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Russia's New Capitalism


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RUSSIA'S NEW CAPITALISM

In 1990, some recent graduates of the Moscow Aviation Institute gathered for a gripe session on the Soviet airline industry. They found plenty to talk about. Aeroflot, the huge state monopoly, was an international joke, with atrocious service and a plummeting safety record. It was hardly the place where the young grads, whose average age was 27, wanted to spend the next 35 years. So why not start an airline, someone suggested.

Four years later, this small group of dreamers runs Transaero, an airline that is growing with extraordinary speed. Starting with just one flight a week, the carrier now operates leased Boeing jets on 75 flights a week to such diverse spots as Tel Aviv and Tashkent. With British Airways and Air France training its flight attendants, Transaero plans to double its flights next year. By 1997, the upstart hopes to be taking Russian tourists to Disney World, near Orlando. Says Transaero's President Alexander Pleshakov: "We have been able to achieve the almost-impossible in Russia: offer first-class service."

Transaero is just one of thousands of new, private Russian companies that are emerging from the collapsed Soviet economy. In a number of key sectors--transportation, retailing, high tech, finance, and many others--Russian entrepreneurs are laying the foundations of a private economy.

The new entrepreneurs have deliberately sought low profiles to avoid shakedowns from Kalashnikov-toting mafiosi and to escape greedy and corrupt tax inspectors from Moscow. Some of them even have to establish their own security forces. And because Russia does not yet have fully developed accounting and disclosure standards, few private-sector operators are eager to disclose their revenues. But some have already built substantial businesses with thousands of employees and profits in the tens of

millions.

These companies aren't likely to absorb workers in their 50s or 60s who have been subject to dramatic cutbacks in their working hours--and pay--at failing state enterprises. But the evidence is growing that the efforts of these businesspeople may be just enough to bring Russia's dramatic economic slide to a halt. Even the overly pessimistic official numbers show production bottoming out, inflation falling, and personal income and savings soaring. Even the continued uncertainty over the value of the sinking ruble hasn't been great enough to stamp out the increase in private-sector activity. "We are witnessing a turnaround," says Yegor Gaidar, the radical reformer and former Deputy Prime Minister who fell from power when voters rejected his shock therapy in 1993.

YOUNG MAVERICKS. Everyone acknowledges that Russia still has a long way to go. Roughly 60% of the measurable economy, including some sectors of both the old state-owned and the newly privatized sphere, is deeply troubled (table). But the other 40% of the economy is healthy and meeting payrolls. "The market economy is developing faster than most people think, and it's larger than most people think," says Daniel Yergin, a specialist on Russia and president of Cambridge Energy Research Associates Inc.

Russia's highly successful privatization program has been a big factor. President Boris Yeltsin and his cohorts have stuck with this program, shrugging off both domestic and Western carping. In just under three years, more than 70,000 state enterprises have been at least partly privatized, and at least 18,000 new private companies have been formed. By comparison, notes Roger Gale of International Finance Corp.'s Moscow office, "there were less than 8,000 companies privatized worldwide" from 1980 to 1989.

The result has been sweeping change in large swaths of the economy. Some 90% of small businesses are now in private hands. Two out of every three workers in core industries now work for private companies. Shareholders and managers have been empowered.

Spearheading the big switch are a diverse group of young Russians. Some are maverick entrepreneurs who got started in dusty backwaters of the old Soviet empire. Others are well-connected Muscovites with backing from the former Communist Party or the KGB. Many are academics or engineers who became fed up with the pin money the state system paid them.

It's not easy to measure exactly how much this group is contributing to the economy, officially pegged at $130 billion. Everyone agrees their output doesn't show up in the official numbers. "The cash economy is huge: 40% to 50% of income is unreported," says Alexander S. Bevz, executive director of the Civil Society Foundation. Russia is like a typical Latin American country with 90% poor, 10% middle class, and 1% superrich. But the situation is dynamic. He adds: "The middle class is growing rapidly, and statistics don't show its strength."

SPREADING CASH. The new business class tends to be staunchly nationalistic. In politics, they spread their money around centrist and reformist parties--shunning the former Communists as well as such hardliners as right-wing extremist Vladimir V. Zhirinovsky. The entrepreneurs aren't anti-Western, but they are learning to use their newfound political clout to protect their turf from foreign competitors. Last year, for example, the big rubles that bankers contributed to Gaidar's reformist Russia's Choice party helped persuade him to slap restrictions on foreign banks. Entrepreneurs are also lob- bying hard for more favorable tax regimes and commercial codes.

Still, the emergence of a legitimate private sector is creating more opportunities than barriers for Western interests. After years of disappointment, U.S. and British money managers, including PaineWebber, Salomon Brothers, and London-based Robert Fleming and Morgan Grenfell are setting up funds in Russia and scouring the country for buying opportunities. This year foreign investment should reach $4 billion, three times what it was in 1993, says privatization boss Anatoli Chubais.

About 15 blue-chip companies in Russia, including the nationwide phone company Rostelecom, utility United Energy System, and oil giant Lukoil are already drawing in cash from such savvy investors as CS First Boston Group Inc. Big money managers such as Mark Mobius, portfolio manager of the Templeton Emerging Markets Fund, are also attracted to the Russian private sector. Mobius thinks Russia's huge privatization program could eventually help it to rival China as an investment play.

STATURE GAP. What distinguishes the new private-sector entrepreneurs from the con men and thugs is that they are making real investments and creating stable employment. Many of their owners, including Alexander S. Panikin, proprietor of a Moscow-based textile company called Paninter, are taking advantage of an abundance of cheap, skilled labor. Panikin, a 44-year-old former theater manager, made enough money trading goods in the Gorbachev era to set up a tiny establishment with six sewing machines in 1989.

Now he employs 1,000 workers who tend top-quality German looms and churn out a million pieces of clothing a year. Panikin doesn't squeeze his employees the way some of the new entrepreneurs do. He pays them twice the usual $100-a-month state rate--if the state pays at all. "To sell oil abroad is simple," he explains. "You bribe someone in government. But to produce and manufacture something--that takes a lot of talent and work."

There are also a host of companies taking advantage of Russia's large cadre of talented programmers and software engineers. Moscow-based Paragraph, for instance, has supplied the technology for handwriting-recognition software for Apple Computer Inc.'s Newton Notepad. "At the time, they had, and still have, the best cursive handwriting recognition available," says Sandy M. Benett, a senior engineering manager in Apple's Personal Interactive Electronics Group.

Paragraph's workers shuttle from Moscow to their U.S. office in Sunnyvale, Calif. The company was formed by a group of blue-jeaned computer jocks from Moscow State University who got together on weekends to teach children about the machines. They have let Matrix I, a venture-capital group based in Boulder, Colo., buy a 50% stake. Today, working out of a casual Moscow office, Paragraph specializes in such rarefied applications as

multimedia and digital photography.

One of the most compelling questions about the new private-sector players is whether they will grow enough in stature to emerge as big players in heavy industries and energy. So far, the answer is that upstarts haven't been able to achieve that size. But they are able to take pieces of the old system and fashion them into something new--and private. That is definitely the case in the energy field, where the government plans to carve 10 new giants out of its dying state dinosaurs.

So far, the most intriguing of these new entities is Lukoil, which is a world leader in oil reserves. Located in a beautifully renovated brick building across the street from Moscow's famous Sandunovsky steam baths, the company now produces about 15% of Russia's oil output and 25% of all the oil in Western Siberia, the nation's most important oil patch.

CREATIVE FINANCING. While the state still holds a majority stake in Lukoil, it is gradually relinquishing control. CS First Boston is one of the foreign investors with an early position. Lukoil President Vagit Alekperov, a 44-year-old former oil and gas deputy minister, says that Lukoil aims to be a world player like Royal Dutch/Shell Group or Mobil Corp.

Although it still clearly has shortcomings in management and technology, Lukoil is pushing its way into big-time projects as an instrument of Russian foreign policy. Earlier this year, the Kremlin employed some hard-knuckled bargaining to persuade the government of Azerbaijan to grant Lukoil a 10% share in a $9 billion project offshore in the Caspian Sea led by British Petroleum Co. and Amoco Corp.

Many observers thought that the biggest obstacle to the emergence of a private sector in Russia would be financing. Just three years ago, Russians had no securities markets and one of the world's most hidebound banking systems.

Surprisingly, however, private-sector Russians have taken to stock trading and creative financing with abandon. Some 3,000 commercial banks have been formed. To be sure, some aren't banks at all but shady finance companies bound to tumble at any time. The most notorious example is MMM, which ran a hugely popular pyramid scheme that fell apart in July.

TIGHT WITH THE KGB? But others are offering valuable services. Six-year-old Inkombank, for instance, has become the leader in offering personal banking services, such as Visa credit cards, and also has close ties to big industries, such as oil. It now has $1.7 billion in assets, 4,500 employees, 15 Moscow branches, and offices in 23 Russian cities as well as Frankfurt and Geneva. The company reports $43 million in earnings for its last fiscal year.

Like many of the startups in other industries, Inkombank was the brainchild of a young crowd. The average age of its directors is 33. "Younger people are better able to adapt to fast-changing conditions," says the bank's chairman, 38-year-old Vladimir V. Vinogradov. A stocky fellow with piercing blue eyes, he holds court in his office with a huge Russian flag on the wall and a formidable plainclothes bodyguard nearby.

Vinogradov is part of a small elite of wealthy young Russian bankers who got started in the late 1980s and managed to stick it out. Mikhail B. Hodorovsky, 31, who heads the $1 billion Menatep Bank, is another star in this group. So is 41-year-old Vladimir A. Gusinsky. Besides being MOST Bank's president, Gusinsky also founded and owns the liberal newspaper Sevodnaya ("Today") and the new Independent Television Network.

The successful bankers have all carved out very specific niches for themselves. Menatep lends to textile factories, while MOST specializes in construction and high technology. Another important player, Stolichny Bank, finances the aviation industry.

Both Menatep and MOST have long been rumored to have tight ties with former KGB officials or to have gotten started with Communist Party money--charges both bank presidents deny. "Do you think the [former] KGB chairman is going to loan money to a 25-year-old boy?" asks Hodorovsky, who has the pelt of a rare Ussuri tiger on the floor of his office.

It doesn't seem to make any difference--even if the charges are true. These youthful financiers are bullish on the long term. Hodorovsky, for example, predicts his bank's assets will grow at least ten times by 2000, despite a widely expected shakeout of weaker banks. They will be an important tool for channeling Russian savings into the companies that can build a more stable economy.

Russian companies may soon be able to use the rapidly developing securities markets to raise capital. Right now, organized trading is limited to only about 15 of the biggest companies. But that is about to change. Russia's new securities commission is working with KMPG Peat Marwick under contract for the U.S. Agency for International Development to develop a U.S.-style NASDAQ electronic-trading system that will pump capital into

predominately small and midsize new companies.

By yearend, NASDAQ-type trading will begin in Moscow, St. Petersburg, and Ekaterinburg. Later, Novosibirsk in central Siberia and Vladivostok in the Russian Far East will join in. Because of the vast distances between cities, trading via modem is critical, and some 150 companies are likely to go on the system. Russian savers are also being offered other options for their funds, including higher bank interest rates and pension and mutual funds. These instruments could also help attract some of the estimated $40 billion Russians have stashed away abroad.

PRIVATE SECURITY. But when you talk with Russian entrepreneurs, raising money is usually not at the top of their list of problems. They are more likely to gripe about corrupt bureaucrats, greedy taxmen, and mobsters. Cheating on tax bills that range up to 90% of profits has become obligatory.

So has hiring private bodyguards for protection against mobsters. In the past year, organized criminals have assassinated scores of Russian executives, including 17 bankers. The police are little help, and many former KGB agents have gone into the private security business. Some of these private agencies resemble small military units, and some businesses are said to have responded to threats with "hits" of their own. "Our security force is as strong as the organized criminal groups," says Valery Nezerov, chairman of the Hermes financial group. "Unfortunately, we have had to demonstrate our force."

Some executives believe that the crime wave will lose steam as legitimate business gains momentum and society stabilizes. "There's a saying," says Nikolai Shmelev, an economist at the Institute for Europe. "My grandfather was a bandit, my father graduated from high school, and my son went to Harvard."

None of these changes for the better means that doing business in Russia is simple or predictable. The revolution is far from over; millions of people face uncertain prospects. As long as society itself is in turmoil, entering the Russian business world will be an

adventure.

Probably the biggest threat to Russia's developing a healthy economy is the huge money-losing former state sector, whose plants still employ more than half of the workforce. There's no way the fledgling private sector can readily absorb the millions of workers who could lose their jobs at weapons factories, shite-elephant steel mills, and played- out coal mines. The private-sector hotshots don't want these people or, indeed, any workers over 40. "We refuse to hire anyone who has had more than five minutes' work experience with Aeroflot," says Sergey Grachev, Transaero's marketing director.

So the best option may be for Yeltsin and his cohorts to arrange to let the big state industries die a very gradual death. While the young capitalists will ultimately be hit with high taxes for subsidies and support of retirees, the alternative of sudden wholesale layoffs is much worse.

This transition from old to new could take a decade or more to play out. And plenty of difficulties remain. But the days when Russians worried that their entire society could collapse have eased. While still wild and chaotic compared with the West, Russia has settled down considerably, giving its people a badly needed whiff of hope. Russian capitalism is definitely taking hold. Now, if only it's given the opportunity to grow, it could help Russia achieve its unrealized potential.

RUSSIA IN TRANSITION

THE OLD ECONOMY

IS WEAKENING...

-- Heavy manufacturers, with $48 billion in unpaid bills, are screaming for

government credits

-- The agricultural sector is in deep trouble, facing the worst harvest in decades

-- The weapons industry, lacking orders, is in crisis

-- Factories are slashing workers' hours and pay

60% of the economy, both public and private, is troubled

...BUT A PRIVATE SECTOR IS EMERGING

-- 90% of small companies are in private hands

-- 80% of service-sector companies are private

-- Overall, 70% of the total economy is privately held

-- Employment is rising

rapidly; two-thirds of jobs in core industries are in the

private sector

40% of the economy, both public and private, is growingPeter Galuszka and Patricia Kranz in Moscow and Stanley Reed in New York


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