Russia, Ukraine, and all that

Cliff Gaddy and I have posted several pieces on the Ukraine crisis on the Brookings Website.

One article is entitled Ukraine: A Prize Neither Russia Nor the West Can Afford to Win. This post discusses the integration of the Russian and Ukrainian economies.

The second article is entitled "Can Sanctions Stop Putin?" The subject is obvious, and the answer is no. We discuss the difference between the impact of sanctions -- how much pain is induced -- and the effectiveness of sanctions.

A third one will be posted soon.

Who Wins in the Russia-China Gas Deal? All of Us!

The 30-year, $400 billion natural gas deal just agreed to by China and Russia has evoked much commentary. Most of it, however, tries to parse the implications for U.S. foreign policy and geopolitics in general. This leads to much confusion. One day, for instance, ForeignPolicy.com posts an article about “The Deal That Wasn’t” (writing that failure to clinch a deal on the first day of Putin’s visit to China was “a shock, a blow to Putin's objectives, and a reminder of how much China has the upper hand when it comes to gas deals with [Russia]”) and then a day later, “Gas Deal Could Complicate Sanctions Threat Against Russia” (the deal—which, of course, was clinched—was an “important win [for Putin] in his ongoing standoff with the Obama administration and its European allies”).

One day, China is not ready to play ball, the next day China is saving Russia from international sanctions, even though the deal will not start to deliver gas to China for several years.

While everyone tries to figure out who won, there is, however, a much more basic dimension to this agreement—energy security—that makes it beneficial to all of us. Consider that the gas Russia will deliver to China will come from two rather undeveloped fields in eastern Siberia, and that the deal will build new infrastructure for delivery. Then notice that Russia will deliver to China an amount of natural gas equivalent to the annual consumption of the state of New York. This means that China’s demand for gas will be met by new energy supplies. This must be good for everybody. It is not a shift of supply by Russia from Europe to China. It is a net new addition to world natural gas supplies made possible by the investment in infrastructure to deliver from geographically isolated fields.

China is happy that Russia will deliver from fields that are dedicated to them. Russia is happy that it is developing the new fields and has a paying customer to deliver it to. But everyone else should be happy that this means there are 1.4 trillion cubic feet of natural gas available to the rest of the world. This is energy security.

Sachs, Building Booms and Reforms

Jeff Sachs comments on the reforms in Poland and Russia in Scientific American. He writes of the contrast between Warsaw and St. Petersburg.

Warsaw has enjoyed a building boom, with impressive new business towers going up despite the economic slowdown in western Europe. St. Petersburg glories in the architectural treasures of the past but with much less evidence of current dynamism.

This is because Poland has had successful reforms and Russia has not:

In Russia, on the other hand, corruption has run rampant during the past 20 years, and the public shows little capacity to rein it in. The institutions of civil society, suppressed by centuries of tsarism and obliterated by Soviet-era state brutality, remain weak. Because the constraints on corruption were so toothless, vast state wealth—especially oil, gas and mineral wealth—was transferred in the mid-1990s into private hands, creating the so-called oligarchs of the new Russia. A few years later powerful bureaucrats wrested back control of many of these assets. The rise and fall of the oligarchs was murky, without the transparency needed for a healthy market economy. Russia, not surprisingly, lands at a dismal 146th on the Transparency International corruption list.

But the comparison is contrived. As anyone who has visited Moscow in the last ten years knows, it has experienced a tremendous building boom. Indeed, all one reads about in Moscow is how building is trampling on its architectural heritage. There are skyscrapers and apartment buildings everywhere. Outside the home of the New Economic School in Moscow we are surrounded by huge apartment blocks, obscuring what used to be great views of southwestern Moscow.

So if Sachs had visited Moscow would he have written that corruption has no effect on economic performance? Of course there are reasons why Moscow benefits more than St. Petersburg, primarily because it is the capital and business wants to be close to officials. Is this also the explanation for Warsaw? I do not know enough to answer. But it is an odd comparison.

Russian Court Shopping

The New York Times today reports on the dispute between Telenor, a Norwegian cell phone provider and Alfa Group, the powerful Russian investment group. They are partners in the cell phone provider VimpelCom. The dispute arises, apparently, from a dispute over strategy:

The Siberian litigation blossomed from a simple dispute between Telenor and the Alfa Group, a Russian financial investment company, over plans to expand a jointly owned business, the VimpelCom cellphone company, into Ukraine. The companies are also in court in Manhattan, Geneva and Ukraine.

That a dispute over whether to invest in a Ukrainian provider ends up in an Omsk court is interesting enough. What is more interesting is that the suit was brought by an unknown tiny investor in the British Virgin Islands that owns .002 of the shares in VimpelCom. And that a dispute over a bacon producer may have entered into the final court decision.

This is certainly a case where expert use of the courts may lead to western shareholder expropriation, not new in Russia. The interesting question is whether it will lead to a strike of foreign investors regarding Russia. Is it another Lena Goldfields (see previous post)? My guess is that the impact will be minimal, especially regarding potential investments in oil and gas. But we shall see.

The Missing Quadrant

The Obama administration has been talking about pushing the reset button on our relations with Russia. This partly reflects shock at how Russia has acted recently, and a belief that we can somehow go back to a golden age of relations in the Clinton-Yeltsin era. This is, of course, a myth. To understand why, Cliff Gaddy and I wrote a short note on this that focuses on the missing quadrant. It explains why westerners -- especially US policymakers -- seem to be caught so off guard.

To read "The Missing Quadrant" click here.

Crisis Deepens

Two signs that the crisis is deepening worldwide. From Russia we see that industrial production fell in January at an annual rate of 16%. Russia is of course suffering from the collapse of the world economy, oil prices declining, and the outflow of capital from its thin financial system. Moreover, since its prosperity had bubble-like features, it is not surprising that its collapse looks so severe.

Meanwhile, Japan's GDP fell by 12.7% in the last quarter, the worst fall since the first oil shock in 1974. See the pictures here. Japan is suffering from the collapse in demand for its exports, and the unwinding of the carry trade which had kept its currency undervalued. Edward Hugh argues that the aging of Japan's population makes them especially vulnerable to declines in export demand since consumption growth is restrained.

And I was already depressed by the "Buy America" features of the stimulus bill. We live in an interdependent world, and such policies are only going to make things worse.

Whose Interests Are They?

Today's NYTimes has an editorial about Mr. Obama and Russia. The article is quite remarkable. Their suggestion for starting a new relationship with Russia is for America to focus on arms control and Iran. They write:

Arms control may be the most promising area for early progress. The 2002 Moscow treaty, Mr. Bush’s one and only agreement, allows each country to deploy between 1,700 and 2,200 long-range nuclear weapons. They could easily go to 1,000 weapons each.

One might wonder why Russia would be interested in this. After all, decommissioning nuclear weapons is more expensive than maintaining them. Perhaps they want to eliminate the one factor that makes Russia relevant in international relations?

The highlight of the article, however, is this gem:

The administration also will have to test whether Moscow will do more to help end Iran’s nuclear program. That, too, is in Russia’s clear strategic interest, even though the Kremlin has yet to see it.

The problem with the whole article is that it wants to create a new Russia by focusing on issues that are of concern to us but not to Russia (of course, we know Russia's interests better than they do). We want Russia to cooperate on things we care about and we want them to endure (in silence) our complaints about their behavior in other areas. Hard to build a relationship that way.

As attentive reader Clifford Gaddy notes:

Well, I hope Putin's checks his NYT daily, so he can see what Russia's strategic interests really are.

The Crisis Spreads to Emerging Markets

The financial crisis has spread to emerging markets:

Argentina’s bond markets were savaged on Tuesday as credit risk rose to all-time highs amid a broader surge in risk aversion towards emerging markets.

The move came as Russia’s stock market suffered its biggest one-day fall since the financial crisis of 1998, the South Korean won dropped by its most in a decade and the Ukrainian stock market fell 14 per cent.

Trading has been suspended on the Russian exchanges as shares nosedived:

Russian shares suffered their steepest one-day fall in more than a decade on Tuesday, losing up to 20 per cent, as a sharp slide in oil prices and difficult money market conditions triggered a rush to sell.

This is the biggest one-day dive since the August 1998 crash of the ruble. It is the combination of the credit crunch leading to margin calls and the fall in oil prices which (as we noted in a previous post) is the key fundamental driver of the Russian economy.

Russian Stock Market

Many observers have argued that the decline in the Russian stock market since the outbreak of conflict in Georgia shows that Russia is being punished by foreign investors. For example, Dan Drezner wrote:

Russia is paying a price for its actions. Last week Russia's RTS Index dropped 7 percent, and has fallen by 33 percent since July. Last month $20 billion left Russian markets in search for safer havens. Moscow has had to intervene aggressively in foreign exchange markets to defend the ruble.

This seems to be a common thread. But how then to explain the fact that the RTS fell faster before the crisis then after? As my colleague Cliff Gaddy has noted:

In the four weeks before the invasion, the RTS lost more value than in the four weeks after -- $192 billion before and $167 billion after. In fact, the Russian market has been declining since early July.

Cliff points out in this Moscow Times article the extent to which the fall in the Russian stock market is due to the usual culprit, oil prices. You can get an idea of the argument by looking at this chart of what has happened to the RTS:

You can see that the decline in the RTS really starts when oil prices fall. The fall due to Mechel (see my old post on this) is just a blip as is the Georgia crisis. lThe prior sharp fall is the dropping of electricity giant UES from the index.

Now let us look at oil prices. We see a similar pattern:
What is unexplained is they the RTS started falling when oil prices were still rising. Here I think the answer is the world financial crisis. May 19 was also an interesting day on Wall Street. The S&P 500 started to fall and this sucked capital out of emerging markets. Let's look at what happened to the S&P500 during this period.



So the basic story would be that oil prices explain most of the fall in the RTS, not a response to Georgia, and that the initial fall was due to the crisis facing most emerging markets.

Foreign Investment and Lena Goldfields

There is a lot of discussion today about how Putin's actions will hurt foreign investment in Russia. Does Putin just ignore the impact? Does he not care? I think there is another explanation at work here. Gaddy and I call this the "Lena Goldfields phenomenon," and it is discussed in our forthcoming book (Russia's Addiction: The Political Economy of Resource Dependence). Let me give a brief explanation here and then quote from the book.

The Lena Goldfields phenomenon is a recurring theme in western interaction with the Soviet Union and Russia. It is the belief that the rules will soon change to favor foreign investors and that the rights of those investors will be protected. This belief recurs despite Russia’s long history of defaults on foreign debt and its shabby treatment of foreign investors in the past (for an interesting article on Russia's history with debt repudiation, see this article by Yulia Sinyagina-Woodruff). The Lena Goldfields case is the classic example and shows how willing foreign investors can be.


Here is the excerpt from the book:

Lena Goldfields was an English company set up in 1908 with heavy ownership from other Western countries. It bought out an existing Russian company originally founded in 1855. It was quite profitable until it suffered during episodes of violent labor unrest before World War I and then the war itself. The Bolsheviks nationalized the company in 1918.

The story become interesting as the Soviet Union launches the New Economic Policy and the post-Rapallo wooing of foreign capital. The USSR now promises that foreigners can come in and be allowed to invest in all kinds of industries; including highly profitable ones such as mining and metals, and that they will be allowed to repatriate profits. They need only pay regular taxes in the USSR.

The owners of Lena Goldfields fall for this lock, stock, and barrel. This is 1922-23. Recall, now, that five years earlier they had lost everything they had in Russia. So what do they do? First, they renounce all claims on the Soviets for their nationalization losses. In other words, they give the Soviets the market value of the original Lena Goldfields. Then they spend £4.5 million to go around in the West and buy out all the shareholders of all of Lena’s Russian subsidiaries (which also had been nationalized). The sole reason for doing this is so that they (Lena’s financiers) could then legally renounce all the claims those companies might have on the Soviets. Then they agree to invest a massive amount of additional capital to modernize the mines.

In return, they actually believe – because that’s what the concession agreement that they finally conclude in 1925 says – that they will be allowed to control of “30 per cent of the gold, 80 per cent of the silver and 50 per cent of the copper, lead and zinc production in the Soviet Union.” [Veeder 1998: 758]

To understand how crucial this is, substitute “oil” and “gas” for “Gold,” “silver,” “copper,” and so on and think about the situation today. Those metals were the oil and gas of the 1920s – the almost exclusive source of foreign exchange for the state. And the Lena owners think the Bolsheviks are going to let them control it all. (They perhaps fail to notice that the entire Soviet economy at that time was being supervised by Felix Dzerzhinsky, in his dual role as head of the Supreme Economic Council and head of the Cheka. Or, of course, maybe that is exactly why they think they have a good deal: their own concession agreement is countersigned by Iron Felix.)

So why did the Lena owners do this? As Veder (p. 757) notes, “For Lena Goldfields’ financial backers this [spending £4.5 million to buy out the subsidiaries’ shareholders] was a large investment, in addition to the substantial investments already lost upon Soviet nationalisation; and it reflects how both English investors and the Russian exiled community still retained the hope that the Bolshevik regime would collapse or at least mutate into a more benevolent form, allowing nationalised properties to be returned to their private owners [emphasis added].”

In other words, Lena’s owners were making exactly the fatal mistake that Khodorkovsky made: they were betting that the rules of the game were going to change. They were so sure that the system was going to “mutate” in the right direction that they bet the house on it. But the mutation went in the opposite direction.

To be sure, it for a while looked like they had called it right. The number of other companies who sought and were awarded concessions boomed. In 1923-27 the Main Concessions Committee (“Glavkoncesskom”) received over 2,000 applications. About 100 foreign concessions were operating in mid-1928. At the same time, the Soviet government announced it was going to further liberalize the concession rules; it needed even more foreign capital. A brochure that the Soviets published in the U.S. in 1929 reported that the First Five Year Plan specified a list of available concessions, broken down by type of plant or facility. It lists over 200. [The Soviet Union: Facts, Descriptions, Statistics, 1929, Soviet Union Information Bureau, Washington D.C.]

By early 1929 Lena had produced gold worth £3.6 million (about a quarter of total Russian gold production). Its profits were only £760,000. But it had only been able to repatriate £170,000. That left the company in financial trouble. It gets into debt and fails to make the royalty payments it owes the Soviets. At the same time, thanks to the labor problems described by Bazhanov, the company fails to fulfill the production quotas it had committed to. So the formal breach of contract is a reality. After that, it’s a slam dunk for Dzerzhinsky & Co.

“From the autumn of 1929, Lena Goldfields was increasingly subjected to rough treatment,... On 15 December 1929 matters between Lena Goldfields and the Soviet Union came to an abrupt head, with massive raids carried out by the OGPU throughout the night on Lena Goldfields’ establishments in Siberia, Moscow and Leningrad. Its papers were confiscated; and its senior officers and staff arrested.” [Veeder 1998]

Lena Goldfields was the beginning of the end. In November 1929 “the chairman of the Council of People’s Commissars (A. I. Rykov) declared to the Main Concessions Committee ... that the Soviet economy would henceforth do ‘no business with counter-revolution’. There was to be no room for concession agreements with foreign capitalists. Accordingly, these foreign concessions began to disappear; by 1936, only 11 remained; and by 1938, none....” [Veeder 1998]

There is an interesting footnote to this case.[1] Bazhanov (politburo secretary under Stalin) claims that after the owners complained to the British Government, the Politburo discussed the defense of the Soviets by Ramsey MacDonald, leader of the British Labor Party. He quotes Bukharin as noting that “the most remarkable thing is that these cretins in the Labor party have taken our arguments at face value…I propose that we send Comrade MacDonald to be secretary of the Party committee in Kyshtym, and appoint M. Tomsky prime minister in London (198).” Bazhanov claims that when he fled the Soviet Union he had the Politburo’s written decision on this matter and that he showed the document to British Intelligence, show shared it secretly with MacDonald, thus accounting for the latter’s break with Russian communism before he became Prime Minister.

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[1] See Boris Bazhanov, Bazhanov and the Damnation of Stalin, translated by David Doyle, Athens, Ohio University Press, 1990: 197-199. He discusses the general policy of attracting concessions and then using labor actions to cause violations of the concession, as Politburo policy (99).

Belief in the Lena Goldfields fantasy is a recurrent theme among western investors when they view Russia. And Russian governments understand this. In particular, they know that reputational concerns are not decisive when it comes to western investors. Russian governments know that there is always the perception that tomorrow is a new day, or that “the rules will change when we invest.” Hence, the cost to the Russian government and to the Russian economy of crackdowns on foreign investors is much smaller than it would be if reputation mattered in the way that economists usually suppose it does. The penalties – lack of access to foreign capital markets, or falls in FDI – are always short-lived. The lure of Russia is too great for foreign investors to stay out very long. Hence, the Russian government can crack down with relative impunity on foreign investors without much cost.

Irony and Loyalty

The New York Times has an article about William Browders' troubles in Russia. Browder was one of the most prominent foreign investors in Russia. His fund, Hermitage Capital, had $4 billion under management. He was a champion for minority shareholder rights in Russia. In that capacity he stepped on some important toes. Since 2005 he has been unable to secure a visa to return to Russia.

The irony is that Browder (the grandson of Earl Browder, former head of the US Communist Party) used to be one of Putin's biggest cheerleaders. He argued that Russia needed Putin's strong leadership, and applauded when Mikhail Khodorkovsky was sent to jail in October 2004.

Browder's fate does might seem to reflect a lack of loyalty on Putin's part. But what it really signifies is the risk inherent in challenging the system Putin created for control and distribution of resource rents in Russia (see my article with Cliff Gaddy on Resource Rents and the Russian Economy for a discussion). Browder's calls for transparency challenged the fundamentals of the Putin system. That is why he lost his visa.