Russia's Crony Capitalism

by Anders Aslund

  By 1994, the great mob war started to fade. New big businessmen, commonly called oligarchs, had set up their own security services, becoming “powerful enough to ignore the old gangsters.” The oligarchs were everything the Soviet Union was not, fast and innovative, unconventional and conspicuous. Most of all, they were opportunists prepared to take any risk. They were self-made men, most of them young, bright, and educated in the best Soviet engineering schools. After having imported computers in the late Soviet years, they concentrated on oil exports from 1990 and moved into banking, profiting from cheap credits from the Central Bank of Russia and high-yielding treasury bonds. From 1995 to 1999, they purchased oil, mines, and metallurgical companies to make great fortunes on the ensuing commodity boom in the 2000s. To facilitate their businesses, they got deeply involved in policy-making and media.35

  Two issues rendered the oligarchs infamous. Before the presidential elections in the summer of 1996, seven top oligarchs threw all their money and media power behind President Yeltsin and probably managed to turn the election to his advantage. This intervention was widely seen as a big step toward the demise of Russia’s democracy. The seven oligarchs were Boris Berezovsky, Vladimir Gusinsky, Mikhail Khodorkovsky, Alexander Smolensky, Vladimir Potanin, Mikhail Fridman, and Petr Aven. Berezovsky and Gusinsky controlled media companies and were forced out by Putin in 2000. Smolensky’s big SBS-Agro Bank went bankrupt in the crash of 1998, and he disappeared. Khodorkovsky was arrested in 2003 and sentenced to eleven years’ prison in Putin’s showcase trial. Potanin remains the dominant owner of Norilsk Nickel, and Fridman and Aven are co-owners of Alfa Group, Russia’s biggest private holding company.36

  The other controversy concerned the so-called loans-for-shares privatization in 1995, which many perceived as the oligarchs’ original sin. At the time, it was politically impossible to sell large enterprises to foreigners, but the government was desperate for cash. Moreover, the reformers wanted to tie the new businessmen to reform and the reelection of Yeltsin in 1996. In the end, only twelve companies were privatized in that fashion, and merely three changed principal owners: Yukos, Norilsk Nickel, and Sibneft. Oneximbank of Vladimir Potanin and Mikhail Prokhorov bought Norilsk Nickel for $170 million. Mikhail Khodorkovsky’s Menatep purchased 86 percent of Yukos’s shares for $309 million. Boris Berezovsky and Roman Abramovich acquired a majority of Sibneft for $100 million. These were privileged insider privatization, but nothing else was sold for more. Forty percent of Gazprom was sold for $100 million, although Gazprom was worth ten times more than Sibneft.37

  These three companies were economically extraordinarily successful. Economist Andrei Shleifer and political scientist Daniel Treisman noticed: “Between 1996 and 2001, the reported pretax profits of Yukos, Sibneft, and Norilsk Nickel rose in real terms by 36, 10, and 5 times, respectively.” The stock market valuation of Yukos and Sibneft surged more than thirty times in real terms. Their economic success led to the conspicuous enrichment of their young owners, which Russian society could not stomach.38

  Several important events concluded the 1990s. On August 17, 1998, Russia experienced a shocking financial crash, which in hindsight may be seen as the completion of the building of a market economy. In August 1999, President Yeltsin named Vladimir Putin his prime minister. Soon afterward, Putin launched a second war in Chechnya. On December 19, 1999, Russia held a new Duma election, and the new government party Unity gained 23.8 percent of the votes cast. Together with like-minded parties Unity could form a parliamentary majority in support of the government for the first time since 1991. On December 31, Yeltsin resigned to the benefit of Putin.39

  President Putin’s first term, 2000–2004, stands out as Russia’s happiest. The economic policy was better than ever, and Russia was still quite a free society. Cunningly, Putin exploited the economic success to consolidate his political power.40

  Russia’s finances had finally stabilized, and from 1999 to 2008 the economy grew as never before, at an average of 7 percent a year (fig. 1.1). Russians’ standard of living surged even faster. The private sector boomed, peaking at 70 percent of GDP in 2003. This was also a period of great structural reforms. The federal state was back, and the big losers were the regional governors and the oligarchs, but also the communists. The Russian state imposed its rules on the whole country, centralizing federal finances and leveling the playing field.41

  Fig. 1.1 Real GDP growth, 2000–2017. Source: BOFIT (2018)

  In 1999, when people asked whether the Russian economy could survive, the worldwide management consulting firm McKinsey Global Institute published a study of great foresight. It concluded that Russia had sufficient physical and human capital for a sustained growth rate of 8 percent a year. The main hurdles were a distortional tax system, a dysfunctional government, the subsidization of inefficient companies, and the absence of a land market. Neither the banking system nor the legal system posed significant impediments to high growth.42

  The Russian government pursued this line of reform. After having assumed power in early 2000, Putin appointed Herman Gref, a young liberal lawyer from St. Petersburg, minister of economic development and trade, while his liberal St. Petersburg colleague Alexei Kudrin was appointed minister of finance. In the early 1990s, Gref and Kudrin had worked closely with Putin in St. Petersburg. They continued the economic reforms of their friends Gaidar and Chubais. Mikhail Kasyanov, who had been minister of finance and was seen as close to the Yeltsin family, succeeded Putin as prime minister.

  Putin asked Gref to write an operative reform program. Gref gathered the best and brightest liberal economists in Moscow, and in July their program was adopted. The Gref program is a bureaucratic document of about two hundred pages with instructions to officials to compose hundreds of legal acts on structural reforms. Impressively, much of this program was legislated and implemented in 2000–2003.43

  The big question was how Putin would handle the oligarchs. On July 28, 2000, he convened a much-anticipated meeting with twenty-one leading Russian businessmen in the Kremlin, telling them in no uncertain terms: “You stay out of politics and I will not revise the results of privatization.” The two media oligarchs Vladimir Gusinsky and Boris Berezovsky were already out of favor and did not attend. The state was back and the old Yeltsin oligarchy was over. The Kasyanov government functioned as a coalition government of liberals and big business, being the most effective government Russia ever had.44

  Tax reform was key. The Russian tax system was an unwieldy, arbitrary, and inefficient mess. Russia had two hundred taxes, and multiple agencies competed over the same revenues. A draft tax code had been lying in the Duma since 1997. From 1998 to 2003, it was adopted in steps. Small, inefficient nuisance taxes were abolished as the number of taxes was slashed to sixteen. Four different payroll taxes were merged into one unified social tax. All tax collection was concentrated to one tax service. The tax rates were reduced and loopholes eliminated. The sensation was the replacement of a progressive income tax, peaking at 30 percent, with a flat personal income tax of 13 percent. The tax reform boosted tax revenues.45

  The 1993 constitution had guaranteed the right of Russian citizens to own land, but until the 1999 elections the communists and agrarians in the State Duma had blocked the adoption of a land code, which was needed to legalize private land ownership. Publicly Putin avoided this sensitive issue, but he tacitly supported the liberal Union of Right Forces that drove this law through the Duma in October 2001. In July 2002, the Duma legalized the sale of agricultural land. Other important economic reform laws were a civil code reinforcing private property rights, a new bankruptcy law, a new labor code, a pension reform introducing compulsory private pension savings, and substantial deregulation for small enterprises.46

  The years 2000–2003 encompassed Russia’s most successful period of economic reform, and the economic results were stellar. Putin had successfully satisfied multiple constituencies to consolidate his power. Veteran Kremlinologist Lilia Shevtsova assessed: “Pu
tin was simultaneously a stabilizer, the guardian of the traditional pillars of the state, and a reformer. He was a statist and a Westernizer. He appealed to all strata in the society.”47

  Putin showed his political genius and opportunism in his selection of national symbols. He stuck to the liberal tricolor flag while bringing back the tsarist double eagle as the coat of arms, and he rehabilitated the magnificent old Soviet national anthem with new words. Although these choices might have appeared ideologically inconsistent, each enjoyed a popular majority.

  Putin’s second term, 2004–2008, was characterized by the oil price boom, which helped him breed state capitalism in Russia. Thanks to the economically successful loans-for-shares privatization, the new private companies drove up oil production by an astounding 50 percent from 1999 to 2004. In late 2003, global oil prices started rising sharply. The economy seemed to be on autopilot, delivering high growth, a large budget surplus, and a reassuring current account surplus. Having now consolidated power, Putin could cast aside his mask and proceed to what he really wanted. His new goal was state capitalism, but he waited to clarify that until 2006.48

  By and large, structural reforms ended in 2003 and have not been resumed. Putin’s last attempt at a serious structural reform was the monetization of social benefits in January 2005. It was poorly explained, and the public understood it as their loss of social benefits. As a consequence, old-age pensioners started large-scale street protests around the country. The government made certain concessions, and it dropped the idea of further structural reforms. Why bother with reforms when economic success seemed guaranteed?

  The turning point foreshadowing Putin’s second presidential term was the arrest of Mikhail Khodorkovsky, the main owner and CEO of the Yukos oil company, on October 25, 2003. Khodorkovsky was the richest man in Russia, with a wealth assessed at $15 billion. The initial official accusation was a dubious privatization of the mineral fertilizer company Apatity, but the prosecution moved on to tax fraud, although that case never seemed plausible. The Kremlin’s real aim was to confiscate Yukos, although Putin denied it repeatedly. In 2004–2005, Yukos was expropriated and its assets were transferred largely to Rosneft in closed auctions at low prices.49

  The Yukos confiscation was a pivotal political event. It preceded the State Duma elections in December 2003 and the March 2004 presidential elections, and it helped Putin to gain complete political control. The Yukos confiscation also marked the end of privatization and structural reforms and a much more negative attitude to international economic interaction.

  The president continued to speak in favor of a free market economy, but his policy had changed. After three failed attempts to privatize Rosneft, the government decided to keep it. Rosneft also fought off several merger challenges. In July 2004, Putin appointed his former personal assistant Igor Sechin chairman of the supervisory board of Rosneft, which became the leading purchaser of oil companies. Gazprom tried to keep up with the competition. It bought Sibneft in 2005 and forced Royal Dutch Shell and its partners to sell 51 percent of their Sakhalin II project at a price set by Gazprom in 2007. It also ousted TNK-BP from its giant Kovykta gas field in Eastern Siberia.50

  Putin and his men were building a new state capitalism. In 2006–2007, several large state companies and corporations were formed. The idea was that Russia needed “national champions,” meaning national monopolies. In several sectors, a state monopoly was to be formed with Gazprom as the model. In 2006, the United Aircraft Corporation was created, as were the United Shipbuilding Corporation and the Atomic Energy Industry Complex (Rosatom) in 2007. Some seven hundred armament companies were merged into the state corporation Rostec. The new state enterprises were confusingly similar to old Soviet industrial ministries. Their chief executives were longtime friends of Putin.51

  The Orange Revolution in Ukraine in November–December 2004 delivered a major shock to Putin. He seemed convinced that the United States had instigated this grassroots revolt. He grew increasingly suspicious of the West, favoring less economic cooperation. In early January 2006, Gazprom’s chairman and Russia’s first deputy prime minister Dmitri Medvedev turned off the gas tap to Ukraine in a macho display on Russian television because of a pay dispute. But 80 percent of Gazprom’s exports to the European Union passed through Ukraine, prompting not only the Ukrainian government but also the EU and the United States to protest. Although a settlement was reached within a few days, Gazprom repeated the trick in January 2009 for two weeks.52

  Putin had persistently advocated sound market economic policy, but in a televised question-and-answer session on October 25, 2006, he abruptly changed tone, returning to former Soviet rhetoric. He favored industrial policy, extensive state intervention, centralized micromanagement, state investment, subsidies, trade and price regulation, protectionism with higher custom tariffs, export taxes, and import substitution, as well as ethnic discrimination. In characteristic fashion, Putin adjusted his rhetoric to the policy he had in fact adopted three years earlier.53

  In May 2008, Putin’s second presidential term expired. Before he departed, his government produced a policy agenda called “Strategy 2020.” It was supposed to be a follow-up to the Gref program of 2000 and guide his chosen successor, Dmitri Medvedev. Strategy 2020 was full of lofty reform ideas, but it was never taken seriously because its proposals differed so markedly from Putin’s actual policies, and it proved to be of little significance.54

  After the arrest of Mikhail Khodorkovsky in 2003, Russia could no longer be called an oligarchy. The centralized state had returned with a vengeance. Putin ruled with the assistance of his security police, ministers, and state enterprise managers. A popular anecdote showed how times had changed: a young woman was advised that it was better to marry a high state official than an oligarch, because the money was the same, but the state official enjoyed a much more secure tenure. Big private businessmen started talking about their companies as their temporary loans, expecting that the state could take them over at any time.

  Putin’s third informal term, 2008–2012, saw the rise of asset stripping and crony capitalism. In 2008, its tenth year of high economic growth, the Russian elite was blinded by hubris. In current US dollars, Russia’s GDP had skyrocketed from a miserable $200 billion in 1999 to $1.9 trillion in 2008 to become the sixth biggest economy in the world (fig. 1.2).

  The possibilities seemed unlimited. In May 2008, Gazprom became the most valuable listed company in the world, with a market capitalization of $369 billion. In June, Gazprom CEO Alexei Miller predicted that oil prices would rise to $250 per barrel by 2010 and that Gazprom would become the first company in the world to reach the value of $1 trillion. On July 11, the price of oil hit the unprecedented level of $147 per barrel.55

  Although democracy was gone, hopes for modernization persisted. By serving just twice, Putin showed respect for the limit of two consecutive terms set by the 1993 constitution. On December 10, 2007, Putin announced that First Deputy Prime Minister Dmitri Medvedev was his preferred successor. The Kremlin’s four obedient Duma parties instantly endorsed him. In March 2008, Medvedev was “elected” president in tightly controlled elections, and he obediently appointed Putin prime minister.

  Fig. 1.2 GDP in current US dollars, 1992–2017. Source: IMF (2018)

  All along, Medvedev was considered a weak underling to Putin, but he was younger and more reformist, and he did not come from the KGB. Instead Medvedev had taught law at St. Petersburg University before becoming Putin’s assistant in 1991. The runner-up for president had been the other first deputy prime minister, Sergei Ivanov, who was a KGB general of Putin’s age from St. Petersburg.56

  Medvedev presented his manifesto “Forwards Russia!” which was a creed for modernization. His key question was, “Should a primitive economy based on raw materials and endemic corruption accompany us into the future?” US president Barack Obama took Medvedev seriously as a modernizer and launched a “reset” of US policy to Russia soon after his inauguration in
January 2009.57

  Alas, little came out of the anticipated modernization. Putin retained ultimate power, so these years should be seen as his third informal term as ruler. Seemingly in contradiction to his endeavor to build state capitalism, Putin spearheaded a swift stripping of assets, generating a new dimension of crony capitalism. Several friends of his from St. Petersburg now assumed outsized roles. The most important are Gennady Timchenko, Arkady Rotenberg, and Yuri Kovalchuk. The main object of their asset stripping was Gazprom, where Putin functioned as the real chief executive. Rotenberg and Timchenko owned the main subcontractors that built Gazprom’s new pipelines in privileged no-competition contracts. Timchenko became the main trader of Russian oil. Kovalchuk controlled Bank Rossiya, which was the financial hub of Putin’s St. Petersburg friends, and it purchased Gazprom’s ample financial and media assets. Putin’s travels abroad as prime minister focused on promoting Gazprom pipeline construction in the European neighborhood, especially South Stream.58

  The opposition politicians Boris Nemtsov and Vladimir Milov have estimated that the total value of assets removed from Gazprom and placed into the private hands of Putin’s friends from 2004 to 2007 at about $60 billion. Not surprisingly, Gazprom’s market value has sunk from a high of $369 billion in May 2008 to some $46 billion in August 2017 because shareholders know that they do not really own the stock. They receive only dividend yields. Putin and his friends established their network in the early 1990s, but only in his second term did their larceny become truly astounding.59

  The global financial crisis came as a rude surprise to the Kremlin. As late as September 2008, Putin exuded arrogance, calling Russia a “safe haven” in the budding crisis, although both stock market and oil prices had been falling from May and July, respectively. This time, Russia had accumulated substantial reserves. The state spent generously, but to no benefit, bailing out big bad companies rather than forcing them into bankruptcy as in 1998. Russia’s GDP plunged by 7.8 percent in 2009, more than in any other G-20 economy, and its future productivity had been deflated.