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15 February 2016

Privatisation in Russia? Here’s why it won’t happen

Remembering the first wave of privatisation in the 1990s, when things fell apart.

By jana Bakunina

Earlier this month, Vladimir Putin met with the heads of Russia’s major state companies, including Aeroflot, diamond miner Alrosa and oil companies Rosneft and Bashneft, to discuss their potential privatisation.

Russia needs to plug a hole in its government coffers, unable to meet its 2016 budget, which was based on an average crude oil price of US$50 per barrel.

Russia’s economy is still heavily dependent on oil and gas revenues, which have dropped markedly with crude oil currently trading at around US$30 per barrel.

Economists predict another year of recession for Russia, and while the government is revising its budget and cutting public spending, the contemplated sale of state-owned assets may be the only way to raise a meaningful amount of cash. 

Business analysts began to speculate which Russian enterprises may attract most investors – with Alrosa, which accounts for about a quarter of the global diamond production, and Sovcomflot, a ship-building company which earns the majority of its revenues abroad, leading the pack.

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Financial papers published their estimates of how much the auctions may raise, with the views ranging from 500bn to 1trn roubles (£4.4bn–£8.8bn).

But some experts do not share their optimism. “Privatisation simply won’t happen,” claims Bill Browder, an investment banker turned political activist who is the founder of Hermitage Capital Management.

His argument is simple: “There are no buyers.”

Hermitage Capital Management was the largest foreign investor in Russia until 2005, and its founder took an active part in the first wave of privatisation in the 1990s.

Browder describes his experience, and the corruption he encountered, in his book Red Notice, which also includes the tragic story of Sergei Magnitsky – the Russian auditor murdered in custody – who was Browder’s lawyer.

It was Boris Yeltsin, Russia’s first president, who announced mass privatisation reforms. But his intention to “make Russians capitalists” drowned in corruption.

Russian citizens received so-called vouchers from the government, which were exchangeable for shares in state enterprises. In practice, these vouchers were sold for cash (or vodka) to ubiquitous profiteers and ended up in the hands of insiders. 

“At that time there were no laws to protect minority shareholders; the companies barely disclosed any financial information, and the entire system was flawed from the outset,” says Browder.

“Western investors had a 50/50 chance of losing everything or making windfall returns.”

Browder gives the example of being offered the shares of a Russian oil company in 1996 at a price 60 times lower than the share price of BP, which at the time controlled about the same amount of oil and gas as the company. 

Most privatised enterprises ended up in the hands of the few, giving rise to a new class: Russian oligarchs. Some of them used their wealth to buy political power; all of them continued to enrich themselves.

Browder’s fund bought small stakes (around 1 per cent.) in companies that were controlled by oligarchs. As an investor, Browder had access to the companies’ financials and says he found corruption on an “industrial scale” and “in every possible way”.

Some enterprises ignored the arm’s-length transfer pricing principle and sold commodities to legally related entities at giveaway prices. Asset stripping was another popular ruse.

When Putin became president in 2000, he appeared as a young, sombre technocrat on a mission to impose the rule of law and take the power away from the oligarchs.

When Browder began fighting corruption by exposing embezzlement, shareholder dilution and asset stripping by sending reports of his team’s analysis to the press, Putin too launched an attack on oligarchs.

The arrest of Mikhail Khodorkovsky (rumoured to be Russia’s richest man at the time) in October 2003 was a powerful message that was used by Putin to show oligarchs “who is the boss”.

In his book, Browder muses that after Khodorkovsky was shown sitting in a court cage on national television, all other oligarchs came kowtowing to Putin, who, in turn, began enriching himself by taking a cut in every deal from then onwards.

Browder claims that Putin owns some 50 per cent of all oligarchs’ wealth. In his estimate, Putin’s riches would amount to approximately US$200bn in last year’s money and $US100bn today. No longer a modest technocrat, Putin may well be the richest man in the world, according to Browder.

Putin’s alleged wealth is conditional upon him staying in power. His authority is in many ways derived from people’s support who like the image of a strong leader and feel grateful to their batyushka (little father) for restoring Russia’s political influence and improving social welfare.

However, both social services and foreign campaigns need funding. Foreign investors are extremely unlikely to be tempted by the Russian assets because of the privatisation practices of the 1990s, the current frosty political climate and sanctions, worsening economic conditions, and companies’ future prospects.

And potential Russian investors may prefer keeping their money in the safe havens of London football clubs, for example.

But it is possible that some of the oligarchs may be forced to invest in privatised enterprises under the banner of “de-offshorisation”.

Still, ordinary Russians won’t like the idea of privatisation, sorely remembering the 1990s as the decade when things fell apart. In their mind, strategic Russian enterprises need to be owned by the state, especially since the Western alternative of self-governing, efficient markets lost its invincibility.

Regardless of whether the government promises to retain controlling stakes in Aeroflot, Rosneft and Russian Railways, it is the symbolism of “selling off” that Putin cannot afford.