Western-Style Capitalism, but With a Russian Accent

By Steven Pearlstein
Friday, July 13, 2007

MOSCOW

There is a deep contradiction developing in the Russian economy. On the one hand, Russians are embracing capitalism of the sort you'd find in Western Europe or Asia. But at the same time, the country is slipping back into a new kind of state-guided capitalism built around expansionist state-owned enterprises, national industry champions and a new breed of oligarchs who take their cues from the Kremlin.

The march toward free-market capitalism is led by multinational corporations that are bringing Western management techniques, governance, reporting and accounting standards to what had been something of a free-market free-for-all during the first decade after communism's collapse. But these days they are joined by home-grown Russian companies eager to gain access to Western investors and lenders and achieve the respectability and wealth that comes with listing shares in Frankfurt, London or New York.

It is these developments that have given companies such as Alcoa the confidence to invest more than $550 million to buy and modernize two formerly state-owned aluminum plants that are hundreds of miles from the capital.

Alcoa's Russian manager, Bill O'Rourke, doesn't gloss over the challenges involved in shedding 3,000 employees, focusing those who remain on safety and productivity or even just getting new equipment through the maddening Russian customs system without paying a bribe. And although the two plants are not making money, Alcoa is sufficiently encouraged by the quality of the workforce and the potential of the growing auto and aerospace markets here that it is thinking about expanding its presence.

Equally enthusiastic is General Motors, despite a somewhat rocky start with a joint venture that, at one point, was shut down over a dispute involving the cost of engines and parts supplied by its partner, AvtoVaz, a state-owned company.

Although not known for its quality or styling, the Niva is the best-selling SUV in the booming Russian car market, turning a profit for GM. Now, GM has decided to go it alone by building a $115 million plant to produce its own cars, just as Volkswagen, Ford, Nissan and Toyota have done. The plants are clustered just outside of St. Petersburg, which is quickly becoming the Detroit of Russia.

Even oligarchs who may have got their start obtaining state-owned assets through unsavory means have now adopted the trappings and strategies of the multinationals, hiring Big Four auditors and Wall Street law firms, making strategic acquisitions in the West and traveling to industry conferences to tell analysts that their shares are undervalued.

One such oligarch is Vladimir Yevtushenkov, a PhD in economics and chemical engineering who parlayed his longtime association with Moscow's powerful mayor to rank No. 14 on the list of Russian billionaires. Yevtushenkov got his start by buying the Moscow telephone monopoly after three other parties mysteriously dropped out of bidding.

But his $11 billion-a-year AFK Sistema empire, which is run out of an elegantly restored 19th-century mansion that once housed the city department he headed, has long since branched out from its Moscow base. It now has significant holdings in banking, retail, aerospace, tourism, cable television, health care, oil and real-estate development. One of his companies produced the 2005 Woody Allen movie "Match Point."

But just when you think Russia has caught the free-market bug, you are confronted with another industry that has been naturalized or consolidated around a politically chosen national champion, or a state energy company that has decided to buy a bank or a newspaper, or a minority shareholder who has just been robbed of his investment.

There was always some plausible explanation for these exceptions to the global rules -- the pursuit of some still-evolving industrial policy, protection of strategic industries, enforcement of tax and environmental laws, or recovery of ill-gotten gains. But the fact that they almost always come at the direction of the Kremlin and with the connivance of the courts serves as a frequent reminder that property rights and the rule of law are still evolving notions in Russia.

"This is still a system where you have to rely on those you know and trust, because the legal infrastructure and general business culture haven't yet evolved," said Pat Cloherty, who has managed three successful investment funds in Russia, including one for the U.S. government.

Andy Somers, the president of the American Chamber of Commerce here, acknowledged that the higher returns companies earn from doing business in Russia are, at least in part, a reflection of the higher legal and political risks. And those who don't have the stomach to play by Russian rules, he added, should probably look to do business somewhere else.

There is something about this mix of East and West, corrupt and legitimate, authoritarian government and free-market, that strikes even Russians as . . . well, Russian. As one financier put it to me, paraphrasing an old Russian saying, "In the last five years, everything has changed. In the last 200 years, nothing has changed."

Make no mistake that it is Russian President Vladimir Putin who has concocted this seemingly contradictory mix of instincts and policies.

The modern-day czar doesn't hesitate to instruct his oligarchs to "invest" a billion dollars or two in Russia's successful bid for the 2014 Winter Olympics in the resort city Sochi or order the state arms monopoly to buy up a state-owned car company rather than allow 100,000 employees to lose their jobs. No major corporate transaction happens without his say-so, and those who cross him are almost certain to receive a visit from the tax police.

At the same time, Anatoly Chubais, who served in the government of Putin's predecessor, Boris Yeltsin, assures that it was Putin who overrode the opposition of every governor, every party leader, every oligarch and virtually the entire bureaucracy and backed Chubais's controversial plan to break up and privatize the massive state electric monopoly and deregulate prices. The process has created dozens of private companies competing to produce and distribute power, with no dominant player. And when the restructuring is completed next spring, Chubais will have raised several hundred billion dollars in badly needed capital to modernize the industry.

If Putin steps down next March, as he has said he will, the odds are that the next president will not be so clever at balancing these two economic policies. The succession battle raging behind the walls of the Kremlin is said to have little do with policy or ideology or even personality.

Rather, I'm told, it is a battle among competing oligarchs and state-owned companies, each with its own candidate, its own ministries and financiers.

And while Putin has been able to protect and enhance his power by cleverly playing these various forces off against each other, history suggests the next guy won't be shy about punishing the losers and consolidating his political and economic power.

As it all unfolds, the West may want a better strategy than it now has for strengthening the hand of market-oriented liberals. The wrong approach is to lecture the Russians or threaten them, such as by holding up their admission to the World Trade Organization. The Bush administration favored those tactics, and they seem to have generated more defiance than cooperation.

At the same time, it only encourages the Russians' worst instincts when oil company executives, having just had their assets seized or their joint venture arrangements forcibly renegotiated, show up at the recent St. Petersburg Conference on Investment and declare how wonderful it is to do business in Russia.

"You are trying hard to discourage us from investing in Russia," one oil industry chief executive recently told Yegor Gaidar, a former prime minister who now heads an economic think tank here. "The problem is that you are just not trying hard enough."

A better policy is surely to be found somewhere between disrespectful threats and obsequious butt-kissing. Western business and political leaders should insist on fair commercial dealing as a precursor to further investment, while disabusing Russians of their widely held belief that favoritism, corruption and unfair dealing are just as prevalent in the West. (I lost count of how many times I had Halliburton thrown back at me during my visit.)

At the same time, the West should make clear to Russians that while they are free to run their domestic economy as they see fit, Russian companies owned or highly favored by the government won't be allowed to use their outsized profits to compete in our markets or buy up our companies.

In the end, however, it will be Russians themselves who will decide whether free-market or state-managed capitalism wins out. Although most Russians distrust government, they distrust markets even more. And as long they are willing to tolerate high levels of public and corporate corruption, the economy is likely to continue its current drift toward state control.

For in Russia, Chubais said, corruption and government control of the economy are really just "two sides of the same card," the one enabling and feeding off the other. That was true under the czars, it was true in Soviet times and it is true today. And, as Chubais and others now see it, the concentration of political and economic power that they have re-created probably can't -- or won't -- be broken until energy prices fall, economic boom turns to bust and an angry public demands reform.