Essar Wrap: A Word on Rosneft’s India Move

The news just dropped that Rosneft’s repeatedly delayed acquisition of Essar Oil, its massive refinery, its 2,700 filling stations, and the deep-water oil port of Vadinar has finally gone through. The Obama administration attempted to use Treasury’s Office of Foreign Assets Control (OFAC) and existing financial sanctions to scuttle the deal last August. Beyond that, much of the roughly $13 billion deal was Rosneft and partner Trafigura buying Essar Oil’s debt. Essar had hoped for an equal stake agreement between the two firms, but Essar’s poor debt gave Rosneft leverage to push for captive power and the port in the deal. As one might expect when CEO Igor Sechin has a financial edge, the deal wasn’t exactly friendly. It’s quite possible that the negotiating process and shutout of India’s firms will leave a poor taste in the mouths of India’s corporate leaders interested in acquiring Essar on the cheap, making the deal a classic Russian proposition: a tactical advance with a less clear strategic rationale or calculus.

It’s quite possible that the negotiating process and shutout of India’s firms will leave a poor taste in the mouths of India’s corporate leaders interested in acquiring Essar on the cheap, making the deal a classic Russian proposition: a tactical advance with a less clear strategic rationale or calculus.

Rosneft’s acquisition is big news for several reasons. First, Russia has historically struggled to sell oil to the Indian Ocean for the obvious reason that Gulf producers are right there. By acquiring a refinery in Gujarat at a capacity of about 400,000 barrels a day, Rosneft has a guaranteed entry point for oil supplies. It’s been suggested that Rosneft would source its Venezuelan production, perhaps less likely given political instability there now but a link between Russia’s foreign policy interests in the Caribbean and its Asian oil strategy. On top of that, the OPEC cuts have eaten at the margins for specific Gulf blends commonly traded in the region, giving Russian oil traders a more competitive look on the Indian market as prices for Russia’s Ural blend are too low to not draw interest. Furthermore, ONGC Videsh and other Indian firms have bought into Rosneft’s Vankor field, which is likely contributing to a rise in Russian oil exports to India. Finally, it gives Russia a deep-water port in a region fast becoming central to Russia’s foreign policy outlook. The Eurasian Economic Union is already pursuing free trade agreements with Iran and India and has just announced interest in reaching one with Pakistan. Russia isn’t a major infrastructure investor, but can use this port to broaden its commercial reach regionally.

Before getting ahead of ourselves, India’s Home Ministry and its Intelligence Bureau have red-flagged the acquisition of the port for security reasons. It’s relatively close to Pakistan, India has military installations in the region, and it will provide Russia a facility that could potentially be used for espionage activities. Despite the refinery deal, it’s still possible in the future with rising production in Iran or elsewhere that Russia’s oil simply won’t be competitive. The likeliest reason to prefer Russian oil supplies would be that East Siberian and Far East fields yield oil that burns cleaner, important for climate and health sensitive policies. Overall, it’s big news and a win for Rosneft and Russia in the region. But security fears and the bad blood over the deal may still derail the acquisition of the port.

Analysis by Nick Trickett

In Translation: Incomes to Bounce Back by 2020, Pensions Won’t At All

Article by Olga Kuvshinova and Aleksandra Prokopenko. Translation by Nick Trickett. 

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Pensioners, under the Ministry of Economic Development’s plan, will pay for growth today or tomorrow. Will the Kremlin risk throngs of angry babushki? (Photo: Andrei Gordeyev)

In the target scenario of its macroeconomic forecast through 2035, which assumes a growth rate higher than the world average, the Ministry of Economic Development sees near zero real growth for pensions over the next 20 years (“Vedomosti” has seen the document).

To raise the economy’s growth rate in the target scenario, the plan proposes increasing the number of those employed, boosting investment activity, and improving labor productivity. Employment growth is achieved, among other things, by raising the retirement age to 65 for men and 63 for women following from the demographic parameters presented in the forecast. The number of pensioners by 2035 falls 23%, or by 7 million people compared to 2017 (without reforms, it increases by 5.4 million people) with the growth in total employment by a million (without reforms, a decrease of 3.2 million).

However, the increase in the retirement age is accompanied by a sharp drop in the level of pensions: their size in relation to wages falls from the current 35% to 22%. In this way, at least a fifth of the population not only won’t benefit from the realization of the plan to increase the economic growth rate but will lose: their incomes will actually fall in relative terms.

In this way, at least a fifth of the population not only won’t benefit from the realization of the plan to increase the economic growth rate but will lose: their incomes will actually fall in relative terms.

This double reduction – the replacement rate and the number of pensioners – will almost halve the ratio of pension outlays to the National Pension Fund – from 28% to 15%. Then investments can grow 1.5-2 times faster than the economy, and productivity faster than wages.

Wages and incomes will grow more slowly than the economy over the next two decades, growth that, per the prognosis, won’t be outstanding.

In case of the successful realization of reforms, economic growth reaches 3.5% by 2026, after which it will slow down somewhat but by then, the Ministry of Economic Development calculates, world growth will be lower. As a result, the real income of households, which has fallen by 10% over the last three years, will only reach their pre-crisis 2013 levels in 2022.

In comparison with 2016, incomes will increase by 55% over the next two decades, real wages by 56.5%, GDP by 78%, and pensions by all of 2.5%. Their growth resumes in 2024, but they’ll be reduced in real terms until 2032, the Ministry suggests. As a result, pensions will remain 4% below their 2013 level by 2035.

In the target scenario pensions are indexed annually from the 1st of February in line with the previous year’s inflation rate, clarifies an official at the Ministry. Additionally, there are plans to raise pensions from the 1st of April in accordance with the growth of the Pension Fund’s incomes – but by no more than 1% per year. In calculations, pension indexation is reserved for non-working pensioners, he specifies.

According to the forecast, with 2.5% real growth for pensions, the pensions of non-working pensioners increase 20% in real terms over 20 years. This means that converting into today’s rubles, the average insurance pension in 2035 will amount to just a bit more than 13,000 rubles and the pension of a non-working pensioner will increase to about 15,500 rubles.

It would be strange if the savings from an increase in the retirement age weren’t directed – at least in part – to pensions, but to other spending items. It’s a very tough situation, comments an expert (who asked not to be named to avoid a quarrel with Ministry). All the latest proposed innovations in the pension sector — for example, the transfer of a fixed payment to the budget or savings on transfer — are similar to an attempt to make a poverty benefit out of insurance pensions worries Yuri Gorlin, deputy director of the Institute for Social Analysis and Forecasting of the Russian Academy of Science and Technology.

Alexei Kudrin’s Center for Strategic Research (CSR), judging by the Ministry’s calculations, supports increases the retirement age to 65 for men and 63 for women. However, the CSR assumes the age increase and other measures to tighten conditions for the allocations pensions are see maintenance of the salary replacement rate at about the current level: no less than 35%. Raising the retirement age offers some savings, it would be fair to share them with pensioners says Tatyana Maleva, director of the Institute for Social Analysis and Forecasting of the Russian Academy of Science and Technology. There isn’t really talk of raising the pension provision now. Even the realization of the whole range of measures proposed by the CSR allows only to maintain the ratio of pensions and salaries at a socially acceptable level.  The actual freezing of pensions for 20 years is fantastical, Oksana Sinyavskaya, deputy director of the Institute for Social Policy of the Higher School of Economics, believes. It’s socially dangerous. Similar forecasts, apparently, are poorly calculated and don’t take into account how they mesh with reality, she believes.

That a reduction in workloads will lead to increased investment by freeing resources for enterprises is completely unrealistic, says BCS chief economist Vladimir Tikhomirov. Low investment growth is a worldwide problem, he notes: companies aren’t investing, despite historically low interest rates and the colossal sums of cash on their balance sheets. When demand doesn’t grow, there’s no point investing in expansion: it’s highly doubtful that it can be the other way round in Russia, he says. Although, on the other hand, cutting costs really gives a stimulus for investments, he continues, but this is related to automation, robotization i.e. accompanied by a reduction in jobs – it leads to growth in labor productivity but not to employment growth. The situation is aggravated by the growth in the number of pensioners. As a result, states are forced to reduce previous social obligations. By 2035, these world trends will reach Russia, Tikhomirov predicts.

In Translation: Problem Loans Make Up 40% of VEB’s Portfolio

Article by Margarita Papchenkova. Translation by Nick Trickett.

Vedomosti has examined VEB’s credit portfolio as of the 1st of May. An employee at the state bank revealed a list of loans with names of debtors, the amount of debt, the amount of reserves for the debt, and how bad the debt is. Another confirmed its authenticity. VEB’s press secretary declined to comment on the document, saying that the list is a commercial secret.

unnamedWithout accounting for subsidiaries Svyazbank and Globex, VEB has issued 155 loans worth 2.2 trillion rubles. The state bank has divided them into four categories depending on their quality: green, yellow, red, and black. The first two, in the words of a VEB employee, denote good or acceptable loan performance. Red implies a difficult situation while black means a very difficult one – as a rule, default.

The credit portfolio attributed to the black category is worth 275.6 billion rubles, but it’s near entirely covered by loss provisions – 251.7 billion rubles (91.3%). For the red category, these figures stood at 685.6 billion, 110 billion, and 16% respectively. Yellow loans are reserved at an even higher average rate of 17.8%. And for many, this figure exceeds 50%. If 51% of the credit is reserved, then it can already be considered problematic, suggests Anton Lopatin, an analyst at Fitch Ratings.

However, last year, VEB received government guarantees worth 547 billion rubles for Ukrainian assets. The bank, for example, credited Russian investors’ purchase of control in the Industrial Union of Donbas, as well as owning the local Prominvestbank. Government guarantees allowed the bank to release reserves, explained an employee from VEB.

“VEB is a development institution, and no one said such an institution should have a good portfolio: it’s often used where business won’t go,” added a VEB employee. On the other hand, there are projects in the real estate section of the portfolio, he remarks, “of which many are in the black zone. What does that have to do with development?”.

On the other hand, there are projects in the real estate section of the portfolio, he remarks, “of which many are in the black zone. What does that have to do with development?”

According to the consolidated financial statements under IFRS for 2016, VEB’s credit portfolio was worth 2.7 trillion rubles, including 2.5 trillion for the parent bank. Of these, 580 billion have been depreciated and 480 billion are overdue. At the same time, nearly 800 billion rubles in provisions for depreciation were created, notes Lopatin. In general, things look better than they did 2-3 years ago. It’s difficult to evaluate just how adequate reserves are, continues Lopatin. Every loan has to be considered individually.

The Central Bank defines 5 categories of borrowers by quality. Depending on the risk, reserves are created for them at 0%, 1-20%, 21-50%, 51-100%, and 100%, comments S & P analyst Sergei Voronenkov. There are hard, formal attributes referring to the categories: for example, if a restructuring took place higher than in third category, it can’t be carried, an expert explains. But the amount of reserves can decrease by the level of collateral. VEB operates without a banking license and can formally not comply with a regulator’s demands, using them only as guidelines, Voronenkov concludes.

Last year, VEB created 510.4 billion rubles in reserves. This led to an annual loss of 111.9 billion rubles. VEB has not yet disclosed how much more it needs to create reserves. Voronenkov calculates that VEB will see profits again next year.

VEB has been used to finance political projects, but the issuance of loans has become toxic, overlaid with funding problems due to sanctions. As a result, at the end of 2015, the bank needed help from the state – 150 billion rubles per year in capital. Now the state betting big on VEB as a source of project financing, but before they can, VEB has to sort out old problems, notes a high-ranking official. VEB prepared three strategies for all its assets: credit, default, and a combination. The first involves a continuation of work with the borrower. The second involves the sale of assets, possibly at a discount, employees of VEB say. Most of the black debts fall under the default strategy as stated in VEB’s materials.

The history of VEB’s fall was presented as an outcome of being overloaded with political assets, but a very large share of bad loans came from pettiness not connected to big politics, says a person whom the government consulted when creating VEB. The top 5 red and black accounts come to about 500 billion rubles, or more than half of all problematic loans. Yet all the rest are small loans, many of them within the range of 10 billion rubles.

“On one hand, the bank itself set up the issuance of loans poorly; there wasn’t any expertise. On the other hand, it was perceived to be an anti-crisis tool and the bank often didn’t take any real collateral,” a VEB employee retorts. VEB is trying to change this and that now, Vedomosti’s source says: it’s reforming its business subdivisions, advancing fixes to loan syndication that will allow co-investment with other investors under the same conditions and under a single deposit.

In Translation: China has decreased investments in the new “Silk Road”

Article by Gabriel Vildau and Ma Nan. Translation by Nick Trickett.

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Certain state companies are complaining about the unprofitability of projects associated with China’s ambitious One Belt One Road Project. (Photo: Greg Baker)

Investments in President Xi Jinping’s high-profile project One Belt, One Road declined in 2016, evidenced by several indicators. This calls into doubt commercial enterprises’ preparedness to sink money into the strategy, which pursues not only economic but geopolitical goals.

The leaders of 28 states will gather this weekend in Beijing at a conference dedicated to the initiative, which includes the creation of two transport corridors – the Economic Belt of the Silk Road, and the Maritime Silk Road of the 21st Century. First proposed in 2013, they call for the construction of road and trainline networks, ports, fuel pipelines, and power plants on the route connecting China with Southwestern and Central Asia, the Near East, Africa, and Europe. The new Silk Road has even occupied a central place in Beijing’s economic diplomacy and become a subject of its propaganda. But certain data suggest that the hype surrounding the initiative may be exaggerated.

China’s Foreign Direct Investment (FDI) into the countries taking part in One Belt, One Road dropped 2% in 2016 and another 18% year-on-year from the beginning of 2017, according to data from the Ministry of Commerce. Non-financial FDI into these 53 countries stood at $14.5 billion in 2016 – a mere 9% of China’s total volume of FDI. This volume rose to a record 40% last year, which forced Chinese regulators to restrict the foreign activity of local companies and the outflow of capital. Additionally, the geographic distribution of FDI connected to the initiative makes one question how much money is actually going into infrastructure. Singapore received the largest amount of investment in 2016 and has well-developed infrastructure.

“With large investments, especially abroad, the numbers won’t necessarily grow each year,” says Xiao Qing, chairman of the Committee on Control and Management of State Property of China (SASAC). He stresses one should not watch the growth of investment in annual terms, but the development of the projects themselves. Xiao therefore expressed confidence that in the long-term, investments in the Silk Road countries will grow. According to SASAC, 47 Chinese state companies were involved in 1,676 projects in these countries.

But privately, some bankers and representatives of state-owned enterprises complain that the government forces them to take part in unprofitable projects. “Many state-owned companies are now fixated on this: the government forces us to do what we do not want,” says a recently retired top manager of one of the largest state-owned enterprises.

In addition to FDI, cross-border lending is an important part of the initiative. But the loans issued by the China Development Bank (CDB) fell by $1 billion to $100 billion in 2016, according to information on its website. The share of CDB loans going to Silk Road countries peaked at 41% in 2014, falling to 33% in 2016. The CDB declined our request for comment.

Chinese experts insist that these figures don’t reflect the full picture. According to Jia Jinjing from the Chunyang Institute of Financial Studies at the People’s University of China, most Chinese FDI passes through other countries before reaching its final destination. This makes the Ministry of Trade data an unreliable tool for assessing investment in the countries of the Silk Road. “To assess them, you need to look at how many countries signed a memorandum of understanding to participate in the One Belt, One Road initiative and how many heads of state or other important guests and delegations will attend the summit. That’s the most important thing,” says Jia.

In Translation: Officials Drill Ahead on Oil Tax Reform

Article by Margarita Papchenkova and Elizaveta Bazanova. Translation by Nick Trickett.

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Photo: E. Razumniy, Vedomosti

On April 20th, a long-awaited reform for oil sector taxation was approved during a meeting with Russia’s Deputy Prime Minister, Arkady Dvorkovich. According to two federal officials, the transition from the severance tax (MET) to a tax on added income (NDD) will take place from next year. Dvorkovich’s representative refused to comment on the matter.

Unlike the MET, which depends on the quantity of extracted oil, the NDD is taken from the revenue of oil sales against the deduction of expenses for extraction and transportation. The rate will be 50%, with an export duty preserved in  a reduced form, as well as a small MET. The new tax is intended for the pilot fields in Western Siberia that are 20-80% depleted (as of 1 January, 2016) with production up to 10 million tons a year, as well as for new fields with depletion rates at 5%. In order to insure against budget losses, there will be limited expenses accounted for before the tax is calculated: the initial bar was 9,510 rubles per ton, but the Ministry of Finance then lowered it to 7,140 rubles.

The Ministry of Finance and the Ministry of Energy had been unable to reach an agreement on the reform for two years, and when they finally reached a compromise, Rosneft upset their plans at the finish line. Last year, the company requested an exemption from the MET for its gigantic Samotlor field due to its high water cut. Prime Minister Dmitry Medvedev was tasked with working through the request, but the Ministry of Finance laid down an ultimatum: take the NDD or the exemption. “You can’t carry out tax reform with one hand and continue giving out exemptions to the MET with the other. It’s not a systematic approach,” Alexei Sazanov, director of the Ministry of Finance’s tax department explained. The Ministry of Finance proposed Samotlor be included on the list of projects covered by the NDD.

You can’t carry out tax reform with one hand and continue giving out exemptions to the MET with the other. It’s not a systematic approach.

Dvorkovich approved the NDD without a binding decision for Samotlor. According to a participant at the meeting, the Deputy Minister pledged to evaluate the effect of an exemption for Samotlor without offering a concrete timeframe. According to an official from the Ministry of Energy, it’s not necessary to bind the NDD to the Samotlor exemption – it’s guaranteed that the exemption will increase production at the field, and the NDD is still an experiment. He added that the whole sector would benefit from the NDD, and that Rosneft would be the only exemption.

According to two officials, the fate of the Samotlor exemption will likely be decided by the president. One high-placed official is certain that if the question isn’t raised again, it’s possible the “topic will go away.” Officials told Vedomosti that Andrei Belousov, aid to president, supported an earlier exemption to the MET for waterlogged fields.

Falling budget revenues from the Samotlor exemption may reach 80 billion rubles, by the Ministry of Finance’s calculations. The NDD reform will also bring losses – around 25-30 billion rubles proceeding from the latest parameters of the bill. The Ministry of Finance points out that it will create a hole in the budget together with possible losses from small returns from state companies’ dividends (less than 50% of net income under the IFRS). The Ministry of Energy objects, says one official: there are additional oil and gas revenues, primarily from the freeze on oil extraction, which can plug the hole.

It’s surprising that a reasonable decision was reached in the end, remarks Grigoriy Vygon, Managing Director of Vygon Consulting. He says that the bill on the NDD was ready long ago and needs to get going. Direct accounting of costs in the taxable base helps make the tax system more complete and develop new reserves that are unprofitable in the current conditions, says Denis Borisov, the director of Ernst and Young Moscow Oil and Gas Center. “The quicker the experiment with the NDD starts, the better.” Vygon is patient, saying that for two to three years, they’ll administer the reform and then talk about scaling the experiment can start. “In the coming years, the current regime will remain the basis of the tax system – no fewer than three years are needed for the pilot tests of the NDD and the assessment of results,” says Borisov. Borisov believes that point-based tuning should continue on the basis of “win-win” (more extraction, more budget and company revenues, more revenues from related sectors), including the creation of stimulus for fields with a high water cut. “It’s a question of a compromise between budget interests, companies, and the country’s economy,” he says. “It’s necessary to evaluate the need for exemptions, not only for privileged waterlogged fields, but for the industry as a whole.” Vygon is categorical in saying that this calls for thinking about modifications to the NDD’s  parameters, not a new exemption per the MET: “in this way, the decision will be systemic rather than targeted as it has been thus far”.

Dirty Jobs: Being a Governor in Russia is Proving Tough

Guest Contribution from Fabrice Deprez

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Sverdlovsk Oblast acting governor Evgeniy Kuvaishev. (Photo: Valeriy Sharifulin)

It’s a rough time to be a regional governor in Russia. Since last year, arrests and resignations of local leaders have piled up and accelerated in the last few weeks, with five governors gone since February. Described by some as a way for the Kremlin to prepare the presidential elections, whether by pumping “new blood” into Russia’s political system or by demonstrating its will to fight corruption at the highest level, the shake up is putting the regional establishment into a difficult position.


Russian media outlet Gazeta described the position of governor in a recent op-ed as “a dangerous job”. “Ten years ago, it was difficult to imagine a criminal case being opened against a governor. Now though, they are being arrested almost on an industrial scale”, Gazeta wrote.

Last year, the gubernatorial turn-over had been interpreted as a way for Putin to tighten its control over the regions by installing little-known but loyal people, who often had a background in the security services. Later, it took the appearance of an anti-corruption drive aimed at addressing Russians’ number one concern one year before the presidential election.

Carolina De Stefano, a visiting researcher at Moscow’s Higher School Of Economics, writes that “there is the feeling—particularly in non-economically relevant regions—that local politicians could increasingly become the target of an anti-elite stance, which is mainly aimed at lending an impression of honesty to the federal leadership”.

Whatever the real reason, Moscow’s recent preference for young technocrats from the state apparatus and the anti-corruption rhetoric had the consequence of making goverernship less appealing than ever. “Not only have governors stopped to be untouchable,” Gazeta writes. “On the contrary, the position now feels like it’s being put in front of a firing squad”.

The arrest of the governor of Mari El only added to the general feeling that local leaders cannot trust Putin’s word anymore, say Russian journalist Andrey Pertsev. As he accepted Leonid Markelov’s resignation, Putin publicly declared that Markelov wanted to “find a new job”, implying that, as that often happens, the politician would get a cozy semi-retirement position, maybe in the Senate. Instead, one week later, Markelov was arrested on suspicion of taking a RUB250m bribe.

“On the contrary, the position now feels like it’s being put in front of a firing squad”.

“If not for this remark, Markelov’s arrest would have been trivial”, Pertsev writes. “[But] the word of Vladimir Putin is almost the foundation of Russia’s personnel policy”.

“Other guarantees of one’s political future could change: support from “United Russia”, protection from people close to the president, economic success, good relations with the “People’s Front”…it can all come and go, but the president’s promise has always served as a reliable beacon.” With Markelov’s arrest, Pertsev argues that “[the] beacon doesn’t exist anymore for the Russian elite”.

The problem is not simply the feeling that any governor could be forced to resign or arrested on short notice, or that they no longer have the support of the Kremlin. Regional heads are also feeling pressure from below.

A Protest Headache

The March 26 anti-corruption protests, surprising in their regional reach, has made the task of governing even harder. Governors are now being forced to deal with rising discontent in a crucial electoral period while, in some instances, being short on cash.

“All governors, whether technocrats, security officials or public politicians, have to work with the constant eye of the Kremlin looking over them”, Gazeta writes. “Citizens, in turn, are well aware that they are being sent obscure officials. And they can either look around philosophically and think “we’ll survive this”, or they can start protesting.”

Some already have. In the Siberian city of Novosibirsk, a planned rise of utilities pricing by local authorities mobilized several thousand people into the streets over March and April, over at least seven separate protests. The gatherings were organized and mostly attended by local pensioners, a strategic constituency for the Kremlin, but opposition figures were also in attendance, including Alexey Navalny.

In oil-rich Tatarstan, the surprise collapse of one the region’s biggest bank in March lead to pickets, then larger gatherings of locals demanding access to their savings. Just like in Novosibirsk, protests that started for purely economic reasons in Tatarstan turned political, with protesters in both regions demanding their local governor’s resignation. It was unsuccessful in Tatarstan, but managed to convince Novosbirsk’s governor to back down on the utilities rate rise. The rare win for protesters illustrates the tough situation local heads are discovering themselves in.

The Delicate Balance of Regional Politics

Despite this, Putin has had no problem so far finding willing officials to take the job. But Moscow’s situation is one of delicate balance, according to Tatyana Stanovaya, a Russian political specialist. Stanovaya says that the Kremlin needs “effective regional managers who can be painlessly removed if things go wrong”, that is, people good enough to handle local issues efficiently and hand Putin a good score in next year’s election, but not so good that they could start enjoying electoral support and be tempted to become more independent.

In fact, Carolina De Stefano believes, this may very well have been the strategy behind the reinstatement of direct gubernatorial elections in 2012: “it performs [an] important task in times of trouble: in case of popular discontent, there is someone other than the central government to blame”.

This danger may appear far-fetched in the short term: local authorities traditionally enjoy far less support than the president. They tend to bear the brunt of mismanagement and corruption accusations, while Putin is seen as the potential solution rather than part of the problem (in both Novosibirsk and Tatarstan, the protesters demanded the resignation of their locals authorities while asking the federal center for help). According to a Levada poll, 48% of Russians approved the work of their local governor in March, a steady rise since a historic low of 30% in October 2014, but a far cry from Putin’s steady 80% approval rate.

This could explain why Putin has been replacing leaders in troublesome regions with loyal siloviki: the regional establishment stills holds significant power and, Stanovaya argues, could potentially form a new “counter-elite”:

Recently, the Kremlin has been appointing as governors not strong managers but men associated with the security services and conspicuous only by their loyalty. This attempt to simplify and strengthen governors’ subordination to Moscow will only result in more mistaken and dangerous decisions at the regional level.

If federal power gets weaker, the overwhelming majority of the regional political establishment will end up in opposition to Moscow. Literally the whole of the regional elite, with the exception of those with personal ties to the president, can potentially turn into a counter-elite.

That is, of course, a big “if”. For now, Moscow’s “power vertical” is alive and well, and governors are stuck with contradictory obligations to ensure their political survival. They need to be loyal to the Kremlin, but maintain some semblance of independence when managing their regions. They must be effective, but still unpopular enough to take the bullet for Putin when protests arise. They should help Putin get elected next year, but not mind the potential threat of arrest or forced resignation.

A tough job indeed.

In Translation: Death of a Bank

Tatfondbank’s demise shows even a state-backed institution can fail. Article by Svetlana Petrova for Vedomosti. 

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Protesters gather outside a Tatfondbank branch in January. (Photo: Maksim Bogodvid, RIA News)

Kazan’s Tatfondbank had everything for success: a long history (the bank was founded in 1994), a good reputation, ranked second for market share in Tatarstan (and forty-second overall in Russia), a major shareholder in the state, respectable international ratings, and International Financial Reporting Standards (IFRS) status with an international audit. This past November, the bank even managed to place $60 million in Eurobonds.

It turned out, however, that Tatfondbank was actually in deep distress, and the consequences of its subsequent collapse have been unprecedented. Many of the bank’s senior managers are behind bars and have had their personal property and that of their relatives seized, and the head of the National Bank of Tatarstan as well as the Republic’s Prime Minister have resigned. All this happened within a month of the bank’s license being withdrawn, spurring angry deposit holders to take to the streets.

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Protesters in Kazan. (Photo: Yegor Aleyev, TASS)

The protests started with small pickets by bank clients on the periphery of Kazan at the beginning of January this year, after around 2,000 people were told they would not be able to claim deposit insurance payouts. After this, their savings were transferred to a trust managed by a subsidiary investment company of Tatfondbank Finance. When the Central Bank announced Tatfondbank’s license withdrawal on March 3rd, depositors crashed President of Tatarstan Rustam Minnikhanov’s vkontakte page. The pickets grew into spontaneous protest actions (most visibly on March 4th near the Cabinet of Ministers of Tatarstan) and then into organized gatherings. Initially, the demonstrators only put forward an economic demand: pay back depositors from either the bank or the local budget. But they moved on to political demands, calling for the resignations of the Prime Minister of Tatarstan Ildar Khalikov, the republic’s government, and even President Minnikhanov himself.

There is a simple explanation for why the people’s anger was aimed at the republic’s leadership. The government of Tatarstan owned around 40% of Tatfondbank, while Prime Minister Khalikov served as head of the bank’s board of directors for almost three years.  On 15 December, 2016, the Central Bank took temporary control of the bank and ceased its operations. The local authorities called on people not to panic, and the bank’s clients trusted in the clean-up. On 27 February, the head of Tatarstan’s press service announced that one of the strongest financial-industrial groups in the republic—TAIF—was to take part in the bank’s clean-up as a strategic investor, stating “the relevant appeal from TAIF and its partners for possible variations of support for the bank was directed to the Central Bank of Russia”. But over the four days from 3 March on, the Central Bank announced the withdrawal of Tatfondbank and Intekhbank’s licenses, both of which were under the control of the Tatarstan State Council Deputy Robert Musin. The leadership of the Central Bank revealed falsifications of financial statements, a debt hole worth 97 billion rubles ($1.7 billion – nearly half of Tatfondbank’s deposits), and a flawed model crediting the business of a key beneficiary and administrator of the bank – Musin himself. He was arrested later that evening and indicted for fraud involving over 3 billion rubles in Central Bank credit.

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Robert Musin. (Photo: Yegor Aleyev, TASS)

Everything Went Offshore

“We chose a bank that had a branched network good enough to be stable and more or less strong,” says Ilya Novikov, managing director of Raiden, a small property management company and client of Tatfondbank. He added that it was convenient for residents to pay their rent and utilities because the bank had many branches and didn’t take a commission. “Plus, the head of the board of directors is the Prime Minister of Tatarstan, and half the money in the bank was state-money,” says Novikov. “The last thing we expected was that Tatfondbank would fail.”

Novikov recalls that there were warning signs. For example, at the end of November, right in front of him, a bank employee talked a client out of moving millions from a rated account to a personal account, paying interest up to 10%. “It caught my eye, but nothing foretold of any problems,” recalls Novikov. Everything went on as before “until the first ten days of December, when our payments were frozen”. A Vedomosti source says “they explained everything away as temporary technical problems, but after a couple of days, Tatfondbank closed its doors. Even after the introduction of an interim administration and a moratorium on operations, the employees of Tatfondbank explained that it was temporary, that everything was stabilizing – that we just have to wait for the leadership and the Central Bank’s decision. I believed in good things,” Novikov says. “Even till March 3rd, no one was talking bankruptcy. And the leadership of the republic said talks were moving forward with the Central Bank, everything will be fine, everything will work again.” Now his company will, in the best case scenario, get a small percentage of its assets back. Novikov is upset.

On March 3rd, First Deputy of the Central Bank Dmitry Tulin and Deputy Chairman of the Central Bank’s board Olga Polyakova told reporters that when employees at their head office started examining Tatfondbank, they immediately spotted problems that their local colleagues had not. It became clear in May 2016 that the bank was already in a very difficult financial situation. A captive business model, focused on lending to businesses of Tatfondbank’s beneficiaries, led the bank to a dead end. On its balance sheet, the Central Bank found technical assets and loans to a key owner of the bank (which Vedomosti later found to be Musin) comprised about 65% of the lending portfolio. Additionally, the bulk of borrowers were in a state of bankruptcy.

The last thing we expected was that Tatfondbank would fail.

Of particularly note, Tatfondbank credited 29 companies, including LLC Consumer Electronics, New Electronics, and Smart Electronics which are part of the DOMO group (which Vedomosti has linked to Musin), a representative of the regulator explained. “Their activity is characterized by a significant volume of operations, completed mainly within the group, which is one of the telltale signs of shell company operations,” he told Vedomosti. The financial means provided to Tatfondbank through completed loan agreements with the aforementioned companies were then transferred to an offshore holding, of which Musin was the ultimate beneficiary. Most of these lenders were bankrupt. The Central Bank sent this information to security organs, the representative of the regulator said.

A Balance out of Balance

97 billion rubles in the hole, Tatfondbank was second-most in debt behind the behemoth Vneshprombank, at 215 billion rubles ($3.85 billion). But this is merely a conservative estimate by the Central Bank, and the loss figures may grow. At the end of November, the leadership of Tatfondbank asserted that it wasn’t possible to save the bank with its own resources, said Olga Polyakova. After that, management started withdrawing assets, exacerbating the situation. She laments that liquidity in the form of shares was written off the bank’s balance sheet, transferred, and sold; liquidity that could have provided operational income.

On December 13th, 2016, a meeting of Tatfondbank’s board of directors was called with a single item on the agenda: measures for the financial recovery of Tatfondbank. The bank didn’t say what the meeting accomplished. Before the meeting, it was known that Tatarstan would not give money to bail the bank out, so it instead resulted in a petition to the Central Bank for implementation of bailout measures —“the provision of assistance by the help of other entities for the bank in the shortest possible time” – since independent executive bodies had failed to, according to a member of Tatfondbank’s leadership.

On December 15th, the bank’s management transitioned to a caretaker administration overseen by the Deposit Insurance Agency (DIA), and on March 3rd, administration management moved to the Central Bank. Neither the DIA nor the Central Bank answered Vedomosti’s queries about the meeting of the board of directors.

According to calculations by the Central Bank and DIA, Tatfondbank needed 220-230 billion rubles to rehabilitate itself, while a conversion of debt into shares (bail-in) should have covered 60-70 billion rubles in obligations to customers. However, according to Dmitry Tulin, the bail-in only managed some 5 billion.

Why didn’t TAIF, the key player in the bailout, raise more? Simple: it had no plans to.

Dmitry Nemanov, head of TAIF’s press service advised that all questions be addressed to a “primary source of information” about the preparedness of his company to participate in the rehabilitation of Tatfondbank: “we’ve never declared that TAIF is prepared to invest in a bailout or how much”.

The TAIF Group wasn’t a major creditor of Tatfondbank and the intention of Tatarstan’s authorities to secure a financial recovery package for the bank met with no result. “There was no official confirmation of TAIF’s interest in participating in Tatfondbank’s bailout from TAIF to the Bank of Russia,” said a representative of the Central Bank.

No Help from the Republic

Even in August of 2014, according to Khalikov, who headed the bank’s board of directors at the time, it was clear that Tatfondbank’s situation was complicated. He says Tatarstan had no right to shy away from Tatfondbank’s problems and abandon the bank without trying to save it. “But the questions remain: why did the Central Bank delay the decision? Why didn’t they inform us why major international auditors approved the statements? And why did international ratings agencies give high ratings to Tatfondbank each year?”

Tatfondbank’s ratings were actually quite low a year before the default, says Moody’s analyst Maria Malyukova. The bank’s credit rating was Caa1, which indicates a high probability of default without outside support (about 30%). “This assessment reflected the weak financial standing of the bank: its unprofitable financial results, high volatility of liquidity and funding, weak credit quality of assets, including high concentrations on individual clients and lending to related parties, as well as investments in non-core banking assets,” Malyukova lists.

Why didn’t TAIF, the key player in the bailout, raise more? Simple: it had no plans to.

Since 2014, the bank had been unprofitable “mainly from low interest rates, a high reserve ratio, as well as volatile results on the financial market and one-off expenses for the bailout of BTA-Kazan and the Soviet Bank,” she says. On April 1st of 2016, losses reached a Tatfondbank record of 3.4 billion rubles. The bank’s accounts show that it periodically violated the H6 standard, the maximum amount of risk per borrower or group of related borrowers.

At the same time, Moody’s was “betting on a factor of moderate external support” from Tatarstan. The final deposit rating of the bank was B3, with a negative outlook which Malyukova says “also reflects high risks with a probability of default at 15%”.

“Our opinion about the moderate probability of external support came from the 40% ownership by companies connected to the Republic of Tatarstan (that figure grew from 28% over the past two years, including through capital injections), a significant share of the bank in Tatarstan’s market (36% in deposits, 20% in assets), and the fact that chairman of the board of directors was Prime Minister Khalikov,” she explains.

The deterioration of the economic situation in Russia since 2014, the devaluation of the ruble, and the spiking of the Central Bank’s key rate to 17% in December of 2014 all undermined Tatfondbank. In February of 2015, Tatfondbank’s board of directors approved the “Plan of Recovery of the Financial Strength of Tatfondbank for 2015”. A year later, in 2016, it had failed to work.

By 2016, the bank’s margin had recovered a little after a gradual drop in the refinancing rate. There had been capital injections, but profits before allocations to reserves were still low (.7% of assets). The quality of assets left much to be desired. “The bank’s liquidity remained low and volatile due to a highly concentrated depositors,” Malyukova says. “This fact, as well as the problems of the Peresvet Bank, whose securities were pledged by Tatfondbank through repo agreements, ultimately led to the fall of the bank,” the Moody’s analyst summarizes.

Billions for the Turnaround Manager

On February 20th, 2017, the Central Bank on behalf of the DIA placed Kazan-based Timer Bank (formerly BTA-Kazan) and Petersburg-based Soviet Bank under administration to prevent their bankruptcy. This was exceptional, as both banks were in the process of reorganization. They had been entrusted to Musin’s entities: Timer Bank from May of 2014 was bailed out by New Petrochemicals along with the DIA, and the Soviet Bank from March of 2016 by Tatfondbank. For their recovery, the DIA has already provided10-year loans at 0.51% APR for 20.65 billion rubles. The two banks fell under the operational control of Tatfondbank, upon which, as a result, the resources of the DIA and they themselves depended.

In June 2014, the DIA allocated a 9.9 billion ruble loan to the reorganizing Timer Bank, Tatfondbank gave another 1.2 billion rubles in the form of an interbank loan, and Musin’s New Petrochemicals loaned 1.8 billion rubles, according to Timer’s annual report for 2014. From this financial aid of 12.9 billion rubles, 4.4 billion immediately went to pay off Timer’s debts to clients. The rest ended up in Tatfondbank through a scheme involving the interbank loan. Of that, 6 billion rubles were invested in Tatfondbank’s bonds (above market price), and a further 1.5 billion rubles went into shares of the Tatfondbank Rent Investment Fund. According to the Tatarstan e-newspaper Business Online, which had access to the Central Bank’s materials from the Timer verification, the Tatfondbank Rent Investment Fund was a mutual fund of Tatfondbank.

The Soviet Bank situation was similar. The former owners had been waging a legal battle against reorganization for a year. They lost the appeal of the transfer of 99.99% of the bank’s shares to Tatfondbank, but were able to challenge the legality of interbank crediting during the reorganization of Soviet Bank in two instances. Per a lawsuit filed by Alexander Teplyakov, who owned a 17% stake of the Petersburg bank (now a minority shareholder with a stake less than 0.01%), the St. Petersburg Arbitration Court and then the appellate court invalidated the interbank lending transaction and required Tatfondbank to return the debt together with interest to Soviet Bank —15.2 billion rubles.

The court pointed out that this was a major deal (more than 25% of Soviet Bank’s assets) with interest that went against legal requirements. It was not approved by a shareholder meeting, the transaction was non-market, interest was not paid, the borrower carried out “stably unprofitable activity”, and the placement of the interbank loan in Tatfondbank did not have a positive effect for the reorganization of the creditor-bank; i.e. its financial performance had deteriorated. Soviet Bank has filed an appeal, scheduled to be heard on April 25th.

“The money allocated to heal the [Soviet] bank went to save the turnaround manager itself, Tatfondbank,” says Alla Gerasimova, a representative of the former owners and now minority shareholders of Soviet Bank. “According to the report at the end of the year, in addition to the 15 billion rubles from the interbank loan, Soviet Bank became the “lucky owner” of 3.5 billion rubles worth of Tatfondbank bonds.” The official disclosure of information in November of 2016 also shows that the reorganized Timer Bank and Soviet Bank were under the guarantees of an interbank loan that Tatfondbank had issued to Intekhbank. “As the deposits of Soviet Bank’s customers grew, so did the credit going to Tatfondbank (1.28 billion rubles) and Intekhbank (330 million rubles),” Gerasimova says. But Soviet Bank could have saved itself, she laments.

In August 2015, the head of the Soviet Bank’s board of directors, Stanislav Mitrushin, sent a letter and a plan of measures for financial recovery to the Central Bank and its main committee (which Vedomosti has seen). According to Gerasimova, Soviet Bank received no response from the Central Bank between August and October of 2015 and requests for a meeting went unanswered. In October, the DIA put the bank under temporary administration. On March 10th, 2016—before Soviet Bank received a loan for reorganization and Tatfondbank became its majority shareholder—with official approval from the DIA, Soviet Bank credited Tatfondbank and issued it a first tranche of 3 billion rubles (more than 7% of total assets on 1 March), according to court documents. Here the caretaker administration violated bankruptcy law, since it failed to convene a shareholder meeting before issuing loans in excess of 5% of the book value of assets. According to Gerasimova, this is a violation even when the credit institution’s powers are suspended.

Indeed, the formally indicated rule of bankruptcy was violated and the courts established this in two instances, agrees Oleg Permyakov, a senior lawyer of the Goltsblat BLP dispute resolution practice. However, he believes that Soviet Bank can win the appeal if it can prove that the actions of the caretaker administration served the interests of the bank and its creditors.

A representative of the DIA denies that the caretaker administration broke the law. The policy of secure and placing Soviet Bank funds from March 4th, when the Central Bank approved Tatfondbank as the administrator of the reorganization, was actually determined by a new investor, and he says that on 10 March, Soviet Bank “placed free funds from a new investor under market conditions.”


Translated by Nick Trickett. Edited by Marita Petherbridge and Aaron Schwartzbaum.

IN TRANSLATION: Number of Russian “donor regions” nearly halved over 10 years

Article by Olga Kuvshinova. Guest translation by Keary Iarussi.

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When it comes to Russia’s regions, who is carrying who? (Image: Kommersant Vlast’)

In the 10 years from 2006 to 2015, the number of “donor regions” in Russia dropped from 25 to 14; fewer even than the 19 that existed in 2001. Experts from the Leontief Center presented a report at a conference at the Higher School of Economics in April which identified the policy of centralized budget revenues as the main reason for the drop-off, alongside economic crises.

According to the Budget Codex, a region is considered a “donor” if it can finance government services above a set minimum which is calculated on a per capita basis, i.e. if it does not require subsidization from the state.

In 2006, the 25 donor regions provided about 80% of overall regional tax revenue. In 2015, the remaining 14 donor regions accounted for just over 60%, and of this figure, two-thirds came from four regions: Moscow, Khanty-Mansiisk, Yamalo-Nenetsk, and oil-rich Tyumen. Over the 10 years from 2006, the share of these four “core donors” dropped. This was due mostly to the reallocation of their revenues to the federal budget, and the centralization of the mineral extraction tax (MET) revenue. Despite the reallocation [изъятия] and a falling share of the tax profit in these regions’ revenues, the report’s authors conclude that the regions remain the core of the budget system.

The report identified some weak donors among the other ten donor regions (see chart). The Nenetsk, Samara and Sverdlovsk regions may drop out of the donor list due to declining contributions to both the regional and municipal budgets. Meanwhile, the Bashkortostan, Perm, Omsk and Tomsk regions could return to the donor list after having previously dropped off: their share of contributions to the budget system is growing.

The federal budget has offset the loss of revenues for a few regions by increasing subsidies, which depend either on the regional elite’s strength of negotiating position (Tatarstan, Chelyabinsk, Orenburg regions) or a change in the regional political leadership, according to the experts. For example, despite the Moscow and Yaroslavl regions’ robust tax revenue growth they received significant subsidies after changes in leadership. Meanwhile, the report links rising reallocation of revenues to the federal budget and lowered subsidies in Krasnodar, Irkutsk and Astrakhan regions with a push by the federal center to bring regions with strong local interest groups under its control.

It seems that the goal of intergovernmental budget policy is to control the actions of regional governments through centralizing rent revenues in exchange for aid.

The use of subsidies as a means of exerting influence on regions is seen in the fact that some donor regions that are not eligible for equalization payments continue to receive subsidies and other financial aid. Meanwhile, some regions that have lost their donor status receive almost nothing besides the equalization payments set out by the law.

It seems that the goal of intergovernmental budget policy is to control the actions of regional governments through centralizing rent revenues in exchange for aid. The report concludes that such measures do not create the incentive or economic stimulus needed to increase tax revenue or raise the effectiveness of expenditures.

According to the Director of the Institute for Public Finance Reform, Vladimir Klimanov, the revenue sharing arrangement preserves the regional economies’ ineffective structures. He contends that they are “overloaded” with a large number of different types of aid (there are more than 80 types of subsidies alone) that overlap and go to the same regions. Subsidies push regions into inefficient practices: for example, you can get funds to co-finance the construction of a school, but only after the school has been built. Klimanov says that regions rush projects along, often to the detriment of quality. Agriculture, which has low labor productivity, is the sector leader in terms of federal. “Money earmarked for projects, in contrast to equalization subsidies,” Klimanov says, “should be co-financing development of new high-tech infrastructure, but we continue down the path of co-financing the current expenditures of failing sectors”.

The strongest regions are stripped of co-financing for development. Kaluga Region is a prime example: as soon as its fiscal capacity exceeded the statutory ratio of 0.008, it was removed from all aid programs and co-financing programs for targeted investment projects, which then had to be halted, according to Kaluga Governor Anatoly Artamonov. Klimanov says that in response to the “Kaluga phenomenon”, adjustments were made to the methodology so that the regions would not lose so much.

According to Klimanov another issue is overregulation. Federal funding has become a way for the center to control the actions of regions and municipalities, restricting their ability make independent decisions. Of the RUB11.5 trillion of consolidated regional expenditures (including healthcare funding), regions have control over just RUB0.8tn-10.7tn. This means more than 90%, is regulated, according to Deputy Prime Minister Dmitry Kozak: the federal center decides how much the regions receive and how they spend the funding.

The latest decisions to centralize revenues has caused discontent among regional governors. The decisions see the shrinking of regional shares of oil product excises, and an increase of one percentage point on the 20% federal tax on profits. As of 2017, the regions take 17 percentage points, down from 18. Tatarstan lost RUB8bln, or around 5% of its revenue, taking away the motivation for development. “Citizens are indifferent, they only see government – they do not care what level it is,” says Tatarstan President Rustam Minnikhanov. “If the president’s confidence is there, it means there should be enough authority to carry out his policy.”

Krasnodar Governor Viktor Tolokonsky complained at the Gaidar Forum of the demotivating influence of the intergovernmental budget policy. “We are not evening out social inequalities, but putting the brakes on investment.” Natalya Zubarevich of the Independent Institute for Social Policy has concluded that flows of federal transfers reflect current political – and especially since 2014 – geopolitical, priorities: the Far East, North Caucasus and Crimea.

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Keary Iarussi is an editor and translator at an investment bank in Moscow. He has studied the Russian language for more than five years, including through a CLS grant in Kazan and a FLAS grant at Indiana University. He holds degrees in Eurasian studies and global politics from Miami University (OH). His interests include fiscal policy, domestic politics and Russia’s political and economic development since the late Soviet period.

A Doubled-Edged Sword: Corruption and Russia’s Pivot East

By Nick Trickett

 

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“Strengthening Friendship in the Name of Peace and Happiness!”

 

Last year’s election cycle in the United States has created a surging interest in Russia’s array of tricks and conceits to influence, undermine, and rend western democracies. Democracy and, more importantly, transparency abroad threaten the legitimacy of the Russian regime at home, pushing Russia to seek out coercive or subtle means of disrupting democratic norms and engendering corruption for its own aims. For a regime that needs foreign investment at the same time it exploits corruption elsewhere, these tactics don’t always produce desired outcomes. Russia’s oft-maligned Pivot to Asia showcases this conundrum: corruption at home constrains Russia’s actions in Asia as much as being a tool to advance the Kremlin’s interests in Europe.

The Far East is one of Russia’s greatest strategic liabilities. Roughly 6.2 million people occupy an expanse accounting for a third of Russia’s territory next to an ascendant China with money to burn and historical interests. Vladivostok is about 5,600 miles from Moscow by ground transport. Goods come from far away and cost more, infrastructure of all kinds is of low quality, and local industries remain largely geared towards extraction and basic agriculture. 75% of the region’s goods went to market in Russia prior to 1991. Only 6% was exported.

Whereas the Soviets could subsidize everything, today’s Russia is structured differently and has considerably fewer resources to do so. Graft, black markets, weak property rights, and irregular rule of law have stunted the Far East’s turn from Russia to Asia. In the last 25 years, the region has lost a quarter of its population and ethnic Russians are voting with their feet to live further west. These trends and issues present a profound insecurity for Russian planners and drive a significant part of their need to engage China.

Putin announced the so-called “Pivot to Asia” at the St. Petersburg International Economic Forum in June of 2013. Russia would diversify itself away from its reliance on Europe for money and international respect. Selling gas to China could give Russia pricing power over European consumers, the United States would be reminded that Russia could partner up with its most powerful geopolitical rival, and, most importantly, much needed investment would pour into the Far East from elsewhere, not just China.

Instead of strategic diversification, Russia’s pivot has been defined by an increasingly awkward façade of partnership with China that may grow less cooperative in the near-future. South Korea and Japan have proven cautious. Most of their businesses don’t trust the region’s market, the regional authorities, or Moscow. Japanese and South Korean energy firms have not forgotten the Kremlin’s decision to strong-arm Shell and its Japanese partners Mitsui and Mitsubishi into selling a majority of the Sakhalin-II oil and gas project to Gazprom in 2006 by selectively enforcing environmental regulations. The Putin-Abe summit in December did not produce a substantive change in business attitudes and South Korea remains limited by domestic turmoil and Russia’s close ties to North Korea.

To address the region’s reputation, the Kremlin arrested the governor of Sakhalin Island in March of 2015 to create the impression that there are no “untouchables.” In 2016, scandals and arrests hit lower level figures such as the vice governor of Primorsky region and a city official in Vladivostok who stole 160 million rubles. Putin’s envoy to the Far East Yuri Trutnev has made statements about the systemic effects of rampant corruption in the logging and fishing industries, mainstays for the regional workforce. Shuffling governors or launching showy investigations may offer political relief, but do little to address the daily effects of corruption on people’s lives.

The Far East is not so much more corrupt than the rest of Russia. Rather, it’s so far away from Moscow and so haphazardly connected to both Russia and its Asian neighbors that its elites operate as if in a domestic offshore. Foreign investors have little reason to pursue what is a tiny market of consumers in a region burdened by its remote location, bad roads, difficult climate (natural and political), and local elites who continue to plunder the economy. Moscow won’t punish their thievery harshly if they remain loyal and preserve control. Last September’s arrest of Dmitry Zakharchenko, head of an anti-corruption agency within the Interior Ministry, was a move to placate the public with a sacrificial lamb. There’s little appetite for anything other than cosmetic reform.

Public data bears out foreign firms’ lack of trust. The Russian Minister for Far Eastern Development Alexander Galushka announced on March 15th that the Far East had received a total of $23 billion in investments, 20% of which came from foreigners. Definitions are screwy. Last May when the figure stood around $14.3 billion, Russian experts saw that the private firms involved were by and large registered to Russian offshore hubs. Russian firms use offshore intermediaries to jack up figures and make the Far East seem like a more attractive investment. Precious little money comes from elsewhere.

Russian planners often fear becoming a “resource appendage” for China’s massive manufacturing base. But their standoff with the West has forced them to more aggressively deepen ties with China. China has not exploited the Kremlin’s weakness to the extent one might expect. China’s largest banks have complied with western sanctions and approached deals skeptically. Most projects fall under infrastructure or agriculture and are slowly developing.

Japan and South Korea have floated investments in ports and some infrastructure, a decades-long strategy in the region dating back to the Soviet period. Deals signed in the last few years have mostly concerned social infrastructure, an area that Japan has stressed as part of its development agenda through its lending institutions. The billions in announced investments from South Korea and Japan through events like the Eastern Economic Forum in Vladivostok are often framework agreements. They do little more than state mutual interests as both sides jockey around costs: Russian firms generally try to inflate them for the benefit of uncompetitive bids from companies owned by local or national elites with connections.

The problem is compounded by the nature of competition within Putin’s circle in Moscow. Former Economy Minister Alexei Ulyukayev was arrested on corruption charges last November largely due to the machinations of Rosneft CEO Igor Sechin. Ulyukayev was part of a cadre of economic liberalizers and was Russia’s point-man to craft and realize an 8-point plan in conjunction with his Japanese counterpart to promote industrial cooperation in the Far East. His arrest seriously undermined the potential value of the Putin-Abe summit in December.

No one particularly enjoys the prospect of paying for absurd cost overruns, bribing customs officials, covering expenses imposed by lack of legal oversight, ensuring timely deliveries with unsavory third-parties, and so on. Unfortunately for Russia, these issues hobble its push to balance against its reliance on Europe.

Corruption, to paraphrase Dostoevsky, is a double-edged sword. It may weaken and divide Russia’s perceived adversaries in Europe but it also weakens and divides Russia as it seeks new relationships to manage China’s rise. Without Japanese and South Korean investment in areas that aren’t energy, the Far East will be stuck relying on the inadequate sums of money available from Russian elites playing games with the national economy.

Damaging legal norms abroad is a short-term tactic. Russia’s oligarchs need more transparent economies to remain so if they are to keep attracting foreign capital when it’s truly necessary. The latest protests evidence growing dissatisfaction with the way Putin has managed the economy. Mark Galeotti notes presciently that corruption at the highest levels is “impossible to address without breaking the whole machine.”  Russia’s threat to democracy in Europe is its greatest weakness in Asia. The west had best take note as it riddles over whatever it is the Kremlin plans to do next.

A New Generation of Janitors Takes to the Streets

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Photo: Alexey Abakumov

 

“A generation of janitors and night watchmen,” sang Soviet rock pioneer Boris Grebenshchikov in 1987, “have lost each other in the expanse of an endless night”. Though he was expressing the frustration of another generation and another economic downturn, the lyrics seem particularly relevant after protests across Russia this past weekend saw heavy youth involvement. Why did Russia’s young people – including a surprisingly large number of teenagers – turn out? And more importantly, what does it mean for Vladimir Putin as he pursues reelection next year?

The economy isn’t working for them…

If the protests over electoral results in 2011 and 2012 were driven predominantly by Russia’s urban middle class, which was subsequently pushed out of the political arena, this weekend’s “On Vam Ne Dimon!” (He’s Not Dimon to You) were sparked by opposition activist Alexei Navalny and made possible by the participation of young Russians from 15 to 29 years old. This cohort makes up roughly 20% of Russians.

age breakdown
Source: Rosstat

Why are they angry? A quick look at their career prospects and labor market is illustrative. In Fall 2015, the unemployment rate among Russia’s youth was some five times higher than 30 to 40 year olds. According to Elena Panina, Duma deputy and head of the Moscow Confederation of Industrialists and Entrepreneurs, only 30% of those who approached state employment services for help found work. At the time 31.6% of Russia’s urban unemployed were between 15 and 24 (a demographic that accounts for roughly 10% of Russia’s population), with half of that group older than 20.

To note, youth unemployment isn’t a unique issue to Russia, but a feeling of economic hopelessness coupled with popular outrage over corruption harnessed by Navalny (“fairness is what we lack”, as it was put by writer Yekaterina Vinokurova), is a recipe for public anger. Moreover, Russia’s labor market outlook hasn’t brightened much since that data was collected: those figures likely have not improved. There is little realistic hope for the youth that their situation will improve in the near future

… and the propaganda isn’t working on them

To a large extent, the Kremlin’s messaging, and the means of delivering it, are simply not salient to local youth. For one, data from Levada Center shows young Russians are far less trusting of television as a news source than older generations. They’re more likely to get their news on the internet where the Kremlin’s control is not nearly as strong. The problem, however, goes beyond the means of delivering the message: it is with the messaging itself.

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Source: Levada Center, Chart by Zach Witlin

For the time being, the Kremlin lacks a message that truly resonates with young people. Appeals for Russia to retake its rightful place on the world stage after post-Soviet humiliation have no meaning to those who don’t remember the Soviet Union. Similarly, appeals to the stability provided after the chaos and economic turmoil of the nineties don’t work on those who have come of age since then. And while it is undeniable that Russians have grown significantly wealthier under Putin, if you were born in 1995 and turned 18 in 2013, the economy has never looked robust, and that’s unlikely to change for some time. A strong line against the West is also less salient: young Russians were supportive of the Crimea annexation but the Levada Center has found that they see issues with the current geopolitical issues as specific to Ukraine, not as a broader civilizational conflict. Lastly, if “the sanctions do not work” as local leaders so frequently claim, why is the economy struggling?

Russia one and Russia two see eye to eye

Many observers noted after the protests that what was particularly surprising wasn’t their size, but their reach: it was not a shock that Russians turned out in Saint Petersburg in Moscow, it was that they did in far-flung cities like Makhachkala and Perm. To understand the significance of this spread, a look at political scientist Natalia Zubarevich’s work is helpful. Zubarevich identifies what she terms ‘four Russias’: post-Industrial Russia (Moscow and Saint Petersburg), Industrial Russia (one-company towns and smaller cities), Rural Russia, and Peripheral Russia (Dagestan). Some 60% of Russians live in the first two, and Russias two, three, and four are where Putin draws his support.

Protests in Russia, until now, had tended to be confined to one Russia at a time. When Muscovites and Petersburgers took the streets in 2011 and 2012 over political dissatisfaction, those in industrial areas were nonplussed. The recent economic downturn has hit industrial Russia far harder than its urban centers, and labor unrest has tended to be over specific economic grievances and frequently features appeals to Putin, not against him: “Putin, where are our wages?”. Protests by long-haul truckers got media play in 2015 and 2016, but that demographic is both tiny and diluted across Russia’s immense geography. In short, until now there hadn’t been a common grievance that could mobilize people across Zubarevich’s multiple Russias. With his corruption crusade, Navalny seems to have found one.

What this means

Russia is not in revolutionary throes, and Navalny is not on the verge of an electoral shock. It’s not certain yet whether he will even be allowed to run. As my local friends who attended protests tell me, many who took part were there against corruption, not in support of Navalny. What all of this does mean is a serious headache for the Kremlin, which has set itself a goal of 70% turnout and 70% support for Putin in 2018. First, while protest turnout was not large by any means, those who attended did so knowing they might well be arrested. It begs the question: who would have attended had protesting been a less risky endeavor? Second, while the Kremlin can easily sideline Navalny by jailing him, doing so risks driving down voter turnout in the election. One option is for the Kremlin to coopt his message, but the immediate question is how would it credibly do so? Many have commented that Prime Minister Medvedev, whose alleged corruption was the subject of the protests, to go. He has been the fall guy before, but on the other hand, if he is replaced, it will likely be during the actual campaign: the Kremlin is loath to be seen as pliable.

All in all, Putin and co need to devise a means of appealing to young Russians. Doing so, however, may require something not commonly associated with Russian leadership: being “cool.” Perhaps they can borrow more than Navalny’s anti-corruption message: they can borrow his tongue-in-cheek delivery, drones, memes, and production value, too.