Re-Engineering Reform Priorities...or...Deja Who?
Published on April 15, 2005
by CHRIS WEAFER

MOSCOW -- This should have been a good week for the Russian investment case. The build-up to the country's annual investment showcase event in London suggested that the liberal economists, who for most of the past twelve months had been steadily losing influence at the Cabinet table, seemed to be resurgent and confidently promising that the broad reform plan, which was to have been the main priority of Putin's second term, was now back on track. Putin's meeting with business leaders also held out the promise that we are about to finally see an end to the unsettling factors that have held back investment in the economy and offered the prospect of a much better relationship between state and private enterprise going forward. On the back of this, investor sentiment had improved, and so too did equity prices.

Instead, a number of events over the past few days have rattled that confidence, and some observers now question whether the grand statements of recent weeks were no more than political spin ahead of the Economic Forum event in London, an attempt to create a more optimistic investment backdrop ahead of the May gathering of world leaders in Moscow and also as Putin prepares for his annual address to the joint houses of parliament. The pessimists are tempted to point to a sense of 'deja vu'; we heard all these grand sentiments before, i.e. just before Putin's re-election in March 2004, and nothing of significance has happened since. Others, while giving Putin the benefit of the doubt as regards his commitment to the long-term goals of economic, administrative and social reforms, wonder just who in the Kremlin is exerting influence over the intermediary actions and strategy, and exactly what are their objectives.

Equity fair value upgrade reflects increased pragmatism

Early last week we updated our discounted cash flow models with a slight reduction in the equity risk premium and an earnings upgrade based on a higher oil price forecast. The reason for the oil price upgrade is clear. The reason for the equity risk reduction was specifically not because we believe that the originally promised broad-based reform plan is now back on the active agenda or that the influence of the "liberal economists" is restored (as indeed I had speculated several months ago), but rather it is based on optimism that a revised version of the reform programme, i.e. a more pragmatic version, is now emerging and that this offers a more hopeful route to try and shore up existing economic growth. For that to happen, Putin will have to follow through on his promise to end some of the unsettling actions that are driving capital flight and blocking investment. Otherwise, even the revised reform plan will not work, and that risks further deterioration in public support for Putin's government. Not only that, but a loss of public support and a continued alienation of the business elite raises the very real prospect of increased instability at the top of the Kremlin power structure and a serious political challenge to Putin's preferred succession scenario ahead of the 2008 election. The worst-case scenario for investors is of increased political instability at a time when the sustainability of economic growth might also be under question, as this would destroy the hoped-for investment case and undermine asset price growth.

However, we remain more optimistic than that. And the main reason is the coincidence of economic necessity with political priority. This is the only combination in Russia that can be relied on to support progress. I do not buy into the optimism generated by the hoped-for return of the broad (Gref) reform agenda. I do buy into the optimism generated by an assumption of the emergence of a more pragmatic version of a reform agenda. The "liberal economists" have not recovered their position of influence at the top of government, but instead appear to have been displaced by a new group that we may refer to as the "Statists". This is the group that is now pushing the reform agenda. The implications of that is what allowed us to take the first step in reducing the equity risk premium that supports the increase in the equity market fair value to the equivalent of 815 on the RTS. The events of the past few days serve to remind us that not everybody in government supports the revised reform agenda, and also that while Putin may now support it as the only practical way forward, the actual mechanisms to allow progress are still not fully worked out and are more likely, as is now usual, to evolve as a series of responses to unfolding events than ever be set out as a clear strategy.

RTS trading range moved up

Last August we upgraded the fair value for equities to 710 and assumed a trading range of between 650 to 700 as Putin tried to figure out the most practical way forward. Now that this route appears to be decided on - as much because he is rapidly running out of "political time" as anything else - we raise the fair value to 815 and again assume a trading range in the mid 700's to fair value as Putin tries to figure out the best way to implement this revised programme - often with the sort of apparent inconsistency and downright interference we saw this week.

Divisive unity

During Putin's first term there was strong unity within the Kremlin. After all, they had a common enemy to defeat, co-opt or sideline. The enemy was all of the groups that shared power with the Kremlin when Putin assumed the role of acting president in January 2000 and included the oligarchs, the communists, foreign NGOs, etc. Putin made no secret of the fact that the main domestic priority of his first term was to restore the exclusive power of the Kremlin while also pursuing an international agenda of restoring Russia's position at the top table of global politics. To do this he co-opted the group of loyalists that we now refer to as the Siloviki into senior roles in the government structure.

Putin also made it very clear that he would not support any initiatives for major change either in the economy or major industries until he was absolutely sure that the Kremlin could control the process and that no outside groups could interfere or try to change government policies. Hence, during those four years, we had the perfect backdrop to the investment case of any emerging market, i.e. increasing political stability based on greater centralization of power and improving economic health based on oil and prudent management by the economic liberals. Everybody in the government was content, working largely together and preparing for a better economic and political future from the start of Putin's second term.

Instead, we see that several different groups have emerged within the government, and each has its own agenda. The main reason for the stalled reform agenda of the past year and the free hand that state agencies have enjoyed to increase their meddling in the business community is that Putin has been trying to both preserve unity and reconcile the personal ambitions of the different groups while also trying to figure out how best to push forward towards his main long-term goals.

The competing groups

So who are the main groups? Of course, we can only make guesstimates as to the composition of these groups and their main agendas, but there is enough evidence available to help us draw a broad picture.

Note: we will explore this and all of the main themes and ideas contained in this short note in a larger note as part of our Kremlinology series.

Putin's Group
This remains the key power group in government. Putin and those very close advisors who came with him from St. Petersburg and the old KGB in late 1999 and early 2000. This group has an ambition to alter the structure of the economy and Russian society, i.e. to modernize it along a European style model with greater diversification and more equitable wealth distribution. That is their long-term goal, but their more immediate priorities are to ensure Russia has a more important and relevant role in world affairs and that it becomes a respected and trusted member of the top tier of global politics. To support this, Putin wants WTO entry this year, Chairmanship of the G-8 in 2006, and to be seen to have a stable and growing economy.

Putin's group also wants to ensure that their choice of succession option in 2008 is successful so that their long-term vision of a modern Russia can ultimately succeed.

For both of these reasons, Putin needs to now address the issues that have hurt the business and investment climate over the past eighteen months, to build a more reliable partnership between state and business, and to adopt a reform agenda that can actually deliver growth in the tight time frame remaining.

Liberal Economists
The task of this group during Putin's first term was to prudently manage the cash flows from oil, gas and other natural resource exports so that Russia might shed the image of the bankrupt basket case it was seen as in late 1998 and 1999. The second role was to prepare the reform agenda that was to be the priority of the second term and to push some non-contentious changes, such as tax reform. During the first term this group was regularly frustrated by the lack of support from the prime minister - and even from Putin - but seemed content with the thought that their day was coming with the start of the second term. And that was the impression regularly given by Putin.

Over the past year this group has been increasingly marginalized, and despite a recent attempt to regain the initiative regarding the reform agenda it seems as if they remain marginalized.

Revisionists
Undoubtedly there is a group of people at the top of government who would have preferred to send tanks into Kiev during the recent elections and to rebuild the power of Russia based on the Soviet model. Occasionally, this group tries to push their agenda, but so far they remain marginal.

Siloviki
This is the term used to cover all of those co-opted by Putin into government positions as he pushed to restore Kremlin power. Some of these people are now more properly identified as part of other groups, but the term Siloviki is now increasingly associated with those who think that they, having become the new "elite" in Russia, are entitled to enjoy the benefits of that status. This group do not care about economic reforms, nor do they care much what happens outside of Russia's borders. They are much more focused on becoming the new oligarchs or the "late arriving oligarchs", as they are sometimes referred to.

It is probable that this is the group that attempted (and may still be attempting) to stop the merger of Rosneft and Gazprom, as a separate state-owned Rosneft-Yuganskneftegaz would provide a very tempting piggy bank to satisfy personal ambitions within this group.

This is also the group that many fear will become increasingly meddlesome in business - to promote their own or related group interests - and may regularly cause unwelcome surprises for the investment case. The probability is that Putin, having created this monster out of necessity, is not yet in a strong enough position to push the Siloviki aside, and may not be until after the 2008 election.

Statists
These are the new economists. This is the group that seems to be behind the revised reform agenda and who have increasing influence with Putin and the core leadership in the Kremlin. Of course, it is most likely that Putin actually assembled this group to help revise the reform agenda, i.e. having lost faith in the original "idealistic" programme. Either way, we now see substantial evidence that this group of economists, lawyers and other technocrats who are mainly loyal to Putin are now very much the driving force of what is emerging as the new reform programme.

Reform pragmatism

One year ago the investment case for Russia was based on an expectation that the government would use the combination of political strength and financial muscle built up over the course of Putin's first term to support a series of administrative, legislative and budgetary mechanisms designed to help fast track the realization of the main goals set out consistently by Putin in every one of his state of the nation addresses over the previous four years. These were essentially to create a diversified economy by means of transferring wealth from the natural resource sectors to the domestic manufacturing industries, and to specifically help growth among small and medium-sized enterprises (SMEs). That way, Putin hoped to more equitably spread wealth and to create sustainable economic growth that would support his ambition to have Russia respected as an equal partner within the G-8.

The main reason that Putin did not adopt this reform agenda after the March election seems to be a rapid realization that it would not work - especially within the 3-4 year timeframe available - because there was no reliable infrastructure in place. In other words, he has no confidence that the state agencies and bureaucrats can be relied on to efficiently push the reform initiatives.

As a result, we see the revised reform agenda now emerging. The major difference between the two programmes is that while the Gref plan would have concentrated on wealth displacement between the natural resource industries and the manufacturing, SME base, the new programme will most likely prioritize growth in a small number of strategic industries that can more reliably provide continued headline GDP growth that spins off cash and sustains the feel good factor. That way, the government can buy political time and come back to the original reform objectives at a later date.

The strategic industries likely to benefit from this revised strategy are:

• those with existing growth that the government hopes can be expanded on. These are mainly the oil, gas and minerals sectors.
• industries in which the government believes Russia has some competitive advantage that it can leverage off (technology, aviation, defense related, etc); anad
• industries that constitute the commanding heights of the economy, i.e. banking, electricity, fixed-line telecoms, and oil & gas infrastructure.

Apart from a concentration on existing growth areas, which implies even greater dependency - and ultimately vulnerability - to natural resources, the major difference between the original and this emerging revised version is that while the Gref plan called for the state to create conditions that would allow private enterprise to grow as per market conditions and lead the growth model, the revised plan sees a continued role for the state setting the industrial policy for each for the identified strategic industries, acting as regulator within each and having a direct role via national champion industries created - or restructured - within each. In this latter model, private enterprise companies will have to work alongside the dominant state company while also trying to compete with it.

This model also satisfies a key requirement of Putin's vision for the economy, i.e. that of a strongly controlling role for the state, i.e. at least until the process of major reform is completed and private enterprise can work unimpeded by state bureaucracy or corruption. At the current rate of progress, that seems a decade or more away.

Foreign participation

Putin has regularly referred to elements of the Chinese model that he believes can work in Russia. The first part is that the state stays involved at the macro planning level, and the second is the creation of national champion industries (or model structures that resemble them). The third part is that he believes Russia must follow the Chinese example of attracting international major industries in a partnership role to help the local industries modernize as fast as possible.

It is now clear that the government does not want any strategic industries to be controlled by other than a Russian-owned vehicle. That point was made again this week with the Siemens decision. While it is relatively straightforward to create the right co-investment conditions in natural resource industries (i.e. Russia has an abundance of reserves that international majors want/need access to), the same cannot be said for manufacturing or other industrial and service industries. The government's ability to attract partnerships in industries like Power Machines, technology in general, aviation, etc will be the critical determinant of success or disappointment in terms of growth.

For Investors

As stated, we have taken the first step to start reducing the investment risk premium used in our models because we finally see some reason why at least this revised version of the reform programme will now be supported. In practical terms, this means:

• There is now at least a variation of a reform strategy that while not aimed at expanding the economic activity base or trying to create the competitive conditions for SMEs, etc envisaged by the Gref plan, this is at least a plan that will get some support.
• Over the past five years the state was effectively an obstacle to growth as Putin concentrated on establishing control. During this period he was not interested in supporting any major changes to the economy or to key industries. Now, he needs to move fast to stop the decline in the rate of growth or risk the unacceptable political consequences.
• Outside of the selected key industries, there is not likely to be any significant support for growth, i.e. very little of the promised incentives for SMEs and domestic manufacturing industries. That means that while the state will not interfere in these industries and will not have a competing presence, there will probably be no serious effort to tackle corruption or the red tape that regularly slows investment in the smaller companies.
• This may also mean that companies outside of the selected strategic industries may suffer from "meddling" by bureaucrats or state agencies acting on behalf of connected parties for competitive reasons.
• But it does mean that once we are sure that this is the revised reform strategy Putin will support, we can then allocate proper risk and growth factors to the major industries and companies, i.e. depending on where they are in relation to the state or strategic industries.

Why now?

The reasons why we might now be seeing Putin's support for this revised growth model is a combination of the following:

1. Growth is slowing and affecting public confidence in the government. That needs to be addressed in case the level of public support falls so far that the Siloviki or other factions in government attempt to push for greater control.
2. An alienated business community might be tempted to back an alternative political candidate - such as former Prime Minister Kasyanov, who recently re-surfaced after a lengthy silence, perhaps sensing an opportunity. Putin will want to make sure he does not push business so far that they might risk supporting such an alternative.
3. The election season for 2008 could well start as early as next January - depending on many issues of course, not the least of which is Putin's own involvement in that election. If he maintains his stance of not running for a third term, then the intrigues that will start concerning his successor might make it very difficult to get any focus on the economy. Hence the window of opportunity to actually make progress is closing.
4. Current growth and confidence remains vulnerable to the price cycle in commodities, especially oil and especially as the volume growth factor is not gone. Hence, it is better to make progress while conditions remain favorable.
5. Putin wants a favorable climate ahead of his annual address to the joint houses of parliament. He needs to be able to talk about a reform plan that exists rather than make more promises.
6. The government seems determined to be admitted to the WTO at the December meeting. To help this cause, they need to reduce criticism over the lack of effective economic reforms and to reduce tension with the business community.

What we need to see now

In trying to determine whether this view of the likely revised reform and growth strategy is correct, there are a number of issues that will play out over the next few months (one way or another) that will give us confirmation:

Gazprom-Rosneft
The promised timetable for completion of the merger is June or July. If there is a major delay, then investors will have to question whether the Siloviki group are more influential than assumed. This is the group that effectively tried to hijack Rosneft-Yuganskneftegaz and seem to have been defeated by Putin and the Statists. If the merger does not proceed as promised, then we can have much greater confidence that this group are at least sidelined from major reform decisions, albeit they will undoubtedly go after other targets and regularly throw up a nasty surprise or several in the next few years.

Privatization
Putin, in his effort to build bridges to the business community, has promised legislation to limit the review period to three years. Business leaders and investors will want to see this promise actually followed through. Also, the Audit Chamber's privatization review report is still outstanding, and while all indications are that this is now not an issue for investors to be concerned about, the fact that is remains outstanding (as it has been since July last year) still fosters some concerns as to why it is taking so long.

Tax Reviews
Putin also promised to bring some clarity to tax audits. This week's tax claim against TNK is not any great surprise, as TNK along with Sibneft and YUKOS used on-shore tax schemes. The Tax Ministry already said that both Sibneft and TNK would have to pay compensation, while other companies in the natural resources industries will be assessed for lesser amounts. This is expected.

But the fact that the whole process is taking so long is of concern to business managers and investors, and incidences such the announcement of the tax claim against TNK in the midst of the London Economic Forum are examples of the poor government supervision of these audits that Putin has promised to correct.

Investors and business owners will want to see some practical steps taken before accepting this as a low risk.

State Agencies
Putin promised that the government would move to impose greater control over the activities of all state agencies that deal with businesses. Again, everybody will likely wait for some specific proposals rather than just good intentions before reversing capital flight and increasing investment.

Siemens Investment by companies like Siemens is a very important part of the assumed revised reform programme. The critical question is whether Siemens, having had a majority control bid rejected. will now come back in a minority partnership role. If they do not. then it will be very difficult for other companies to make similar investments in the industries that Putin wants to see modernize and grow fast (i.e. other than the oil & gas sector, of course).

YUKOS/Menatep
We are now at the closing stages of this case. Even though investors have now mostly written it off as a sentiment issue, how it finally ends could nevertheless have implications (even more) for the government's credibility with major strategic investors and the international community, which it is eager to join on an equal basis.

In summary, we are confident of a valuation level for equities equivalent to 815 on the RTS (albeit stocks like Gazprom and VimpelCom that are not constituents of the RTS have much better upside) based on our risk and growth assumptions. Inevitably, even if this view of a revised reform strategy and the priorities of the competing groups around the Cabinet table are correct, then we will still be left guessing as to the exact mechanisms to push the programme amidst regular incidents of concern and confusion by other groups at that table. This suggests that we will have continued volatility in the equity market while the issues detailed above are progressed. But that volatility should now be set at a higher trading range than that of the past six months.

Chris Weafer is the Chief Strategist for Alfa Bank in Moscow.

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