RUSSIAN CORPORATE STATISM: WATCH THIS SPACE

C O N F I D E N T I A L SECTION 01 OF 04 MOSCOW 001442

SIPDIS

SIPDIS

STATE FOR EUR/RUS; EUR/ERA; EEB/IFD
STATE PLS PASS USTR FOR DONNELLY, MOLNAR
NSC FOR KLECHESKI AND MCKIBBEN
DOC FOR 4231/IEP/EUR/JBROUGHER

E.O. 12958: DECL: 04/02/2017
TAGS: ECON EINV EIND PGOV RS
SUBJECT: RUSSIAN CORPORATE STATISM: WATCH THIS SPACE

REF: 06 MOSCOW 1306

Classified By: Ambassador William J. Burns for reasons 1.5 (b/d)


1. (C) Summary: The rise of corporate statism in Russia has
been significant. Since 2004, the government has taken over
the world's largest titanium business, consolidated its
position in Gazprom, merged 10 aviation businesses into a
state-owned conglomerate, and taken controlling positions in
other firms. No less fascinating has been the mix of greed,
politics, and business behind the expansion of the state into
the economy. Looking ahead, our contacts are strongly
divided. Some see troubling signs of continued state
ambition. Others believe the process is essentially
plateauing, and will stabilize at lower levels of state
ownership in the economy after two-three years. In our view,
the current trendline may quickly approach some rather
natural limits, and the Kremlin will eventually have to bow
to the market. In the meantime, we should reinforce
market-driven approaches and the cadre of Russian
policy-makers who doggedly keep these ideas in play. End
Summary.


2. (SBU) This cable is based on dozens of conversations with
contacts in industry and banking over the past six weeks,
supplemented by Embassy-based research.

The Breadth of State Ownership
--------------


3. (SBU) The march of the state into parts of the Russian
economy over the past few years has been significant, with
control of swaths of the natural resource, defense, and
select other sectors consolidated in state hands. Annual
revenues of Russia's ten largest state-owned or controlled
companies reached an estimated 20 percent of GDP in 2006.
State-owned or controlled companies account for one-third of
the Russian stock market's capitalization, and in just the
last year, the value of these equity holdings has almost
doubled to an estimated USD 369 billion. And the process
continues: Rosoboronexport is rumored to be in line to buy
Russia's fifth largest steel producer, Mechel; further
consolidation in the energy sector favoring Gazprom and
Rosneft is likely; a new shipbuilding national champion is in
the works; and diamond giant Alrosa has its eye on Norilsk
Nickel, a USD 30 billion company with more than the half the
world's palladium and one-fifth of global nickel output.

Looking Behind This Latest Great Grab
--------------


4. (C) The grab for Russia's resources is an old story, but
contacts agree that traditional motives (greed, power) have
been supplemented in this round with a nationalistic brand of
commercial considerations. Greed in Russia shocks no one,
but the rising value of Russia, Inc. (on the back of high
energy prices) has made the current grab particularly
profitable for some. Power considerations -- both
geopolitical (as in the case of Gazprom) and in the context
of Russia's domestic succession process -- are evident as
well. New to this paradigm is the surprisingly strong role
business considerations seem to be playing -- as the Russian
Government tries to salvage a select few decrepit remains of
Soviet industrial prowess before it is too late. Our
contacts have a lot to say about all three motives; we
summarize what we've heard here.


5. (C) Greed: The Kremlin leadership in the economy is in no
small part about money, and the Sibneft takeover by Gazprom
is perhaps the most blatant example of this (only about a
quarter of the $12b selling price for the firm is said to
have actually gone to owner Abramovich). In general, the
insider offtake from M&A deal flows is said to be so large
now that Swiss banks have told Kremlin cutouts (like
gas-trader Timchenko) that they cannot accept further
deposits without knowing the source of the money. The most
lucrative transfers to the state (usually involving natural
resources) may be wrapped in patriotic rhetoric, but include
a healthy dose of financial opportunism. Yet, as ugly as it
looks, our contacts remind, it is not so different than what
happened in Indonesia and South Korea - and Mexico too. As
one contact points out, "the bureaucrats got rich there too."

MOSCOW 00001442 002 OF 004


6. (C) Power: Creating national champions and projecting a
strong image for Russia abroad has been a leading factor in
many state-connected takeovers and consolidations, including
the removal of the Gazprom ring fence, the Rosoboronexport
makeover, the RUSAL-SUAL deal, and the anticipated takeover
of Norilsk Nickel by Alrosa. Some of what we are seeing is
also is part of the ongoing succession process, putting
individuals into deal flows and thus providing campaign
finance and enhancing their public profile. The decision to
put military hardware exports under Rosoboronexport is seen
in some quarters as buttressing dark horse presidential
hopeful and Rosoboronexport Chairman Sergey Chemezov. Recent
portfolio changes are seen by some as giving First Deputy
Prime Minister Sergey Ivanov a cash-laden institutional base
like that enjoyed by his chief rival for the presidency,
First Deputy Head of the Presidential Administration and
Gazprom Chairman of the Board of Directors Dmitriy Medvedev.


7. (C) Nationalistic-Driven Commercial Considerations: Many
believe that Putin and those around him are also driven by a
sincere desire to right the excesses of the 1990s, or
oligarchic plundering of once-proud, though ruinously
inefficient, Soviet companies. The examples here are truly
varied. In the case of Avtovaz, Rosoboronexport's move to
take over the firm last year may be the only thing saving the
car-giant from complete collapse in the face of global
competition. The emerging Norilsk Nickel story is said to be
as much about saving Alrosa (which experts say will run out
of diamonds in ten years' time) as it is about keeping
Norilsk's palladium and nickel output in Russian hands. And,
as driven by national security concerns as the formation of
the United Aircraft Company might be, also at play is a
long-overdue consolidation of an industry largely on the
verge of collapse. These examples are more about saving jobs
and communities and creating viable competitive companies
than personal enrichment. Although making money is not
precluded here, both Avtovaz and UAC, not to mention plans to
create a new shipbuilding national champion, sound more like
cash sinks than cash cows.

What Next?
--------------


8. (C) Looking ahead, our contacts are divided about what to
expect next. "Statist" believers argue that there are
troubling signs that the trend is far from contained:
state-owned companies are straying farther from their core
business, eyeing the telecom and IT sectors, and expanding
beyond traditional financial services. They point to
Gazprom's movement into electricity; Svyazinvest's
significant stake in privately-held telecom provider Comstar;
and VneshTorgBank's overtures to brokerage house Troika
Dialog (ultimately rebuffed). While no one is predicting
another Yukos-style approach, there is a sense that the
authorities can and will come up with new pretexts for
control.


9. (C) In contrast, others argue the state's reach is
plateauing, and the current mix of state-private ownership
could start to reverse itself before long. They say national
champions in the sectors that make sense have been created,
and industries such as telecom and IT do not lend themselves
to over-centralization. In gas and electricity, given supply
shortfalls, the GOR has to promote private investment to meet
demand and introduce efficiencies. A shrinking current
account balance (on the back of lower oil prices) and the
drive to diversify the economy only heighten the need for
private capital and better corporate governance (which
implies a move away from state ownership and control). The
Kremlin will also find it increasingly difficult to control
emerging interest groups, from the consumer sector to
regional governments. Integration into the WTO and other
western economic institutions will require greater
transparency, better and more equal market access, and lower
protectionist barriers - which will temper the state's
ambition.


10. (C) Some take this latter argument one dark step further.
They say that current GOR leadership, its successors and
supporters, will need to find outlets for their accumulated
wealth, much of which is said to be held in liquid assets
abroad. The theory goes that these funds will start making
their way back to Russia over the next two-three years, and
that the target of the return flows will most likely be the

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same assets that have been carefully squirreled away in state
hands over the past few years -- thus spurring share
offerings by Rosneft, spin offs at Gazprom, etc. These
assets are profitable, and equity ownership in Russia carries
less risk for this particular group of investors than the
prying eyes of regulatory authorities abroad. Likewise,
coming into Russia from an European investment platform, as
one contact cynically noted, may make it less likely that
zealous law-enforcement officials abroad would pursue
criminal or civil cases for fear a U.S. or European firm
could get tangled up in the investigation.

Where We Come Out
--------------


11. (C) Looking at the three motives most obviously at play,
two of them -- greed and nationalistic commercial
considerations -- suggest equally valid reasons why we might
see the state pulling back from its commanding heights over
the next few years. Greed will tend to push those who have
accumulated shares in state companies towards share
cash-outs, just as it will push those who have accumulated
"private" cash abroad to buy back into Russia's safest
investments. Rosneft is a perfect example. We are watching
to see who in the government argues the loudest for Rosneft's
further privatization -- they more than likely stand to
benefit from either the sell or the buy opportunity. For
industries that are less obvious moneymakers, exemplified by
Avtovaz and UAC, the state is even more likely to divest
(wholly, in the case of Avtovaz) as the firms become
commercially viable and need investment capital and strategic
partners, and as they become less social land mines and
resemble more the typical day-to-day slog of the business
world.


12. (C) But pulling back does not mean exiting the field.
XXXXXXXXXXXX does not expect the state ever to
relinquish its control of XXXXXXXXXXXX. Nor will the
GOR allow its stake in Gazprom to drop again below 50%,
although many predict it will shed non-core assets in the
coming years. Nor will the diamond trade or trade in metals
likely see a repeat of the halcyon days of private ownership
in the wake of loans-for-shares. UAC will likely never be
more than 30% privately-owned.


13. (C) But even if every firm in the natural resources
sector ends up in state hands, as significant as that would
be, it would account for around 12% of the Russian economy.
Add in state monopolies in the transport and communications
sector, defense industries, and space, and state control over
the economy rings in around 25% of GDP. As disturbing as
this figure might seem, it is not wildly out of line with
other market economies rich in natural resources. As
recently as two years ago, the Norwegian state owned
approximately 32% of the companies listed on the Oslo Stock
Exchange, and still holds shares in 10-15 percent of
Norwegian industry, including controlling shares in oil,
telecoms, and the national airline. In Mexico, the state
fully controls the oil, gas, and nuclear power industries and
has reserved for the state in whole or part the
telecommunications, air travel, and postal sectors.


14. (C) And these back of the envelope estimates ignore
important counter trends to the movement toward greater state
control. Whole swaths of the economy, our interlocutors
again and again confirm, lie fully outside the ambitions of
the state -- and are thriving. One seasoned businessman (who
has had his hat handed to him on more than one occasion over
the past 15 years) is back in Russia and growing fast, and he
chalks up his current success to the booming service and
retail sector, a place where he says he never comes in
contact with the designs of the Kremlin. There are also
instances, like with XXXXXXXXXXXX, where, despite the
new ownership
structure, the state has left the firm to run the business
without Rosoboronexport grabbing off profits or instructing
where production should go. Lastly, it would be
irresponsible to ignore the progress being made toward the
break-up and privatization of both the electricity and rail
sectors. When all is said and done, these massive reforms
will move some 2-3 percent of GDP from state to private hands.


15. (C) There is another reason why more of this economy
will likely move into the private sector. Economic
modernizers, as they have come to call themselves here, may still

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ultimately get the upper hand. XXXXXXXXXXXX,
XXXXXXXXXXXX, XXXXXXXXXXXX and others
recognize that only through greater private sector
participation in the economy will Russia be able to attract
the capital needed to sustain growth over the long run. This
is also where working to bring Russia into international
institutions will help drive policy here in the direction we
favor. Locking the Russian Government into such institutions
and exposing Russian companies to the discipline of the
global market will reinforce the trends we seek to encourage.
Doing so this year, before the election process starts to
create new winners and losers, is a bet on the modernizers
worth taking.