Zaks Investment Advisory Service

Russian Economy: Monopolies and Bureaucracy

Last time, we started to discuss the Russia economy. I described how after climbing out of its post-Soviet crisis, the economy began to grow. From 1999, it grew by an annual average rate of seven percent. The per capita gross product was significantly higher in 2007 than in the final years of the Soviet regime. Most state enterprises have been privatized. A stock market has been created which lists shares of several hundred companies.

On the other hand, several negative trends have emerged in recent years. The state has nationalized several major enterprises (Yukos, of course, being the most famous example). It was also involved in the creation of monopolies, or, as the Russians like to call them, “strategic enterprises” and “national champions.” This, of course, is a bad idea, since a tendency toward economic nationalization and monopolization results in less competition and higher prices. It would have been far more productive if the government did the opposite and tried to fight monopolies such as Gazprom. At the same time, the government should have been creating the legal and financial frameworks to promote competition while helping companies grow.

Monopolies, both large and small, are characteristic to the Russian economy as a whole. Very often, this is linked to corruption: companies create their own market in which they function as monopolies, using officials and bureaucratic harassment to keep other companies from finding their way into that market. Bureaucracy continues to grow despite the launch of endless campaigns to try and stop it. According to some figures, the number of bureaucrats in 2006 was 40 percent higher than in 1999. Bureaucracy leads the way to corruption. According to Transparency International, Russia’s corruption level leaves it ranked 143^rd in the world, at about the same position as Angola and Nigeria.

There is a whole slate of other problems associated with the structure of the economy itself. Its foundation is based on companies that export natural resources. In 2006, for example, oil, gas, metals and timber were responsible for 80 percent of all exports. A lion’s share of all tax revenues also depends on natural resource exports. This, of course, leaves the economy subject to price fluctuations in world commodity prices. Luckily for Russia (and mostly thanks to the growth in the economies of China and other developing nations), natural resource prices have been rising since about 1999. But as we all understand, at a certain point, they could fall.

Russia’s industrial base has become obsolete and must be almost completely replaced before Russia’s industry can grow. This will require enormous investments, but attracting these investments has become more difficult: the Russian ruble has appreciated by almost 20 percent against the dollar over the past two years, which makes the Russian economy less competitive.

We may confirm everything we just said by looking at the list of the largest companies whose shares are traded on the RTS stock market: monopolies and companies that export natural resources dominate this list.

The largest, in terms of market capitalization, is Gazprom. It simultaneously falls into both categories: monopolies and natural resource exporters. Moreover, Gazprom is a double monopoly: it not only controls more than 90 percent of all gas deposits, but also owns the entire distribution network through which this gas reaches consumers and is exported abroad. It is interesting to note that a similar position was held in the United States at the end of the 19^th century by Standard Oil. Unlike Gazprom, it did not control most of the deposits, but it was a monopoly in the area of oil transporting and refining. In 1911 (i.e. almost 100 years ago), the US Supreme Court ruled that Standard Oil was a monopoly that was using its market position to impede competition, and ordered it to be split into 34 companies. Splitting Gazprom into just two companies – one involved in the production and the other in the distribution of gas – would be a very nice start.

The second-largest company, Rosneft, is 85-percent owned by the Russian government. Most of Rosneft consists of Yukos assets that in essence were expropriated by the state in 2004. The former Yukos owner Mikhail Khodorkovsky, as you know, is serving time in a penal colony in Chita. No one knows when, or whether, he will be released.

Sberbank is third. The Central Bank of Russia holds 60 percent of Sberbank shares. Formally, Sberbank is not a monopoly – thousands of banks operate in Russia. But in practice, all we have to do is look at the figures: private deposits in Sberbank are valued at about $100 billion. The second-largest bank VTB (formerly the state-owned Vneshtorgbank) has about $5 billion, i.e. 20 times less.

Out of Russia’s top 20 companies, 75 percent are involved in natural resource production and export. What we will not find on that list, however, are any high-tech companies. If we take a look at a corresponding list of American companies, we will find many familiar names: Microsoft, Google, Apple, Cisco, Intel, IBM. Not in Russia. Nevertheless, the Russian stock market has been growing rapidly in recent years. Next time, we will talk about how American investors may take part in this growth. But with this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.