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Moscow Times
August 18, 2004
The Chilean or Indonesian Model?
By Christopher Weafer
Christopher Weafer, chief strategist at Alfa Bank, contributed this comment to The Moscow Times.

The reason why Russia's richest oligarch is sitting in jail is because he wanted Russia to become the new Saudi Arabia. President Vladimir Putin said he wants Russia to pursue a European economic model and prefers to focus on catching up with Portugal (until recently the poorest of the EU member states in per capita wealth). Events of the past few months concerning the Yukos tax case and a lack of progress in pushing ahead with key economic and administrative reforms have raised doubts among both domestic and foreign investors about exactly which model the government is likely to reproduce.

That uncertainty has led to a sharp rise in the rate of capital flight -- up to $12 billion is expected this year -- and a sharp drop in the valuation of assets on the stock market (down 30 percent over the past four months). Whether these trends prove temporary or long-lasting will depend on whether the government moves to restore confidence or cements current doubts through the continued absence of positive action.

An authoritarian government with easy access to export-generated cash flows is the perfect combination for fast-tracking wide-ranging reforms that then translate into broad expansion and growth in the economy. It is also a perfect recipe for the apathetic misuse of fiscal strength and for missed opportunities. Today, Russia is at a crossroads or, more accurately, a T-junction: It has to turn one way or the other.

One road is the route successfully traveled by countries like Chile and points the way to Portugal and Putin's vision of a European economic model; the other is the path down which Suharto took Indonesia and will inevitably lead to Saudi-style dependence on the commodity price cycle, continued wealth concentration (albeit shifting to the "late-arriving oligarchs" among the siloviki) and protection for inefficient state-sponsored industries.

Today, and every day this year, Russia will earn approximately $300 million from the export of oil and gas. Six years ago that daily average was only about $70 million. There can be no doubt that the rapid growth in export revenues was as critical a factor in the country's recovery from the August 1998 financial crisis as the 1990s decline in the oil industry was a major contributing factor to the default. But the decline and recovery in the value of energy exports only tell part of the story.

One of the reasons why events concerning the Yukos case and the lack of progress on the reform agenda are having such a negative effect is because investors had come to believe that Russia was on a fast track to global integration and modernization. Putin had convinced investors that not only were the days of economic chaos and political confusion, experienced under Boris Yeltsin, well and truly over, but that they had been replaced by the two critical factors which differentiate a stable economy from one with continued high risk and volatility. These are political stability and economic predictability.

In 1999 and 2000, the investment case for Russia was based on the simple formula of very cheap assets, following the collapse of 1998, becoming less cheap as oil revenues propped up the fragile economy and political structure. From 2001, investors slowly became convinced of the case for political stability and economic predictability. And despite the arrest of Platon Lebedev and Mikhail Khodorkovsky -- events that were seen as part of bringing closure to some of the Yeltsin-era legacy issues -- by the time Putin was re-elected in March, capital flight had reversed and assets were trading at valuations close to global emerging-market peer groups.

But political stability is about more than just having an authoritarian government that is unchallenged by external dissent. The political stability that investors look for is that which General Augusto Pinochet oversaw in Chile and Mahathir Mohamad established in Malaysia. Chile is of course a difficult model for comparison because of the regular brutal suppression of political opponents, a legacy of the overthrow of the previous regime. Such a situation, where the newly established government had forcibly ousted an established popular regime, did not exist in Malaysia nor does it exist in Russia.

The chief characteristic as regards management of the process of economic change is that both governments were internally united on a strategy for economic reform, created growth incentives for small-business development, reduced bureaucracy and obvious corruption, and established a strong partnership with industry. These are also at the heart of the reform agenda that Putin has set out for Russia.

Similarly, economic predictability is more than a country's ability to service its foreign debt and pay its bills on time. It is about establishing a credible strategy that can deliver long-term economic growth and wealth expansion.

Right now investors have serious concerns. The apparent inconsistency between the broadly pragmatic statements of the president and his senior ministers regarding the objectives and likely endgame of the Yukos tax case and the aggressive actions of certain state agencies and bureaucrats suggests that there may be one or more factions within the siloviki that favor a different outcome. That outcome, it is feared, may have more to do with wealth reallocation than preserving the goal of an attractive investment climate -- something Putin has consistently said is required if Russia is to successfully compete for investment capital with countries like China and India. The lack of any real progress on key reforms has also called into question the government's ability, or willingness, to deliver on its stated strategy.

To many investors, these concerns raise the specter of the Indonesian syndrome. In this case, senior members of the government structure under Suharto, although initially committed to wide-ranging economic reforms, actually used Indonesia's growing commodity-based wealth to enrich themselves and to favor selected industrial groups, while slowly abandoning their previously stated lofty goals. When Suharto was ousted from power in 1998, as a result of the riots that followed the Asian economic crisis, he was ranked as the sixth-richest man in the world with a personal fortune estimated at $16 billion, while Indonesia was on the brink of bankruptcy. Mahathir, on the other hand, is not regarded as personally very wealthy, and his presidency and economy survived the Asian crisis.

Again, it has to be stressed that this review is purely focused on the economic success achieved by regimes that solidly stuck to their stated economic goals and did not allow either internal government dissent or external pressures to deflect them from those goals. Their record on human rights and political freedom is an entirely separate issue that is beyond the scope of this article.

It must also be noted that all three leaders stayed in office for more than two decades, while Putin has indicated that he will not seek a third term. That raises the important question of whether he will be successful in building a common ideology in government that will survive the transition in 2008. A critical factor in this will be Putin's ability to prevent the entrenchment of factions within government, and how the Yukos case ends will probably be decisive in answering this question.

The stock market, notoriously abhorrent of any uncertainty, will undoubtedly rally once the Yukos case ends, almost regardless of the structure of the endgame. But whether this is simply a relief rally or a resumption of long-term asset price appreciation will depend on how investors view the integrity of the assumptions that drove the market in 2002 and 2003 -- i.e. political stability and economic predictability.