Moscow Rising

Pity the prospective investor in Russia. He tries to reserve a business-class seat for a last-minute flight to Moscow, but forget it. Sold out. So are the hotels when he arrives. Alas, it's banishment to the shabby outskirts of town.

As a consolation, he treats himself to a pricey dinner at the aptly named Snobs--realizing, belatedly, just why Moscow has become the most expensive city in Europe. Nothing that a credit card can't take care of, he tells himself. But then he goes to an after-dinner club called First. Just as he sits down to marvel at the spectacle of a willowy trapeze artist gyrating high overhead, a black-tied waiter solicitously approaches. "I'm sorry, sir," he says. "This table costs $1,000." What's going on, when an American on an expense account so obviously can't afford a drink?

Everyone is saying it. But it's true. The boomtown citadel of the old Evil Empire is back. After losing nearly 90 percent of its value in the infamous crash of 1998, the Russian stock market last week hit its old peak. Its closely watched RTS index gained 34 percent in 2002 and has nearly doubled so far this year. Annual GDP is blazing along at 7.5 percent, if you believe the more upbeat numbers. That makes Russia the fastest-growing economy in the world, nosing past China, though of course it's only a quarter as large.

With hoopla and high hopes, Western investors are returning en masse. U.S. Commerce Secretary Donald Evans was in town last week, talking up deals and touting Russia as America's new partner in "energy security." George Bush Sr. buttonholed Vladimir Putin at the Russian president's retreat in Sochi, on the Black Sea, just before the Camp David summit. Would he block ExxonMobil or ChevronTexaco from taking a big stake in Yukos, the country's largest oil company, in a deal worth anywhere from $11 billion to $30 billion? (He won't, according to sources who met the former U.S. president.) A conference last week sponsored by UBS Brunswick, a famously boosterish investment bank, was oversubscribed by a factor of three. Everyone here is thinking the same thing, chief executive Jeffrey Costello told 400 or so bankers and brokers. "Is it deja vu all over again?" Will 2004 reprise 1997, the superheated prelude to a crash? "No," he said. Russia is ready to break out, not fall back. If anything, its economy will accelerate over the coming few years, added Peter Boone, head of UBS research. "The great Russian bull has a good way yet to run."

Even optimists agree, however, that Russia remains an open question, its future uncertain. At times, debates over the country's prospects take on an almost religious quality. Believers talk up promising political and economic changes, real or imagined. Skeptics dismiss it all as naive balderdash. Clearly, any number of things could derail Russia's comeback. Hence the lingering wariness. A Russian-American filmmaker in Moscow, scouting financial backing for a movie, sums up the uneasy coupling of expectancy with cautiousness by recalling a puffy NEWSWEEK cover story, published in late 1997, celebrating Moscow on the rise. Soon after, a U.S. trading company called Long Term Capital Management lost $533 million on its Russian holdings in a single day--precipitating one of the biggest bloodbaths in Wall Street history. Markets tanked around the world. Nobody suffered more than Russians. Average incomes fell from $166 a month to $63. Per capita GDP fell by half. Retail sales shrunk by two thirds, almost eliminating what had been one of the fastest-growing sectors of the economy. Russia's central bank defaulted on its debt. Foreign investment dropped below zero as capital fled the country.

Once burned, twice shy. Investors may be back, but for now they are merely testing the waters, hestitant to commit real money. "It's true that the large oil companies are becoming more active in Russia, but they have the highest tolerance for risk," said George Russell, former chairman of the U.S.-based Russell mutual-funds group, cautioning businessmen at a meeting of the EastWest Institute in Moscow. Look at the numbers, he suggested, and you see that ordinary investors are far more reticent. Last year the countries of Western Europe received some $1,200 in foreign direct investment, per capita. Russia received barely $20, translating to an expected total of about $25 billion in 2003, only $2.4 billion more than last year. Russell believes that's not enough to keep Russia booming.

Others don't see it that way at all. Patricia Cloherty, an American venture capitalist, pioneered high-tech start-ups in Silicon Valley long before anyone had heard of the Internet. Her private equity fund, Delta Capital Management, has invested $260 million in 41 small- to medium-size Russian companies, most of which have thrived. "The good news is that you can only lose 100 cents on the dollar," she says. "The upside is that you can make multiples of that."

Russia, she flatly declares, is the next big thing--the most undervalued market in the world, the most promising of the newly hot emerging markets. She points to signs large and small: an explosive growth in credit cards, an emerging mortgage market, the fact that tens of thousands of Muscovites can suddenly afford cars and apartments, that the Swedish home-furnishings giant Ikea does bigger business in Moscow than at any other of its stores in the world. And she's not alone. According to a poll of chief executives just released by the international management-consulting company A.T. Kearney, Russia now places among the top 10 of the world's most attractive countries for foreign investment--jumping from 17th place last year to eighth in 2003, one notch below the United Kingdom. Moody's will soon upgrade Russian securities to investment quality, possibly by the end of this month.

Much of this seems incredible--a Russian variant, perhaps, of the "irrational exuberance" that not long ago burst America's stock market bubble. It's worth noting that Moody's, along with other rating agencies, declared Russia to be a good credit risk in 1997, just before the crash. Then, as now, the talk was about the financial killing everyone stood to make in Russia's hot new markets--in between binges at the chic new clubs.

Still, a lot has changed since 1998. Then, Russia was out of control, prey to speculators and the whims of the rapacious tycoons who took over banks and newly privatized industries. The vast sums of money flooding into the country went largely to subsidize the state, where often as not it was stolen rather than channeled into productive investments. Today, by contrast, the country has a stronger and more pro-business government, increasingly committed to modernizing Russia and creating more favorable conditions for foreign investment. Fiscal and monetary policies are sound, earning World Bank and IMF approval. Powered by strong oil sales, Russia enjoys a huge surplus in trade, amounting roughly to 8 percent of GDP. The federal budget is firmly in the black. Foreign reserves are the ninth largest in the world, at $62 billion. A cheap ruble continues to buoy exports and local manufacturers; inflation is trending down toward 12 percent, from 120 percent in 2000. With productivity rising sharply and a growing share of economic growth coming from new domestic demand, rather than traditional oil sales, Russia could be poised for real prosperity, says Evgeny Gavrilenkov, chief economist of Troika Dialog in Moscow.

What could go wrong? Plenty. But the chief risks are not what's commonly thought--a fall in oil prices, for starters. A slide may be inevitable, industry analysts say. UBS Brunswick expects a drop from $26 a barrel to as low as $19.50 over the coming year or so. But will that derail growth? Not unless prices fall to about $15, according to UBS. At $18, Russia would run a slight deficit in government spending--but economic growth and investment prospects would largely remain healthy.

The real risk is political, according to the new generation of moneymen. Ironically, much of their concern surrounds the man who made the good times possible, Vladimir Putin. As they tell it, Russia's future depends less on oil prices, on what the Duma does, or even on the progress of various business-related reforms, important as they are. Instead, the deeper issue is Putin's power--how he wields it, and how the old system hasn't really changed. The image they sketch is of the "new Russia" as a sort of Potemkin village, with Putin as a Pinochet or Suharto, a more or less benevolent dictator (except when it involves Chechnya) determined to use his power to improve the lives of ordinary people but who brooks no challenge to himself or the state. He speaks about the importance of rule of law and individual and market freedoms, and he may believe it. But neither he (nor, certainly, many of those around him) will hesitate to break or use those laws to defend or advance key interests.

What might this imply for foreign business? One successful foreign investor--call him a purveyor of lifestyles to the rich and famous--speaks quietly of how former KGB elements within Putin government use tax inspectors as a weapon, either to get political cooperation or to line their own pockets. He never felt threatened under Yeltsin, he says. "Today I am scared. The old ways are coming back." Other investors remark upon the disparity between Moscow and the provinces. In the capital, they say, you can win redress for official wrongdoing, either by going to the courts (still a dicey proposition) or (more reliably) appealing to a higher bureaucratic power. In the regions, foreign businessmen are often prey to local satraps who operate largely with impunity. And of course, outside the oil industry, Russia's new boom is largely confined to Moscow. Even there the benefits go overwhelmingly to an elite stratum of the superrich. The vast majority of Russia's people live hand-to-mouth, often in near destitution, waiting perhaps fruitlessly for their lives to get better.

Recent political events are also not reassuring. Even businessmen excited by Russia's prospects cannot wholly ignore the sense that, under Putin, democracy seems to be backsliding. In Chechnya on Sunday, voters went to the polls in an election that human-rights groups condemned as a farce. There was only one possible victor, the Kremlin's handpicked man in Grozny, Akhmad Kadyrov. His rivals had all dropped out: one was called back to a plum job in Putin's administration, another was ousted in a sham judicial proceeding, a third dropped out after meeting with presidential staff. And when, some weeks earlier, Russia's most respected polling agency reported that support for Putin's policies in the breakaway province had dwindled to 26 percent, the institute's director and research team were abruptly fired, replaced by Putin loyalists.

This comes against a more familiar backdrop: the closing of independent TV stations, coupled with Putin's apparently growing willingness to do whatever it takes to promote favored political candidates in the upcoming Dec. 7 parliamentary elections. Perhaps most unsettling for foreign investors is the government's ongoing investigation of the Yukos oil company; the firm is owned by billionaire Mikhail Khodorkovsky, Russia's richest man, who has contributed as much as $50 million to political parties opposing Putin and favoring democratic and market reforms. Just last week, police again charged into Yukos offices, seizing computers and documents. The crackdown challenges the privatizations of the 1990s, the basis of Khodorkovsky's wealth and almost every other major industry as well. Change that, and every business relationship in Russia is suddenly uncertain.

Putin has a ready reply to those who accuse him of being a crypto antidemocrat. "If by democracy you mean dissolution of the state, then we do not need democracy," he recently told a group of American journalists, including NEWSWEEK. Most Russians tend to agree. So do foreign investors. A friend of the president's, not associated with the Kremlin, tells NEWSWEEK that Putin is obsessed with two things besides Chechnya: one is preserving a strong central government, capable of imposing order on the country's unruly, almost feudal business chieftains and warring political factions. The other is improving the lives of ordinary people and creating a new Russian middle class. Both goals presuppose strong economic growth, which in turn requires substantial foreigninvestment.

That helps explains Putin's cautious handling of the Khodorkovsky affair. Before departing for the Camp David summit, he told journalists that Yukos was "a special case." The privatizations of the 1990s would not be challenged, he added. At the World Economic Forum in Moscow last week, Putin went out of his way to reassure investors that he was determined to reduce government interference and make Russia a more secure place to do business.

It remains to be seen how far Putin will go to defend foreign investors. But there are clues. A year ago, for example, one of the country's most powerful oligarchs, Oleg Deripaska, the owner of Russian Aluminum, went after the holdings of Ilim Pulp of St. Petersburg, the country's largest forestry enterprise. There were threats against its Western managers, and armed battles between the company's security guards and Deripaska thugs, who sought to take control of the company by sheer force. When Putin got wind of it, he called the tycoon. Desist, he said, or "I will break you." The Russian verb he used, razorvu, means to smash, to tear into little pieces. Not long after, the strong-arm tactics ceased. Says Frank Graves, the company's Canadian chief operating officer: "We love Putin."

Among the more troubling elements of this tale, obviously, is how it highlights an enduring fact of Russian business life. At bottom, the scene remains ad hoc, changeable, prey to happenstance or even whimsy. Despite the new boom, notwithstanding how far the country has come, Russia remains what it has always been: a nation governed by almost feudal elites, at war with one another, pursuing very different agendas, some casting themselves as reformers, others as something else entirely. "Putin hovers over these fighting minions, the ultimate arbiter," shifting his balance as interests and power ebb and flow, says Pavel Felgenhauer, an independent political analyst. Yet the consequence is that nothing is fixed, nothing is predictable. How will Putin move? Who are his allies? Who will succeed him, if he stands down as promised in 2008, and will his policies endure if he does? "No one knows where Putin will take this country," says Felgenhauer. "Perhaps in a circle."

There's an eerie echo here. As Western businessmen descend anew on Moscow, seeking deals and a bed for the night, they would do well to remember Gogol's "Dead Souls" and its famous evocation of Russia as a horse-drawn troika hurtling pell-mell through a forest, the world flashing by, ever faster, "the whole road flying, no one knows where, into the unseen distance."