Yukos shadow over Putin’s second term

by Simon Pirani

Russia’s ability to hit president Vladimir Putin’s target of doubling GDP growth in the decade to 2012 depends largely on his own ability to deliver the next stage of reforms.

Economically, he’ll probably never have better conditions. Politically, investors are looking for him to strike the right balance in government after his re-election in March next year – and undo the damage to sentiment done by the security forces’ assault on Russia’s richest oil company, Yukos.

The RTS stock index sunk 20% in the month after its 20 October high, during which Yukos chief executive Mikhail Khodorkovsky was arrested and resigned his post, and a 39.5% stake in the company controlled by him and others was frozen.

The implied threat to property rights, above all, made Russian business nervous. Capital flight apparently surged; other oligarchs (politically influential billionaires who rose in the 1990s) publicly distanced themselves from Khodorkovsky; some key deals were put on hold.

Investors’ and analysts’ view of prospects depends, ultimately, on their interpretation of the Yukos affair and its implications for Putin’s second term, which he is universally expected to start after the presidential election in March.

Most observers agree that Khodorkovsky was arrested because he broke the deal struck between Putin and the oligarchs in 2000: that if they kept out of politics, law enforcement agencies would not revisit the exotic privatisations of the 1990s in which they got rich.

But it’s important to bear in mind which precise aspects of Khodorkovsky’s political meddling provoked his enemies. He had hinted that he might stand for president in 2008, but that wasn’t the real problem. More serious was not only his publicly expressed support for right liberal political parties, but his aggressive and well-funded parliamentary lobbying to reduce the oil companies’ tax burden. He had also senior Kremlin figures by talking up Russia’s role as a post-11 September source of dependable oil for the US and agitating for a privately-owned pipeline to Murmansk to supply that oil.

No wonder that defence minister Sergei Ivanov, considered a senior voice of the “siloviki” (men of force, i.e. military and security services) that are gunning for Yukos, said on 17 November that the state would face “dire consequences” if it failed to invest significantly in oil and gas exploration, and warned against it “losing control of significant [economic] sectors”.

The “siloviki” clearly believe that handing the oligarchs control of the natural resources industries in the 1990s was a mistake. And a clear conclusion from the Yukos affair is that the tax burden on oil and minierals may get heavier, and that oligarch-related stocks must carry additional risks: neither non-Yukos oil companies nor Norilsk Nickel will be immune from such fallout.

A bigger question – the answer to which may not be known until Putin appoints his first second-term cabinet in April or May 2004 – is whether he can manage the alliance on which he now rests, of the “siloviki” with liberal economic reformers such as economic development minister German Gref and finance minister Aleksei Kudrin.

Michael Marrese, Russia analyst at JP Morgan Chase, says: “The market is concerned, and Russian citizens are concerned, first, about the balance of power shifting to those with security forces connections and possible authoritarian and anti-property inclinations; secondly, about a possible broader attack on property rights.

“We remain confident that Russia is not going down that road. But we’ll only have greater clarity after the appointment of Putin’s second-term government.”

James Fenkner, chief strategist at Troika Dialog, the Moscow brokerage, says a weathervane may be the disposal of the frozen Yukos share. “An extremely optimistic scenario is a sale to a US oil major. A worst-case scenario is that the prosecutor’s office triggers licence reviews and the stake is brought back under state control. The outcome will depend largely on the balance of forces in government.”

Christopher Granville, political analyst at United Financial Group, the Moscow investment group in which Deutsche Bank took a 40% stake last month [November], argues that the best way to stop the conflicts of the 1990s being an obstruction to growth in this decade is to formalise the 2000 deal between oligarchs and president. “It would be good to draw a line: for example, not to offer immunity, but to guarantee that punishments would not include confiscation of property.”

He acknowledges that that is difficult – and that the presidential election campaign may well be fought alongside a noisy trial of Khodorkovsky. “Putin appears to be muddling through, and talking about the need for due process. So as well as the specific uncertainty about the Yukos shareholding, you will have general uncertainty about what the rules of the game are for the oligarchs, and an inherent instability that could get really bitter – not in the 2004 election, but between then and 2008 during the struggle over the Putin succession. All this will result in a higher risk premium on Russian asset prices.”

Notwithstanding all these problems, most observers believe that in the first part of his second term the president will persist with an economic strategy that can be bought into: the management of Russia’s bulging oil windfall to stimulate broader development across sectors; acceleration reform of public administration, the “natural monopolies” (rail, gas, power) and financial services; and measures aimed to lift 30 million Russians up from below the poverty line.

Chris Weafer, head of research at Alfa Bank in Moscow, said: “The message that appears to be coming from the Kremlin is that the concentration of wealth in recent years has made the economy vulnerable; that to recreate Russia as a world power the economy has to be something more than a bigger version of Venezuela’s; and that wealth creation and fighting poverty means diversification away from oil.”

That means that Kremlin policy will drive towards a balanced economy to sustain long-term growth, Weafer believes. “This would prioritise support for SMEs, the creation of growth incentives by a higher tax take on natural resources industries to fund development in other sectors – and a further development of the crackdown on corruption, which we estimate costs the economy $35 billion a year.”

Weafer’s investment case is therefore caution on oil and an inclination to domestic growth stories, of which telecoms is the most obvious. Private equity will play an increasing role from here, he adds.

Strategic investors have taken the Yukos crisis in their stride. Shell, which just before Khodorkovsky’s arrest announced a $1 billion investment plan in a west Siberian oil joint venture, Salym, made a point of reiterating enthusiasm for it after the arrest. And the Chinese national oil company CNPC spent $115 million on a 62% stake in Stimul, a southern Urals oil and gas joint venture with Gazprom.

But selling Russian stories in to the capital markets is going to be more difficult, at least until the presidential election. The biggest deal to be put on hold envisaged Alfa Access Renova – which this year signed a $6 billion-plus merger of its oil company, TNK, with BP’s Russian assets – monetising some of the three $1.25 billion tranches of BP shares due to it for each of the next three years.

Among the alternatives discussed with investment bankers were a syndicated bank loan, or sale into the market of an instrument linked to the BP shares. A banker familiar with the plans said: “The hope a few months ago was to sell it to UK investors as a BP-related story. The contractual risk would have been negligible. The Yukos business has made that impossible.”

Whatever the market sentiment, long-term observers of Russia believe that while the Yukos affair has brought an over-bullish market sharply to its senses, that strong economic fundamentals and reform plans that are sound overall are the themes for 2004.

Willem Buiter, chief economist at the EBRD, said at a press conference last month [November]: “We didn’t go along with the euphoria that followed the Moody’s upgrade [of Russia to investment grade], and we also take a balanced view of the events around Yukos. The independence of the judiciary and of the media are defining characteristics of the rule of law, and have long been weak in Russia, and we are concerned as to whether the letter and spirit of the law will be applied even-handedly.”

From an investment viewpoint, Fenkner of Troika was similarly sanguine. “After the Moody’s announcement we heard people saying ‘buy, buy, buy’, and that was wrong. The market was overheating. We estimated the RTS index’s fair value at 547, and we are near that now.”

This article was first published in the Financial News supplement on Russia,
1 December 2003
; © 2003 Simon Pirani

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