Book: Russian Roulette

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Financial Services

An expatriate relocation Web site, settler-international.com, has this
to say about Russian banks: "Do not open a bank account in a Russian
bank : you might not see your deposit again." Russia's Central Bank,
aware of the dismal lack of professionalism, the venality, and the
criminal predilections of Russian "bankers" (and their Western
accomplices) - is offering "complementary vocational training" in the
framework of its Banking School. It is somewhat ironic that the
institution suspected of abusing billions of US dollars in IMF funds by
"parking" them in obscure off-shore havens - seeks to better the
corrupt banking system in Russia.

I. The Banks

On paper, Russia has more than 1,300 banks. Yet, with the exception of
the 20-odd (two new ones were added last year) state-owned (and,
implicitly, state-guaranteed) outfits - e.g., the mammoth Sberbank (the
savings bank, 61% owned by the Central Bank) - very few provide minimal
services, such as corporate finance and retail banking. The surviving
part of the private banking sector ("Alfa Bank", "MDM Bank") is
composed of dwarfish entities with limited offerings. They are unable
to compete with the statal behemoths in a market tilted in the latters'
favor by both regulation and habit.

The Agency for the Reconstruction of Credit Organizations (ARCO) -
established after the seismic shock of 1998 - did little to restructure
the sector and did nothing to prevent asset stripping. More than one
third of the banks are insolvent - but were never bankrupted. The
presence of a few foreign banks and the emergence of non-bank financing
(e.g., insurance) are rays of hope in an otherwise soporific scene.

Despite the fact that most medium and large corporations in Russia own
licensed "banks" (really, outsourced treasury operations) - more than
90% of corporate finance in 2000-2001 was in the form of equity
finance, corporate bonds, and (mainly) reinvested retained earnings.
Some corporate bond issues are as large as $100 million (with 18-months
maturity) and the corporate bond market may quintuple to $10 billion in
a year or two, reports "The Economist", quoting Renaissance Capital, a
Russian investment bank.

Still, that bank credits are not available to small and medium
enterprises retards growth, as Stanley Fischer pointed out in his
speech to the Higher School of Economics in Moscow, in June 2001, when
he was still the First Deputy Managing Director of the IMF. Last week,
the OECD warned Russia that its economic growth may suffer without
reforms to the banking sector.

Russian banks are undercapitalized and poorly audited. Most of them are
exposed to one or two major borrowers, sectors, or commodities. Margins
have declined (though to a still high by Western standards 14%). Costs
have increased. The vast majority of these fledglings have less than $1
million in capital. This is because shareholders (and, for that matter,
depositors) - having been fleeced in the 1998 meltdown - are leery of
throwing good money after very bad. The golden opportunity to
consolidate and rationalize following the 1998 crisis was clearly
missed.

The government's (frail) attempts to reform the sector by overhauling
bank supervision and by passing laws which deal with anti-money
laundering, deposit insurance, minimum capital and bankruptcy
regulations, and mandatory risk evaluation models - did little to erase
the memory of its collusion in the all-pervasive, massive, and
suspiciously orchestrated defaults of 1998-1999. Russia is notoriously
strong on legislation and short on its enforcement.

Moreover, the opaque, overly-bureaucratic, and oligarch-friendly
Central Bank is at loggerheads with would be reformers and gets its way
more often than not. It supports a minimum capital requirement of less
than $5 million. Government sources have gone as high as $200 million.
The government retaliates with thinly-veiled threats in the form of
inane proposals to replace the Bank with newly-created "independent"
institutions.

Viktor Gerashchenko - the current, old-school, Governor - is set to
leave on September 2002. He will likely be replaced by someone more
Kremlin-friendly. As long as the Kreml is the bastion of reform, these
are good news. But a weak Central Bank will remove one of the last
checks and balances in Russia. Moreover, a hasty process of
consolidation coupled with draconian regulation may decimate private
sector Russian banking for good. This, perhaps, is what the Kremlin
wants. After all, he who controls the purse strings - rules Russia.

II. The Stock Exchange

The theory of financial markets calls for robust capital markets where
banks are lacking and dysfunctional. Equity financing and corporate
debt outstrip bank lending as sources of corporate finance even in the
West.

But Russia's stock market - the worst performer among emerging markets
in 1998, the best one in 2001 - is often cornered and manipulated, prey
to insider trading and worse. It is less liquid that the Tel-Aviv Stock
Exchange, though the market capitalization of RTS, Russia's main
marketplace, is up 430% since 1998 (80% last year alone). Bonds climbed
500% in the same period and a flourishing corporate bonds markets has
erupted on the scene. Many regard this surge as a speculative bubble
inflated by the high level of oil prices.

Others (mostly Western brokerage houses) swear that the market is
undervalued, having fallen by more than 90% in 1998. Russia is
different - they say - it is better managed, sports budget and trade
surpluses, is less indebted (and re-pays its debts on time, for a
change), and the economy is expanding. The same pundits talked the RTS
up 180% in 1997 only to see it shrivel in an egregious case of Asian
contagion. The connection between Russia's macro and micro is less than
straightforward.

Whatever the truth, investors are clearly more discriminating. Both the
New York Times and The Economist cite the example of Yukos Oil (up
190%) versus Lukoil (up a mere 30%). The former is investor friendly
and publishes internationally audited accounts. The latter has no
investor relations to speak of and is disclosure-averse. Still, both
firms - as do a few pioneering others - seek to access Western capital
markets.

The intrepid investor can partake by purchasing mutual funds dedicated,
wholly or partially, to Russia - or by trading ADR's of Russian firms
on NYSE (10-20 times the US dollar volume of the RTS). ADR's of smaller
firms are traded OTC and, according to the New York Times, one can
short sell Russian securities through offshore vehicles. The latter are
also used to speculate in the shares of defunct Russian firms
("shells") traded in the West.

III. Debt Markets

Perhaps the best judges of Russia's officially minuscule economy
(smaller than the Netherlands' and less than three times Israel's) -
are the Russians. When the author of this article suggested that
Russia's 1998 chaos was serendipitous (in "Argumenti i Fakti" dated
October 28, 1998), he was derided by Western analysts but supported by
Russian ones. In hindsight, the Russians were right. They may be right
today as well when they claim that Russia has never been better.

The ruble devaluation (which made Russian goods competitive) and rising
oil prices yielded a trade surplus of more than $50 billion last year.
For the first time in its modern and turbulent history, Russia was able
to prepay both foreign (IMF) and domestic debts (it redeemed state
bonds ahead of maturity). It is no longer the IMF's largest debtor. Its
Central Bank boasts $40 billion in foreign exchange reserves. Exactly
a year ago, Russia tried to extort a partial debt write-off from its
creditors (as it has done numerous times in its post-Communist decade).
But Russia's oft-abused creditors and investors seem to have
surprisingly short memories and an unsurpassed capacity for masochistic
self-delusion.

Stratfor.com reports ("Russia Buys Financial Maneuverability" dated
January 31, 2002) that "Deutsche Bank Jan. 30 granted Vneshekonombank a
$100 million loan, the largest private loan to a Russian bank since the
1998 ruble crisis. As Russia works to reintegrate into the global
financial network, the cost of domestic borrowing should drop.

That should spur a fresh wave of domestically financed development,
which is essential considering Russia's dearth of foreign investment."

The strategic forecasting firm also predicts the emergence of a
thriving mortgage finance market (there is almost none now). One of the
reasons is a belated November 2001 pension reform which allows the
investment of retirement funds in debt instruments - such as mortgages.
A similar virtuous cycle transpired in Kazakhstan. Last year the
Central Bank allowed individuals to invest up to $75,000 outside Russia.

IV. The Bandits

In August 1999, a year and four days after Moscow's $40 billion
default, the New York Times reported a $15 billion money laundering
operation which involved, inter alia, the Bank of New York and Russia's
first Representative to the IMF.

The Russian Central Bank invested billions of dollars (through an
offshore entity) in the infamous Russian GKO (dollar-denominated bonds)
market, thus helping to drive yields to a vertiginous 290%.

Staff members and collaborators of the now dismantled brainchild of
Prof. Jeffrey Sachs, HIID (Harvard Institute of International
Development) - the architect of Russian "privatization" - were caught
in potentially criminal conflicts of interest.

Are we to believe that such gargantuan transgressions have been
transformed into new-found market discipline and virtuous dealings?

Putin doesn't. Last year, riding the tidal wave of the fight against
terror, he formed the Financial Monitoring Committee (KFM). Ostensibly,
its role is to fight money laundering and other financial crimes, aided
by brand new laws and a small army of trained and tenacious accountants
under the aegis of the Ministry of Finance.

Really, it is intended to circumvent irredeemably compromised extant
structures in the Ministry of Interior and the FSB and to stem capital
flight (if possible, by reversing the annual hemorrhage of $15-20
billion). Non-cooperative banks may lose their licenses. Banks have
been transferring 5 daily Mb of encoded reports regarding suspicious
financial dealings (and all transactions above 600,000 rubles - equal
to $20,000) since February 1 - when the KFM opened for business. So
much for Russian bank secrecy ("Did we really have it?" - mused
President Putin a few weeks ago).

Last month, Mikhail Fradkov, the Federal Tax Police Chief confirmed to
Interfax the financial sector's continued involvement in bleeding
Russia white: "...fly-by-night firms usually play a key role in illegal
money transfers abroad. Fradkov recalled that 20 Moscow banks inspected
by the tax police alone transferred about $5 billion abroad through
such firms." ITAR-TASS, the Russian news agency, reports a drop of 60%
in the cash flow of Russian banks since anti-money laundering measures
took effect, a fortnight ago.

V. The Foreign Exchange Market

Russians, the skeptics that they are, still keep most of their savings
(c. $40-50 billion) in foreign exchange (predominantly US dollars),
stuffed in mattresses and other exotic places. Prices are often quoted
in dollars and ATM's spew forth both dollars and rubles. This
predilection for the greenback was aided greatly by the Central Bank's
panicky advice (reported by Moscow Times) to ditch all European
currencies prior to January 1, 2002. The result is a cautious and
hitherto minor diversification to euros. Banks are reporting increased
demand for the new currency - a multiple of the demand for all former
European currencies combined. But this is still a drop in the dollar
ocean.

The exchange rate is determined by the Central Bank - by far the
decisive player in the thin and illiquid market. Lately, it has opted
for a creeping devaluation of the ruble, in line with inflation.
Foreign exchange is traded in eight exchanges across Russia but many
exporters sell their export earnings directly to the Central Bank.
Permits are required for all major foreign exchange transactions,
including currency repatriation by foreign firms. Currency risk is
absolute as a 1998 court ruling rendered ruble forwards contracts
useless ("unenforceable bets").

VI. The International Financial Institutions (IFI's)

Of the World Bank's $12 billion allocated to 51 projects in Russia
since 1992, only $0.6 billion went to the financial sector (compared to
8 times as much wasted on "Economic Planning").

Its private sector arm, the International Finance Corporation (IFC)
refrained from lending to or investing in the financial sector from
March 1999 to June 2001. It has approved (or is considering) six
projects since then: a loan of $20 million to DeltaCredit, a smallish
project and residential finance, USAID backed, fund; a Russian
pre-export financing facility (with the German bank, WestLB); Two
million US dollars each to the Russian-owned Baltiskii Leasing and
Center Invest (a regional bank); $2.5 million to another regional bank
(NBD) - and a partial guarantee for a $15 million bond issued by
Russian Standard Bank. There is also $5 million loan to Probusiness
Bank.

Another active player is the EBRD. Having suffered a humiliating
deterioration in the quality of its Russian assets portfolio in
1998-2000, it is active there again. By midyear last year, it had
invested c. $300 million and lent another $700 million to Russian
banks, equity and mutual funds, insurance companies, and pension funds.
This amounts to almost 30% of its total involvement in the Russian
Federation. Judging by this commitment, the EBRD - a bank - seems to be
regarding the Russian financial system as either an extremely
attractive investment - or a menace to Russia's future stability.

VII. So, What's Next?

No modern country, however self-deluded and backward, can survive
without a banking system. The Central Bank's pernicious and
overwhelming presence virtually guarantees a repeat of 1998. Russia -
like Japan - is living on time borrowed against its oil collateral.

Should oil prices wither - what remains of the banking system may
collapse, Russian securities will be dumped, Russian debts "deferred".
The Central Bank may emerge either more strengthened by the devastation
- or weakened to the point of actual reform.

In the eventuality of a confluence between this financial Armageddon
and Russia's entry to the WTO - the crisis is bound to become more
ominous. Russia is on the verge of opening itself to real competition
from the West - including (perhaps especially so) in the financial
sector. It is revamping its law books - but does not have the
administrative mechanism it takes to implement them. It has a rich
tradition of obstructionism, venality, political interference, and
patronage.

Foreign competition is the equivalent of an economic crisis in a
country like Russia. Should this be coupled with domestic financial
mayhem - Russia may be transformed to the worse. Expect interesting
times ahead.

The Russian Devolution

The Regions

Russia's history is a chaotic battle between centrifugal and
centripetal forces - between its 50 oblasts (regions), 2 cities (Moscow
and St. Petersburg), 6 krais (territories), 21 republics, and 10 okrugs
(departments) - and the often cash-strapped and graft-ridden
paternalistic center. The vast land mass that is the Russian Federation
(constituted officially in 1993) is a patchwork of fictitious homelands
(the Jewish oblast), rebellious republics (Chechnya), and disaffected
districts - all intermittently connected with decrepit lines of
transport and communications.

The republics - national homelands to Russia's numerous minorities -
have their own constitutions and elected presidents (since 1991).
Oblasts and krais are run by elected governors (a novelty - governors
have been appointed by Yeltsin until 1997). They are patchy fiefdoms
composed of autonomous okrugs. "The Economist" observes that the okrugs
(often populated with members of an ethnic minority) are either very
rich (e.g., Yamal-Nenets in Tyumen, with 53% of Russia's oil reserves)
- or very poor and, thus, dependent on Federal handouts.

In Russia it is often "Moscow proposes - but the governor disposes" -
but decades of central planning and industrial policy encouraged
capital accumulation is some regions while ignoring others, thus
irreversibly eroding any sense of residual solidarity. In an IMF
working paper ("Regional Disparities and Transfer Policies in Russia"
by Dabla-Norris and Weber), the authors note that the ten wealthiest
regions produce more than 40% of Russia's GDP (and contribute more than
50% of its tax revenues) - thus heavily subsidizing their poorer
brethren. Output contracted by 90% in some regions - and only by 15% in
others. Moscow receives more than 20% of all federal funds - with less
than 7% of the population. In the Tuva republic - three quarters of the
denizens are poor - compared to less than one fifth in Moscow. Moscow
lavishes on each of its residents 30 times the amount per capita spent
by the poorest region.

Nadezhda Bikalova of the IMF notes ("Intergovernmental Fiscal Relations
in Russia") that when the USSR imploded, the ratio of budgetary income
per person between the richest and the poorest region was 11.6. It has
since climbed to 30. All the regions were put in charge of implementing
social policies as early as 1994 - but only a few (the net "donors" to
the federal budget, or food exporters to other regions) were granted
taxing privileges.

As Kathryn Stoner-Weiss has observed in her book, "Local Heroes: The
Political Economy of Russian Regional Governance", not all regions
performed equally well (or equally dismally) during the transition from
communism to (rabid) capitalism. Political figures in the (relatively)
prosperous Nizhny-Novgorod and Tyumen regions emphasized stability and
consensus (i.e., centralization and co-operation). Both the economic
resources and the political levers in prosperous regions are in the
hands of a few businessmen and "their" politicians. In some regions,
the movers and shakers are oligarch-tycoons - but in others,
businessmen formed enterprise associations, akin to special interest
lobbying groups in the West.

Inevitably such incestuous relationships promotes corruption, imposes
conformity, inhibits market mechanisms, and fosters detachment from the
centre. But they also prevent internecine fighting and open,
economically devastating, investor-deterring, conflicts. Economic
policy in such parts of Russia tend to be coherent and efficiently
implemented. Such business-political complexes reached their apex in
1992-1998 in Moscow (ranked #1 in creditworthiness), Samara, Tyumen,
Sverdlovsk, Tatarstan, Perm, Nizhny-Novgorod, Irkutsk, Krasnoyarsk, and
St. Petersburg (Putin's lair). As a result, by early 1997, Moscow
attracted over 50% of all FDI and domestic investment and St.
Petersburg - another 10%.

These growing economic disparities between the regions almost tore
Russia asunder. A clunky and venal tax administration impoverished the
Kremlin and reduced its influence (i.e., powers of patronage)
commensurately. Regional authorities throughout the vast Federation
attracted their own investors, passed their own laws (often in defiance
of legislation by the centre), appointed their own officials, levied
their own taxes (only a fraction of which reached Moscow), and provided
or withheld their own public services (roads, security, housing,
heating, healthcare, schools, and public transport).

Yeltsin's reliance on local political bosses for his 1996 re-election
only exacerbated this trend. He lost his right to appoint governors in
1997 - and with it the last vestiges of ostensible central authority.
In a humiliating - and well-publicized defeat - Yeltsin failed to sack
the spectacularly sleazy and incompetent governor of Primorsky krai,
Yevgeni Nazdratenko (later "persuaded" by Putin to resign his position
and chair the State Fisheries Committee instead).

The regions took advantage of Yeltsin's frail condition to extract
economic concessions: a bigger share of the tax pie, the right to
purchase a portion of the raw materials mined in the region at "cost"
(Sakha), the right to borrow independently (though the issuance of
promissory notes was banned in 1997) and to spend "off-budget" - and
even the right to issue Eurobonds (there were three such issues in
1997). Many regions cut red tape, introduced transparent bookkeeping,
lured foreign investors with tax breaks, and liberalized land
ownership.

Bikalova (IMF) identifies three major problems in the fiscal
relationship between centre and regions in the Yeltsin era:

"(1) the absence of an objective normative basis for allocating budget
revenues, (2) the lack of interest shown by local and regional
governments in developing their own revenues and cutting their
expenditures, and (3) the federal government's practice of making
transfer payments to federation members without taking account of the
other state subsidies and grants they receive."

Then came Russia's financial meltdown in August 1998, followed by
Putin's disorientating ascendance. A redistribution of power in
Moscow's favor seemed imminent. But it was not to be.

The recommendations of a committee, composed of representatives of the
government, the Federation Council, and the Duma, were incorporated in
a series of laws and in the 1999 budget, which re-defined the fiscal
give and take between regions and centre.

Federal taxes include the enterprise profit tax, the value-added tax
(VAT), excise, the personal income tax (all of it returned to the
regions), the minerals extraction tax, customs and duties, and other
"contributions" . This legislation was further augmented in April-May
2001 (by the "Federalism Development Program 2001-2005").

The regions are allowed to tax the property of organizations, sales,
real estate, roads, transportation, and gambling enterprises, and
regional license fees (all tax rates are set by the center, though).
Municipal taxes include the land tax, individual property, inheritance,
and gift taxes, advertising tax, and license fees.

The IMF notes that "more than 90 percent of sub-national revenues come
from federal tax sharing. Revenues actually raised by regional and
local governments account for less than 15 percent of their
expenditures". The federal government has also signed more than 200
special economic "contracts" with the richer, donor and exporting,
regions - this despite the constitutional objections of the Ministry of
Justice. This discriminating practice is now being phased out. But it
has not been replaced by any prioritized economic policies and
preferences on the federal level, as the OECD has noted.

One of Putin's first acts was to submit a package of laws to the State
Duma in May 2000. The crux of the proposed legislation was to endow the
President with the power to sack regional elected officials at will.
The alarmed governors forgot their petty squabbles and in a rare show
of self-interested unity fenced the bill with restrictions. The
President can fire a governor, said the final version, only if a court
rules that the latter failed to incorporate federal legislation in
regional laws, or if charged with serious criminal offenses. The
wholesale dismissal of regional legislatures requires the approval of
the State Duma. Some republics insist that even these truncated powers
are excessive and Russia's Constitutional Court is currently weighing
their arguments.

Putin then resorted to another stratagem. He established, two years
ago, by decree, a bureaucratic layer between centre and regions: seven
administrative mega-regions whose role is to make sure that federal
laws are both adopted and enforced at the local level. The presidential
envoys report back to the Kremlin but, otherwise, are fairly harmless -
and useless. They did succeed, however, in forcing local elections upon
the likes of Ingushetiya - and to organize all federal workers in
regional federal collegiums, subordinated to the Kremlin.

The war in Chechnya was meant to be another unequivocal message that
cessation is not an option, that there are limits to regional autonomy,
and that the center - as authoritative as ever - is back. It, too,
flopped painfully when Chechnya evolved into a second - internal -
Afghani quagmire.

Having failed thrice, Putin is lately leaning in favor of restoring and
even increasing the Federation Council's erstwhile powers at the
expense of the (incensed) Duma. Governors have sensed the changing
winds and have acted to trample over democratic institutions in their
regions. Thus, the Governor of Orenburg has abolished the direct
elections of mayors in his oblast. Russia's big business is moving in
as well in an attempt to elect its own mayors (for instance, in
Irkutsk).

Regional finances are in bad shape. Only 40 out 89 regions managed, by
February, to pay their civil servants their December 2001 salaries
(raised 89% - or 1.5% of GDP - by the benevolent president). Many
regions had to go deeper into deficit to do so. Salaries make three
quarters of regional budgets.

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