In 1991, the ideological struggle enveloping the world for nearly a half century ended after the Soviet Union collapsed under its own weight. The turmoil that followed Russia's transition to capitalism and democracy left no corner of society untouched. A select few, the "oligarchs," capitalized from the chaotic times, acquiring untold wealth and power through political connections. Yet most Russians remained destitute and disenchanted, yearning for the powerful leaders of yesteryear.
After crisis hit again in 1998, Russians would soon get their wish—Vladimir Putin brought Russia nearly full circle with the ideologies of its Soviet past. His was a unique form of state-led, oily capitalism, and the ensuing recentralization of key energy and materials assets under his rule would alter the investment landscape. The Soviet Union's collapse and the ensuing years of reform reveal the effects of unbridled, state-concentrated political power on markets.
We'll first examine Russia, then shift south to dissect South Africa's turbulent legacy of racial relations and markets. Apartheid, a system of legal racial segregation with the minority as the dominant force, blighted one of Africa's most prosperous and promising nations. It is an unfortunate page in history, but it offers unique lessons for investors.
Mikhail Gorbachev came to power as the Communist Party's general Secretary in 1985 (the de-facto head of state for the Soviet Union), following a brief period of musical chairs at the end of Leonid Brezhnev's 20-year regime. Gorbachev represented a new vein of Soviet thinkers. He was the first Communist leader born after the Bolshevik Revolution, and grew up in a generation exposed to a range of intellectual freedoms denied under previous regimes. He was well-educated—with a law degree from the prestigious Moscow University and an advanced economics degree—and worldly, with exposure to a wide swath of intellectual thought. He symbolized a break from the country's technocratic and anti-intellectual predecessors.
Despite the problems and hardships endured because of the Soviet system, Gorbachev's generation still firmly believed it could be reformed. To them, the Soviet Union held a unique place in the world—not in isolation from the West but right alongside it.[104] Gorbachev's ambition was to bring the Soviet Union closer to the modern world.
Conscious of the weight of history, Gorbachev knew he must build political support to have any chance of breaking the state away from anachronistic Soviet norms. After all, nowhere else in the world did the state penetrate as deeply into society. It intruded everywhere, and almost everyone was connected to it in some form. Many staked their livelihoods on its continuation and gained self-worth from their rank within it. Given the corruption, embedded self-interests, and rampant poverty throughout the Soviet system, adherence to its ideals seemed paradoxical. But the power of the Soviet empire was a profound source of pride to many of its citizens, inextricably intertwined with their identity.
Gorbachev stumbled out of the gate. In early 1986, an experiment at the Chernobyl nuclear power plant in northern Ukraine went horribly awry, sending a plume of radiation nearly a mile into the sky.[105] Gorbachev took 18 days to disclose the accident to the world—an eternity given the gravity of events. The resulting social and political fallout was enormous. The Communist Party spent over half a century carefully crafting its image of a state in complete control, and Chernobyl suddenly threw this into question.
Losing support by the day, Gorbachev sped up his reform agenda, embarking on a flurry of activity. His overarching philosophy rested on two concepts: glasnost (reform, openness, and transparency) and perestroika (restructuring). In the next few years, he opened the media (which had served as mouthpiece of the state for decades), signed a joint venture law to attract foreign capital, and issued several other similar decrees. More subtly, he empowered Soviet businesses and citizens to do anything not explicitly forbidden; whereas, in the past, they adhered to a list of permitted activities.
But glasnost and perestroika had the unintended consequence of further revealing the ugliness behind the powerful Soviet façade. It was soon evident to the world just how brittle, secretive, and insecure the country was after 70 years of isolation. It may have looked like a superpower from the outside—and in many ways it was—but beneath the exterior it largely remained a third-world country.
Life was a struggle for most Russians—they often lacked the simplest necessities, from matches to toothpaste to hosiery. Gorbachev's policies of transparency also revealed something much larger and more subversive—the illegitimacy and hypocrisy of the state. The Communist Party ruled with an iron fist, poisoning society with an incestuous mix of economic and political power. Despite his best intentions, Gorbachev unintentionally exposed the grim realities of the Soviet system.
Gorbachev's reforms didn't resonate with the populace as much as he hoped. In hindsight, this was understandable. Decades of totalitarian and centrally planned rule had left the population unable to interpret market-based reforms in the proper context. In fact the word "market" itself was prohibited in the Soviet Union.[106] Moreover, few even knew how to capitalize (pardon the pun) on such a system. Those who did were connected politically to previous regimes and had much to lose from a declining state. It simply proved too difficult to quickly reverse such an embedded worldview.
Politically, Gorbachev was stuck in a more complicated position than his predecessors. He increasingly found himself caught between two distinct groups within the Communist Party: the conservatives, who wanted to stop reform, and the liberals, led by the enigmatic Boris Yeltsin, who wanted to accelerate it. These two sides were moving further and further apart in the late 1980s. In response to pressure from Yeltsin to speed the pace of reform, Gorbachev created the Congress of People's Deputies (CPD) in 1988—a legislature with two-thirds of its deputies chosen through uncontested elections.
Such a move was unfathomable in the Soviet heyday—the very fabric of the Soviet state rested on the Communist Party's leading role. The CPD ushered in the first legal opposition in nearly 60 years at the 1989 parliamentary elections, though it was only a small minority.[107] Gorbachev's consensus-building created a multiparty system at odds with the existing structure of government.[108] He didn't realize it at the time, but the move was a major tipping point toward the Soviet Union's collapse.
Gorbachev's reforms also exposed deep-rooted but hidden issues of nationality and identity in the Soviet satellite states. In August 1989, a non-communist government was elected in Poland. The Berlin Wall—a highly symbolic barrier of the Iron Curtain—crumbled in November 1989. And in March 1990, Lithuania declared its independence. Turning one's back on the Soviet Union was intolerable, even to Gorbachev. He responded forcefully. In Lithuania, for example, Gorbachev sent in the KGB and imposed economic sanctions, revealing the bluntness of Soviet power.
But those efforts failed. By the start of the 1990s, Gorbachev's legitimacy hung by a thread. Boris Yeltsin and the liberal opposition were increasingly vocal. In March 1990, radical democrats won control of the largest and most populous of the country's republics—the Russian Soviet Federative Socialist Republic. The group declared sovereignty for Russia, as the territory would be named, and Yeltsin was soon named its leader.
Gorbachev tried several desperate attempts to cling to power, but they proved unsuccessful. An ill-fated coup d'état in August 1991, organized by the entire Gorbachev team (except Gorbachev himself, who was mysteriously on vacation), proved to be the old regime's last gasp. Yeltsin easily squashed the coup, and the Soviet Union collapsed with Gorbachev's resignation on December 25, 1991.
Yeltsin swiftly set about dismantling the Soviet system. The enormity of this change cannot be understated. Virtually overnight, an entirely new system was built from the crumbling remnants of the old: A command economy was now a market system, and an authoritarian socialist state was now a democracy. Not surprisingly, the transition was tumultuous, and the turmoil would dominate the next decade—its effects rippling across the globe.
The first few years of Yeltsin's administration were a veritable no-man's land, stuck between two systems inherently at odds with each other. A major problem was quickly apparent—in the early stages, no one knew what they were doing, at least not beyond the most basic theoretical level. Yeltsin may have staked his political career on the dismantling of communism and centrally planned economics, but, just like his predecessors, he too was a product of the Soviet era. He had no experience with making a market system work. As such, he first focused on action for the sake of action—rules and institutions could wait.
This translated into his "shock therapy" program, which included immediate price deregulation, higher taxes, the lowering of import barriers, increased trade with the rest of the world, and huge cuts to government spending. Many of these initiatives were appropriately based in free market principles, but the precarious environment at the time gave little chance for success.
The privatization of state-run enterprises was a crucial requirement for the transition to a market economy. In the Soviet Union, there was no distinction between a company and the state—they were one and the same. Gorbachev brought forth the idea of privatization, but it wasn't until after the collapse of the Soviet Union that it was possible. Interestingly, the privatization scheme announced in 1992 marked the formative years of Russia's first stock exchange (officially established in 1995).
The program relied heavily on voucher-based privatization. The value of state ownership, estimated at 1.5 trillion rubles, was distributed equally among the 146 million citizens. Every Russian received a voucher for 10,000 rubles, with the right to do essentially whatever they wished. Most exchanged the voucher for shares in their employing company, participated in auctions for shares of others, bought shares of an intermediary organization (or investment fund), or simply sold the voucher for cash.[109]
The latter soon became a widespread business, and enterprising individuals set up shop to entice people with the draw of immediate hard cash. These resellers in turn exchanged vouchers for shares in privatized companies or sold them again at stock exchanges. The first voucher trades occurred on the Russian raw materials stock exchange (RTSE) on October 1, 1992. Soon the voucher paper became the most actively traded issue on the exchange. In 1993, voucher transaction volume on the RTSE accounted for 75 percent of total turnover.[110] Russia's earliest shareholders acquired stakes in companies in this manner. In the end, over 46,000 companies were privatized in 1992. By 1995, the number reached 122,000, or more than half of Russia's total enterprises.[111]
But the voucher program had exposed a recurring flaw in Russia's transition to capitalism—the lack of capital markets infrastructure. Without solid institutions underlying markets, capitalism exists in name only. Thousands of investment funds appeared overnight, offering outrageously high returns. The vast majority were scams and Ponzi schemes. The most famous was the MMM fund, which advertised on television (a novelty considering the media was now free from Communist control), promising returns upwards of 3,000 percent. It was too tempting for many to resist. In mid-1993, shares of MMM sold for 10,000 rubles. A year later, they sold for more than 100,000. After the fund's collapse in 1994, it was estimated 300 million shares were outstanding and over 10 million people were swindled.[112] Others suffered similar fates at similar funds.
The ramifications of Yeltsin's economic reforms were immediately apparent. The fall of the Soviet Union was more economically devastating than any other event in modern history, arguably by several orders of magnitude. Even before the Soviet Union's collapse, the economy was dangerously close to a precipice. But Yeltsin's transition sent it into freefall. Shortages, rationing, and queues for basic goods became common. Abolishment of state subsidies resulted in hyperinflation, with prices rising over 2,600 percent in 1992 alone.[113] Productive members of the Soviet state found themselves powerless in the new system, adding to a sense of despair. In 1993, the economy contracted 9 percent. It fell another 13 percent in 1994 and 4 percent in both 1995 and 1996. Figures are not available for 1992, but they were likely even worse.[114] In the span of six years, the economy contracted by at least a third.
Meanwhile, the political scene also descended into chaos. Yeltsin's motives behind his "shock therapy" program were probably more political than economic. More than anything else, he feared Communists returning to power. Thus, many of his actions were predicated on removing as much power from the government's hands as possible. The ensuing decentralization left control of the various states at the hands of the respective regions, adding to the sense no one was manning the ship.
By 1993, tensions between Yeltsin and other members of Parliament reached a fever pitch. Yeltsin, fed up with the legislature slowing down his reforms, dissolved Parliament and called elections. His opposition barricaded itself in Parliament, a makeshift attempt at a coup d'état. But with a little bit of violence, Yeltsin easily squashed the revolt. He pushed through a new constitution giving him supreme, "super" presidential powers. In effect, his powers were no less absolute than the Soviet Union's General Party Secretary. Over the next few years, Yeltsin issued thousands of decrees, or presidentially mandated laws. Pure Russian democracy proved short-lived.
To maintain power, Yeltsin had to forgo a substantial amount of political capital. By 1996, Russians had given him several second chances for his reforms to bear fruit, but most still lived in impoverished and miserable conditions. Elections were scheduled for the end of the year, and Yeltsin's support was remarkably low—his approval rating a mere 8 percent. Even worse, the Communist Party's candidate had 24 percent of voters' support.[115]
As elections approached in 1996, the economic situation was perilous— the government was bankrupt. In late 1995, Vladimir Potanin, head of the powerful bank Oneximbank, offered the government a solution to its money problem. The State Duma, the lower house of Parliament, had blocked privatizations of state energy and materials enterprises because of their national importance. Potanin proposed commercial banks offer loans to the government, collateralized by shares in these companies. This unleashed a second wave of privatization. The "loans-for-shares" scheme, as it would be called, was a seminal event in post-Soviet history.
The government auctioned controlling stakes in companies on a competitive basis to banks in exchange for loans. But there was a catch. Everyone knew the loans wouldn't really be loans—the bankers held no hope the government would repay them given the precarious state of affairs. In effect, the bankers were trading cash for the ability to purchase strategic state assets. Still, it was a mutually beneficial situation. The state wouldn't starve, and the banks received the right to acquire valuable, previously unattainable assets in return.
On paper, the arrangement was perfectly legitimate. Theoretically, interested parties competed for shares, meaning the assets would be sold for whatever the market deemed appropriate. Unfortunately, the actual mechanics turned out to be nowhere close to such an ideal—a remarkable trail of corruption, vested interests, and downright theft followed.
The auctions began inauspiciously. Scheduled to begin promptly with the New Year, there were only a short few months to establish logistics. Potanin shrewdly leveraged this short time frame to get partial control over the process. Oneximbank and several other financial institutions close to the government (Menatep, SBS-Agro) convinced Yeltsin they were best suited to run the auctions—a blatant conflict of interest.
Once the auctions kicked off in earnest in 1996, the real fun began. The law required at least two bidders for a valid auction, but corruption was rampant. Often, the winner was agreed upon beforehand, and the second bidder was a fake corporation. For example, in the auction for shares of Novolipetsk Steel (NLMK), one of the world's largest steel producers, Oneximbank essentially competed against itself through a subsidiary to provide the illusion of a fair sale.
Even more egregious were the bid amounts. The government was in a bind and desperate for funds, meaning it would be forced to sell the assets at somewhat depressed prices. But the actual terms were beyond imagination. Consider the following:
Oneximbank gave the government $170 million for a 51 percent voting share of Norilsk Nickel, which produces 90 percent of Russia's nickel and cobalt and 100 percent of its platinum. A Western insurance company covered it for $30 billion shortly thereafter, over 100 times more than the purchase price.[116]
The energy giant Gazprom sold for $250 million. Gazprom controls a third of the world's natural gas resources, is the sole gas supplier to the former Soviet Union, and provides Western Europe with about a fifth of its natural gas. If it were a Western energy company, it would have easily been valued 100 times more.[117]
Potanin loaned the government $130 million for 51 percent of Sidanco, the Russian oil company. Within a year, he sold just 10 percent of the company to British Petroleum for $571 million.[118]
Mikhail Khodorkovsky, who controlled the bank Menatep, acquired Yukos, Russia's second largest oil company, for $150 million.
The market value of six of Russia's most important industrial companies—Gazprom, RAO UES, Lukoil, Rostelecom, Yuganskneftegaz, and Surgutneftegaz—mysteriously grew 18 to 26 times their auction price a mere one and a half years later.[119]
By the end of the 1990s, less than 20 Russian companies and banks controlled 70 percent of the economy.[120] The power and wealth of the Soviet empire fell into the laps of a fortunate few. These men represented the new "Russian oligarchy," commonly known as the oligarchs.
The oligarchs profoundly altered the course of Russian politics and markets for years to come. They were open to market-based reforms, but not because they were true capitalists. Rather, such reforms provided a shield against the return of a centrally planned economy, which threatened their prominence. The oligarchs influenced all forms of government policy, from economics to legislation, and dipped their hands in the political sphere by sponsoring ministers and members of parliament. They even managed to propel Yeltsin to victory in the 1996 elections despite his failing health and low approval ratings. In short, they used their newly acquired power to receive favorable treatment and ensure their financial interests remained protected from competition.
The oligarch saga also revealed the importance of the Energy and Materials sectors. The Russian economy runs on it. Energy accounts for over 60 percent of Russian exports and approximately 20 percent of total output.[121] If you include the industry and transportation critical to its production and distribution, its contribution to economic output is even higher. You can see why the oligarchs were so motivated to get their hands on such assets.
Their share of the stock market is even more profound—Russia's Energy and Materials sectors account for three-quarters of its total market capitalization.[122] Therefore, changes in oil prices have a tremendous impact on the overall Russian economy and stock market. Though historical data are limited, Figure 4.1 shows the directional relationship between the price of oil and Russian stocks. The lesson for investors: Russia is inescapably tied to commodity prices.
The second wave of privatization also heralded a new set of investors. Western bankers were omnipresent in Russia and deal making surged. Many oligarchs used this international buzz to fuel expansion of their newly acquired empires with foreign capital. Alexander Smolensky, the oligarch in charge of the powerful SBS-Agro bank, borrowed $168 million from two Western banks and floated a $250 million Eurobond. He later admitted he didn't know what he would do with the money from the bond issuance, but he went along with it because the lenders said he could.[123] This optimism translated into huge gains for the budding stock market, which returned 98 percent in 1997.[124]
Despite the glossy appearance, Russia fundamentally remained in dire straits. Inflation reduced real wages to half their Soviet levels, and only about 40 percent of workers were paid on time. The oligarchs dramatically reduced their tax payments as payback for securing Yeltsin's election victory—nearly all the main companies with tax arrears at the end of 1996 were energy companies.[125] The price of oil collapsed, depriving the government of another large revenue source. And the government remained chronically undisciplined in its spending.[126] Russia found itself stuck in a fiscal tsunami.
Previously, the government printed money to meet its deficit, but it stopped doing so by the mid-1990s because of hyperinflation's destabilizing effects. Starting in 1993, it began to borrow on the capital markets. The government issued short-term bonds, usually with a three- to six-month term, called GKOs (an abbreviation of the Russian for "short-term government obligations"). The initial amounts were tiny. By year end 1994, only $3 billion were outstanding. But the amount soon exploded—by mid-1998, there were nearly $70 billion in GKOs.[127] To put this in context, Russia's total nominal economic output was around $400 billion.[128]
It was no secret the Russian economy had problems, yet GKOs still managed to attract interest. Every investor has his price, and Russia paid a pretty penny—short-term interest rates were 200 percent at the start of 1995.[129] These high rates had a perverse effect, diverting capital away from more economically productive assets. Foreigners had little desire to invest directly in Russian projects when they could earn several hundred percent in the span of a few months. Few Russian companies did either, for that matter. This meant that desperately needed infrastructure and development projects moved forward ever more slowly.
The government initially used these bonds as intended—to finance the deficit. However, the interest rate payments soon proved too exorbitant. In 1994, 75 percent of the proceeds from GKOs went to cover the deficit. By 1997, 91 percent were used to pay off previously issued bonds, leaving only 9 percent for new spending![130] Not surprisingly, the government soon ran into a shortfall. In April 1998, for the first time, the money collected from new GKO issuance was less than what was needed to pay off investors—the government had to delve into alternative funding sources for another $164 million. The shortfall rose over the next several months and hit $10 billion in early July.
Something more ominous was also brewing on the horizon—the Asian Financial Crisis. As we mentioned in Chapter 2, currency problems in Asia spread swiftly across the globe to seemingly unconnected markets. One of those markets was Russia. In 1995, the government had pegged the ruble to a range versus the dollar to finally tame inflation. Though the peg had the desired effect, the flood of investor capital from GKO bonds and renewed international interest left many believing the ruble was overvalued. Speculators were on the prowl searching for weakened emerging markets, and they soon swooped down on Russia—putting enormous downward pressure on the ruble. The government was forced to spend its currency reserves in defense. It was estimated that, between October 1997 and August 1998, the Russian central bank spent $27 billion of US dollar reserves to keep the peg, on top of a $5 billion loan from the World Bank and IMF.[131]
Finally, on August 13, 1998, Russian markets relented under the conflux of pressures—stock, bond, and currency markets collapsed as Russia ended its increasingly desperate attempts to keep the country solvent. Within a month, the ruble fell more than 70 percent (see Figure 4.2). What little savings Russians had became effectively worthless. After falling to a manageable 11 percent in 1997, inflation reignited to 84 percent in 1998. The stock market fell 85 percent.[132] Some of Russia's biggest, most influential companies—and their associated oligarchs—also collapsed.
An outside observer taking stock of Russia in the wake of the crisis would have been horrified. By 1998, the economy had officially contracted by nearly a third since the fall of the Soviet Union.[133] Unofficially, that number was likely much higher. Institutions were weak and sickly. The government lost all semblance of legitimacy. And the average Russian wallowed in extreme poverty, resenting the farce of the privatization process. Simply put, the past decade was a disaster. The country was ripe for change, and it came from an unexpected source.
Elections were due in 2000, and the oligarchs, who effectively controlled the country, sought a suitable replacement for Boris Yeltsin. They had their eye on a relative unknown, Vladimir Putin, then head of the Federal Security Service (FSB), the successor to the infamous KGB. They saw Putin as someone capable of leading the country but not someone who would seek to unwind the privatization results (and thus their wealth). Not surprisingly, they got their way—Yeltsin named Putin to be prime minister in August 1999, the fifth man to hold that job in the past two years.[134] On New Year's Eve, Yeltsin unexpectedly announced he was passing the duties of president to Putin. The public reaction was mixed, and Putin's 30 percent approval rating was commensurate with his status as a relative newcomer. But Putin's calm and measured responses to guerrilla attacks in late 1999 (presaging the war in Chechnya) led to a surge in his popularity. In mere months, his approval rating soared to 80 percent. It has been strong ever since.
Putin won presidential elections in 2000 with a strong moral mandate, securing 52.5 percent of the popular vote.[135] He perfectly fit the country's cultural identity and thirst for political power. Despite several years of Western, free-market thought, Russian culture remained rooted in a centuries-old obedience to authority, from the great tsars to the Soviet empire. The country's Orthodox Christianity religious heritage also left a strong moral aversion to greed, pride, and excessive wealth. With this in mind, it's not surprising to see how quickly Putin achieved widespread popularity—he symbolized a return to the powerful figures of the past.
To accomplish his goals, Putin needed to renegotiate the state's previously entrenched relationship with the oligarchs. He made clear early on he didn't intend to embark on a renationalization campaign given the chaos and struggle that would ensue. Instead, he offered a bargain: If the oligarchs paid their taxes and stayed out of politics, they could keep the property they acquired under the previous administration.
Meanwhile, the economy showed signs of a remarkably swift recovery from the 1998 crisis. Russian gross domestic product grew a healthy 6 percent in 1999, followed by 10 percent in 2000.[136] The ruble devaluation restored competitiveness to the trade sector, which was previously decimated by cheap imports. Extensive restructuring with the London Club of commercial creditors helped ease the country's massive debt burden.
Many of Putin's first policies as president also aided the recovery. Between 2000 and 2003, he pushed through a flat personal tax at 13 percent, one of the lowest rates in the world, and substantially lowered corporate rates. Lower taxes stimulate investment and consumption by putting more money into productive hands (i.e., the private sector). They also increase the willingness of people to actually pay the taxes. Additionally, Putin updated the labor code, legalized the purchase and sale of both urban and agricultural land, and dramatically reduced bureaucratic red tape.
Perhaps most importantly, however, Putin's firm grip on power gave the country a degree of stability and predictability that were largely absent in the tumultuous 1990s. That grip would soon be tested, with lasting implications for investors. The 2003 Yukos affair signaled a turning point in Putin's laissez-faire relationship with the oligarchs. It also proved to be something much more: Russia reacquainted itself with its Soviet past.
The oligarch Mikhail Khodorkovsky acquired Yukos, Russia's second?-largest energy company, in the loans-for-shares auctions. At the time, Khodorkovsky controlled Menatep, one of the privileged banks coordinating the privatization auctions, and he leveraged this power to purchase 45 percent of Yukos. Menatep disqualified several competing bids on formalities, eventually paying $150 million for the shares. It also agreed to finance $200 million of development projects for the company, which made the total price a very reasonable $350 million.
There was no question Khodorkovsky got a deal. But the figures are more complicated than at first glance. The company was far from profitable and laden with debt—it had a negative net worth of about $3.5 billion.[137] Its lifting costs—or the cost to get oil out of the ground—were prohibitively high due to decades of underinvestment. No foreign company wanted anything to do with it.
In 1996, Khodorkovsky left his post at Menatep and joined Yukos management as a vice president. Two months later, he became the chairman of the board. With Khodorkovsky at the helm, the company turned around. He invested heavily in technology and infrastructure, leading to remarkable gains in efficiency over the next few years—Yukos's lifting costs were reduced eight times, to $1.57 per barrel. The company expanded to 50 regions in Russia—a 10-fold increase in the period following the takeover. Production reached 86 million tons of oil per year—double that of 1998. The company's market capitalization increased from $350 million to over $10 billion.[138]
Khodorkovsky also instilled levels of transparency unfathomable to those accustomed to the climate of secrecy underpinning Russian capitalism. In 2002, he publicly disclosed Yukos's ownership structure, and his dealings increasingly adhered to Western standards. Yukos became a well-respected and influential international organization, and Khodorkovsky symbolized a new and improved Russia, based in Western values and flush with opportunities.
Success also reformed Khodorkovsky. He was no longer content to play the role of obedient oligarch and began openly challenging the corrupt business practices dominating Russian society. Putin regularly met with key business leaders, and in a February 20, 2003, meeting, Khodorkovsky openly challenged Putin on rampant government corruption. Specifically, he drew attention to a recent deal where state-owned Rosneft outbid Yukos for a small oil company with an outrageously large sum (the acquired company was run by a friend of Putin's). In return, Putin questioned Khodorkovsky's own acquisition of Yukos. The day proved highly symbolic—the grand bargain struck between Putin and the oligarchs was breached.
The ensuing events recalled the unchecked political power under Soviet rule. On July 2, 2003, one of Khodorkovsky's lieutenants was arrested on charges of embezzlement. Police raids on Yukos buildings and a government investigation followed. The government shortly charged Yukos with tax evasion and slapped the company with a $33 billion bill for back taxes—an amount larger than the combined tax bill for the entire oil industry. Khodorkovsky was arrested in October for fraud and tax evasion, and in the ensuing sham of a trial, he was sentenced to nine years in Siberian prison.
The government soon began dismantling the company. In December 2004, it auctioned Yukos's key asset, Yuganskneftegaz, which held the bulk of its oil reserves. The auction removed any semblance of doubt Putin was at work—the acquiring entity was an unknown company, Baikalfinansgrup, allegedly registered at the address of a hairdresser's salon in Tver.[139] The fictitious company was immediately sold to state-owned oil producer, Rosneft. In another auction, Yukos's glass and steel headquarters sold for $3.9 billion, despite estimates it couldn't be worth more than $250 million.[140] Similar auctions over other Yukos assets also raised eyebrows.
Ostensibly, the government was making it known it had no reservations stealing valuable assets for its own enrichment. The initial public offering (IPO) of Rosneft in 2006—the largest listing in Russian history, raising $10.4 billion—illustrated to the world the new paradigm of Russian markets, one where the state controlled markets and held a firm grip on power.[141] Indeed, the next several years saw the government repeatedly flexing its muscles, especially in renationalizing energy assets. Several joint ventures between Russian and Western oil companies were suspiciously shut down for environmental reasons. Other Western firms were told to surrender a controlling stake if they wished to remain in business. Though the state started with energy firms, many other sectors found themselves targets in the ensuing years.
To understand the full implications of the return of Soviet-style authority, consider the story of Mechel, Russia's largest exporter of coking coal (a vital input into the steel-making process). An economic boom and massive infrastructure build-outs in emerging markets kept demand for such natural resources inordinately high from 2003 to 2007. Mechel smartly leveraged this demand by selling its coking coal into the more expensive foreign spot markets. It consistently posted exceptional earnings growth, and its share price soared.
But its actions angered the Russian steel sector, which wanted the company to enter into long-term contracts with domestic steel makers at a lower cost. Someone in the sector clearly had Putin's attention. Putin called a meeting with steel makers to discuss the situation, but Mechel's CEO was unable to attend due to heart problems. The perceived snub angered Putin. He called for Russia's antimonopoly organization to investigate Mechel for price-fixing and charged the company with tax evasion. At one point, the government considered adding criminal charges. Figure 4.3 plots Mechel's share price at the time. As you can see, Putin's attack cut the company's market value by more than half in a mere two days—a stark reminder to foreign investors of Russia's inherent political risks.
From the outside, Mechel appeared guilty only of smart business sense. In freely functioning markets, a company is allowed to sell its goods at the highest price the market bears. Herein lies the most valuable lesson—Russia is not a true market. Years of heavy-handed recentralization under Putin changed the rules of the game, and property rights are tenuous at best. The government can single-handedly erase an investment position to zero in a flash. Caveat emptor.
Does this mean investors should avoid Russia entirely? Probably not. As we'll discuss in subsequent chapters, zero allocation to an important country like Russia means taking on a substantial amount of benchmark risk. Investors simply need to remain cognizant of Russia's history and political tendencies. Russian firms may appear to operate in a competitive market, and their managers may say they act independently. But they all work within a strategic framework ultimately dictated by the state and the legacies of its Soviet past.
South Africa has a long and complicated racial history. European settlers in the seventeenth and eighteenth centuries colonized its coast for ports vital to trade with the East. These settlers enslaved many native Africans, beginning a trend of racial conflict that would last over three centuries, from the Zulu kingdom to the Boer Wars to apartheid (a set of laws allowing the ruling white minority to segregate and discriminate against the black majority). In no other corner of the world is the relationship between race and broader society as institutionalized as South Africa.
The end of apartheid in 1994 is a microcosm of this history. It bridged two worlds, leaving lasting inefficiencies while creating new ones. Apartheid and its aftermath teach us race can play a key role in shaping a country's investment climate.
Eighteenth-century South Africa was a melting pot of culture and race. Indigenous Africans mingled with Dutch, French, and German immigrants. The mixture was transformative—assimilation bred unique cultures and ideologies. The Afrikaners (also known as the Boers) were a group born from this period. Farmers of European descent, Afrikaners developed their own language (Afrikaans) and practiced a distinct form of fundamentalist Calvinism. Apartheid would be their lasting legacy.
Afrikaners originally settled around South Africa's coastal areas, but the arrival of the British at the end of the nineteenth century forced them into the northern reaches of the country. There, they successfully battled the Zulus, a dominant African tribe, establishing white superiority over the region. In the 1850s, the British granted independence to two Boer states—Transvaal and the Orange Free State. For the next several years, Afrikaners lived peacefully on their new land.
But the discovery of gold and diamonds in their territories put the Afrikaners in the direct path of British imperial might. The British mistakenly gave away a key asset and now they wanted it back. Tensions between the Afrikaners and British boiled over toward the end of the nineteenth century, leading to the Boer Wars. The British emerged victorious, but the brutality of the conflict created lasting implications.
Afrikaners were banished to industrialized urban areas and quickly fell into poverty. Once the owners of African slaves, Afrikaners now found themselves in direct competition with them for jobs—vast numbers of migrant black workers appeared in the settlements, offering to work in the mines cheaply. Afrikaners themselves were subjected to increasingly venomous racism by their Anglo peers. A strident nationalism was born from this suffering, laying the foundations for apartheid.
By the early to mid-twentieth century, a growing number of Afrikaner intellectuals began unfurling concepts supporting racial segregation. Calvinist religious leaders played a key role. They popularized the idea Afrikaners had the divine right to exist as a separate nation, free from the British model that forced them to assimilate as a minority among other ethnic groups. To preserve their culture and heritage, the Afrikaners felt they had no choice but to repress black development. From this, the leap to apartheid was easy. Racism begat racism.[142]
The nationalist Afrikaner National Party unexpectedly won South Africa's 1948 parliamentary elections. Race played a large role in governing society in the previous decades—there were already several laws on the books regulating blacks' ability to purchase land and what jobs they could hold. But Afrikaner nationalism brought about a complete social transformation along racial lines. Apartheid became their "manifest destiny," a way to cement white rule.
The main impetus for apartheid was political, but its methods were all-encompassing. Apartheid stripped away nearly every economic, political, and social liberty for all non-white citizens. Logistically, the system was based on a series of laws related to race. The first few touched aspects of social life, such as the marriage between different races. But they soon became increasingly restrictive and institutionalized—a flurry of acts passed by the Afrikaner legislature in the 1950s condemned blacks to second-class citizens. Here are some of the most impactful:
Population Registration Act (1950): Required all South Africans to be racially classified into one of three categories: white, black (African), or colored (mixed). Something as mundane as a person's habits, education, speech, or demeanor could be used as qualifying criteria.
Bantu Authorities Act (1951): Established "homelands" to which every non-white person was assigned and eventually deported. These were independent states, and all political rights were restricted to each person's homeland. To enter South Africa for any purpose (including work) required a passport.
Pass Laws Act (1952): Required all black South Africans to carry a "pass book" at all times. This book stipulated where, when, and for how long a person could remain in a specific area. The lack of a pass book was grounds for arrest and imprisonment.
Bantu Education Act (1953): Enforced racial segregation in all educational institutions. The law also led to a substantial reduction in government aid to already struggling black schools.[143]
Stories of brutality from the National Party's enforcement of these rules are too numerous and abhorrent to recount in their entirety. Unsurprisingly, blacks fought back against their oppression, and uprisings were common. The African National Congress (ANC), the political party that supported black rights, rose in prominence and became a beacon of black support. But as the Sharpeville (1960) and Soweto (1976) massacres showed, the white government wouldn't give in easily—they had staked their livelihood on the success of the apartheid system.
If one looked past the blatant racism, however, apartheid capitalism seemed to work economically at first. In the first 30 years of National Party rule, the South African economy grew nearly 5 percent per year on average.[144] The country's deep supply of minerals and vast pool of cheap black labor fueled the growth boom. South Africa possesses some of the planet's largest deposits of gold, platinum, chromium, vanadium, and manganese, and it holds significant reserves of many others. In 1970, South Africa accounted for nearly 80 percent of the world's gold output.[145]
But abundant natural resources and steady economic growth hid deep-rooted problems. Apartheid was inherently at odds with economic progress. Blacks—the majority of the population—were economically and politically devastated. Not enough jobs were created to employ migrants from the homelands. The domestic consumer market struggled to grow with so many impoverished citizens. And institutionalized racism proved expensive—the government spent increasingly large sums to keep the economy moving despite constraints facing four-fifths of its population.
International forces also weighed on South Africa's economy. The end of the gold standard in 1971 meant the price for the country's key commodity now fluctuated wildly, depriving the government of a solid revenue base. The government's inward-looking policies soon squandered away windfall revenues from previously high, stable gold prices. More importantly, a strong distaste for apartheid's racism prompted governments around the world to impose significant economic sanctions on South Africa, blocking access to export markets, imports, and investment capital. This proved to be an economic death blow, and the economy began to falter—from 1982 to 1992, it barely grew 1 percent a year.[146] Without strong growth diverting attention from the country's entrenched problems, the ugliness of the apartheid system was exposed.
An increasingly large and vocal portion of South African society began publicly opposing the government's policies. After brutally resisting for decades, the white government finally relented. There was no seminal event, but the National Party began a peacemaking process with the African National Congress in the early 1990s. Negotiations lasted several years, and in 1994, the ANC won South Africa's first democratic elections—marking the official end to the apartheid era.
Apartheid left South Africa with dramatic structural problems. Blacks claimed no meaningful physical property, no shares in important businesses, no ownership over the political process. Simply put, South Africa was among the most unequal places on Earth at its end, the average per capita income for whites was about 9.5 times higher than for Africans, and well over half of blacks lived below the poverty line.[147]
A large part of this inequality stemmed from poor job prospects. Apartheid barred blacks from all but the most arduous and worst- paying jobs, and the education system deliberately kept them qualified for little else. The "color bar" meant there was no point to train blacks as professionals since it was illegal for companies to offer them such jobs anyway. These policies bequeathed a high supply of unskilled labor and a chronic shortage of skilled workers. This remains evident today, South Africa's official unemployment rate hovers around 25 percent.[148] The rate for blacks is likely substantially higher.
Labor inequality also gave rise to increasingly influential trade unions. When the ANC took power in 1994, it was in alliance with the Congress of South African Trade Unions (COSATU), the country's preeminent labor organization. To appease its power base, the ANC immediately embarked on a campaign to improve the labor environment. The rise of trade unions had unintended consequences, they shielded black workers from traditional market forces, making labor markets less flexible.
Apartheid also left a very concentrated ownership structure. In 1992, the top six conglomerates accounted for 85 percent of the Johannesburg Stock Exchange by market capitalization.[149] The Afrikaner ethos of self-reliance meant it wasn't just blacks that Afrikaners wanted no part of—this philosophy extended to the outside world as well. For example, the National Party employed exchange controls in 1961 prohibiting the convertibility of the rand, the country's currency. No company could expand internationally, so they did so horizontally instead, creating vast monoliths dominating the domestic economy. South African Breweries (SAB), for instance, controlled 98 percent of the country's beer market. With this market cornered, it diversified into furniture making, department stores, and watches.[150] This brewed inefficiencies—there are few synergies between beer and time pieces.
Apartheid's most enduring legacy for investors was an affirmative action policy called Black Economic Empowerment (BEE). Conceptualized in the first several years after apartheid's end, its objective was simple: to redress the systematic exclusion of the majority of South Africans in the full participation of the economy. Few disagreed with its aims, but its implementation evoked widespread controversy.
At first, the government provided few guidelines for empowerment, leaving various arms of the state, private enterprise, and other interested parties to their own devices. Since apartheid deprived blacks of any modicum of wealth, banks began lending money to black consortia (BEE companies) to acquire shares in white businesses. These groups would purchase shares in return for voting rights. The banks in turn received the share performance, up to a certain rate, and anything beyond that went to the black consortia. But the logic behind this scheme was flawed—it capped the bank's return on the upside, yet they remained responsible for all the downside. Inappropriate risk-taking by the BEE companies ensued, and when markets turned sour in the late 1990s, many of these consortia collapsed.
Recognizing the need for a broader, more formalized approach, the government vetted ideas among politicians, the business community, and Africans. In September 2003, South Africa's parliament ratified the Broad-Based Black Economic Empowerment (B-BBEE). President Thabo Mbeki signed the bill into law in January 2004—affirmative action was now officially institutionalized.
The legislative framework relied on "scorecards," like Table 4.1, to evaluate every South African company on seven factors. Firms were assessed on the level of black ownership, the color of the managers and staff, their degree of assistance to black entrepreneurs, training provided to black workers, the amount spent on black social programs, and to what extent their supply chain was also "empowered."[151] Many industries also published additional criteria specific to their businesses.
A company's BEE "score" has widespread implications. BEE is mandatory only for government or state-owned companies. But companies ignore the system at their own peril—non-compliance means potentially losing out on key licenses or government contracts. Good empowerment credentials are pretty much required for those wishing to do business with the government.
Table 4.1. The BEE Scorecard
Core Component of BEE | Indicators | Conversion Factor | Raw Score | Weighting | Total Score |
|---|---|---|---|---|---|
Source: Department of Trade and Industry (DTI). | |||||
Direct Empowerment Score | |||||
Equity Ownership | % share of economic benefits | 20% | |||
Management | % black persons in executive management and/or executive board and board committees | 10% | |||
Human Resource Development and Employment Equity Score | |||||
Employment Equity | Weighted employment equity analysis | 10% | |||
Skills Development | Skills development expenditure as a proportion of total procurement | 20% | |||
Indirect Empowerment Score | |||||
Preferential Procurement | Procurement from black-owned and empowered enterprises as a proportion of total procurement | 20% | |||
Enterprise Development | Investment in black-owned and empowered enterprises as a proportion of total assets | 10% | |||
Residual 10% | |||||
To Be Determined by Sector/Enterprise | 10% | ||||
Total Score out of 100% | |||||
South Africa's Anglo Platinum, the world's largest producer of platinum, illustrates this struggle. An industry BEE charter stripped mining rights from companies and put them into state hands. Mining companies like Anglo Platinum had to reapply for "new" rights within five years, and the government's process for granting new rights included several BEE requirements, such as the transfer of 26 percent ownership to blacks by 2014.[152] Anglo Platinum worked on its compliance, but the government accused it of being too slow. Only in February 2008, after several years of wrangling, did the company finally receive new order mining rights. Anglo Platinum's long-running spat with the government adversely affected their expansion plans.
BEE legislation also created several other inefficiencies. Critics complain BEE is rooted in cronyism—that only a small lucky and well-connected few have benefited. In addition, initial empowerment deals were rooted in the taking over of existing enterprises, not the creation of new ones, translating into fewer jobs for the black masses. More broadly, the policy adds operational costs for companies through such things as legal fees and share-price discounts. One estimate puts the additional cost at approximately 3 percent of stock market capitalization for the first 10 percent of capital transferred to new black owners.[153]
BEE policies also scare away foreign investors. In 2007, three Italian mining companies filed an international lawsuit demanding $350 million in compensation for mines the government seized in its BEE initiative.[154] Weak property rights hardly instill investor confidence.
Most importantly, BEE allowed the government to circumvent market forces and redistribute wealth through a spate of instruments—legislation, regulation, preferential treatment, institutional and financial support, and partnerships with the private sector. Such action has enduring consequences for investors. For instance, a perfectly qualified company may lose out on a government project because it did not spend enough on social programs to help blacks or failed to meet a hiring quota.
The ANC's rise to power did not symbolize the end of South Africa's relationship between race and capitalism, but the beginning of a new chapter. Affirmative action added new layers of complexity to markets, and BEE amounted to forced wealth redistribution, similar in spirit to the Latin American populist polices described in Chapter 3. Few can argue against the need for redress for blacks after decades of brutally enforced racism. But for markets, which are our primary focus, such policies are anathema.
Chapter Recap
Russia's quick recovery from that crisis owes much to Vladimir Putin.
Yet he brought the country nearly full circle with the ideologies of its Soviet past, nationalizing key energy and materials assets—and wielding influence over many others.
His rule dramatically altered the country's investment landscape. Today, Russian markets are less "market" than a medium for political power.
South Africa also presents a unique case for investors—race and markets are intertwined.
Decades of race-based rule under apartheid left severe economic dislocations the country still struggles with today.
However, the policies adopted to redress these inequalities have only made investing in the region more complicated and fraught with inefficiencies.