Theft of the Century: Privatization and the Looting of Russia

An Interview with Paul Klebnikov

Paul Klebnikov is author of Godfather of the Kremlin: Boris Berezovsky and the Looting of Russia. He is a senior editor at Forbes magazine and has reported from Russia since 1989. A fluent Russian speaker, he has won four press awards for his writing on Russian business. He holds a Ph.D. in Russian history from the London School of Economics.

Multinational Monitor: The initial plan for handling privatization in Russia was a voucher distribution system. What was the voucher plan, and how did it work out

Paul Klebnikov: The idea was that, since the vast majority of industrial assets in Russia were state-owned and hence every citizen had an equal piece of those assets, the vouchers [giving each citizen a proportionate stake in privatizing assets] would be the vehicle by which the state would promote equality in share ownership of those state-owned assets. On the face of it, it’s a very noble idea. Theoretically, it could create a kind of Jeffersonian broad-based middle class of small property owners, who, in turn, would be the foundation for a democratic Russia.

It all went terribly wrong. Initially, it was simply a case of mismanagement and incompetence. The so-called young reformers in the Yeltsin government, led by Anatoly Chubais and Yegor Gaidar, decided to carry privatization out too quickly. They made the fundamental mistake of putting too much of Russia’s state-owned industrial and natural resource wealth onto the market at once. It’s an elementary mistake that could be predicted by anyone with even a minimal understanding of how a market works. If you throw a huge quantity of products onto the market at once, your price is going to be very low because there’s not that much demand for it at that point. Moreover, the face value of the voucher was very low. All this meant that the average citizen, after having received the voucher, said to himself , “this thing isn’t worth anything.” So most people immediately sold their voucher on the street for about seven dollars. You could get two bottles of cheap vodka for the price of one voucher. At that price, all of Russia’s industrial and natural resource wealth was valued at $5 billion. You can see for yourself that something in this operation went horribly, horribly wrong.

The whole concept was a mistake. I don’t think it was a cynical maneuver at that stage, but simply a product of incompetence. Of course, there was also a cynical calculation behind the decision to privatize one-third of Russia’s national resource wealth in a single year. The young reformers were motivated not by economic considerations, not by considerations of how to get the most money into the government’s coffers, not by a desire to promote the greatest efficiency of those enterprises that they were privatizing, but by purely political considerations. They saw that they needed to move very quickly to “break the back” of the power of the “red directors” who controlled the state-owned enterprises. These were the old industrial managers. Some were very competent; some were incompetent.

Gaidar and Chubais thought that they needed to act quickly, radically and dramatically to get these guys out of power. That’s why they took this step.

As a result, ultimately the value of these enterprises shrank to almost meaningless amounts. The vast majority of the Russian population got nothing out of the voucher privatization. The people who did benefit — the insiders and financial operators who bought up all the vouchers — ended up buying up control of the main enterprises at a fraction of their market value.

MM: Who ended up with control of the vouchers?

Klebnikov: For the most part, they ended up in the hands of the directors themselves. The very thing that Chubais and Gaidar wanted to avoid happened in most of the enterprises.

Let’s say there is a timber company. The general director, together with five or six of his closest subordinates, would get together and buy all the vouchers from their workers. They could do this because they had grown rich or moderately wealthy by embezzling funds from the enterprise in the preceding years. Because the market price was so low — seven dollars per voucher — the general director and his cronies would end up buying control of the company for almost nothing. So the workers got expropriated –– albeit voluntarily.

Ordinary citizens who didn’t work in a plant and didn’t invest their vouchers in the shares of that plant either sold their voucher in the street or invested it in a so-called voucher fund, a kind of mutual fund for vouchers. The government licensed 600 mutual funds without any supervision of how they operated or whether they respected the rights of their shareholders. The vast majority of those voucher funds turned out to be pyramid schemes that enriched the crooks who started them up, while the citizens lost everything.

MM: Gazprom, the largest Russian company, was privatized through the voucher operation?

Klebnikov: Yes. The typical stake in a company that would be privatized through vouchers is anywhere from 29 percent to 35 percent. The government took most of the big companies in Russia, including all the natural resource producers, and privatized 29 percent through vouchers. So about a third of Russia’s industrial and natural resource wealth was privatized through vouchers.

Gazprom, which is the natural gas monopoly of Russia, owns one-third of the global reserves of natural gas. If you valued it as an American company per cubic meter of reserves, it would be valued anywhere between $300 billion and $900 billion. Of course, it’s not an American company and property rights in Russia are weaker and so forth. But even in the Russian context, this is a company that had a stock market value in 1997 of $40 billion. So, when the government decided to privatize 29 percent of Gazprom in the 1994 voucher auctions, what happened? First, they gave the right to design the whole voucher auction to the Gazprom management.

The general director of Gazprom, probably Viktor Chernomyrdidn, the Prime Minister of Russia (who was the former director of Gazprom), and the top 100 or 200 managers of Gazprom got together and did several things. First of all, people who wanted to buy shares could only buy them in the tiny Siberian and Arctic villages where Gazprom had its deposits. Secondly, Gazprom management reserved the right to buy your share if you were an outsider at a price it dictated. The result was that only Gazprom people ended up buying the shares, and of course it was the managers who had the money to buy the vast majority of those shares and who ended up benefiting from the auction. As a result, the price at which Gazprom was privatized in 1994 through the vouchers was $250 million, which is 160 times less than the price the stock market would put on the company a mere three years later. So it was less than 1 percent of the stock market value of the company. That makes it one of the great robberies of the century.

MM: You talk about the “privatization of profits,” borrowing the quote from Boris Berezovsky, one of Russia’s former “oligarchs.” The case you highlight is Aeroflot, the airline. What was the scheme there?

Klebnikov: A lot of the theft in Russia in those days was an operation carried out by simple-minded crooks. Berezovsky was a far more brilliant man. He devised a whole scheme whereby you could rob a state-owned enterprise without ever having to own it. He called it the first stage of Russia’s privatization — the “privatization of profits” of an enterprise. Only in the second stage do you actually privatize the enterprise as a property. But first you privatize its profits.

What do you do? One way or another, you get the managers of a state-owned company into your pocket — either by bribing them or by placing your own subordinates in the controlling position of the management. Once you have your managers running the state-owned company, they then sign all these deals that surround the company with a whole series of your middlemen — banks, financial advisers, consulting companies, marketing companies, equipment supply companies, etc. In other words, all the channels whereby that company interacts with the outside world become controlled by your particular little companies. They’re usually unknown little enterprises that are registered either in Cyprus, Switzerland, Luxembourg or the Caribbean somewhere.

They then sign the contracts that result in elementary transfer pricing whereby all the profits, and most of the cash revenues, accumulate in those intermediaries. The cash cow — the state-owned corporation — becomes bankrupted, because it’s bleeding all its cash out to these intermediaries. So the state and government end up with a bankrupt company and you end up tremendously wealthy.

Berezovsky did this with a number of companies; the most clearly documented case is Aeroflot. In fact there’s currently a warrant out for his arrest in Russia on charges of fraud and embezzlement at Aeroflot. A number of his top managers who ran Aeroflot for many years are due up for trial. They will be up for trial in the next couple of months in Moscow. Berezovsky himself is living in Britain and France and, of course, is not returning to Russia, because if he did he would be arrested and put on trial for this.

What Berezovsky did, specifically, is set up a company that would pay Aeroflot’s foreign bills. Aeroflot had fuel bills, landing fees at foreign airports, leasing fees for foreign aircraft, etc. This little company owned and set up by Berezovsky and his top manager at Aeroflot paid Aeroflot’s bills in the West. The money they did that with was considered a loan with an effective dollar-based annual interest rate of 50 percent. But they weren’t satisfied with that profit margin, so they in turn contracted with another company, also owned by Berezovsky and his top managers, and registered in Ireland. They had this company give a loan to the first company, charging an interest rate of 30 percent. Effectively, you had a kind of daisy chain of ridiculous, extortionate loans being granted to Aeroflot. You ended up with Aeroflot having to pay a 95 percent dollar-based interest rate on hundreds of millions of dollars of completely unnecessary loans given to it by financial companies owned and operated by Berezovsky and top Aeroflot managers.

A simpler way in which this was done was with natural resource companies. Most oil companies, metal companies and timber companies would set up a trading company to handle their exports. The company in Russia would sell the oil, for instance, to a trading company in Cyprus or somewhere for a fraction of the world oil price. The trading company, which would be directly owned by the oil company managers, would turn around and sell the oil for the world market price and keep all the profits in personal bank accounts offshore.

As a result of all this, you had huge capital flight out of Russia. No matter how many billions of U.S. taxpayer dollars were going into Russia through the IMF and other institutions, several times that amount was flowing out of Russia through these kinds of criminal schemes. That’s the way the Russian state was bankrupted. It got no tax revenues. Russian enterprises were eviscerated, left short of capital because they had no money. The Russian currency eventually collapsed, because it had no foreign currency to back it up. All the foreign currency reserves were being stashed abroad by a handful of very unscrupulous traders.

MM What were the loan-for-share schemes that came in the next phase of privatization?

Klebnikov: This was a much more cynical type of privatization than the voucher auctions. It didn’t even pretend to have a noble concept underlying it. Anatoly Chubais, who by 1995 was the privatization czar effectively running the Russian economy under Boris Yeltsin, decided to take the top 12 export-oriented companies in Russia — mostly oil and gas producers and metals exporters — and privatize the controlling stakes. The voucher privatization privatized only 29 percent. Now the question was how to privatize the 51 percent stake in those companies that was still owned by the government.

What Chubais did was gather a group of six to eight top Russian financiers — the crony capitalists who later would be called the “oligarchs.” They agreed among themselves who would bid for which company and at what price.

Theoretically, these 51 percent stakes would be put up for auction with a starting price and it would be open to everybody to bid. But no foreigners were allowed to bid, and, in fact, all outsiders, even if they were Russians who came to try to bid, were disqualified for one reason or another.

Each of these companies then fell into the hands of the oligarch who had been chosen to get the company. The prices they paid were anywhere from 10 to 30 times less than the price at which these companies were selling on the market in the mid-1990s. In other words, the insiders bought these companies at these rigged auctions at anywhere from 3 to 10 percent of their market value.

This was a very cynical ploy by Mr. Chubais to sacrifice the interests of the state of Russia, the interests of the national treasury and therefore of the citizens of Russia for political purposes. The reason was that he wanted to get the oligarchs’ support for reelecting Yeltsin in 1996. He essentially gave them Russia’s dozen best exporters in return for an ironclad commitment that these people would support Yeltsin and finance his campaign in 1996.

The economic interests of Russia, the legal propriety and financial soundness of the Russian state, was sacrificed for the narrow political goal of getting Boris Yeltsin elected in 1996.

In the final analysis, the Russian economy suffered its worst decline since the Nazi invasion of 1941 — a 42 percent decline in GDP. The population was impoverished. Mortality rates skyrocketed and the Russian state was essentially bankrupted. In August of 1998, the ruble collapsed and the government defaulted on its debts. Essentially the government had declared bankruptcy. This was a result of all of these misguided privatization policies.

MM: How did the oligarchs pay back Yeltsin in the 1996 election?

Klebnikov: Partly through their media assets, which they bought and subsidized. The Russian mass media in 1996 was almost completely monopolized by either the state — which was subject to the orders of Boris Yeltsin himself — or to these oligarchs. Therefore you had an almost complete media blackout of any rival candidates and a massive propaganda campaign glorifying Yeltsin in 1996, even though Russia was in a catastrophic condition due to Yeltsin’s bungling. That was one way.

The second way was that Berezovsky, Chubais and the other oligarchs organized a secret financing of the Yeltsin campaign, collecting at least 300 times the legal limits on campaign contributions from themselves and other businessmen.

MM: What kinds of sums were involved?

Klebnikov: The official maximum that any candidate could receive in private contributions (there were state contributions as well) was slightly more than $3 million, which at the time in Russia could go quite far. The actual amount collected and mostly spent by the Yeltsin campaign was between $1 billion and $2 billion.

MM: In the evolution of the various privatization schemes, how important was the role played by outside advisers, such as the IMF and Jeff Sachs?

Klebnikov: Unfortunately, all kinds of Western institutions, including governments such as the American government at the time, august Western universities such as Harvard, and international financial institutions like the IMF, bear significant responsibility and must answer for their complicity in creating this whole catastrophe.

The Western politicians may have had their own rather cynical reasons for pushing the young reformers and other parts of the Yeltsin government to carry privatization out in this way. Perhaps the academics were simply misguided. Academics are often very intelligent but wrong. In this case, you had highly intelligent people coming to Russia and saying, “Listen, this is the only way you can do it. You’ve got to do shock therapy. You’ve got to do it quickly; you’ve got to do it radically,” and so on. The Russians were fools for accepting this advice unquestioningly. And the Western academics, if they really believed they were giving the right advice, were fools for giving it.

The Yeltsin government was highly sensitive to the advice of both Western governments and Western academic institutions, and almost slavishly followed the advice given to them. So the role of the advice coming out of the West at the time was huge.

MM: By way of contrast, though, it’s not the case that foreigners were part of the acquiring teams in the privatization?

Klebnikov: That’s right. Foreign investors did not really benefit that much from Russia’s privatization, so you can’t say that Western multinational corporations bought up Russia on the cheap.

For all their faults, Western investors, Western financial institutions and Western multinationals do maintain an ethical standard which prevented them from participating in the kind of blatantly crooked scheme which was Russia’s privatization in the 1990s.

Western investors tended to come in and play by Western rules. They’d invest in these Russian stocks and the Russian companies once they were already selling on the stock market. Or they would grant loans to Russian companies. Or they would occasionally buy the rights to produce oil. But they would function according to the rules of a civilized market; they were not privy to the inside of the market where the vast majority of Russian money was made.

MM: Are there any significant counter-examples of privatizations in Russia that actually worked?

Klebnikov: The one successful case of privatization in Russia was the very first stage of it, which involved the privatization of small shops and very small enterprises, like small lumber mills, small textile workshops and maybe a few small food processing plants. This was done by cash, and many of them did sell for real money. Many of them were bought by managers who really wanted to make them work. They were conscious of the fact that they were investing their real money for an enterprise. It was more healthy and realistic than these massive, unbelievably wealthy companies that were sold off for pennies.

There was also a good privatization scheme where people got their apartments for a nominal price. Many people got something of real value. But this is very small scale.

The Yeltsin government should’ve proceeded in that manner. They should have started with the small shops, small enterprises, small plots of land, and then moved up gradually to slightly bigger ones and pieces of the bigger ones. The market has to evolve. You can’t just create it in a year or two. You can’t hope that by privatizing the vast majority of Russia’s natural resource wealth in two years that all of a sudden you’re going to create a market or make anyone but a handful of insiders wealthy.

MM: What’s happened with the looted privatized enterprises? Is the state taking them back? Do the enterprises continue to function?

Klebnikov: A lot of the enterprises that got run into the ground, especially in the manufacturing sector, did in fact collapse and are now a mass of rusted metal, silent ruins. But the natural resource producers continue to exist and continue to be incredibly wealthy because most of their natural resources are still in the ground, and it’s impossible to loot them completely.

What happened is that most of the so-called oligarchs were very bad managers. As soon as President Putin came in, and after the bankruptcy of the Russian state, the devaluation of the ruble and the debt default of 1998, there was a change of tone in the Russian government and a groundswell of outrage in the Russian population. There was an understanding among the oligarchs that they would have to change their tactics. They couldn’t just simply strip the assets and strip the wealth from these companies. They had done their looting, and now if they wanted to hang onto their companies, they had to suddenly act like real managers and build the companies up.

This is something that Putin made very clear when he came to power. This was unexpected. People like Berezovsky expected him to be a wishy-washy character.

But an informal deal was struck. Putin said he wouldn’t look into the past and the criminal way in which the oligarchs acquired the companies, but from now on, they were going to pay taxes and stop sucking all the money out of these companies and parking it in their personal bank accounts abroad. They were going to have to take the profits from the companies and reinvest them, or at least reinvest them into the Russian economy. And those financiers that agreed to this deal started acting differently and are now acting in a more civilized manner. There were a few that did not want to make the transition and took whatever wealth they could carry and are now living abroad.

Not a single major Russian industrialist or financier to date has been put on trial for any significant misdeed or criminal act, which points to the weakness of the legal system in Russia.

MM: Are there any significant assets left to be privatized in Russia?

Klebnikov: The big ones are agricultural land and urban real estate. Right now you can buy a building in a city like Moscow, but you can’t buy the land underneath it. The government just passed a law last year enabling municipalities to privatize the land in the cities. This will have to bear watching. I can only hope that the privatization of urban lands won’t be carried out in such a destructive and crooked fashion as the privatization of Russia’s natural resource wealth.