Kremlin crackdown

Call it the grand alliance, Moscow-style.

Russia's transformation over the past five years from a nearly bankrupt state to one of the world's best-performing emerging markets rests upon a tacit understanding between the country's political and economic leaders. After taking office in January 2000, President Vladimir Putin gave a handful of oligarchs free rein to develop the business empires they had grabbed on the cheap during the '90s, effectively telling them to get rich for the sake of Mother Russia. The oligarchs, in return, were expected to steer clear of the political manipulation that had made Boris Yeltsin look like their vassal in his waning years.

This alliance has succeeded beyond most investors' dreams. The Russian economy is growing at a rate of 6 percent a year, foreign currency reserves are bulging, and Western corporations are scrambling for a piece of the action. A recent A.T. Kearney poll of Western CEOs ranked Russia as the world's eighth-most-attractive market for foreign direct investment. But the arrest of a key aide to Mikhail Khodorkovsky, boss of the giant oil company Yukos and poster boy for the new, investor-friendly Russia, threatens to shatter the alliance. If that happens, the country's economic boom may be the first casualty.

Prosecutors arrested Platon Lebedev, Khodorkovsky's right-hand man, on July 2 and charged him with stealing state property in a 1994 privatization of a fertilizer producer called Apatit, now controlled by Khodorkovsky and some of his Yukos partners. At the same time, they charged Alexei Pichugin, Yukos's chief of economic security, with the murder of two friends who had allegedly tried to blackmail him last year. But, this being Russia, where few things are as they appear and conspiracy theories abound, no one doubts that the real target was Khodorkovsky himself. The 40-year-old billionaire has aggressively lobbied the country's legislature, the Duma, and bankrolled the two leading market-oriented parties ahead of parliamentary elections in December.

It would be bad enough if Lebedev's arrest were a politically motivated attempt to blunt Khodorkovsky's influence. But the clash pitting Yukos against the prosecutors appears to reflect a much broader, behind-the-scenes power struggle between the two strongest forces in Russia today. On one side are the oligarchs, whose seizure of much of Russia's natural-resource-based wealth turned a country that ranks 84th globally in per-capita GDP into No. 4 on Forbes's world billionaire list, with no fewer than 18 names. On the other side are the siloviki, or "power men," functionaries of Soviet police bureaucracies that are at best half-reformed -- and spoiling to reassert their once-dominant position.

The ultimate aim of the siloviki is nothing less than "a creeping coup" that would yield "a redistribution of property in their own favor and a mass change in elites on a federal and regional level," contends Gleb Pavlovsky, who served as Putin's media guru in the 2000 campaign and then stayed on as a part-time adviser to presidential chief of staff Alexander Voloshin.

Russia's new rich appear to be taking Pavlovsky's warning seriously. Private capital started fleeing the country again over the summer after the first half of 2003 saw net inflows of $2.7 billion, the first in post-Soviet history, according to Credit Suisse First Boston. Russia's foreign reserves surged from $47.8 billion at the start of the year to a peak of $64.9 billion on July 4, the week of Lebedev's arrest, before declining to $62.1 billion in mid-September, central bank figures show.

Far from being silenced by Lebedev's arrest, Khodorkovsky has gone into full-fledged campaign mode, portraying himself as a patriot willing to risk everything to stop a revanchist bid for power by Soviet-era holdovers. The lobby of Yukos's sleek new Moscow headquarters is festooned with Communist-style propaganda posters proclaiming, "The prosecutor lies like an old horse" and "Corrupt bureaucrats: demons with epaulets."

"If they can allow themselves to act this way with the biggest and most transparent Russian company, that doesn't bode well for anybody else," the Yukos chief asserted in a joint interview with Institutional Investor and the Los Angeles Times. "But enough people are ready to resist that we can put this last barrier, the unreformed law enforcement system, behind us."

Critics allege that Khodorkovsky and his fellow oligarchs have been trying to gain influence ahead of the December 7 parliamentary elections. Putin himself alluded to these allegations of excessive influence-peddling in televised remarks in July, shortly after Lebedev's arrest. "Even softer reforms are not getting passed by the Duma because those who are not interested in getting them passed are blocking them," he complained. He quoted Duma Speaker Gennady Selznyev as having told him, "The things that business is up to in the hall just overstep all boundaries."

Khodorkovsky dismisses the critics, however, and touts his overt lobbying almost as a badge of honor: "I don't hide the fact that I give money to one political party or another. All big businessmen do this, but I announced it publicly because our company is following a general policy of transparent information."

Beyond the immediate power struggle, the Yukos affair highlights the weakness of Russia's fragile democratic institutions -- a weakness that threatens to undermine the economic gains of recent years. In this game of chicken between the nation's top cop and its richest entrepreneur, neither has much credibility with the Russian public. The common assumption is that every big business is guilty of something -- or, as former-Kremlin-Svengali-turned-exile Boris Berezovsky once put it, "Any businessman who was not asleep for the past ten years could be thrown in prison today." The cynicism about the oligarchs is balanced by the belief that the prosecutor must have an ulterior motive for going after Yukos. And the Duma is presumed to be for sale to the highest bidder.

The events at Yukos illustrate "the illegitimacy of the national elite in the eyes of the people," Georgii Satarov, the former national affairs adviser to Boris Yeltsin who now runs the Indem polling agency in Moscow, told II.

Russia has a popular leader in Putin, who is cruising to his own reelection in March 2004 with 75 percent approval ratings. But the president waited almost three months to say anything about the Yukos affair before making some truly Delphic utterances.

Speaking to reporters before his September meeting with President George W. Bush, Putin dismissed as "complete rubbish" the suggestion that the Yukos arrests were politically motivated. Some recent Kremlin decisions support that view. In August the Anti-Monopoly Ministry approved Yukos's proposed $36 billion merger with smaller rival Sibneft. The deal will create the world's fourth-largest oil company by sales, with more than $20 billion a year, second only to Exxon Mobil Corp. in reserves, with 19.4 billion barrels.

Exxon also is reportedly jousting with ChevronTexaco Corp. for a minority stake in the new YukosSibneft.

But Putin had some potentially menacing words for the oligarchs. He said that Russia's business barons "lack a sense of social responsibility" and added: "They have already made enough money for themselves, their children and grandchildren. It is time to do something creative."

With such a lukewarm endorsement of the new business culture, few Russians believe that the Yukos affair, and the wider conflict between the new rich and the old secret police, will evaporate easily. The rule of law is still weak, and fresh battles could break out between the oligarchs and the siloviki at any moment, threatening the gains of the past five years. "We've returned to the classic Russian situation where the people who make the money in the country are a different class from the ones who have power," says Ruben Vardanian, chief executive of Moscow investment bank Troika Dialog. "We would all prefer to forget where we live, but in reality we are still living through a traumatic period. That's why investment returns here have to be higher."

For all of the speculation about the real motives behind the events at Yukos, the striking thing is that business has ticked along very nicely since Lebedev's arrest. The Moscow Stock Exchange RTS index rose to a post-1998 high of 560 on September 16. The oligarchs have continued to wheel and deal. Alfa Group's Mikhail Fridman spent a cool $300 million in August to purchase a 25 percent stake in cellular phone company MegaFon. Vladimir Potanin's Norilsk Nickel paid $34 million in August for the rights to a gold mine in Russia's extreme northeast, and it is considering participating in a government auction of rights to mine gold in Siberia next year, which could cost $1 billion.

The business activity reflects a newfound confidence instilled by Putin. Although a silovik by virtue of his training as a KGB man, the president allied himself with the oligarchs early on. He had seen the benefits of capitalism as a spy peering over the wall into West Berlin during the 1980s and then tried his best to import them to Russia when he was a deputy to St. Petersburg's reforming mayor of the 1990s, Anatoly Sobchak.

The results of Putin's pragmatism have been fantastic. The IMF projects that Russia's economy will grow 6 percent this year and 5 percent next year, and Putin has declared a goal of doubling GDP within ten years. The Treasury is bulging with upwards of $60 billion in reserves. BP became the country's biggest foreign investor this summer when it completed a $6 billion joint venture with Tyumen Oil Co.

The oligarchs, meanwhile, have gone a long way toward transforming themselves from asset grabbers to value builders. Khodorkovsky and Sibneft's Roman Abramovich (lately more famous in the West as the free-spending owner of London's Chelsea Football Club) have spearheaded an expansion that has boosted Russian oil production by a third since 2000. Oleg Deripaska has brought order out of chaos in the aluminum industry by forming the world's No. 2 producer, Russian Aluminum, and preparing it for an initial public offering.

Putin not only gave the oligarchs a free hand but chose his two top officials from politicians associated with them. Prime Minister Mikhail Kasyanov fits in this category, as does Alexander Voloshin, the presidential chief of staff Putin retained from Yeltsin's government. Economic policy is steered by Kasyanov and Western-leaning deputies like German Gref, who is minister of Economic Development and Trade.

What Putin hasn't tolerated from the oligarchs is overt meddling in politics -- at least, in electoral politics at the federal level. TV impresario Vladimir Gusinsky, who threw his NTV network behind Putin's most serious rival in 2000, Moscow Mayor Yuri Luzhkov, was quickly driven out of Russia. But so was Berezovsky, who loudly supported Putin's promotion from obscurity to prime minister in 1999. Gusinsky was arrested in Greece this August, and Russia asked for his extradition on fraud charges, a request Spain refused two years ago. Berezovsky was granted political asylum by the U.K. in September, quashing attempts to return him to Moscow for trial.

Putin, whose favorite rhetorical phrase is "dictatorship of the law," hasn't forgotten his old colleagues in the security services, either. Siloviki dominate the seven federal superregions that the president set up to rein in Russia's governors, a fact that Western investors appreciate for bringing some predictability to Russia's often wild interior. And they crept up quietly behind Voloshin's back in the presidential apparat, which in Russia can be more powerful than the formal government.

The siloviki lack sources of income, however. Pavlovsky, Putin's media adviser, says that they intend to rectify the situation, starting with the intimidation of Yukos. In a recent article on his Web site (www.kreml.org), he alleged that the arrest of Lebedev was the opening gambit of a "creeping coup" by the siloviki. This power faction is led by Igor Sechin and Viktor Ivanov, two former St. Petersburg KGB men who are now deputy heads of the presidential administration, Pavlovsky wrote. Putin, he warned, is in danger of becoming a "hostage to the policies of the group."

The looming parliamentary election has brought the subterranean tensions between the oligarchs and the siloviki to the surface. Russia's only known mechanism for regulating the conflict is back-room mediation by Putin. But after a three-month stalemate between Yukos and prosecutors, Kremlin watchers are puzzled. They can't tell whether the president has already cut a deal in a way too subtle to recognize, or whether he won't -- or can't.

In some respects, it is encouraging that anyone cares who sits in the Russian legislature. Yeltsin disbanded the Duma with tanks in 1993, then largely ignored it for the next seven years. Today, however, Parliament holds the last word on taxes (currently among the world's lowest for oil companies) and wields influence over other economic issues, like state monopolies on oil companies and natural gas, both of which Yukos and other private companies would like to smash.

"One of the biggest changes in Russia over the past two years is that the president can't arbitrarily issue a new tax any more," says Paul Collison, oil analyst at Brunswick UBS Warburg in Moscow. "Now he has to go through the Duma."

Unfortunately, the Duma is practically tailor-made for manipulation by special interests. Six parties control half of the legislature's 450 seats, and their ideologies can best be described as fluid: Communist leader Gennady Zyuganov blasted Platon Lebedev's arrest as "barbaric," an incongruity that to many observers confirmed that Yukos funds his party, too. "There's no question Khodorkovsky is taking out some political insurance with the Communists," says Christopher Granville, equity strategist at United Financial Group. Khodorkovsky denies any connection. The other 225 Russian lawmakers, so-called single-mandate deputies, are elected directly from their districts. With no party affiliation, they need money to get their message to voters, which leaves them susceptible to influence-buying by big business.

Putin is belatedly trying to shape this protean parliamentary mass, declaring his support late last month for the Unity Party, a bloc top-heavy with cabinet ministers and regional officials. But that comes after four years of unwillingness to risk his all-things-to-all-people image by direct involvement in party politics or legislation. "In Russia power is traditionally associated with one person controlling everything," says Roland Nash, research director at Renaissance Capital in Moscow. "Putin feels he would lose his Charles de Gaulle quality by associating himself with any interest group."

That gives Khodorkovsky and other business kingpins a free hand to influence the Duma. The result, detractors say, is a set of economic ground rules skewed toward the natural-resource fat cats at the expense of the rest of the nation.

Russian oil companies pay an effective tax rate of 12 to 13 percent, about half what BP or Exxon Mobil Corp. cough up globally, Collison estimates. That forces the government to rely on a 20 percent value-added tax that punishes small business and the public at large by making most goods more expensive. The Finance Ministry and central bank are keeping the ruble artificially weak by building up excessive hard-currency reserves and funneling currency trading through state-owned banks like Sberbank, where the exchange rate is easily manipulated, charges James Fenkner, chief of research at Troika Dialog. A weak ruble swells profits on sales of oil and metals abroad while reducing consumer purchasing power at home. Russia has the third-most-undervalued currency in the world, according to The Economist's Big Mac index.

"You can't have checks and balances in this country, because the oligarchs write all the checks," concludes Fenkner.

Pliant legislators also keep foreign competition at bay. In particular, Yukos's lobbying damaged the prospects for foreign oil companies in Russia by sinking a proposed production-sharing law that would have extended investment guarantees and tax benefits to foreign companies, UFG's Granville says. At that point, he postulates, Putin decided to send a "message" to Khodorkovsky, a signal the prosecutors interpreted overzealously for their own ends.

Eric Kraus, chief of research at SovLink brokerage in Moscow, theorizes that the trigger for the Yukos assault was the parliamentary defeat of a proposed rise in oil export taxes.

Whatever the reality, Khodorkovsky is unapologetic. "What my opponents consider an unacceptable level of political involvement on my part is a completely normal thing for any normal country," he says. "For us to pay more taxes, the government would have to accept a lower rate of economic growth."

Yukos openly funds the two most liberal parties in the Duma: the Union of Right Forces, headed by veteran reform warriors Boris Nemtsov and Anatoly Chubais; and Yabloko, led by eclectic economist Grigory Yavlinsky. That is perfectly understandable for a big corporation, but critics say the company multiplies this influence through clandestine deals with single-mandate deputies and one-off agreements that give Khodorkovsky something like a veto on any legislation not to his liking.

"Vladimir Dubov, who owns about 4 percent of Yukos, sits in the Duma on the budget and tax committee," notes Erik Wigertz, co-head of research at United Financial Group in Moscow.

When asked about the allegations of undue influence-buying, Khodorkovsky offers a candidly Machiavellian view of Russian political calculus that is unlikely to reassure his critics. "Thirty percent of our Duma deputies are with the Communists, and 30 to 40 percent are generally pro-government," he says. "On the other hand, besides Yukos there's Tyumen Oil Co., UES [Russia's state-owned power monopoly], Lukoil, Gazprom. Do you really think that in this situation we could get even that remaining 30 percent?"

How to circumscribe the oligarchs' power in the nation's interest is a vital question for Russia today, much as it was for the United States a century ago. Most ordinary Russians, who would feel lucky to earn $200 a month, look upon the oligarchs' vast wealth as stolen or, at best, granted in trust by a state that maintains ultimate rights over it.

Although Khodorkovsky has done a brilliant job of persuading Wall Street that he really owns Yukos's vast oil reserves, the fact that he hasn't convinced many Russians leaves him, and by extension his rival billionaires, wide open to legal assaults.

"The country has to find closure on the privatization deals of the '90s," asserts Christof Rühl, the World Bank's chief economist for Russia. "You can't build a new system if 90 percent of the population feels cheated." Rühl proposes a Moscow economic version of the Truth and Reconciliation Commission that aired the evils of apartheid South Africa with the aim of healing and fixing the rules of the game going forward.

But if containing oligarch power is the right goal for Russia, Prosecutor-General Vladimir Ustinov and his shadowy Kremlin allies may be the wrong people to pursue it. Most progressive Russians -- the people who ended Soviet rule and represent the country's best hope for the future -- lean instinctively toward the camp of spin doctor Pavlovsky and fear silovik power much more than they fear the oligarchs' power.

"The main obstacle to development in Russia is that the law enforcement organs make it dangerous to be successful," argues former Yeltsin adviser Satarov. "The attack on Yukos is no different than attacks on business that occur all the time, and it will make prosecutors across Russia bolder in their own blackmail."

A motley but impressive coalition has lined up to urge restraint from prosecutors, if not exactly to support Khodorkovsky. The group extends from Prime Minister Kasyanov himself, who called Lebedev's arrest "excessive" -- Ustinov's spokeswoman shot back that "each branch of power should mind its own business" -- to Lyudmilla Alexeeva, director of human rights watchdog Moscow Helsinki Group. "It's as if the prosecutor set out purposely to show everyone to what extent they can break all procedures and laws," she says of Lebedev's arrest. For starters, she contends, the appropriate legal sanction for someone charged with economic crime is a lien on property, not being thrown in jail.

Considering the boldness of their initial strike on Lebedev, Ustinov and his allies have proceeded carefully since then. They've brought no charges against Yukos itself, or its boss. It helps, of course, that with its billions in wealth and phalanx of attorneys, Yukos bears little resemblance to the hapless defendants of Soviet-era purges.

"Khodorkovsky understands perfectly that 2003 in Russia is not 1993," says Evgeny Satanovsky, president of the influential Russian Jewish Congress. "He doesn't feel physical danger."

It is a measure of Putin's hold over Russia's psyche, and its levers of power, that both sides imagine him secretly backing their position. Khodorkovsky's foes are convinced that the president is directing Ustinov's investigators. Yukos supporters believe that the prosecutors are overreaching and that Putin is searching for a politically palatable way to rein them in.

"The fundamental lesson of all this is that Russian politics is still very weak," concludes Renaissance Capital's Nash. "There is one strong person at the top, but he has to wield a club to do anything."

A resolution of the crisis will require Putin to finally show his hand. The best hope is that he brokers a compromise that leaves both sides -- Yukos and the prosecutor -- a bit chastened rather than triumphant. "The worst outcome would be if one party wins and the other loses," says Kaha Kiknavelidze, Troika Dialog's oil analyst. "I don't think Putin started this, and that's why a deal is possible."

A truce also might make oligarchs and siloviki more cognizant of their limits in what should be an emerging democracy. That would be a real alliance for Russia's future.