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#12 - JRL 7266
Russia's Pursuit Of Yukos Rattles Foreign Investors
July 25, 2003

NEW YORK -- If neither Wall Street professionals nor Washington think tank analysts fully understand the motivations behind the Russian government's moves against one of the country's most powerful oligarchs, they all think it's negative.

While it may be politically expedient, economically it can only hurt Russia's ability to attract investment and move closer to a coveted investment-grade credit rating, experts say.

The criminal investigations into oil giant OAO Yukos (R.YUK) range from tax evasion to theft of state property to murder, and appear designed to bring down Mikhail Khodorkovsky, the billionaire chairman of financial group Menatap, which controls 61% of Yukos.

There's plenty of speculation about why authorities are going after Khodorkovsky, Russia's richest man, and his business associates.

Celeste Wallander, director of the Russia and Eurasia Program at the Washington-based Center of Strategic and Economic Studies, cited several possible "messages" that authorities are said to be sending to the oligarchs, those made rich during the country's tainted privatizations in the 1990s.

The signals, she said, may be that Khodorkovsky should refrain from completing the merger of oil firm Sibneft (R.SBN), if officials consider that Yukos, Russia's largest oil producer, already is big enough. Or that he shouldn't fund opposition parties to help them compete in December parliamentary elections. Or that he should bury any personal political ambitions that he may harbor.

Clifford Gaddy, a Russia expert at the Brookings Institution in Washington, said the message may well be that President Vladimir Putin, under pressure from the country's security apparatus, will not allow private players such as Yukos to overplay their cards in future developments, including an oil pipeline project in Russia's far east. "Control of the energy sector is regarded as strategic as nuclear weapons," Gaddy explained.

When Putin was elected in 2000, he essentially told the oligarchs they could keep their assets but they would never be permitted to "shape the overall direction of the country" in pursuit of profits, added Gaddy, suggesting that Khodorkovsky may have violated such an understanding.

And with presidential elections next March, coming down on the oligarchs may also be politically expedient for Putin, who's expected to be re-elected.

"Perhaps it's a purely populist move," said Helena Hessel, Russia sovereign analyst at Standard & Poor's in New York. "All these oligarchs are not being accepted by the population at large, so it would be a good way to gain popular support."

Whatever the reasons, the offensive against the oligarchs comes at a significant cost. Since billionaire Platon Lebev, who's also a major Yukos shareholder, was arrested July 2 and charged with embezzlement in a 1994 privatization of a fertilizer plant, the net capital inflows in the first half have are now shifting into net outflows.

Despite Prime Minister Mikhail Kasyanov's recent comment that privatization results are "unchangeable," the market clearly appears unconvinced that the state will respect property rights.

Yukos has shed about $7 billion in market capitalization since early July. Russian stock prices overall have fallen 7.9% so far this month on Morgan Stanley's MSCI equity index, after soaring 44% in the first half of the year.

"I've dramatically reduced my exposure in Russia ," said Uri Landesman, who manages about $500 million in international equities at Federated Global Investment Management in New York. "I've sold my whole Lukoil (R.LKO) position. I've sold my whole Yukos position, (though) half of that before all this started."

He noted that he still has a stake in the world's biggest natural gas producer, OAO Gazprom (R.GAZ), a state monopoly and owner of the country's gas pipeline network.

Gazprom is "a much safer play," Landesman said. "I don't think they'll go after the whole energy sector."

Still, just how far and how long the investigations will go remain unclear given the elections, he said. "At first I thought it was just saber rattling, and now it looks like they're really going after them."

Although Landesman doesn't expect the businessmen to "rot in jail," he pointed out that foreign investors don't have to stick around to find out.

"Most who those who invest in Russia don't have to," Landesman said. "If it gets hairy, they don't have to be there. They can take the pain and can go back later."

At this point, he added, the risk premium on most Russian assets isn't high enough for his tastes.

Kasyanov acknowledged on Thursday that the charges have rattled the market. "The situation has continued for a long time, and still there is no resolution," he said, adding that it "doesn't support the national image and is negatively influencing the mood of investors."

Nor are ratings agencies favorably impressed.

"It calls into question property rights and shows an abuse of power," S&P's Hessel said. It betrays "a lack of transparency" because it's unclear who within the government is actually pushing the charges against Yukos - which has made strides in improving its corporate governance - and why they would choose to do it now, she added.

Nor have the authorities explained why they're going after Khodorkovsky and his associates and not other oligarchs involved in the privatization process, she said. These are the "legal and institutional aspects (of the case) that undermine the belief that Russia had stepped forward" democratically, she added.

Indeed, "the whole political system is not yet tested, solid, and can be undermined by people whom we can't even identify," the ratings analyst said.

While the influence of the oligarchs through the oil sector should be reduced, the best way to achieve this is through more structural reform that diversifies the economy to ensure sustainable growth over the longer term, she added.

In a sign of progress on administrative reforms, Putin on Wednesday signed a decree calling for the reduction of state involvement in the economy and eliminating various public sector redundancies. But "political issues" still delay reforms such as those meant to strengthen the "very weak" financial system, Hessel said.

S&P has a BB foreign currency rating with a stable outlook on Russia .

"It will still be a while before Russia is investment grade," Hessel added.

Gaddy, from the Brookings Institution, said analysts and investors should keep in mind that for Putin the market "is a means not an end," and is used to promote a strong state that will itself determine the strategic direction of the country and to finance its military industrial complex.

In Putin's recent speeches, he noted, "the rhetoric was straight out of the (now-defunct) Soviet Union."

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