Danger For Russia Comes From Within: The Siloviki

L to R: Igor Levitin, Vladimir Putin, Vladimir Yakunin,
and Sergei Ivanov--only one missing is Dmitry Medvedev

The can dress better than American leaders--or Canadian ones--but the men pictured above, who were instrumental in rescuing Russia from its downward spiral, may also end up killing Russia.

Among the top Russian bureaucrats and business leaders, more than one-quarter have their roots in the so-called power ministries of the government, of which the old KGB is first among equals, according to Olga Kryshtanovskaya, a sociologist who tracks Russian elites. These men are known collectively as the siloviki, from a Russian word for "force." "You could say they control the crown jewels of the Russian economy," says journalist Yevgenia Albats...

(source: How the KGB (and friends) took over Russia's economy, by Bill Powell, September 10, 2008. Fortune.)

Bill Powell has written an excellent feature piece for Fortune on the influence on the Russian economy from a clique of the FSB, which was formerly called KGB. I don't necessarily agree with everything--the action in Georgia, for example, is very minor in the grand scheme of things, except for some neoconservatives and expansionists in the US government--but the article is balanced and covers the current scenario quite well.


Clearly the Russian government has been clashing with private investors who them don't seem to agree with. Anyone following the mining company Mechtel (MTL) would be familiar with how the company is being pressured:

Putin overtly threatened Igor Zyuzin, the CEO of Mechel (MTL), a mining and metals giant, accusing him of price fixing in order to evade corporate taxes. When the billionaire Zyuzin failed to show up at a meeting with Russian authorities, saying he was ill, Putin told a group of steel executives in Nizhny Novgorod: "Illness is illness, but I think he should get well as soon as possible. Otherwise, we will have to send him a doctor and clean up all the problems."

There is no way a prime minister or president in Canada or America would say that. Yet here we have a direct threat, almost seemingly straight out of a spy handbook. The only hope is that Dmitry Medvedev is more of a "business type" and seems softer than the rest. The others, led by Putin, are clearly tough and ruthless.

A lot of outsiders--especially American politicians--never seem to have understood what happened in Russia. They also don't seem to grasp the fact that Putin and Medvedev enjoy immense popularity. Even if you could magically adjust for questionable ballots and propaganda strength of the state, Medvedev (and Putin before that) would have received more votes than a typical leader in Canada or America. I am not justifying a totalitarian like Vladimir Putin but it makes sense why he is cherished in Russia.

Russia was a total mess unlike any other in the late 90's. I vividly remember reading a story when I was a teen that talked about how women in Moscow were so scared of organized criminals or police who were infiltrated by criminals, that they stayed with "boyfriends" who they didn't even love. That is, they basically swapped sex for protection with people they didn't even like. It was ridiculous. There are poorer countries like China, India, Cambodia, and so forth, where something like that would be rare. Yet here we had it happening in a relatively large scale in Russia. I also remember quite a few stories of businessmen being executed seemingly at will.

You can see how the accidental autocrat, Vladimir Putin, can become popular in such a scenario (here is an excellent article from 2005 on Vladimir Putin from The Atlantic: Accidental Autocrat, by Paul Starobin, March 2005, The Atlantic.) A lot of people also don't realize that Russia implemented a lot of pro-free-market policies during Putin's regime. When it comes to big countries, Russia is one of the few successes in the world in implementing a flat tax--something favoured heavily by libertarians and many free-market proponents, although I'm like a typical leftist in preferring a progressive tax. Part of the reason it was easy to implement in Russia was because very few were paying their taxes before (most people were cheating on taxes.) So the flat tax actually increased tax revenues for the government.

However, as the article mentions, and is clear to everyone observing Russia, the government is encroaching into the private economy. This is going to end up in a disaster if it isn't reversed. Already it seems that some of the strategists who worked successfully with Putin have left under disillusion.

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.

In my eyes, the problem isn't really Putin. I don't agree with his policies and don't like him, but I simply view him as an accidental autocrat. In my opinion, he isn't evil like some in Canada and America claim. The real risk for Russia and the rest of the world, is what happens after Putin. Regardless of the tough actions by Putin, one can't claim he is extremely corrupt. He is "mostly clean" in my opinion: he hasn't looted the country like many autocrats do; and he hasn't allied himself with organized criminals (if anything, he basically destroyed them.) But do note that he is also the one who sent Mikhail Khodorkovsky to jail for seemingly bogus reasons (but I wonder if there is something about Khodorkovsky that we don't know.) I wonder about others who may be more corrupt. How about all those low level individuals? Those people are a huge question mark and I'm sure Russians are thinking about them.

Is Russia still a worthy investment destination? It's part of the famous BRIC grouping so it will likely play a big role for the foreseeable future. However, it is worth considering what Bill Bowder of Hermitage Capital--once the most successful foreign Russian fund--says:

"It was one thing, in the 1990s, to invest here - whether as a foreigner or as a Russian - when the stock market was trading at two times earnings," Browder says. "Despite the risks, it was pretty much a no-brainer." Now, however, the cost has gone up - the Russian market trades at about eight times earnings - and the risk hasn't diminished a whit. "They need to get a grip on this stuff, plain and simple, and, as Medvedev says he wants, implement the rule of law," says Browder.

I didn't know Russia was trading at a P/E of 2 in the 90's. It makes sense though. Its currency was collapsing, its government was defaulting on its soverign debt, organized criminals were running loose, and, commodities were hitting multi-decade lows. Well, who wanted to invest in a country like that?

I think Browder's comment about Russia's valuations being higher now without much change in property rights needs to be kept in mind. This is why I say that one needs to discount Russian stocks heavily to account for the political risk. You just never know when your company gets charged with two of the most dubious charges in any country: tax evasion or environmental violations.

If Putin is as smart as I think he is, it is quite possible that he picked Medvedev, a lawyer, to get a handle on the legal situation. The legal system is a total joke in Russia and if Medvedev wants to boost the economy, reforming that will produce greater long-term positive than anything else. The economy is humming along, and although it will slow down due to the slowing world economy, Russia should be able to manage it far better than India or China. India can easily face a inflationary bust, while China can face an inflationary bust or deflationary bust (the latter more likely IMO) whereas Russian inflation will come down if commodities drop. But since Russia is the 2nd largest oil exporter (or something like that), and since it is located close to Europe and Asia, there will be demand for its resources.