Protection Rackets

The NYTimes reports about Oleg Deripaska suing Vedomosti over disclosure of financial information. The key points:

Rusal, the world’s largest aluminum company, is closely held by wealthy Russian businessmen, including Oleg Deripaska, once Russia’s richest man. As a private company, few details of its business are public.

The company hopes to raise $2.5 billion in an initial public offering in Hong Kong that will be an important test of international investor interest in Russian equities.

A series of articles in the business newspaper Vedomosti at the end of October detailed Rusal’s dismal financial results for 2008 and included other facts about the company. The articles cited documents given to bankers at a conference closed to the public.

That scoop is evolving into a legal test for business publications in Russia, a country where the political press is already kept on a tight rein.

Something appears to be missing in this story. Why is Deripaska doing this? Clearly, this lawsuit threat can have nothing to do with RUSAL’s impending IPO. The information that Vedomosti published is already published! A lawsuit, even if successful, is not going to put that genie back in the bottle. Moreover, Deripaska’s hypersensitivity about this can only serve to heighten suspicions that RUSAL really does have something to hide. In short, threatening a lawsuit is not in Deripaska’s immediate interest at all. So why is he making the threat?


The answer is that Deripaska is acting here not primarily on his own behalf but on behalf of all the members of the small club of oligarchs in Russia who – like Deripaska - participate in Vladimir Putin’s “protection racket.” Clifford Gaddy and I are writing in detail about this scheme in our new book, Russia’s Addiction. Beginning in the year 2000, when he entered office as Russia’s president, Putin has had a deal with the most powerful business owners. In that deal, the oligarchs agreed to abide by a few clear rules about their behavior inside and outside Russia; in return, Putin guaranteed them not only protection against expropriation by the state but also, and even more important, protection against each other. To be able to deliver on that latter guarantee, Putin has since 1999 at the latest preserved a monopoly on damaging financial information about the oligarch-controlled companies. That is, he and only he (along with one or two key associates) possesses the information, and he protects it from any leaks. Financial information is the nuclear weapons of Russia’s thoroughly opaque corporate elite. When Putin took over, the oligarchs were on the verge of all-out and all-destructive war against one another using such information. He ended the era of proliferation and brinksmanship and enforced a peace that has lasted to this day.


But if Putin’s power over the oligarchs rests on a monopoly of financial information, what could be more threatening to him and his system than independent collection – and release – of financial information? If independent media seek out the goods on the oligarchs, Putin's authority is dissipated. Ending internecine warfare among the oligarchs was the key event in the formation of the protection racket. The main terrain on which that war had been fought was ... the "independent media." Independent in quotes because, of course, the oligarchs owned the media and used it as weapons against each other. That is how kompromat was disseminated prior to Putin's accession. Putin took the media over to insure the oligarchs against each other. Deripaska’s threat against Vedomosti is intended to send the message to the press today not to upset the system Putin established a decade ago.

Putin Makes Every Economists' Day

What unites economists in their frustration at politicians? No doubt, it is their fixation on domestic production over free trade. The Obama fiscal stimulus plan features "buy America" provisions. Nobody doubts the intelligence of Obama or the qualifications of his economic advisers, but these policies seem to be a fixture in so many countries.

It is thus refreshing, and certainly surprising, to hear Prime Minister Vladimir Putin arguing recently:

But if we speaking in general about the economy then there is no reason to engage in import substitution if we can buy things more cheaply abroad. Because if we always just try to play catch up, we will always be behind.

Why the difference? Is Putin smarter? Or are western politicians subject to more political pressures?

Last Days of the Oligarchs?

That is the title of this article in the New York Times. There seems to be this conventional wisdom that the oligarchs are finished in Russia. The basic point:

Once-invincible oligarchs now look extremely vulnerable. With or without state aid, the government is likely to gain more control of their operations. If they get no help, many could go into bankruptcy, with nationalization of one form or another likely to follow. And any new bailout would probably mean larger equity stakes for the government.

And here is an interesting snippet:

In the initial collapse of the Russian stock market from May to October last year, Bloomberg News has calculated, the richest 25 people on the Forbes magazine list for Russia lost a collective $230 billion. Some of those unable to win state bailouts put up planes, yachts and mansions on the Côte d’Azur as collateral for loans, said Oleg V. Vyugin, the director of MDM Bank.

But the article does not really focus on the question of what would replace the oligarchs. And this is a key point. Putin does not believe that the state can effectively run industry. He wants private owners who are beholden to him. (Cliff Gaddy and I have been talking about this in many places, see for example, this article in The National Interest, Putin's Third Way). He is much more likely to protect them and thus tie them even closer to him than let them go. If he got rid of the oligarchs he would have to create a new group of them anyway.

Putin I and Putin II

You hear a lot of discussion recently about Russia's new assertiveness (sometimes a different description is used!). And it is obvious that high oil prices have a lot to do with it. But this picture produced by my colleague Cliff Gaddy puts it neatly in perspective. He compares Russian government foreign debt with its foreign exchange reserves.

In the Putin I regime, Russian government debt was much larger than foreign reserves. In Putin II we have more than a complete reversal (though I should note that foreign debt of state-affiliated companies would add to government debt -- presumably if Rosneft cannot pay its Eurobonds the government will). In the Putin I regime the west had lots of leverage on Russia. Now that leverage is gone.

Protection Racket

Many people wonder why Putin is willing to engage in activities that seem inimical to Russia's economic interests. These comments tend to miss the point of what Putin cares about. Cliff Gaddy sends in this comment that has it exactly right:

People ask, Why would Putin allow this to happen? It is not in Russia’s or his own interest. Foreign investors will be discouraged, oil production will suffer, and so on. It doesn’t make sense.

Thinking in these terms confuses efficiency as seen from the economic point of view and what might be termed political efficiency. Putin does indeed desire economic efficiency, that is, continued production of resource rents. But his first priority is control of the use of those rents – political efficiency. And here, informal taxes have two big advantages for Putin. First, informal taxes can be collected and redistributed much more flexibly than formal taxes. He and his inner circle need to be able to channel resources to precisely the people and purposes they choose, when they choose. One might object that they can do that anyway with the budgetary flows (the formal taxes) at their disposal. But those flows are not nearly as flexible. Putin is very concerned about his ability to react flexibly to changing circumstances. He needs to call on key actors to channel resources quickly.

The second advantage of informal taxes is even more important. Informal taxation is a key component of the property rights protection racket – Putin’s mechanism for manipulating the behavior of the resource owners. The world of informal taxes is a world of quasi-legality at best. Keeping companies in that world gives Putin leverage. It is absolutely a good thing for Putin that companies engage to a controlled extent in various forms of illegal payments such as bribes, kickbacks, padded contracts, and the like. Precisely because the actions are illegal, they make the companies vulnerable to the tax authorities and the police. Paying informal taxes forces companies to violate laws. And that is the point. The evidence of their financial crimes is collected at the same time that their money or favors are collected. The individual chiefly responsible for this branch of “Russia, Inc.” is Putin’s no. 2, Viktor Zubkov. Since his days as founder of Putin’s Financial Monitoring Agency (a “financial intelligence service”, as Putin once described it), Zubkov has been the personal repository of information that can destroy any major company and any wealthy individual in Russia. He can see to it that real – not fake – charges are brought against anyone, at any time. This is the way the Protection Racket works. Informal taxation is at its heart.

In a ruling handed down by the United States Supreme Court in 1819 (“McCulloch v. Maryland”), Chief Justice John Marshall wrote the famous words that apply to any society: “The power to tax involves the power to destroy.” In today’s Russia, the discretionary power to informally tax is an equally potent instrument of destruction and, more important, of control.

TNK-BP Part Two

My previous entry discussed the basics of the TNK-BP affair and the opinions of the competing sides. AAR believes the joint venture is ill-run, BP thinks that AAR wants to force them out so they can sell the company to a third party (Gazprom?). Many observers think AAR is really acting on behalf of Putin so that the state can take over the company.

Here is my take. When the partnership was formed both sides brought valuable assets to the table. BP brought technology and marketing skills. The former allowed the company to recover oil economically than previously was considered too costly -- reserves were greatly enhanced. And the marketing skills helped with distribution. This was important because when the partnership was created oil prices were much lower and the cost of Russian oil is relatively high.

What did the AAR partners bring to the table? Of course the Tyumen Oil Company (TNK). But that is not all, or even the most important part -- they could have just sold the company to BP if that was what mattered. What AAR brought was relational capital. This is key asset for any company operating in Russia. It is the insurance that prevents expropriation and the trust that makes contracts operate (see here and here for a discussion of relational capital). AAR had high relational capital due to the investments of its leaders. BP could not buy this. It had to partner with them. The important point is that western companies cannot invest in relational capital because many of the payments are made informally, and adherence to even minimal international accounting standards prevents such payments.

Now return to 2008. Oil prices are much higher. So the profits of TNK-BP are much higher. So the payments the joint venture has to make to maintain its relational capital are higher. But only the Russian partners pay these insurance premiums. So the value of their contribution to the partnership is rising, while with higher oil prices the contribution of BP is less important. Moreover, as this article in the Financial Times discusses, oil services companies like Schlumberger make it easier to tap deposits without the expertise of the oil majors. The conditions have thus changed dramatically since the bargain was formed. Is is odd that AAR wants to revise the contract?

What about Putin? Let's think of this in the simplest way possible using the notion of resource rent distribution that Gaddy and I have outlined in our work (see here). At today's vastly higher oil prices, companies like TNK-BP earn more resource rent, and Putin wants Russia to get its share. Of course the budget is automatically getting more revenue from the oil sector as the oil price rises. But that is only the formal side of the story. Much of the payment of the rent takes place informally. We call this "informal taxation" - payments that range from the innocuous (social spending, philanthropy) to the outright illegal (bribes, kickbacks), with a large grey zone between (so-called "voluntary" contributions to politicians' off-budget funds, and so on). You could call it a "protection racket." As Cliff noted in this article:

Another term for what is going on is “protection racket.” In a protection racket, there is a threat against which someone offers to protect you. The catch is that the threat emanates from the protector himself. Here, the threat is the loss of property rights. Sharing rents locally is one way to pay the protection money. There is also a national version of the protection racket, designed primarily for the very largest companies...Companies are expected, for instance, to pursue certain policies in their foreign activity that further the geopolitical interests of the Russian state, even if they sometimes don’t quite make sense from a strict business perspective...In sum, companies...are expected to do three things: (1) pay their formal taxes; (2) pay their informal taxes (share locally); and (3) serve the foreign policy agenda and promote other strategic interests of the state. It is very important to recognize the informal rent sharing. This is the part of the iceberg that lies below the surface. That’s the part that is hidden, and the part that tends to be larger. It’s the part that can cause
shipwrecks.

Yukos and Mikhail Khodorkovsky were victims of the hidden iceberg. We have used this picture to illustrate the iceberg phenomenon and the distribution of the rent.


To the extent that TNK-BP adheres to international accounting standards, it is highly constrained in paying these kinds of informal taxes. And even if it were able and willing to compensate by paying more formal taxes, there are reasons why that would not be acceptable to Putin. The ability to collect and redistribute informal taxes is at the heart of Putin's system of management of "Russia, Inc." It is their opaqueness that is key. Thus, from Putin's standpoint, formal taxes are less efficient than informal taxes. So I would expect that he would not be displeased if AAR wins this battle.

Addendum: A Tyumen court just ruled against BP in a dispute over the Board of the joint holding.

Investors Know Who Runs Russia

An article in today's NYTimes notes the impact on the stock price of a Russian steel producer, Mechel, that was criticized by Prime Minister Putin. Putin gave a speech that was critical of the steel producer for charging higher domestic prices for steel than for its exports. The shares of Mechel are traded on the NYSE via American Depositary Receipts. The article notes that the market value of the companies shares which closed Wednesday at $36.61 in New York, tumbled $13.77 on Thursday to close at $22.84, wiping out $6 billion in value. Or, as the article notes, about $1.2 billion per sentence of Putin's speech.

What is interesting is that this points out that western investors believe that Putin is still in control in Russia. I have not checked what happened to the price of Mechel shares in Russia, but this belief is also widespread there of course.