2.3, near the bottom of the 10 point scale of its Corruption Perceptions Index.

Because Russia’s legal and commercial systems were unprepared for the fall of Communism, capitalistic anarchy resulted in a free-for-all among politicians and company managers to gain control of assets. It has been estimated that the underground economy is equivalent to 40% of GDP. The Duma believes that organized crime costs the nation $15 billion/year. Interior Ministry once stated that crime cartels control 40% private enterprise, 67% of state enterprise and 50-85% of banks. And the Russian Association of Criminology Survey in 2000 concluded that typically tax inspectors demand 25% of tax and customs officials demand 20% of duties. While conditions have improved since these statistics were developed, the problem remains a large one.

Several examples of abuses at Gazprom was uncovered by Heritage Capital Management and reported in Business Week, February 18, 2002. While Itera company claims to be independent of Gazprom and its management, several transactions raise questions about this independence, based on evidence of “asset stripping” from Gazprom to Itera: Gazprom loaned Itera $616 mil. Then Gazprom, claiming to be cash-poor, bartered gas for taxes with tax authorities of the Yamal-Nenetsh Province at $2-4 per 1000 cubic meters. The province traded the gas to Itera in return for cash at the same price. Then Itera sold the gas on the world market at $30-90 per cubic meter for a profit of $5.5 billion. In another transaction, Gazprom sold 32% of Purgas to Itera for $1,200 while Price Waterhouse valued Purgas at $1.7 bil. These do not seem like arms length transactions, yet they were approved by Price Waterhouse in its audit. (Meanwhile, Price Waterhouse has received $80 million in audit and consulting fees from Gazprom over five years.)

What do we expect?

We have considered some of Russia’s strengths and weaknesses, but in many ways, the country is typical of emerging markets. Many of Russia’s weaknesses are very disappointing, even shocking, but we must remember that the country is still emerging from the dark days of Communism. Several comparisons may help to put the characteristics of the country in perspective. Corruption, for example, largely explains the dismal level of FDI, as shown Exhibit 7 below. If Russian reforms can reduce corruption, FDI flows will come.

Exhibit 7

Exhibit 8

Life expectancy, on the other hand, is even lower than would be expected given Russia’s GDP per capita, estimated at $2356 for 2002. Minister of Economic Development German Gref calls the wages paid to medical professionals a “joke”. Any improvement in Russian healthcare, could result in sharp gains in both mortality and morbidity for the nation. If this were combined with lower alcoholism, the productivity improvement for male workers could significantly benefit the economy.

Exhibit 9

An interesting study by Inglehart and Klingman [2001] in the chart above shows the decline in the percentage of Russians who described themselves as happy and satisfied with life as a whole between 1980 and 1995. The decline and eventual collapse of communism followed by the chaotic days of Russia’s early capitalism clearly affected the mood of the country.

Exhibit 10

Russia’s dissatisfaction is shared by many other former communist countries, while the happiest people seem to be those in historically protestant societies in Europe and North America. The data do suggest, however, that increases in GNP/capita can improve happiness and satisfaction significantly.

Exhibit 11

Another perspective on Russia’s position is the survey of the “percentage who trust people in general”. While there is a positive relationship of trust with income level, there also seems to be a religious influence on the data. Confucian societies like China are remarkably trusting relative to their income while the French Catholics are less trusting than one would expect. Short of converting to Confucianism, the Russians have much to gain from greater economic prosperity.

Exhibit 13

This final global comparison shows that happiness and freedom go together. Any cause/effect relationship is hard to define, but it seems logical that if Russia can become richer, the Russian people will grow more happy, healthy and free.

Reforms

Many major steps toward reform have been taken in the last two years:

1) Tax Reform has introduced a 13% flat personal tax rate and a 24% corporate (vs 35%). One result has been a 28% increase in tax revenues, a collection rate of 90% and reduction in non-cash payments from 40% to 10%. In addition, Russia has no capital gains tax on stocks, bonds or homes.

2) Judicial Reform has resulted in the most significant changes since 1864, including trial by jury, quadrupling of judges’ pay to make them less susceptible to bribes and passing significant laws including the Bankruptcy Law, Anti-money Laundering Law and Foreign Securities Law (ADR voting rights etc).

3) Land Code Reform now provides for ownership rights of residential property, and most former government property has been transferred to the occupants. In addition, the sacred topic of agricultural land sales is now being considered in the Duma.

4) Banking Reform is now beginning to get underway following the resignation of Central Bank Minister Gerashchenko in March. The current condition of banking in Russia is dismal, with the Central Bank bloated to 85,000 employees. There are 1500 banks in the country, but most are small and used only for corporate work, including money laundering. Deposits in the Russian economy are only 10% of GDP versus 40% for Poland and 100% in West. As of yet, there is no mortgage market to provide liquidity in housing. First Deputy Chairman of the Central bank, Andrei Kozlov, says that 13% of GDP is held by individuals at home under their mattresses, most of it in dollars. An ironic benefit of Russia’s underdeveloped banking sector is that the economy is equity based. As one observer said, “No credit…. No credit crunch!”

5) Regional integration is a major achievement of the Putin administration. When he took power, 70% of regional laws were in conflict with Federal Laws. This has been reduced to 3%.

6) Corporate Governance Reform has addresses many of the most blatant aspects of Russia’s wild capitalism. Many of the new requirements, however, represent a minimum of the protection shareholders need in order to invest: Share issues over 25% now require general shareholder meeting, to prevent abusive dilution of minority shareholders, transactions of more than 25% of assets require shareholder or board approval, shareholders have right of first refusal of share issues, the board can dismiss CEO and information on shareholders owning over 20% must be disclosed.

The reforms Russia has legislated are critical to progress, but equally important is their timely implementation. “De-bureaucratization of the economy” is the goal of Finance Minister Kudrin, who harbors no illusions about the difficulty of getting the country’s far-flung administrators, judges, regulators and inspectors to obey the Kremlin.

Meanwhile, outside government channels, a Private Sector Initiative is taking shape in Russia, with sponsorship by The EastWest Institute, the World Bank and the Frank Russell Company. This is targeted at four areas: Pension reform, small business development (small business can be an engine of growth, yet it employs on 13% of workers in Russia versus 54% in the U.S.), Russia’s entry into the World Trade Organization and corporate governance. A recent breakthrough in corporate governance is the commitment of Mikail Kodorkovsky, head of YUKOS, to fund half of the budget of the Corporate Governance Center in Moscow. YUKOS has been accused of abuses in the past, but Mr. Kodorkovsky is one of the oligarchs who is most outspoken in support of the Putin government and its reforms (Putin made a tactical decision to make peace with some of the oligarchs by not ordering a review of privatizations and by recognizing their property).

Although significant growth in the small business sector will depend on effective sources of finance through a restructured banking system, the government is taking helpful steps in other areas. The fees for registering a business have been reduced from $600 to zero, and the time required has been cut from 3 months to one week. In response, over 300,000 businesses have been registered in the past three months (although many were perhaps operating unregistered before). Another change under consideration is the simplification and reduction of taxes on small business: A profit tax 20% versus 24% for companies with less than 20 employees and revenues under 10 mil rubles, an alternative Revenue Tax of 8-10% and a two year exemption from 20% VAT and 5% sales tax.

Do Countries Change?

The chart below puts Russia’s progress in perspective. Differences in styles of government are shown in two dimensions, from “bureaucratic” to “entrepreneurial” on the vertical axis and from “rule of law” to “chaos” on the horizontal axis. While other countries don’t have the same balance of freedom and stability as the U.S., capitalism is thriving in many countries today. The more entrepreneurial environment of Hong Kong or the more controlled environment of Singapore may be more favorable to certain types of capitalism than the environment of the U.S.

Exhibit 14

Russia had made great progress from the bankrupt Communist state that existed in 1989 and has made even greater progress in the past two years of the Putin administration. Still, it is a challenging environment for business, and the economy has yet to attract the investment capital it needs to sustain a high long-term growth rate. It may be unfair to expect more of Russia at this point, when we consider that China has had a twenty-year head start in its reforms. Russia veered more toward “chaos” than did China, but it has become more democratic as well. Now the trend toward “rule of law” has begun, and hopefully both Russia and China will converge toward the top left of the chart.

A group of Russian businessmen, called Club 2015, has been working on the choices facing the country by developing scenarios for discussion with political and economic groups. Their framework, shown below, is rather similar to ours: “Rule of Law” becomes “Playing by the Rules”, while “Chaos” becomes “Playing with the Rules”. “Bureaucracy”, however, is described as “The Vertical of Power”, which represents the authoritarian idea that with enough power, any laws can be enforced. As Tacitus said in Rome: “The more corrupt the society, the more laws” [Hill]. Fortunately, Russia has not turned in this direction, however, much still needs to be done to achieve Club 2015’s goal of “Real Time Russia”.

Exhibit 15

Conclusion

In Russia today, there is significant positive change. But this momentum is fragile and must be nurtured carefully. If Russia and the West grow in shared prosperity and harmony, then the total wealth of the world will be magnified. Building a friendship between the US and Russia could be the most important feature of this century.

One member of the Club 2015 said, “We would like for us and our children to live in our country without regrets.” For this to occur, there are several steps to be taken. On Russia’s part, banking reform is a first priority. This is essential to create an effective economic system for the allocation of capital. Second, Russia must not squander the opportunity to diversify her economy from resources to a broader array of products. This is necessary to assure the effective utilization of the country’s valuable intellectual capital. Finally, Russia must adopt Western standards of business ethics. Economic partners should expect that all contracts will be honored in full throughout the life of the contract. Building trust is critical to allowing Russia to take its place in the global economy. It is far more important than any short-sighted gains from short-term self-interest.

On our part, we should adopt the recommendations of the EastWest Institute task force report: Let’s bet on Russia… we can afford to. This means encouraging Russian membership in the World Trade Organization and encouraging increased direct investment and portfolio investment in Russia. At the same time, however, we must insist on transparency and clear terms of corporate governance.

After the fall of Communism, foreign investors were first viewed as saviors, able to sustain Russia’s crumbling companies. Then, foreign investors came to be viewed as sharks, only interested in stealing the best resources of the country. Next foreign investors were considered with contempt, as fools to be fleeced [LeBaron]. None of these views is true. For richer or for poorer, we and Russia are joined in the world social and economic system. If we can live in friendship, we can truly make the whole world a better place. Abraham Lincoln once said, “The best way to deal with an enemy is to make him a friend”. This is especially true in our relationship with Russia today.

References:

Aslund, Anders, “Russia”, Foreign Policy, July-August 1001

Broder, David S., “Bush’s Bet on Russia”, Washington Post, August 1, 2001

Hills, Roderick M., The Economics of Corruption”, LookingAHEAD, Volume XXIII, No. 2

Inglehart, Ronald, Modernization and Postmodernization, Princeton University Press, 1997

Inglehart, Ronald and Hans-Dieter Klingmann, Genes, Culture, Democracy, and Happiness

Inglehart, Ronald, “Globalization and Postmodern Values”, The Center for Strategic and International Studies and the Massachusetts Institute of Technology, The Washington Quarterly, Winter 2000

LeBaron, Dean, Mao, Marx and the Market, John Wiley and Sons, Inc., 2002

McFaul, Michael, “Getting Russia Right”, Foreign Policy, Winter 1999-2000

“Russia’s Enron?”, Business Week, February 18, 2002

“The Russian Economy in March 2002”, Center for Strategic and International Studies, Washington, D.C.

Transparency International, Corruption Perceptions Index, The Economist, March 2, 2002

Transparency Internatuional, “Nations in Transit 2001”, www.freedomhouse.org

“Toward the Common Good, Building a New U.S.-Russian Relationship”, EastWest Institute, July 2001

World Values Survey, Some Findings, 11/16/2001 wvs.isr.umich.edu/wvs-find.html