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.