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Moscow Times
September 1, 2004
There Will Be Life After Yukos
By Eric Kraus
Eric Kraus, chief strategist for Sovlink Securities, contributed this comment to The Moscow Times.

The government's egregious mishandling of the Yukos affair -- with the administration either unable or unwilling to explain its actions, and no two ministers seeming to sing from the same hymn sheet -- has clearly caused short-term damage to Russia's financial infrastructure. In particular, the transition of the RTS from a self-contained casino into a source of long-term investment capital has been delayed, as has the well-deserved upgrade of Russia's credit rating. Institutional investors have been badly shaken by huge losses on what, just a year ago, seemed to be Russia's safest blue-chip. Yet despite this, anyone seeing parallels with the 1998 meltdown is quite simply delusional.

The Yukos case seems most unlikely to furnish any happy endings. The core shareholders' problems are of their own making and, at least in retrospect, were eminently foreseeable. Yukos was an oil company with its own foreign policy, while Menatep, its controlling shareholder, undertook what can only be described as a hostile takeover bid for the state: Corrupting functionaries and purchasing lawmakers wholesale, they threatened to paralyze the State Duma, blocking any legislation not to their liking. Given that government by and for the oligarchs -- in particular some of the same individuals now facing prosecution -- was one of the root causes of the August 1998 financial collapse, it was inconceivable that President Vladimir Putin would allow their megalomania to triumph again.

Faced with an insurmountable obstacle, Mikhail Khodorkovsky stuck his own head into the noose by adopting the Napoleonic strategy: The best defense is a robust offense. He scorned the government's offer of amnesty in return for the payment of a few hundred million dollars in back taxes and the relinquishment of his political ambitions. This self-declared patriot has instead wreaked as much damage upon Russia's international reputation as his billions could buy. Intelligent, unscrupulous and fabulously wealthy, by declaring war on the Putin government he has rendered himself far too dangerous to be allowed a comfortable London exile.

With not even Menatep's supporters asserting its innocence, the government's case seems compelling. The "everyone else did it, too" defense is devoid of legal foundation, especially given that several murders are alleged. Yukos' tax avoidance schemes were a flagrant abuse of laws intended to benefit the country's most miserable regions. And Menatep's well documented web of offshore companies and trading vehicles points to the desire of its greedy owners to strip as much value as possible.

It is thus unforgivable that the government has allowed the minority shareholders of Yukos -- innocent bystanders caught in a vicious fight between Menatep and the Kremlin -- to be punished for the sole crime of having believed that Russian companies could change. It would be entirely possible to maintain Yukos as a going concern, while moving to have the courts seize the assets of Menatep by declaring it a criminal organization -- the equivalent of an American RICO action. It is unclear whether the recent stream of dramatically contradictory information coming from the government was intended to earn a trading fortune for a few well connected insiders, or was simply the result of gross incompetence. Markets will assume the worst.

A great deal of intellectual effort has been wasted discussing the "profound implications" of the Yukos affair; in fact, there are precious few, save perhaps that investors would do best to avoid companies owned by any oligarch involved in a vicious fight with the government. Given the salutary example of Khodorkovsky's severed head impaled beneath the Kremlin wall, such oligarchs are now becoming exceedingly hard to find. There is no doubt that the judicial system is in serious need of further reform, while property rights are subject to attack both by rapacious oligarchs and by bent functionaries -- none of this is news, and to some extent it is characteristic of all emerging markets.

Predictably, the doomsayers are smugly announcing the "death of the Russian investment case," and once again they are simply wrong. With commodities prices at historic highs, Russia is awash in liquidity; the rapid increase in fixed investment is readily funded by domestic sources, while virtually every major international investment bank and oil company is actively -- sometimes desperately -- seeking to increase its Russian exposure.

From the macroeconomic standpoint, Russia's twin surpluses -- budgetary and current account -- would be the envy of any other G8 country. Certainly, high oil prices have and will continue to prove a boon, yet oil prices were high in 1996, with the benefit accruing solely to a handful of oligarchs. Perhaps thanks to the lack of any real opposition, the Kremlin has resisted the temptation to buy popularity with fiscal profligacy, instead opting for a hyper-orthodox fiscal policy. Not only has foreign indebtedness been slashed from some 120 percent of GDP in 1998 to an estimated 20 percent by the end of 2004, but by combining the budgetary reserve fund and Central Bank reserves, Russia could repurchase its entire foreign debt load with enough cash left over to fund six months of imports.

Facilitated by the windfall, and despite delays in restructuring the gas and power sectors, Russia is seeing impressive root-and-branch administrative reform -- much of it deeply unpopular, all of it vitally necessary. Industrial production is showing robust growth, while services are exploding. As wages and consumption soar, ordinary Russians feel wealthier and more secure -- Putin's popularity is clearly no artifice.

It is deeply unfortunate that the Yukos affair should have distracted attention from Russia's ongoing transformation. Advancing over the bodies of their fallen comrades, smart investors will take advantage of the ambient pessimism to load up on cheap assets, in particular non-oligarch companies, as well as sovereign and corporate debt. Once again Russia's investment case has been pronounced dead and once again, like the proverbial nine lives of a cat, it shall soon enough be catching fat mice.