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KGB (pg. 2)

By Bill Powell, senior writer
Last Updated: September 10, 2008: 8:42 AM EDT

Hoping to calm nervous investors, the leaders of Russia Inc. have taken great pains to give their businesses a sheen of transparency and respectability. Two years ago Sechin and his CEO, Sergei Bogdanchikov, hired former Morgan Stanley banker Peter O'Brien to be Rosneft's CFO. Bogdanchikov runs the day-to-day business in Russia, and O'Brien presents a reassuring face to the West. Both ultimately answer to Sechin, who in turn answers to Putin.

But skeptics believe the buoyancy of the Russian economy, and a corporate sector in which key assets are increasingly controlled by the state, can't last. "These guys are running around now acting as if they're geniuses," says a senior executive at a foreign subsidiary based in Moscow, "because the Chinese and Indians are getting rich and driving up demand for everything. Talk about being born on third base and thinking you hit a triple."

A cautionary example is the oil and gas sector, the main beneficiary of the sharp rise in prices over the past three years - and a key sector in which the state has reasserted control. Production, analysts note, may actually decline this year as a result of flagging investment. In response, Russia cut corporate taxes in the oil and gas sector this past spring, but it's not clear that it will be enough to revive what should be a booming industry. A former Yukos executive who did not want to be identified says the problem is soaring costs and aging fields - both of which require "the industry's best technology and management to rectify. Unfortunately, they're doing their level best to drive that out of Russia. Look at Yukos. Look at TNK-BP now."


* * *

The philosophical glue that holds together many of the siloviki, the former spooks now running Russia, is that they despised the myriad changes in their homeland during Boris Yeltsin's presidency. They believed the dissolution of the Soviet Union was a humiliation, and the chaos, crime, and corruption that erupted in the decade that followed were a disaster. And the thing about it is, they are not entirely wrong.

I was here back then, as a foreign correspondent during Yeltsin's second term, from 1996 to 2000. Putin and his cronies are surely misguided in their nostalgia for the Soviet Union and the Cold War rivalry with the West. But the second part of the indictment of post-Soviet Russia - the economic chaos, the crime, and the corruption that the guys now in charge dwell on when they speak of those years - well, they're right about that. What happened to average Russians in that period was often deplorable. Virtually anyone who worked for the state, including teachers and military officers, would go for months without being paid because the government was broke, literally defaulting on its sovereign debt in 1998. I once traveled to Kamchatka, in the Russian Far East, to interview the family of a young military officer who had killed himself because he could not afford to throw his wife a birthday party. The government hadn't been paying his unit's salaries.

Last spring, sitting at a table in a large receiving room in the headquarters of the Russian national rail system, I told its current CEO, Vladimir Yakunin, one of Putin's closest friends, that foreign correspondents in Moscow used to have a saying about Russia in the late 1990s: The turmoil "was good for journalism - but bad for Russia." He perked up instantly. He looked at me and said in his fluent English (from his six years in New York City, ostensibly as a diplomat): "You were right." Unprompted, he then brought up an infamous incident from 1994, when Yeltsin visited Berlin for a ceremony to accompany the withdrawal of Russian troops. To men like Yakunin, the fact that the troops were leaving - in effect, in defeat - was bad enough. Yeltsin then added insult to injury when, plainly tipsy after a long lunch, he started playfully conducting a German military band that was playing outside the home of the German President. Even today, the memory makes Yakunin seethe. "Embarrassing," he snaps.

It's a revealing moment. For the board members of Russia Inc .- men like Yakunin, Sechin, and Sergey Chemezov, who runs Russia's $6.2-billion-a-year weapons-export monopoly - strong feelings about the past are guiding their vision of Russia's future. They're not naive enough to believe the entire Soviet Union can be restored. Indeed, they are not naive at all. But like Yakunin, they are almost all nationalists - fiercely so. And as such, their first instinct is to expand still further the role of Mother Russia in the national economy. Yakunin gets particularly animated when talking about how he has insisted that the foreign companies that want to sell railcars to Russia must now manufacture locally. And what has the international reaction been to that? "Our foreign partners have been very enthusiastic," he says, beaming. An executive of one foreign supplier to Russian Railways acknowledges that he has productivity and quality concerns with moving manufacturing into Russia. "But at the end of the day, we'll do it if we have to," the executive says. "The market is promising to us."

***

Vladimir Putin inherited a Russia in utter disarray. The nation had defaulted on its sovereign debt and devalued the ruble, and was having trouble paying hundreds of thousands of state employees. Putin implemented a budget discipline that simply didn't exist under Yeltsin - thanks in part to a team of advisors who were not former intelligence agents but trained economists. He even included some fiscal liberals like Finance Minister Alexei Kudrin. One advisor, Andrei Illarionov, who was Putin's senior economic advisor in the Kremlin as well as his personal representative to the G-8, had impeccable free-market credentials, and he and Kudrin put the country's economic policy on a firm footing. They implemented a 13% flat-tax rate and created a national stabilization fund, drawn from taxes on oil and gas sales, that now amounts to $157 billion.

But some of those same advisors are frustrated that they've stabilized Russia's finances so the government could then grab control of swaths of the economy. Illarionov left the Putin administration in late 2005 because of what he saw coming: a state with an appetite that went beyond simple control of key assets, like oil and gas and diamonds and copper; a state that, if it didn't like what the owner of a business was doing, would push that owner aside. Last year he publicly lamented a growing "climate of fear" in Russia.

Bill Browder, who co-founded Hermitage Capital in 1996 with the late billionaire banker Edmond Safra, would be the first to acknowledge he made a fortune in Russia. While running Hermitage, he became a tenacious promoter of minority shareholder rights in the new Russia, fighting famously fierce battles at Gazprom and UES, Russia's largest electric utility. "I was persistent, but I think other minority investors, foreign or Russian, believed I was a constructive force," he said. Yet Browder evidently made some high-powered enemies as well. He has not been able to get back into the country since his visa was revoked in late 2005, but that was to become the least of his worries. In early 2007 an officer of the Interior Ministry called Hermitage's office in Moscow and - according to transcripts of the conversation provided by Hermitage, which taped the call - hinted that Browder's visa issue might be resolved "depending on how you behave [and] what you provide." Hermitage officials believe this was an effort to elicit a bribe from them. They declined. (The Moscow office of the Russian Interior Ministry declined to comment for this article.) Four months later, a 25-man team from the Interior Ministry raided Hermitage's Moscow office, seeking, the chief investigator said, tax documents related to one of Hermitage Capital's clients. The same day, a unit showed up at the Moscow office of Hermitage's law firm, Firestone Duncan, seeking similar documents. When one of the attorneys objected, witnesses say, he was escorted to a conference room and beaten.

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