SCENESETTER: TREASURY U/S LEVEY'S VISIT TO MOSCOW

C O N F I D E N T I A L MOSCOW 011830 SIPDIS SIPDIS STATE FOR EUR/RUS TREASURY COX/ALIKONIS/BAKER NSC FOR TGRAHAM, TRACY MCKIBBEN E.O. 12958: DECL: 12/19/2015 TAGS: ECON KTFN EFIN PTER OTRA OVIP RS SUBJECT: SCENESETTER: TREASURY U/S LEVEY'S VISIT TO MOSCOW Classified By: Ambassador William J. Burns, Reasons 1.4 (b/d). ¶1. (C) On behalf of the U.S. Mission in Russia, we extend a warm welcome to you and your delegation. Your visit offers an opportunity to continue your discussions with the Russians on combating terrorism financing as well as our grave concerns about Iran's and North Korea's activity in this regard. Your visit will help continue these themes of how our two countries can work collaboratively to lessen the threat posed by North Korea and Iran, including disrupting threatening financial flows to, through, and from them. The Russians, as always, are most receptive to a message that we share a common threat and that only by working together can we ensure greater peace and stability. ¶2. (SBU) One major development since your most recent visit was the murder of Central Bank of Russia First Deputy Chairman Andrey Kozlov last month. Kozlov was an energetic reformer who enjoyed political support at the highest levels. The interlocutors with whom you will meet during this visit held Kozlov in high regard. He championed the strengthening of counter-terrorism financing and anti-money laundering controls, and led efforts to revoke licenses of banks complicit in these activities. President Putin has publicly vowed to carry on Kozlov's work and has called for the establishment of an interagency working group to rid the country's financial system of shadow economy entities. MONEY-LAUNDERING -------------- ¶3. (SBU) Russia, as you know, now has developed a solid legislative and regulatory foundation for combating money laundering and terrorism financing. Its role in spearheading the creation of the Eurasia Group of Combating Legalization of Proceeds from Crime and Terrorist Financing (EAG) has demonstrated both the political will and capability to improve the region's fight against money laundering and terrorism financing. Nevertheless, vulnerabilities remain. Russia's Federal Service for Financial Monitoring (FSFM) estimates that Russian citizens may have laundered as much as $7 billion in 2005. Experts believe that most of the dirty money flowing through Russia derives from domestic criminal or quasi-criminal activities, including evasion of tax and customs duties and smuggling operations. ¶4. (SBU) Oversight of the banking system also needs strengthening. Banking reform efforts have emphasized enforcing more stringent capital adequacy standards and strengthening anti-money laundering controls. Authorities have revoked more than 110 licenses from banks that have not fulfilled their capital adequacy and suspicious transaction control requirements. Despite this progress to make the banking sector more transparent, Russia continues to suffer from a weak system of financial intermediation. Profitability among commodities producers has generated an excess of capital, but there is an equal-size demand for capital that domestic banks are not meeting. NORTH KOREA -------------- ¶5. (C) In your discussions with the Russians before the G8 Summit, you have urged the GOR to conduct investigations to ensure that North Korea does not use Russian financial institutions to facilitate illegal activities. This theme was echoed at the Summit in other high-level G8 meetings. The Central Bank has warned Russian banks to be aware of entering into relationships with North Korean banks. Russia's Federal Financial Monitoring Service is monitoring all contacts with North Korea and North Korean financial institutions. AN AGREEMENT WITH THE UNITED STATES? -------------- ¶6. (C) The Director of the Federal Financial Monitoring Service (Russia's Financial Intelligence Unit) Viktor Zubkov has praised cooperation with the U.S. on financial crimes investigations. Russian business daily newspaper Vedomosti reported that Zubkov credited a recent instance of information sharing with the U.S. for helping to identify terrorist cells operating in the North Caucasus. He and Central Bank of Russia Deputy Chairman Viktor Melnikov, however, have criticized the pace with which Financial Action Task Force (FATF) requests are processed. During their meetings with you, they are likely to raise the issue of formalizing a bilateral information-sharing agreement. TERRORIST DESIGNATIONS -------------- ¶7. (SBU) Russia is generally supportive of the process of designating terrorist entities within the UN Security Council and a Russia's support was key to the passage of the UN Security Council Resolution 1617, the successor resolution to UNSC 1267. ¶8. (SBU) As you will recall, the United States has placed a hold on the Russian-sponsored designation of a Chechen at the UN 1267 Committee, citing a lack of evidence to meet the legal threshold for a terrorist designation. In April 2005, Russia placed a hold on two U.S.-sponsored designations - Buisir and Al-Hiyari, also citing lack of legal evidence. The issue has become an irritant in our otherwise productive and positive relationship on terrorism finance and financial crimes. BACKGROUND ON THE RUSSIAN ECONOMY -------------- ¶9. (SBU) Since 2000, Russia has been an economic growth success story driven by high oil prices and strong, sustained consumer demand spurred by Russia's emerging middle class (20-35 percent of the population). GDP has increased at impressive annual rates of six-to-seven percent for eight straight years. Real average incomes have risen as well, and the poverty level has dropped from 40 percent of the population in 1998 to 20 percent today. Unemployment is a relatively low seven-to-eight percent. Russia has used its ample foreign reserves (over $261 billion) to pay off its debts. Russia has tucked away almost $70 billion, or roughly 6.7 percent of GDP, in a Stabilization Fund to insure against future oil price fluctuations. At the same time, the Government has pursued a firm course of fiscal conservatism, running budget surpluses (a record 7.5 percent in 2005),and resisting significant pressure to spend Russia's oil windfall. Foreign investment, which lagged for years, is finally reaching levels comparable to other emerging markets (recent projections put FDI in 2006 at almost $20 billion, or 3 percent of GDP). ¶10. (SBU) Nonetheless, significant weaknesses remain. Growing and pervasive high-level corruption, increasing state control over murkily-defined "strategic sectors," excessive bureaucracy, lack of transparency and rule of law, disregard for property rights, and the unpredictable application of the tax code are the biggest threats to long-term growth. Social reforms (namely health care, municipal housing, and education) have stalled, largely because of political reluctance to embark into uncharted territory in the run-up to the 2008 presidential election. Inflation persists in the low double-digits; the budget is slowly becoming more dependent on high energy prices; and higher social spending and government salaries are increasing expenditures. These problems are exacerbated by the labor market in Russia, which faces two critical challenges: shortages caused by poor labor mobility between regions and a demographic crisis - the population is declining by 700,000 people per year. ¶11. (U) Since its consolidation in 1996, the Russian stock market has experienced growth that has led emerging markets. Capitalization was close to USD 1 trillion by the end of August, compared to USD 346 billion at the end of August 2005, and USD 177 billion at the end of 2003. Natural resource firms have fueled the vast majority of this growth, thanks to a favorable ruble exchange rate following the 1998 crisis and global increases in commodities prices. The participation of foreign and domestic institutional investors is rising, as are market trading volumes and liquidity. Perhaps the most unsung factor accompanying Russia's swelling market valuations has been the trend among established and emerging firms in Russia to raise primary market equity capital at home. BURNS