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Privatization: Russia

Sergei Blagov

HISTORY

Russia's reform-minded cabinet, which came to power in late 1991 implemented a policy of rapid mass privatization so as to secure broad popular support for otherwise painful economic reforms. All Russians were given privatization vouchers through which—at least theoretically—stocks could be bought on the market. Employees as well as Soviet-era managers were given preferential treatment and could take over as much as 51% of the stakes in their respective enterprises. As a result of these measures, some three quarters of Russian industrial assets were privatized within a little over a year. However, in reality most privatization vouchers (their black market price below $10 apiece) ended up in murky privatization funds, which tended to disappear as rapidly as Russia's privatization itself. Although some selected fund managers reaped lucrative profits, an overwhelming majority of vouchers holders remained empty-handed.

UNLOADING STATE-OWNED ASSETS

The sale of the controlling stake in Slavneft, the nation's eighth largest oil company, became the second largest privatization undertaking in Russian history. At precisely four minutes after the auction started, on Thursday, December 18, 2002, one of the few lucrative oil assets remaining in Russian state hands was sold off. The auction was conducted Christie's-style with a gavel-wielding auctioneer Vladimir Korovkin and broadcast live to journalists sitting in a separate room. Sibneft and Tyumen Oil Co. (TNK) joined forces to acquire the state's 75% stake in Slavneft—one of the last state-owned oil companies with 5 billion barrels of reserves in high-growth fields. Sibneft and TNK paid $1.86 billion in a clearly staged privatization auction that was oddly devoid of competition.

Also in December 2002, 5.9% of the shares in Lukoil, the nation's largest oil company, were offered on the London Stock Exchange and sold to various investors for $775 million. On December 19th Prime Minister Mikhail Kasyanov said that December sales of government shares in the two oil companies could help Russia pay off $15 billion in foreign debt due in 2003. Kasyanov’s statement arguably indicates that—despite official pledges to the contrary—the Kremlin still views privatization as a short-term fiscal instrument rather than a long term restructuring vehicle.

1.) A lack of transparency in the Slavneft deal

The Kremlin hoped the auction of Slavneft would set a new standard of transparency as one of the cleanest auctions in the history of Russias privatization. It was supposed to symbolize a turn away from the scandals that encompassed Slavneft over the summer of 2002. The scandal erupted into a showdown between Sibneft and a rival oligarch group sparking front page headlines of bomb threats and armed police-for-hire. On top of the scandal the governments hopes that Slaveneft would bring a price of $3 billion were dashed when it sold at auction for $1.86 billion.

Not only did Slaveneft sell for far less then expected but the entire auctioning process turned out to be more or less of a farce. All other realistic contenders, except the winner, were eliminated before the auction began. The only foreign oil company to declare itself a bidder—Chinese state-owned oil giant CNPC with its estimated $9 billion war chest—pulled out one day before the auction following strong pressure from government officials and State Duma deputies anxious to keep Slavneft in Russian hands. Rosneft, the only other contender against the Sibneft-TNK team was barred from the auction at the last minute "The most scandalous type of legal maneuver was used to push out a dangerous opponent," Rosneft said in a statement.

Rosneft is believed to be backed by Sergei Pugachyov—a senator and founder of Mezhprombank. Pugachyov has a reputation as the key financier for the so-called St. Petersburg group of Kremlin insiders loyal to President Vladimir Putin and at odds with such Yeltsin-era insiders as majority Sibneft owner Roman Abramovich and Kremlin chief of staff Alexander Voloshin.

Despite the lack of competition, the State Property Fund, which organized the auction, insisted the sale was legal. "We think there were no violations of the law at the auction," property fund head Vladimir Malin told a news conference after the auction. Yet reporters burst into laughter when Malin was unable to answer a question about who was the founder of Invest-Oil, the winning bidder.

All in all, the Slavneft deal fetched a fair price compared to the wholesale state giveaways of the mid- and late-1990s. But politicians slammed the sale as skewed in favor of Sibneft and TNK, which together already held key blocking stakes in major Slavneft subsidiaries and in Slavneft itself. "It is clear the auction was held without any competition," said Duma Deputy Mikhail Zadornov. "Sibneft won, and the budget lost."

Top presidential economic adviser Andrei Illarionov suggested that the barring of other contenders and the absence of a foreign bidder helped deflate the price. Kommersant daily commented that transparent privatization failed to materialize, while the best assets had been sold out already.

MASSIVE SELL-OUT OF STATE-OWNED COMPANIES

Russia’s massive unloading of state-owned property was dubbed as one of the most immense privatization efforts ever. Even before the Soviet Union's broke-up in 1991, communist industrialists carved out hydrocarbon giants Gazprom and Lukoil directly out of Soviet ministries. And since the start of Russia’s privatization, the government has busily unloaded state firms—so far selling off more than 100,000 state companies.

The Kremlin opted for a rapid privatization approach, transferring the ownership of thousands of firms into private hands. Russia's biggest companies were sold first through voucher auctions and then through loans-for-shares privatization schemes. In a series of auctions, described as rigged by observers, stakes were transferred in trust and then sold to insider banks for a fraction of their market value.

1.) The loans-for-shares scheme

The government insists that the key criteria for a sale is the price received for an asset—the more money brought in the better. However, the loans-for-shares scheme—in which investors lent the government money in return for the right to manage state-owned stakes in partly privatized companies—was widely criticized. Stakes often went to the very companies organizing the loan tenders for the government. These deals were terrible bargains for the Kremlin who watched as the nation’s industrial crown jewels went for a pittence. Through the loans-for-shares scheme assets estimated at more than $25 billion were privatized and sold for just $1.2 billion. Overall, from 1992-1999 the Kremlin earned little more than a total of $20 billion from its sales of the nation's oil and gas fields, nickel and gold mines and other economic cornerstones.

2. ) Privatizing aircraft manufactures

Not surprisingly, Russia’s sell-offs are subject to criticism. For instance, in September, 2000 Russia’s Audit Chamber after finding that the government committed immense violations in privatizing the aircraft manufacturing industry in the 1990s called for a review of the sales. Russia last year produced only 30 civilian and military planes—compared with 150 civilian airplanes, 300 civilian helicopters, more than 620 military planes and 390 military helicopters in 1991. Of the 315 aviation manufacturers inherited by post-Soviet Russia, up to 224 were privatized. The state kept a controlling stake in only seven of those 224 plants and lost complete control of 94.

3.) Improper sale of ships and fishing manufactures

In yet another example, formerly state-owned fishing major Rybkomflot is accused of improper sale of its 34% stake to off-shore firms, as well as the transfer of once state-owned trawler ships to private companies. The 79 trawlers in question were commissioned in the late 1980s. The former Soviet government paid 20% of an estimated $1.3 billion cost for the vessels, which were eventually built in Spanish shipyards during early the 1990s. The remaining cost was funded by loans from German and Spanish banks. Under this deal the Russian government was responsible for making the debt payments. With the privatization of the national fleet, the ships passed to off-shore units. The authorities charged that Bergen and Rybkomflot leased the ships and siphoned off profits, but failed to reimburse the government for debt payments on the trawlers.

4.) Privatizing telecommunications

Russian telecommunications giant Svyazinvest used to be the belle of the ball of Russian privatization. In June 1997 Russia sold a 25% stake in Svyazinvest for $1.875 billion to a consortium, Cyprus-registered Mustcom Ltd, which included Deutsche Morgan Grenfell, Morgan Stanley and the Quantum Fund, headed by United States financier George Soros. Allegations of blatant insider dealing for the Svyazinvest stake flooded the Russian media and Soros later called the privatization the worst investment he had ever made. Today Svyazinvest hopes to merge its 87 regional telecoms into 7 larger companies. The 75% state-owned Svyazinvest controls 87 regional telecoms and other companies, which employ 400,000 people. In April 2000, Russian president Vladimir Putin ordered to prepare a tender to sell 25% minus two shares in Svyazinvest, but no deadline was announced.

5.) Suspicion surrounds sale of oil firms

There were other controversial privatizations as well. In October, 1999, a state-owned 9% stake in Russia's biggest oil producer, LUKoil, was sold just $5,000 above its initial asking price to an obscure off-shore entity in an auction with just two participants. The stake in LUKoil, the world's fourth-largest privately owned oil firm, was acquired by Cyprus-registered Reforma Investment Ltd. for $200,005,000. The starting price for the 67 million LUKoil common shares was $200 million—less than half of market price—but the winner will also have to make a $240 million investment. There have been allegations that the bidders could be related to LUKoil.

In December 1999, a state-owned 49.806% stake in Russia’s number 5 oil producer Tyumen Oil Co. (TNK) was sold above the initial price—for $90 million—to a Russian firm Novye Priotitety (“New Priorities”). The initial price for the stake was set at $66.7 million. The winner—who managed to beat three other Russian bidders—will also have to make a $185.256 million investment in TNK. Novye Priorities ownership was never disclosed, but it is widely viewed to be close to TNK’s shareholders.

THE FUTURE OF PRIVATIZATION

Russia’s privatization plans have long included the sale of a 3.37% stake in the world’s largest gas producer Gazprom, 25% plus one share of the oil company Rosneft, and 19.68% of the oil firm Slavneft. The Russian government, which now holds 38.37% of Gazprom, planned to tender a 3.37% stake at the initial price of $250 million. The starting price of a 25% plus one share in Rosneft, Russia’s biggest state-run oil firm, was expected to be set at $350 million. A 19.68% stake in Russian-Belarus oil company Slavneft was expected to be offered for $110 million. All these sales were originally slated for 1999, but the plans have been subject to countless delays, and now these privatization auctions have either been skipped or postponed.

1.) The role of the Federal Property Fund

Vladimir Malin chairman of the Federal Property Fund (FPF) has been in the business of running auctions and tenders since the early days of Russia's economic reforms. He told me that, regardless of Russia’s past privatization history, Russia needs more instruments to go ahead with privatization.

The Federal Property Fund is a state-run agency in charge of running privatization auctions and tenders. The Fund which acts on behalf of the Russian government is a nominal shareholder in some 2,400 companies. The Fund, under current legislation, now relies on just three dominant sell-off schemes: auctions, special auctions and commercial tenders with investment conditions. But the Fund has drafted legislation to introduce up to 16 new schemes, including direct sale to strategic investors.

The Fund also monitors how the investment conditions of the privatization auctions have—or have not—been honored by the acquirers. So far, the Fund has managed to annul by court decisions a total of 21 privatization deals, while the Fund's regional outlets have annulled 290 privatization auctions. Some of these stakes have been nationalized, but in other cases legal battles continue, because certain stakes were eventually sold by initial acquirers to good-faith investors.

2.) Putin’s commitment to privatization

Since President Vladimir Putin’s unexpected accession to power, it has been argued that the country’s new leadership was to bring with it a fair and orderly approach to new privatizations. Former privatization tsar Anatoly Chubais voiced concern that Putin had fallen under the influence of Nobel Prize-winning author and critic of privatization, Alexander Solzhenitsyn. By mid-2000 Putin promised there would be no re-examination of post-Soviet privatizations. However, Russian police and prosecutors have hassled some of the oligarchs associated with dubious privatizations of the 1990s.

Apart from the already sold-off hydrocarbon riches, there are other assets up for grab as well. Set against the backdrop of recently passed legislation authorizing the private ownership of agricultural acreage, it appears that President Putin's government is paving the way for the privatization of farmland. With 406 million hectares of farmland, land is plentiful and cheap. Today some central Russia plots can reportedly be purchased at just $30 per hectare, while in a few years the price is expected to reach $1,000 per hectare.

3.) The successful transparent and competitive privatization of Onako oil

There were some successful privatization deals. In September 2000, the Russian state sold its 85% share in Onako, a small oil company operating near Kazakhstan that produces less than eight million tons of crude a year, for the equivalent of more than one billion dollars. It was the largest sum ever received from an oil sector privatization, in a deal which was described by analysts as transparent and competitive. Onako was bought by Eurotech, an affiliate of Tyumen Oil Company (TNK), which with the purchase moved from fifth to fourth in the list of Russian largest oil companies.

DEMONOPOLIZATION

1.) The unsuccessful demonopolization Gazprom’ gas, electricity and rail monopoly

In early 2000, President Vladimir Putin declared that he strongly opposed breaking up the country's huge natural gas, electricity and rail transport monopolies, Gazprom. Gazprom owns a third of the world’s known gas reserves including the Unified Energy System electric utility, and the Railways Ministry which supplies a quarter of Europe's gas. However, Putin eventually gave tentative support to plans to break up monopolies in natural gas, utilities, railroads, and banks, and even took steps to start the private management of pension funds.

Although the government holds less than 40% in Gazprom, the company is hardly a reformed monopoly. Gazprom has its hands in everything from production, to sales and delivery. It produces natural gas at the cost of $4 per 1,000 cubic meters, then sells it in Russia for $25 per 1,000 cubic meters and abroad for $80. And although it borrows hundreds of millions of dollars, Gazprom claims it operates at a loss.

2.) Attempts to demonopolize the Unified Energy Systems

The government today plans to demonopolize the power sector. In 2001, Prime Minister Mikhail Kasyanov signed a government decree, largely inspired by Anatoly Chubais, calling for a reform of the 52% state-owned national power utility Unified Energy Systmens (UES). The government plans to liberalize the market by 2004 and attract strategic investors. To do this, UES must restructure all of its subsidiaries, including 72 regional energos and more than 30 wholesale power plants. Under the current plan, UES will eventually be broken up into 10 wholesale generation companies and a holding company to manage stakes in the regional generation and distribution companies that are to emerge from the transformation of regional energos. Additionally, new companies—such as the Federal Grid Co. and the System Operator—were created to take over some of UES's functions.

However, key aspects of the UES restructuring plan were stalled in parliament over concerns that consumers may be socked with huge tariff hikes. There are also fears that former privatization tsar Anatoly Chubais is orchestrating, like he did in the loans-for-shares schemes, the sell-offs of valuable assets for the benefit of a handful of powerful industrial groups at the expense of the government—and 500,000 UES’s shareholders. Chubais has already proposed several deals to UES's board that would let major industrial groups snap up electricity assets at an estimated 86 % to 99 % discount.

In September 2002, President Vladimir Putin's top economic adviser, Andrei Illarionov, called for Chubais to quit and stated that the UES management was a “disgrace for the country and a threat to national interests.” In September 2002, Chubais said that he had banned the sale of company assets until their value could be accurately assessed.

Subsequently, in December 2002, the State Duma postponed indefinitely a already scheduled crucial second reading of a raft of bills needed to break up national power monopoly UES. The reform bills, which passed a first reading in October, are broadly aimed at liberalizing the electricity market by separating the generation, transmission and distribution functions of UES.

UES CEO Anatoly Chubais, who has been lobbying hard in favor of the bills, said he believed they would still be approved, but gave no indication of how long he thought it might take. When national power utility UES tried to launch a reform that would end in its own breakup, portfolio investors in the state controlled utility said the management was trying to smash the company into pieces—making it easy pickings for cash-rich tycoons.

In December 2002, Russian President Vladimir Putin said that power sector reforms should bring in foreign and domestic investment but he was concerned about the potential for cheap sell-offs of power stations. "I am worried about this too, and I don't want them to be sold for nothing," Putin said on a nationally-televised question and answer session. In light of concerns over assets sales, Putin said, the Duma's cautious approach was fitting.

3.) Creating a new railway company

The Russia’s railway sector, now fully controlled by the government's Railways Ministry, also moves towards incorporating itself as a state-owned business, spinning the owning-and-operating functions out of the ministry as a new corporation. The Ministry itself acknowledges that its $3.2 billion annual investment program cannot provide needed upgrades on its 84,000 kilometers of track.

President Putin reportedly supported restructuring plans to launch a 100% state-owned railway company. The restructuring plan involves setting up GAK Russian Railways (GAK is Russian acronym for GosAktsyonernaya Kompaniya, or State Stock Company) as the owner all existing trains, rails and train stations, and also 17 state-owned regional railway companies. This new company would continue to own the rails and rolling stock, and the same private freight agents would continue to dominate the shipping market. The reforms pose no threat to anyone's vital interests and offer no guarantees that the newly formed company will not funnel its profits into the pockets of freight agents. To put it bluntly, the government will bear the costs of maintaining the rail network, while private companies reap the profits. However, since former Railways Minister Nikolai Aksyonenko was ousted in 2001, reforms of the railway sector has stalled.

4.) The lack of transparency in the sale of coal companies

Russia’s other valuable natural resources were also sold-off. Since 2000, state-owned stakes in Kuzbassugol, Chitaugol, Eastern Siberian Coal and other companies were sold leaving private companies responsible for three quarters of the country’s coal output. In February 2000, the Russian government sold a 75.6% stake in the country’s major coal producer—OAO Krasnoyarsk Coal Company with annual output of more than 30 million tons. The Russian-registered ZAO Katek-Invest, which offered $30.05 million or $50,000 above the initial price, won—also pledging to make a $67 million investment. The deal drew media criticism for its lack of transparent.

OLIGARCHIC PRIVATIZATION

During the Boris Yeltsin era, much of the nation's wealth ended up in the hands of Kremlin-connected insiders known as oligarchs. Some of those oligarchs, like MOST-Bank and NTV founder Vladimir Gusinsky, have since been forced into exile. But others, like Interros founder Vladimir Potanin, Alfa Bank founder Mikhail Fridman and Roman Abramovich stayed and expanded into a wide variety of sectors. Over the last couple of years, a handful of companies, such as Alfa Group, Interros and what is now called Millhouse, have turned themselves into huge conglomerates by acquiring assets in non-core sectors. The lack of transparency and the lack of a functioning banking system, analysts say, are cause for worry, as giant financial industrial groups like $8 billion Alfa, $5 billion Millhouse-Sibneft and $4 billion Interros look poised to privatize or acquire more lucrative assets.

1.) Privatization-related disputes turn violent

Moreover, in recent years Russia has seen a series of armed struggles over privatization-related disputes at companies and plants across the nation. Russia's sole vanadium producer, Kachkanar Vanadium Mining Complex, with annual sales worth $300 million, witnessed a sort of proxy war between moguls in early 2000. In Moscow, the government called on paramilitary troops wielding chain saws to force their way into the head offices of state-run oil pipeline monopoly Transneft and state-controlled oil firm Slavneft.

Few politicians came away from the privatization schemes with empty pockets. A member of the lower house of Parliament was shot to death as he walked his dog in Moscow—Vladimir Golovlev, 45, was said to be under investigation for his role in the privatization program in the early 1990's.

2.) Government insiders maintain control over Russia’s resources

Yet despite the setbacks, the Kremlin still wants to dispose the remainder of the state property. The government has pledged to privatize stakes in around 10,000 smaller companies in the next two years. However, in September 2002 the Russian government said it was not planning to sell shares in gas giant Gazprom or UES in 2003 because it wanted to keep controlling stakes in while they were being restructured.

Last June, just over four years since the devastating financial meltdown of August 1998, Russia was tentatively recognized as a "market economy" by the U. S. Department of Commerce and the European Commission. However, because of its controversial implementation, the privatization did not lead to self-induced restructuring of firms. Many privatization deals favored parties with ties to government interests, insiders were wary of relinquishing control and hence the country’s assets were left in the hands of a small group of Russian tycoons. Many new owners acquired the properties for a song, being only interested in making a quick buck, hence they tended to squeeze the last kopek out of the companies, at the expense of workers, shareholders and the firms themselves. Such behavior demoralized people and shareholders who felt powerless to hold private owners accountable.

Russia's untapped resources are so vast that the oligarchs might still be tempted to act like robber barons. Mikhail Delyagin, in his previous capacity as independent economist, used to argue that Russia’s current privatization law “was written by bandits for bandits.”

LESSONS LEARNED

The media coverage of Russia’s privatization has amounted to little more than a biased tale of the oligarchs’ intrigues and their insider deals to rig privatization. Few outlets addressed the question of how poorly run state-owned enterprises turned into badly run privately owned enterprises, or why Russia’s “blue chips” tend to act as monopolies. Throughout the history of Russia’s privatization there has been a lack of transparency in decision-making—many decisions were actually not made within official institutions, but rather through "private deals" clinched between officials and oligarchs. The general public had no knowledge of how, when and by whom the decisions were made, and therefore felt alienated. Russian media did little to clear the thick clouds of suspicion and rumors surrounding the privatization process. On the contrary, media coverage of graft scandals, and the public's sensitivity toward corruption only exacerbated negative perceptions of the privatization. Coverage tended to focus on ad hoc reporting, largely devoid of in-depth analysis. Although many publications recorded long lists of rigged deals, tycoons simply chalked up the criticism as media cheap shots.

Theoretically, broad coverage in the mass media was supposed to ensure transparency of privatization. Transparent structural reforms should have helped to revitalize the “social contract.” However, the recent privatization of Slavneft indicate that theses lessons are yet to be learned and Russia’s privatization process may remain murky, at least for some time to come.

CONCLUSION

In retrospect, it is understood now that creating incentives for genuine restructuring of enterprises was more important than moving property into private hands. For instance, the distinguished economic theorist and Nobel laureate economist, Joseph Stiglitz, contrasts China's wise gradualism with Russia's allegedly speedy reforms. On the other hand, it has been argued that although Russia’s massive privatization was carried out without much care for the small formalities of life, in the end, it worked and is starting to is pay off.

Arguably, when attempting to render a final judgment on the success of Russia's privatization a question “What is the goal of privatization?” merits consideration. The sell-offs did succeed in transferring the country’s assets into the hands of a group of extremely wealthy insiders. Yet it remains a matter of debate whether Russia's privatization created incentives for true restructuring of state enterprises.

Moreover, circumstantial evidence suggests that new private owners have largely failed not only to reform their assets but even to replace and update aging machinery. Russian experts have repeatedly warned of the "Problem 2003," the year when many dilapidated Soviet-era industrial machinery, heating systems, communications, gas and oil pipelines, may finally wear out and start to break down, plunging the country into an cycle of technical disasters.

Finally, it has been argued that the only reason why Russia's economy still has a future is because of the high global oil prices. The Russian economy is still in transition and still very dependent on oil despite the progress of the past three years. High oil prices have helped Russia yet the country’s ability to sustain these gains in the event of a decline in oil prices is likely to come as a critical test.

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