Russia's Economic Privatization Plan

13 MINS READOct 25, 2010 | 12:09 GMT
Russia is planning to launch a large privatization program in the coming months. The plan is meant to attract foreign capital and technology; the Kremlin expects to raise $50 billion from the privatization effort. However, the plan depends on many variables and could fall apart before Moscow realizes its goal of securing strength for the state and economy for years to come.
Click here to download a PDF of this report Russia intends to launch a large privatization program in the coming months, selling minority — and in some cases controlling — stakes in some of the country's most strategic and important state-owned companies. The privatization plan is part of a larger restructuring of the Russian economy initiated by Russian Prime Minister Vladimir Putin during his presidency. Putin's economic restructuring has two phases. The first was the Kremlin's consolidation over Russia's main assets while purging foreign and anti-Kremlin influence. Now that the first phase is nearly complete, the second period of economic planning is beginning with modernization and privatization initiatives. This second phase involves inviting foreign players to return to Russia in order to bring in technology and cash. While these initiatives might seem incompatible with the Kremlin-centric consolidation of the past decade, they are in fact a natural part of the Russian government's desire to maintain a strong economy and state while planning for the future.

The Cycle

After the Soviet Union collapsed, the Russian state fell into political, economic and social chaos. Most of the state's assets had been stripped away, sold or in some cases stolen. But when Putin took the helm in 1999 — first as prime minister, then as president before becoming prime minister again — his goals were to end the chaos, consolidate control over the country and create a stronger state. These goals affected every sector in Russia. Economically, Putin began consolidating the main assets that were strategically important to the government by taking them away from the Russian oligarchs or foreign entities that controlled them. After getting them under state control, Putin ordered a reorganization of those firms and assets, eliminating inefficiencies and creating large monopolies that became national champions in the energy, banking, transportation, military industrial, agricultural, telecommunications and other sectors. But the financial crisis of 2008 shook the Russian economy to its core. The Russian government was forced to dump billions of dollars into its state firms and champions, which were no longer able to gain access to foreign credit. The financial crisis forced the Kremlin to start thinking about its economy in a new way. The Kremlin realized that it needed to not only rule the economy, but also to find ways to finance and modernize the pieces of the economy and ensure them a stable future. While it had been an imperative for 10 years for the Russian government to consolidate control over the economy, the Kremlin recognized that it needed two things to continue: technology and cash. Traditionally, the Russian state has to feel confident in its ability to rule and to control the forces inside the country — not just economically, but in the areas of society and security — before it allows any significant private or foreign influence to take hold. The Russian government started to feel this confidence in 2007 after its consolidation efforts in all those spheres, so it could begin acting on its plans for economic modernization and privatization.

The New Economic Plan

During the past few years, the Kremlin formed two plans to bring in foreign technology and cash. The first plan — deemed the Plan for a Modern Russia — has been the most public, especially since Russian President Dmitri Medvedev went on a foreign tour to sign technology deals with firms in Germany, France, Norway, the United States and other countries. As STRATFOR has noted, the modernization initiative is intended to upgrade — and in some cases build from scratch— many key economic sectors, including military industrial, information technology, telecommunications, space, energy, transportation and nanotechnology. The second and less public plan involves privatizing pieces of state companies or assets to bring in cash. The privatization plan, called the "New Privatization Initiative," was created in 2009 and is intended to allow foreign entities to own stakes in a dozen potentially attractive and strategic state companies, as well as partially or fully privatize thousands of smaller state assets. Most of these privatizations are for minority stakes. The state is only privatizing controlling stakes in firms or assets it is not very concerned with or has deemed non-strategic. Both the modernization and privatization plans were conceived by Russian Finance Minister Alexei Kudrin, known as one of the premier economic and financial minds in the government. Kudrin set up a team of Western-trained economists to work with a group of Russian nationalists (who are wary of any foreign influence in Russia) to create a plan that could bring in the technology and cash from abroad while allowing the state to retain control over the economy, businesses and other national priorities. The most difficult balance to strike has been that between allowing foreign groups inside Russia and ensuring that the Kremlin controls the level of influence these groups have. Every member of the Russian government — not to mention the Russian public — remembers the chaos that erupted in the 1990s after Russia opened to privatization after both Perestroika and the fall of the Soviet Union. Kudrin's plan has been deftly arranged in order to account for the needs of a powerful economy and state, now and in the future. Kudrin is also trying to strike a balance between the Kremlin's power circles, which have ties to the various companies being privatized. A bitter struggle is taking place between the Kremlin factions, each of which has its own economic base. Previously the Kremlin clans picked away at each other's economic assets in order to tip the balance of power. But Kudrin is attempting to ensure that his plan has nothing to do with Kremlin politics and instead is about creating a more efficient and stronger state.

The Privatization Initiative

On June 15, 2010, Russia's privatization legislation (called "On Privatization of State and Municipal Property") took effect. Although the Kremlin has maintained involvement in most Russian business negotiations in the past decade, these laws gave the Kremlin an explicit legal right to "engage foreign and domestic entities to arrange and manage the privatization process" on behalf of the Russian firms involved. Russia's state firms are owned by many different groups in the government — ministries, firms, agencies and even government officials. Previously, the Kremlin could make its demands known and influence deals being made. But now the Kremlin itself will make the deals for the stakes up for privatization. The new laws allow one-on-one negotiations between the highest echelons of the Kremlin and any and all potential buyers. (click here to view interactive chart) Under the plan and new laws, the sales are divided into two categories: companies and assets. The state companies are 12-14 national champions that are up for privatization, including oil giant Rosneft and transportation monopoly Russian Railways. The state's assets that are up for privatization are a mixture of small companies and assets that the state does not deem strategic. The private stakes up for sale in the "companies" category range from 10 percent to 49 percent, with most of the stakes on the smaller side. This is because the state considers these firms important enough to limit foreign control over them, but attractive enough to bring in some major international bidders. The government hopes the privatization of the main firms will bring in an estimated $29 billion by 2012. Items in the "state assets" category either remained under state control since the Soviet days, fell under state control during the period of economic consolidation or were picked up by the state during the financial crisis. This category includes some 5,000 small companies and assets that are expected to be privatized before 2014. These firms and assets can be fully privatized, if the state wishes. The government hopes these privatizations will bring in an estimated $20 billion.

The Cash

In total, the Russian government hopes to bring in $50 billion — roughly the entire gross domestic product of neighboring Belarus — over three to five years purely by selling shares in companies and assets. And there is no shortage of sectors in need of that funding. Theoretically, the cash is to be invested back into the firms being privatized. Most of the national champions are in desperate need of modernization, with much of their infrastructure suffering from decades of neglect and decay. Many of the state firms also have large-scale expansion plans for the future. But modernization and future expansion for most of the national champions is an incredibly expensive undertaking; $50 billion is nowhere near sufficient to meet these goals. For foreign investors to be considered for involvement in the privatization program, they must first convince the Kremlin of their plans to modernize and expand the companies in which they invest, but there is an understanding that modernization is to be a joint private-public effort. Should the state renege on this understanding, it will find it difficult to find investors for future privatization rounds — remember, this is being done over five years so that Russia can ease itself into the changes, which means the state must continually express its own financial commitment to the effort to maintain investor interest. This will be difficult, since the state actually plans to use most of the $50 billion of anticipated income to help plug the budget deficit, which Kudrin hopes to decrease greatly by 2014. Russia's forecast budget deficit for 2010 alone is $101 billion, which means $50 billion would not solve the budget problem this year, let alone through 2014. This would leave the government to its own devices to find the cash necessary to fund the modernization and expansion plans.

The Deals

The government has been secretive and cautious in proceeding with its privatization plan. This is in part because several of the state firms selected for privatization are resisting. Longtime Rosneft chief Sergei Bogdanchikov and a handful of his loyalists were sacked after they spoke out against the plan to privatize part of the firm. Nikolai Tokarev, chief of Russian pipeline monopoly Transneft, has also publicly objected to the privatization plan. Sberbank chief Sergei Ignatiev has also voiced concerns about the initiative; he would rather have shares of his firm up for public auction, where they could fetch more money, instead of a private Kremlin deal with a foreign player. However, the Kremlin wants to ensure it can control and monitor every foreign group gaining access inside Russia, which would be more difficult through a public auction. The other reason for the Kremlin's caution is that it is still weighing estimations presented by Kudrin's economic team on whether the still-skittish financial markets would be willing to invest tens of billions in an economy that has a reputation for being less than safe. Even with the nervousness in foreign markets, quite a few foreign players are lining up to strike private deals with the Kremlin on stakes in these strategic firms. In both the modernization and privatization programs, the Kremlin has used economic and financial deals in order to strike strategic bargains with foreign groups and governments. For example, according to STRATFOR sources, Italian energy firm Eni is interested in buying a stake in Rosneft as a way to give Eni more freedom to work in Russia and possibly secure other oil deals previously off-limits to the foreign firm. Similarly, sources say that U.S. firm Boeing and France's Thales are interested in a stake or a seat on the board of Russian Technologies, Russia's military industrial umbrella organization, which could be used to strike private deals for Russia's strategic titanium supplies. Russia is also being cautious with the timeline for privatizing shares in its strategic state monopolies. For any national champion that will see more than a 10 percent stake privatized, the stake will be sold in multiple tranches in order to see if the first sale is successful and not destabilizing. This will give the Kremlin time to reconsider a second tranche if necessary. VTB, one of Russia's largest banks and the first big company the state is considering privatizing, will have its 24.5 percent stake sold in two tranches — first 10 percent and then the remaining 14.5 percent. Thus far, the Kremlin has been in private negotiations with U.S. investment firm Texas Pacific Group, whose chiefs traveled to Moscow in recent months to meet with First Deputy Prime Minister Igor Shuvalov to secure the deal. The first tranche is expected to sell for $3 billion, since VTB is worth $30 billion. According to STRATFOR sources, U.S. firm Merrill Lynch is conducting preliminary negotiations for the sale of the second tranche. But in order for the multiple tranche plan to succeed, the Kremlin will have to prove after each tranche that there will be returns and results, which goes back to the government's need to find reinvestment funding. The Kremlin will also need to prove that it is willing to help with the cash shortfalls associated with the firms' modernization and expansion plans. Without any results, bidders will turn away from the remaining tranches for sale. Another problem in striking deals with foreign groups is the difficulty the foreign firms could face in getting their shareholders to agree to such large deals with the Kremlin, which has proven in the past to be an unreliable business partner. Many firms looking to get back into Russia were burned by business deals there just a few years ago, when the state pushed them out or nationalized their assets. In the end, the overall concern is that Kudrin's strategy for modernization and privatization has created an incredibly ambitious, intricate and fragile plan. There are many variables — bureaucracy, investor skittishness, markets' ability to handle the investments, possible backlash and Kremlin politics — that must align in a certain way in order for Kudrin's vision to materialize. If just one fails to fall into place, Russia's plan for an economically vibrant future could be at risk.

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