Russia's Crony Capitalism

by Anders Aslund

  The Central Bank of Russia maintains excellent statistics on Russia’s international transactions on the web, showing a steady and large current account surplus, which is accompanied with an also large but smaller capital outflow.

  Thus, we know a surprising lot about the situation in Russia, though we must avoid disinformation. The most striking example of misinformation is the official declaration of incomes and assets that senior Russian officials must submit. Only the foolish tell the truth, since only the honest can fear punishment. Official statistics have little to tell about individuals.

  All the wealthy in Russia transfer their liquid assets abroad. The reasons for capital outflows from Russia are many, but they have varied. These large capital flows started as illegal transfers in 1988, when the Soviet Union started its first liberalization. In the late 1980s, no private holdings of capital in Russia were legal, so they had to be safeguarded abroad (in Cyprus). Throughout the 1990s, Russian banks kept collapsing, so wealthy Russians sought secure banks abroad. Until the tax reforms around 2000, Russian taxation was confiscatory, which was another reason for the wealthy to keep their money abroad.

  Since 2006, capital outflows have largely been legal. Still, substantial illicit flows have continued even during the best of times as managers have defrauded the owners of both private and state-owned companies through transfer pricing and underinvoicing to embezzle money from other enterprise owners and evade taxes. As Putin has reinforced his control over law enforcement, businesspeople prefer to keep their money abroad, where property rights are more secure. With the start of Putin’s “deoffshoreization,” capital controls have tightened.3

  The basic reason for capital flight is that money is not safe in Russia. Tax or law enforcement agencies can seize any assets at any time, as Bill Browder has shown so eloquently in the case of his company, Hermitage Capital Management, and the Sergei Magnitsky case. Banks abroad are used even for short-term cash holdings, since most funds that have been transferred abroad return to Russia, whether for purchases of assets, investment, or simple transactions.4

  Russian businesspeople overwhelmingly move abroad when they retire. Business life in Russia is tough. On any given day, a couple of hundred thousand Russian businesspeople sit in pretrial detention. Why take that risk? Russians need to consider that they risk months of arrest by pursuing their trade. Moreover, life in Moscow is expensive, traffic is cumbersome, and the weather is cold.5

  A common assumption has been that the newly wealthy businesspeople would demand judicial reforms to achieve secure property rights when they had enriched themselves, but this has not happened. The old oligarchs no longer matter. They have lost their political clout. They have no voice, while they can still exit, as Albert Hirschman put it, and take their cash with them. Therefore, the old oligarchs, sometimes called the “white oligarchs,” in distinction from Putin’s “black oligarchs,” are no threat to the regime. They are too far from the real power and too well surveyed to intimidate it.6

  If they demand secure property rights, they may lose what they own in Russia and be forced to leave the country, as happened with Yevgeny Chichvarkin, who was mentioned in chapter 5. He was an outstanding entrepreneur who set up the company Euroset with five thousand outlets all over Russia selling mobile phones. When he objected to being expropriated in 2008, he opted for political protest and was forced to emigrate within forty-eight hours. Instead, the truly wealthy remaining in Russia have become ever more cautious and obedient to Putin.7

  The rulers, by contrast, benefit from weak property rights as long as they are in power, because the weak property rights of others allow them to acquire assets in Russia at low prices through corporate raiding. Strong courts in Russia would hinder their wealth accumulation. The wealth of the rulers, however, is secure only as long as they stay in power. Whenever anybody falls out of favor with the Kremlin, his or her property is in danger. No one feels safe until they have all political power and own everything, which explains the rulers’ rapacious lust for both wealth and political control. In Russia power is wealth, and wealth is power. To defend their political power, the rulers aspire to a maximum of wealth, and they transfer their profits abroad, where they enjoy secure property rights guaranteed by British or US law.

  Putin’s authoritarian kleptocracy of three circles is not complete without a fourth circle, the Anglo-American offshore. In the late 1980s, the amassing of vast holdings of money of dubious origin in anonymous companies started in offshore havens. The start was the “big bang” financial liberalization in the United Kingdom in 1986. Dozens of British or former British overseas territories developed into financial centers, ranging from the Channel Islands and Isle of Man to Cyprus and Malta, Bermuda, the many Caribbean territories, some Pacific islands, Dubai, Singapore, and Hong Kong. From 1988, these financial services encountered new demand from private operators in the former Soviet republics, as new smart operators made instant fortunes on commodity trading, buying oil for $1 a ton in Russia and selling it abroad for $100 a ton.8

  Other emerging markets moved along. The first solid study of this topic is Raymond Baker’s Capitalism’s Achilles Heel: Dirty Money and How to Renew the Free-Market System, published in 2005. At that time, he considered that “$1 to $2 trillion annually can be taken as a rough estimate of global dirty money.”9

  Throughout the 1990s, most of the money flowing from Russia seems to have gone through Cyprus because the Soviet Union and Cyprus had concluded a uniquely favorable double-taxation agreement in 1982 that relieved Russians of taxation when they took out their money that way. It was succeeded by a similar agreement between Russia and Cyprus in 1998. As a consequence, Russian commodity traders set up plenty of small trading companies in Cyprus, which had excellent financial services and good rule of law but minimal transparency.

  The Russian money has not stayed in Cyprus. Typically, it just passes through Cyprus to other offshore havens. These havens have varied over time, but the current dominant pattern is first to the British Virgin Islands and then to the Cayman Islands. The money usually passes through several offshore havens, because each haven adds several layers of shell companies. For seriously dirty money, a layer of twenty to thirty shell companies is common. Of these havens, only the Cayman Islands has a large banking sector. Malta is a smaller parallel channel to Cyprus. During the global financial crisis of 2008–2009, several alternative Caribbean islands, such as Antigua and Turks and Caicos, lost out because they ended up in financial crisis and scandals, which led to further concentration in the British Virgin Islands and the Cayman Islands.

  In the end, the money tends to flow to the United States, mainly Delaware, and the United Kingdom. Vladimir Milov, who has an eminent understanding of Russian wealth, observes that since the Western sanctions were imposed in 2014, Russians have increasingly channeled their funds to Dubai, Singapore, and Hong Kong, but these havens have much less financial depth than the United States and the United Kingdom.10

  In 2013, Cyprus went through a severe banking crisis, which was caused by the Greek government writing off much of its bonds. The IMF took this opportunity to investigate Russian investment there. It established that Russian foreign direct investment in Cyprus was 150 percent of its GDP in 2013, or $36 billion, of which $22 billion pertained to “special purpose enterprises,” registered there but invested elsewhere. Thus, Russian direct investment in Cyprus itself was only $14 billion, and the Russian losses in the bank bail-in must have amounted to several billion dollars.11

  The common feature of all these jurisdictions is that they are current or former British territories with good rule of law and extensive usage of anonymous ownership. Unfortunately, these territories offer little relevant statistics. The renowned Organized Crime and Corruption Reporting Project broke the story about the “Russian Laundromat” in 2014, and together with reporters from the indefatigably independent Novaya Gazeta, they detailed how 19 Russian banks laundered $20.8 billion to 5,140 companies with acco
unts at 732 banks in 96 countries from January 2011 to October 2014.12

  Money laundering, which is usually defined as the concealment of illegally obtained money, has long been a concern of Western governments. It is a derivative crime difficult to combat, because the initial crime has been committed in another country, usually lacking good rule of law or even being pervasively corrupt, convicting honest people, while letting true culprits go free. Russia is such a country.

  Therefore, the West has adopted new laws and formed new institutions against money laundering. As early as 1989, Western members of the Organization of Economic Cooperation and Development (OECD) set up the Financial Action Task Force (FATF) to stop such dirty monetary flows. FATF is the international police force for money laundering. Its standard advice to bank regulators is “follow the money!” and know your customer (KYC)! It has compelled small island havens to clean up their act. Even Switzerland has had to give up its cherished centuries-old bank secrecy. In order to be able to investigate dirty money, the US Treasury Department established the Financial Crimes Enforcement Network (FinCEN) in 1990, which remains the main US institution for this task.

  After the terrorist attacks on the World Trade Center in New York and the Pentagon on 9/11, 2001, the United States became serious about fighting money laundering in order to stop terrorist financing. Congress adopted the Patriot Act, which contains strict rules against money laundering. It prohibits the activities of shell banks in the United States and imposes the KYC rule not only on US banks but on all banks that operate within the United States. Whoever violates these rules is subject to large fines.

  But the two biggest offshore havens with a vast capacity to receive anonymous investment are the United States and the United Kingdom, and they remain intact. Although no serious statistics are available, these two countries are undoubtedly the dominant offshore havens in the world, hosting most of Russian anonymous offshore investment. The Financial Times has quoted Alex Cobham, chief executive of Tax Justice Network, a campaign group, stating that the United States is “the elephant in the room.” “If you were going to produce a tax haven blacklist with only one member, it wouldn’t be a small Caribbean island—it would be tax haven USA.”13

  In the early 1990s, the United States opened its floodgates for dubious foreign funds, allowing not only anonymous ownership but also anonymous money transfers. In 2015, the US Treasury assessed that no less than some $300 billion a year was laundered into the country, but the US lack of transparency leads to a dearth of relevant statistics. The United Kingdom is hardly better. The UK National Crime Agency claims that $125 billion is being laundered in that country each year. These are enormous amounts.14

  In the United States, there are four major reasons for this vast inflow of dark money. The most important is the extensive usage of companies with anonymous owners. Second, although real estate was included in the Patriot Act of 2001, after half a year, the US Treasury granted real estate a temporary exemption, which remains in force. A third venue for dark money is that law firms are permitted to take in dirty money under the attorney-client privilege. Last, the US government capacity to investigate dirty money, through FinCEN, is minimal. In 2013, it employed only 350 people.15

  In London, post-Soviet oligarchs have become so conspicuous that “kleptocracy” tours have been organized to display their splendid mansions with price tags of up to $200 million. A few outstanding British journalists have courageously cleaned up the public record. Edward Lucas of the Economist pursued Timchenko, who responded with a vicious libel case. In 2011, Luke Harding was expelled from Russia for his hard-hitting anticorruption reporting, the same year as his Russia book Mafia State was published. Ben Judah has scourged the UK policy, complaining that the Russians “know that London is a center of Russian corruption, that their loot plunges into Britain’s empire of tax havens—from Gibraltar to Jersey, from the Cayman Islands to the British Virgin Islands—on which the sun never sets.” The Russian offshore in London has driven up real estate prices.16

  The ways to transfer money into countries with Anglo-American law are many and shift over time. The most important method, though, is the extensive usage of anonymous companies. The four main US states that produce anonymous limited liability companies (LLCs) are Delaware, Nevada, Wyoming, and South Dakota. Ben Judah and Belinda Li note that the United States “produces more than 2 million corporate entities per year, pumping out 10 times more such shell companies than the world’s other 41 tax havens combined.”17

  Michael Findley, Daniel Nielson, and Jason Sharman have established through a broad survey that with regard to compliance to international transparency rules, “on nearly every count, tax havens outperform the OECD countries.” Their main conclusion is that it “is more than three times more difficult to obtain an anonymous shell company in tax havens than in OECD countries.”18

  The Russian arms trader Viktor Bout, renowned as the “Merchant of Death,” had used “at least a dozen shell companies in Delaware.” In 2012, the New York Times reported that one single building in Wilmington, Delaware, harbored as many as 285,000 legal entities, but nothing has been done to rein in this dubious practice. By comparison, “only” 18,857 companies are registered in the main building for the registration of companies in the Cayman Islands.19

  Money launderers use all kinds of peculiar enterprises that offer anonymity. Through the Panama Papers, Transparency International UK and Bellingcat found that Scottish limited partnerships had become major vehicles of Russian money laundering after a legal amendment in 2008. They reported that 113 such companies had laundered $20 billion–$80 billion from Russia into the United Kingdom in just four years. In 2016, 3,677 Scottish limited partnerships were registered in secrecy jurisdictions including the British Virgin Islands, Belize, and the Seychelles.20

  The embarrassment of all these revelations in the Panama Papers became just too great for the British government. In May 2016, Prime Minister David Cameron organized an international conference to oppose anonymous ownership. Twenty-nine countries already demand full disclosure of beneficiary owners, and at that conference eleven countries agreed to prohibit anonymous ownership. One was the United Kingdom, but in June 2016, Cameron lost the Brexit referendum and was forced to resign, and the political momentum was lost. The United States did not, claiming that the federal government could not decide such a state issue. Even Ukraine has successfully done so with all its banks.21

  The dominant destination of anonymous investment is real estate, which has both great capacity and desired secrecy. Every year, more than $100 billion of foreign funds flow into US real estate, more than half of it in cash.22

  The investigative journalist Oliver Bullough found that “almost one-third of top-end property purchases in America’s biggest cities are suspect, according to the Financial Crimes Enforcement Network, the body at the Treasury Department.” While “China was the leading investor in real estate in the United States by the end of 2015, with $350 billion in related investments and holdings,” Russia is high up on the list, but the United States has no numbers.23

  Dirty Russian investment in real estate appears to abound in New York and Florida. One Reuters investigative report found that “at least 703—or about one-third—of the owners of the 2044 units in the seven Trump buildings [in Sunny Beach Isles in Florida] are limited liability companies, or LLCs, which have the ability to hide the identity of a property’s true owner. And the nationality of many buyers could not be determined.” But the “zip code that includes the Sunny Isles buildings has an estimated 1,200 Russian-born residents . . . U.S. Census data show.” The project generated $2 billion in initial sales, of which at least sixty-three individuals with Russian passports or addresses had bought at least $98.4 million worth of property, while the more dubious Russians are to be found in the LLCs.24

  The situation is similar in the United Kingdom. James Nickerson of the New Statesman cited the assessment that anonymous offshore companies own thi
rty-six thousand properties in London at an estimated value of $156 billion. Russians own a large share of this real estate. In May 2016, David Cameron lamented that ninety-nine thousand buildings in the United Kingdom had anonymous owners.25

  A third major entry point for tainted funds into the United States is law firms. The legal excuse is attorney-client privilege, which is supposed to keep communication between an attorney and his or her client secret, but the United States has extended this secrecy to unlimited money flows. In December 2016 the Wall Street Journal revealed, in an analysis of the looting of the Malaysian sovereign wealth fund 1MBD, that “tens of billions of dollars every year move through opaque law-firm bank accounts that create a gap in U.S. money-laundering defenses.” Companies controlled by the two culprits “sent a total of $489 million into Shearman & Sterling’s pooled account from overseas.” The journalists Rachel Louise Ensign and Serena Ng assess these anonymous flows at $40 billion–$400 billion a year. When these journalists asked the American Bar Association president Linda A. Klein about these practices, she replied that the ABA supported the legal profession’s efforts to prevent misconduct involving client money, but “additional financial reporting requirements would be unnecessary and burdensome because there are few examples of client trust accounts being misused.” Well, without transparency, no evidence would be available.26

  Remarkably, we know far less about Russian financial and real estate investment in the United States than we know about them in Russia. We can assess Russian capital outflows on the basis of Russian statistics, Russian official publications of public procurement, and the Russian Forbes assessments of fortunes of wealthy Russians. In the United States, by contrast, we have no other sources than serious investigative journalism.27

  Money laundering is a complex and often incomplete procedure. Seriously dirty money goes through many countries, and in each country several layers of shell companies are often added. The dirty funds tend to stay in anonymous shell companies, which may be allowed to purchase real estate but little else. When the real estate is being sold, the unexplained wealth remains. Anonymous companies cannot hold money in banks or purchase listed stocks, while they may buy some hedge funds and private equity funds in offshore havens. The many transactions in the process of money laundering easily lead to multiple counting of the laundered volumes, so we focus on the stocks, not on the flows.