New wave of privatization in Russia

Author: us-russia
Comments: 16777215
New wave of privatization in Russia
Published 27-09-2012, 04:16
Strategic industries do not necessarily have to be directly owned by the government, that is, by government agencies authorized to own property. But before we discuss ownership issues we need to define what a strategic industry is.  
In my opinion, the following industries should be regarded as strategic:

  • Natural monopoly industries which entirely control the markets for specific products or services due to technological specifics, such as transport infrastructure, railways and motorways, high-voltage power grids and gas transportation systems;
  • Industries which involve serious health hazards in case of accidents such as nuclear energy and related industries; and
  • Defense industries which involve classified technology and produce high-tech defense products. 
It is important to clearly describe these strategic industries and how best to regulate them. For example, natural monopolies are regulated by setting rates for their services and products for long periods. Adopting clear pricing formulas for the next 10-15 years will create the conditions for further privatization and growing investment in these industries. In that case, an investor will be able to predict cash flows and returns on investment. As such, I do not see any danger for the government in giving up ownership of these strategic industries.

A similar scenario is possible even in nuclear energy and in industries producing classified defense products. Private investors should be able to participate in these projects according to clear rules prescribed for these industries, including confidentiality provisions. In light of the European and U.S. experience in this matter, I do not think that these industries should be entirely government-owned. But at this stage, Russia may not be able to ensure the required level of confidentiality at privately owned companies. Therefore, in these industries, privatization decisions should be taken with due account of the situation in the industry, segment or company in question.

The existing list of state-owned companies marked for privatization includes a wide range of companies in various industries which may be owned by federal, regional or municipal authorities and which also vary in the form of ownership – some are joint stock companies while others are municipal enterprises or state companies which are structurally part of government agencies. This heterogeneous lot cannot be privatized following a uniform procedure. Individual rules should be drawn up for each group of companies. These rules should certainly be transparent and easy to audit, and all procedures should be publicly monitored.

Any attempt to conduct large-scale privatization under one-size-fits-all rules will fail. For example, plots of lands used by the Defense Ministry can be sold through local auction, which can’t be done with the government’s controlling stakes in joint stock companies. Since state giants like Gazprom or VTB Group are incorporated as joint stock companies, their further privatization will probably involve floating their stock on the national and global stock markets.

There need to be criteria to decide whether a controlling or minority stake in them should be sold. When selling a controlling stake, the government can expect a certain premium for control, which means raising more money. It would also be necessary to consider if the time is right to sell, judging by LSE quotes. Selling would actually be very unwise on a highly volatile and nearly collapsed equity market, not only in Russia, but internationally, after crisis-induced fluctuations. Decisions to sell a non-controlling stake require a purely financial assessment: putting the shares on the market would augment the federal budget, while issuing more shares would augment the company’s own capital, which could be wiser.

Whether it is advisable to sell shares at current prices should be decided individually for each company. But the same criteria cannot be used to evaluate the potential profit of selling municipal property or property formerly owned by the Defense Ministry in one of the regions. These tasks are completely different, and there needs to be a clear understanding of the objectives that a government agency is targeting by selling the assets.

Individual decisions need to be taken on privatizing the companies Rosneft, Russian Railways, Aeroflot, United Grain Company, Federal Grid Company, SG Trans, Sovcomflot, Uralvagonzavod, Sberbank, and the VTB Group, based on the current financial expediency and the aforementioned rules of the game.

My understanding of the situation is that the Federal Grid Company would benefit more from raising additional investment than from selling shares for the sake of the federal budget. Russian grid companies are underdeveloped, including the FGC, which transmits high-voltage energy. Any investor who manages to procure a power connection permit can tell you what a pain it was. Finding investors willing to commit to finance nationwide power grid development would greatly benefit Russia; to attract them we need to establish clear and transparent rules for setting prices and rates for all grid companies, especially for federal grid companies, for the next 20-25 years.

Again, I do not see any reason for this major infrastructure company to limit its options to domestic investment. There is no reason whatsoever to avoid foreign investors. The same goes for other large infrastructure companies such as Russian Railways and Gazprom. Recent examples of privatizing power companies shows that foreign investors who bought into the Russian power sector have made good on their investment commitments, while many Russian buyers tried to avoid doing so. Although the situation differed from company to company, it is a fact that foreigners, unlike Russian investors, did not try to dodge their responsibilities even during recession.

As to Aeroflot, I think it would be better to invest in airports rather than in the airline itself. Therefore, it would be best to attract investors who would make commitments to develop runways, not only in the Moscow Region, but elsewhere in Russia too, because our transportation infrastructure is also hugely underdeveloped. 

It is my opinion that privatizing a controlling stake in the VTB Group would be premature because the proceeds would be too low. This would be unwise in the current stock market situation. There is also the option of selling a smaller package, which would do no harm even if it fails to yield a high profit. 

Attracting foreign investor often brings in some management innovations and sometimes technological innovations as well. Foreign partners insist that we observe corporate governance standards such as following the rules for risk management, compliance management and other features of the Basel II recommendations. It is impossible to work in banking without following these recommendations. These are the key issues of the Russian banking industry’s development. This approach fully complies with the Bank of Russia’s requirements.

How we follow the rules of the game largely depends on whether we use internationally accepted practices, that is, whether we observe the Basel II recommendations – or, better still, "Basel 2.5” as we like to say, because I do not think any company in the world is in a position to comply with Basel III at this stage. We must understand that following these recommendations is a must. Foreign investors prod Bank VTB as well as Sberbank in the right direction.

On the whole, most of the companies listed for "new wave privatization” can be privatized without much risk but with benefit for Russia’s market economy.

Yet, selling these assets might not yield huge profits because stock is undervalued in both Russia and Europe, while Russian risks are overblown: confidence in Russia’s economic stability and regulation is extremely low, which affects the market value of Russian stock.

The new privatization should be handled very carefully in unfavorable markets. The only way to do this is take individualized decisions on each type of asset or facility, based on an understanding of what each deal is likely to achieve. Raising money for the federal budget is not the only goal of privatization – it should also promote the development of a specific market, the specific industry the company is working in, and investment in that business. These factors should be weighted carefully. Market price is not everything. There were cases in countries such as Germany where obsolete plants were sold for 1 mark (in former GDR) but the buyers agreed to make huge investments in development and retooling. This arrangement worked, although eastern regions in Germany still receive some development assistance from the federal government, which actually redistributes the revenues contributed by other regions. This isn’t easy; still, if we need to promote a region’s development, it might be possible to sell some of the local assets cheap on the condition of future investment. Naturally, we will have to carefully monitor that they honor to their commitments.

A company’s privatization does not automatically lead to greater efficiency. At the same time, in a competitive environment, private investors often show more flexibility and are more responsive to market demand. They are less likely to engage in monopoly collusion and conspiracy, or to restrict market regulation in any way. They are also better able to respond to changing market conditions. In any case, after joining the WTO, Russia will benefit more from private investment than from government investment.

Russia needs to stabilize private property to improve the investment climate. Investors need to be confident that their assets are legally protected from hostile takeovers. They should have confidence that corporate raiding is illegal and be able to rely on courts if this happens. Operating risks will continue to be viewed as high in Russia, and Russian and foreign investors will remain equally reluctant to buy Russian assets unless we ensure that private property is protected. 

It is also important to adopt a clear stance on the privatization conducted in Russia two decades ago. Some say that its results should be revised, while others believe they should not. In my opinion, while it is certainly unacceptable to fully revise the results, it is still possible to make some adjustments. And, in any case, returning the privatized assets to the government is out of the question.

It would be interesting to examine Britain’s experience in privatizing assets. They used the term "windfall profits” to describe when government assets were acquired too cheap. The new owners were asked to pay a tax based on reasonable market estimates without giving up their property. Most of them agreed to pay and there were no more problems afterwards. This was not so much a financial move, but rather a propaganda campaign that quieted the grumbling about government property being "squandered” for a trifle. 

Will this work in Russia? Privatization in Russia was conducted in several stages, and none of them was easy. The "loans-for-shares” privatization probably sparked the greatest controversy. The government could ask banks – which at the time competed for the right to manage government assets as collateral for loans to the government, or the eventual owners who bought those assets from the banks – to pay a tax now, although it would be difficult to establish who should bear this financial burden. At that time, Russian assets were not quoted on any international stock exchanges, and therefore had no clear market value. How should we estimate a "fair price” now and decide how big the "windfall profit” was? The price of oil was falling. Was there any financial flow that was undervalued? These issues will need to be explored.

The problem requires a calm and constructive discussion; in any politically charged environment, it is bound to be used as a political weapon. It will not serve to ease tensions, but will divide society further. But despite all this, this discussion cannot be avoided for much longer.

The issue of revising the results of privatization should not be swept under the carpet or deployed in populist rhetoric. It should be discussed professionally and openly to see if there is a possibility of making financial adjustments and what exactly these adjustments are expected to achieve. This will only be effective if it is approved and accepted by the public.

Sergei Dubinin is Chairman of the VTB bank Supervisory Council.

Valdai Club

 

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