Oil booms, but investors flee Russia

The price of Russia's main export, oil, is hovering at record highs. The government is currently pocketing nearly $20 on every barrel produced.

So why are foreign investors running for the exits, and the country's economy suddenly slowing?

A high-stakes battle for the direction of the Russian economy is creating new uncertainty, prompting investors and others to pull back. On the one side are Russian liberals, who favor rapid market reform and merging with the world economy. On the other are the siloviki, ex-security men who want to build a state-guided economy.

"This struggle between siloviki and liberals is starting to pull down our economy," says Alexei Mukhin, director of the Center for Political Information, an independent Moscow think tank. "The Kremlin really fears becoming isolated and losing control."

The Kremlin blames the warring Russian bureaucratic clans for smothering growth and fueling social discontent, and has issued an urgent - almost

apocalyptic - appeal for all to unite behind President Vladimir Putin or face a looming crisis.

"Unless we are able to consolidate our elites, Russia as a single state may disappear," Kremlin chief of staff Dmitri Medvedev said in an unusually blunt interview last week in the business magazine Expert. "Whole empires have been wiped off the face of the earth when their elites lost their unity and engaged in deadly battles.... The breakup of the Soviet Union will look like child's play compared to a government collapse in modern Russia."

For the past year, the Kremlin faction of siloviki, a term derived from the Russian word meaning "force," have held the upper hand. Critics say the economic damage of their heavy-handed interventionism is plain to see. Gross domestic product rose at an annualized rate of 4.4 percent in the first two months of this year, down from 7.1 percent in 2004.

According to Russia's Central Bank, capital flight quadrupled last year as worried investors shoveled their assets offshore. Net capital outflow jumped from $1.9 billion in 2003 to $9.4 billion.

A recent report by the World Bank fingered the Kremlin's antibusiness policies, particularly last year's effective renationalization of Russia's most profitable private company, the oil giant Yukos. "The protracted Yukos affair has been the center of attention, but many other companies have also apparently experienced increased harassment," the report stated.

Unexpected bills for "back taxes" have been presented to companies such as telecommunications giant Vimpelcom, while some foreign firms, including BP-TNK, a 50-50 British-Russian joint oil venture, have been barred from bidding on new natural-resource exploration licenses.

"This is the only country in the world where the state sector is growing," wrote former Kremlin economic adviser Alexander Livshits in the daily Izvestia last week. "Last year, the capitalization of state companies grew by 70 percent. No matter what else happens in the economy, the state always seems to win."

In what could signal a change of course, Mr. Putin met with business leaders last month to pledge that the seizure of Yukos would be the last episode of its kind. To bolster confidence, he offered to reduce the statute of limitations on prosecuting illicit privatization deals to three years from 10, a move that would effectively legitimize most property acquired during the 1990s. He also promised to rein in Russia's tax collectors, who've been the siloviki's main instrument. "It is well known that businessmen have a lot of well-grounded grievances against the tax authorities," Putin conceded.

But business leaders say there is less to Putin's olive branch than meets the eye, and they want to see more tangible evidence that the Kremlin's free-market wing is winning the war for control of economic policy. "We're in a downward spiral, and even such a signal emanating from the No. 1 man is not enough to restore confidence," says Igor Yurgins, an investment banker and vice president of the Russian Union of Industrialists and Entrepreneurs, the leading business-lobby group. "The harm was done. Also, the hunting dogs of law enforcement and tax collection are out. Once they've tasted blood, it's very hard to get them back on the leash."

The Kremlin's new outreach to private business does not extend to leniency for the top executives of Yukos, who are on trial for fraud, embezzlement, and tax evasion. The company's former security chief, Alexei Pichugin, who was charged with ordering a double contract killing, was handed a 20-year prison sentence on March 30. Prosecutors in the case of Yukos's founder Mikhail Khodorkovsky are demanding he be given the maximum sentence of 10 years hard labor. Monday, he made his final plea of innocence. "They have jailed me so I can't stop them looting Yukos," Mr. Khodorkovsky said in his closing statement. The judge is expected to announce the verdict on April 27.

"The Yukos prosecution is a pedagogical action, aimed at teaching Russian business who's the boss," says Mr. Mukhin. "The authorities know they have to destroy it to the very end, otherwise they'll look weak."

Underlying the looming crisis, critics argue, is the economy's long-term failure to generate a viable middle class - the bulwark of social stability in most developed countries - based on a rising tide of small and medium businesses. According to OPORA, a Russian business association, Russia has about 900,000 small companies - around the same number as a decade ago - which account for 12 percent of GDP. (In the US, small businesses account for about 50 percent of GDP.)

Even Putin, pointing to the gauntlet of bureaucratic abuse and punitive taxation small businesses in Russia must face, remarked late last monththat "anyone who registers a new firm should be awarded a medal for personal courage."

The Kremlin concern, experts say, is that rising poverty, social inequality, and public unrest - perhaps emulating the recent demonstrations of people-power by some of Russia's neighbors - could spark a crisis that the country's squabbling elites would be unable to manage. "After all those orange revolutions on the one hand, and steadily loss of government authority on the other, of course there's real apprehension in the Kremlin," says Yurgins.