Will Russia Stay a Capitalist State?

Markets: Will Russia stay a capitalist state - at Moneyweek.co.uk - the best of the week's international financial media.

Why is Khodorkovsky under arrest? The billionaire businessman has been arrested on charges of fraud and tax evasion following eight separate investigations into the activities of Yukos, the oil company he controls. He now joins two other Yukos executives already in prison on related charges. President Putin insists the arrests reflect the normal functioning of the criminal justice system and that all three men will be released if innocent. But few doubt that Yukos is being singled out for political reasons; in particular, for Khodorkovsky's refusal to honour a deal made between him and Russia's other corporate oligarchs' and Putin that they would stay out of politics.

Why did Putin do this deal?

Because the Russian economy had all but collapsed during the Yeltsin years. Into the vacuum had stepped the oligarchs, who had made their fortunes during the notorious privatisations in the early 1990s and consolidated their positions via the "shares-for-loans" deals in 1995. Putin came to power vowing to restore the authority of the state. This meant neutralising the power of the oligarchs. In 2000, he drove two of the most powerful, Boris Berezhovsky and Gavlinksy, into exile. He then made a deal with the others that he would not question their privatisation gains if they kept out of politics. But Khodorkovsky went on to fund several opposition parties.

How did investors react to the arrest?

The stockmarket slumped 10% on the first day of trading amid fears that it marked the start of a full-blooded assault on the oligarchs with the aim of reversing the 1990s privatisations. These fears appeared to be confirmed last week when state prosecutors froze Khodorkovsky's 44% stake in Yukos, prompting another 8% fall in the Russian stockmarket and a fall in the rouble on the foreign exchange markets. Many investors argued that this amounted to an attack on private property rights, the bedrock of the capitalist system. At worst, it was seen as the possible start of a return to Communism.

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Is this a return to Communism?

No. Under Putin, Russia has become one of the least Socialist countries in the world. It has a lower ratio of government spending to GDP than any other OECD country, and Putin's decision to introduce a 13% flat rate of income index is the stuff of libertarians' dreams. Under Putin, the economy has performed very well, growing by an average of 6% over the last three years. GDP is now some 36% higher than in 1998.

Is this revival under threat?

Yes - not least because it is not nearly as strong as it looks, says Martin Wolf in the FT. Comparisons are difficult, but the data suggests that GDP is still below 1990 levels. More importantly, despite the strong recovery from the 1998 crisis, Russia is struggling to attract investment. By 2002, the stock of foreign direct investment into Russia was only $23bn against Poland's $45bn. Worse, money is leaving Russia fast. The Economist Intelligence Unit estimates capital flight at $191bn from 1994 to this year inclusive, a sum equivalent to two-thirds of GDP. The danger now is that other oligarchs will pull their money out and foreign investors stop putting more in.

Is there any sign of this?

A number of deals have already been shelved. French food company Danone is putting off its takeover of Will-Bill-Dann, the Russian food company, and a number of firms due to list on the Russian stock exchange may be forced to postpone their IPOs. ExxonMobil and TexacoChevron have postponed talks about buying a stake in Yukos. But it is absurd to suggest foreign companies will allow scruples over democracy to keep them out of Russia, says Anatole Kaletsky in The Times. Oil firms, for example, thrive on relationships with corrupt dictators in the Middle East, Nigeria and Indonesia. So long as Russia remains stable, foreign investors will continue to invest.

Will Russia remain stable?

That seems to be Putin's main aim. He clearly shares the view that this vast country can only be effectively ruled by autocracy. In addition to his actions against the oligarchs, he has already clamped down on other areas of potential opposition. He now controls all the mainstream media. He has also staffed his government with many former senior colleagues from the KGB. According to one analysis, a coalition involving the FSB (the successor to the KGB), the military and the army - collectively known as the siloviki - now holds 58% of the top leadership positions, compared to just 5% during the last years of the Soviet regime. Some have interpreted this as a sign that Putin is keen to re-establish an authoritarian state.

So are others under threat?

Providing they learn the lesson of Khodorkovsky's arrest, probably not. But the risk is that Putin has "started a juggernaut he cannot stop", says the FT. There are many officials across Russia who saw their status and power usurped by the oligarchs during the 1990s and have scores to settle. And the oligarchs are bitterly resented by ordinary Russians, who believe they gained their wealth illegally. Politicians close to Putin are now demanding investigations into other oligarchs, including Roman Abramovich, whose company Sibneft is currently merging with Yukos.