5   Implementation of privatization after 1994

Introduction

In this chapter we look at the progress of privatization in 1994 and beyond, after the voucher programme ended. In doing so, we have not had access to inside information from western advisers on policy, as we had for the material in previous chapters, in part because neither the Russian government nor any of the international agencies asked for policy advice from such advisers (though they were used on occasion for case-by-case implementation). This chapter is nevertheless important for illustrating how mass privatization and loans-for-shares came to be seen together as a failure and a corrupted process, despite being separate policies with different agendas.

The progress of privatization during this period faced many of the challenges and dilemmas of earlier years. For example, there was an overwhelming difficulty in reaching the sort of political consensus necessary for the fair allocation of undisputed property rights, and this forced a tradeoff between different privatization objectives, in particular between the need to raise funds and the limited sources of legitimate funds available in Russia following hyperinflation. Throughout this period there was a growing sense that privatization and other aspects of commercial life were conducted in a way that benefited the privileged few. Nevertheless, throughout the period, the irreversible nature of the market economy became more established, both by law and in terms of the political debate.

As noted in Chapter 2, the voucher programme had involved the sale of numerous companies, but few of any value. Thus, although it granted shares to insiders, this involved a limited transfer of wealth. It was always assumed that the more valuable companies – in natural resources and utilities – would be privatized for cash. And in the mid-1990s that cash was greatly needed by the government of Russia, which was running a substantial deficit.

So one of the key goals of the cash phase of privatization was to fill budgetary gaps. When voucher privatization ended on 30 June 1994, the government proposed to the Duma a new law whereby companies were to be sold through cash auction as the normal procedure. It was rejected by the Duma in July, in part because of failure to agree on how the proceeds were to be split between the centre, the regions and the municipalities.¹ A few days later, Yeltsin nevertheless signed a decree allowing privatization for cash, justified by the urgency of making funds available for restructuring and, particularly, for the government budget (Blasi et al. 1997: 72–3).² As Sergei Pavlenko, director of the Center for Economic Reform, underscored to journalists: “We are not talking reforms. We are talking revenue generation” (Kennet 1995).

Unlike voucher privatization, which promised to raise no money, the cash phase aimed to do precisely that. Also, it opened the possibility of avoiding a diffuse insider-dominated ownership structure. Furthermore, it aimed to create new owners who would pay firms’ debts, particularly their tax liabilities, and who would promote productivity improvement, particularly in export sectors. Lastly, as earlier in the 1990s, this phase had political objectives to further dismantle the state sector in advance of parliamentary and presidential elections.

We see this period as a turning point. From June 1994 until the presidential elections of 1996, the government struggled to continue to implement a reform agenda. In order to do so in the face of parliamentary and other opposition, reformers paid a price. That was the transfer of even more production to even larger insider-controlled industrial giants, whose regional power was consolidated by new Financial Industrial Groups (FIGs). However, this was not a defeat for the government as a whole, rather a victory for those within the government who saw the creation of such enterprises as beneficial for industrial policy.

Despite, indeed in part because of, parliamentary opposition to privatization and rising concern for national security in strategic sectors including oil, the government resorted to the device of loans-for-shares, successfully transferring shares in a number of companies to consortia of banks by offering the shares as collateral for loans which were unlikely to be repaid. “Loans for shares”, Treisman (2010: 216) writes, “was a way to circumvent the Duma’s ban on privatizing oil companies and get private entrepreneurs into management positions.” Kokh (1998: 105), who was involved in the implementation of the LFS, writes that the government would not repay the loans: “after all, the point was to inject huge sums of money into the budget, not to pay them out”.

The LFS programme, which was developed during 1995, was initially opposed by reformers including Dmitry Vasiliev and Anatoly Chubais.³ But it was to open up the sale of firms of significant value even in strategic sectors.⁴ It brought revenue to the state and great profit to the banks that held the shares. Further, by backing the banks in their plans to address management problems at the enterprises that had been sold, the government did help restore the momentum for privatization, which had been slowing since 1994.

However, the LFS device had a cost. In its execution it became a poster child for insider dealing and corruption. The subsequent appointment of Vladimir Potanin as a deputy premier to the 1996 Yeltsin government only reinforced the view, fair or otherwise, that Russia was yielding some considerable political control to the bankers who had benefited from cash privatization.

To be sure, the corruption of some aspects of the privatization process was especially visible during the LFS scheme. This in turn raised further questions about the legitimacy of the buyers, which was, as discussed in Chapter 3 above, the problem of cash privatization: if cash was to be used in privatization, this could benefit only those who had cash. But hyperinflation had wiped out any cash that ordinary Russians might have had. Thus, only those who had been able to protect their money, by legitimate or corrupt methods, could bid for privatized firms. However, privatization did not cause corruption in Russia; nor did it create a special elite of oligarchs, especially given that the red directors were the main beneficiaries of privatization (Treisman 2010), as discussed below.

We have seen that, even during voucher privatization, proposals were being put together by “associations” of companies, often modelled on the old Soviet ministries. These plans were supported by members of the government, but were to some extent hindered by the design of the voucher privatization programme.

In August 1994, a similar proposal for the creation of Financial Industrial Groups (FIGs emerged from the State Committee on Industrial Policy) envisioned the creation of two or three such groups in each sector. Cash privatization facilitated this process since companies could use their own cash to buy one another. Particularly in the regions, cash privatization assisted the consolidation of powerful and politically connected formal and informal FIGs, which were given considerable policy support in view of their potential infusion of investment resources into firms. Barnes (2006: 119–40) shows that FIGs established strong links in this period with regional authorities through cash privatization, thus advancing the business-political nexus in the regions, as well as fostering nepotism.⁵ Lieberman and Kopf (2007: 326) tie the LFS auctions to a clearly emerging industrial policy in the Chernomyrdin government:

The LFS transactions deepened the government’s commitment to an industrial policy focused on large regional and national FIGs. This policy implied an increase in the concentration of corporate ownership, less competition, and more government intervention in the economy. The Russian economic model, therefore, was not modeled after competitive Western markets but Japanese keiretsus and Korean chaebols.

The creation of large industrial holding companies was not an objective of cash privatization. There were other government policies (which during 1992–94 the reformers had resisted) that encouraged the establishment of FIGs. However, any cash privatization that aimed to fill budgetary gaps, but that de facto excluded foreign buyers, would discover that the only likely sources of income were the enterprises themselves. The LFS, therefore, was only one part of a far from coherent industrial policy.

Finally, the course of privatization cannot be divorced from larger political events. The Yeltsin government was losing popularity. Its decision to go to war in Chechnya in December 1994 made things worse. The war was opposed by reformers in parliament, and this would have done little to ingratiate them with the government. The subsequent poor showing of the reformers in the December 1995 parliamentary elections further weakened their influence. Throughout the period, Russia was plagued by economic problems, and, by early 1996, those around Yeltsin were more focused on winning the summer presidential election, a campaign that was headed by Anatoly Chubais, than on promoting a coherent reform programme.

We begin our review of privatization after 1994 with the controversies raised in the literature about the LFS. We then summarize the arrangements in 1995 – the LFS scheme that emerged in response to a proposal by a consortium of bankers in March 1994. We then emphasize the historical context of Russian decision making in 1995, which influenced outcomes of privatization programmes of the mid-1990s.

Interpretations

Most works on transition Russia see 1995 as a turning point in the specific sense that corruption, seemingly, became suddenly widespread. Treisman (2010: 208) summarizes the general view as follows:

Widely condemned, it became a symbol of all the errors and sins – real or alleged – of Yeltsin’s reformers. The program was a “Faustian bargain”, wrote one journalist, a “fiendishly complicated scheme”, in which the liberal ministers had sold their souls to a cabal of unscrupulous tycoons, who – switching metaphors – quickly metamorphosed into a “Frankenstein’s monster”. It “deformed the economy”, “impoverished” the population, and laid “a corrupt, inegalitarian foundation for everything that came after it” (Freeland 2000: 22–3, 169–89). Under loans for shares, contended one Nobel-prize-winning economist, the country’s best firms were stripped of their assets. The enterprises were left on the verge of bankruptcy, while the oligarchs’ bank accounts were enriched (Stiglitz 2002: 160).

Three entire books (Freeland 2000; Klebnikov 2000; Hoffman 2002), drawn from interviews with journalists, oligarchs and other observers, contend – in a widely accepted understanding – that LFS created the oligarchs (Barnes 2006: 110). They argue that the oligarchs thereafter dominated the economy and entered politics in the late 1990s, and thus LFS caused the widespread corruption in the late 1990s.

In our view, and in accord with Treisman (2011) and others (Guriev and Rachinsky 2005; Barnes 2006), this postulate regarding how the oligarchs emerged is overly simplistic.⁶ Former Soviet-era directors were the main beneficiaries of the LFS, not the “new” oligarchs (Guriev and Rachinsky 2005; Treisman 2011). Moreover, in terms of their impact on output, pledge auctions resulted over time in performance improvement by those firms managed by the new outsiders. The same cannot be said about firms managed by so-called red, former Soviet-era, directors (Treisman 2010: 218).

Treisman observes that the scale of the programme was more modest than has been suggested. Initially, 29 enterprises, including Gazprom and UES, were to be part of the LFS process. By the end of the programme, only 12 auctions had taken place, with some projects being removed because of managers’ resistance and others because no bids at all were offered (Treisman 2010: 209). Perhaps more importantly, privatization was not the only, or even the primary, means by which insiders siphoned value from companies.

Another contentious point is that the LFS enterprises were thought to have been abandoned in a near bankrupt state to oligarchs, who proceeded to strip their assets. To the contrary, the story of Norilsk Nickel suggests that those who were in control before the pledge auctions were siphoning off funds. Before Oneximbank acquired its shares, a huge proportion of the company’s output was sold through related companies. Glencore, a major western purchaser, claimed that it had been unable to buy Norilsk Nickel output for five years except through intermediaries. The suggestion must be that the intermediaries were acting on behalf of company insiders, but not in the interest of the company itself.⁷

Economists would rightly point out that such practices were exactly what one would expect when control rights are divorced from cash flow rights. Those in control simply channel valuable assets through companies that they own. No investment is encouraged. With ownership of the enterprise in the same hands as those entitled to control, it makes sense to invest. Thus, some oligarch-controlled companies were subsequently transformed. As Treisman (2010: 220) notes:

Between 1998 and 2003, annual – upstream – investment in the two oligarch-controlled oil companies Yukos and Sibneft increased by about 140 per cent… . In the first 10 months of 2003 (before the Kremlin’s assault), Yukos’ upstream investments came to $1.1 billion, substantially more than those of any other Russian oil company. By 2005, Noril’sk Nickel was investing more than $700 million a year. There is no evidence here that the oligarchs’ companies were increasing their capital spending more slowly than their counterparts.

This said, and as discussed below, the LFS procedures were very shady. Bidders were excluded, often on what seemed like invented technicalities. Foreigners in particular were not allowed to bid in many of the auctions, while the bankers who organized the auctions also bid for (and won) the assets at the stage of loan granting, and then subsequently when the shares were sold. This side of the LFS has been closely tracked by Ira Lieberman (Lieberman and Kopf 2007). Since Lieberman also focuses on the LFS agreement as part of a critically important development beginning around this time – regional support for the emerging powerful FIGs – it is worth touching on how the LFS programme worked.

Summary of the LFS arrangement

In March 1995, a consortium of nine banks proposed to supply a loan of nine trillion roubles ($1.84 billion) to the government, holding as collateral the shares in valuable enterprises. These were to be held in trust until the loan was repaid (initially by 1 January 1996, though this deadline was later extended to 1 September 1996, after the presidential election, thus marrying the fortunes of the banks to the electoral fortunes of the then unpopular President). In the event that the government defaulted, the shares would be sold, and the banks repaid from the proceeds. In addition, the banks would receive 30 per cent of any profit made on the sale.

The proposal emerged as the government was struggling politically and attempting to find a solution to the lag in privatization receipts. In April of that year, privatization had raised only 100 billion roubles out of an annual target of 9,000 billion. By August that figure had only grown to 200 billion.⁸ The proposal was also attractive because it circumvented the Duma. It was not clear that the government had the power to privatize these companies. However, it did have the right to offer their shares as collateral and to default on the loan. As Kokh (1998: 105) noted, “at the expiration of the term of the loan in a future year … the ban on the sale of oil shares that our friends in the Duma had hung around our necks would have expired”.

Given the strength of opposition in the parliament, foreign investors were excluded from many of the auctions. Those likely to benefit were the leading bankers who were, as we have noted, among the few investors in Russia with sufficient cash to offer credit. Many of them were already part of FIGs, and had the expertise to demand change and, of course, to serve later on as financial intermediaries in the sale of these assets (Radygin 2000).

The banks proposed to undertake enterprise restructuring, to pay delinquent arrears of taxes and wages, and to forgo interest. Their returns promised to be substantial in profits from later privatization (Brown et al. 1999). The leader of the consortium of banks that proposed the loan, Vladimir Potanin,⁹ president of Oneximbank, assured the government that even as “temporary” owners, the banks would make investments in Yukos, Sidanko and Sibneft, Lukoil and Surgutneftegaz, where improved productivity would show the benefits of privatization to the electorate. Some government officials agreed. The Minister of Finance Vladimir Panskov commented that, moreover, the LFS would set appropriate incentives for the banks and, if successful, strengthen the banking sector,¹⁰ since, if the government did not repay the loans, the financial sector would gain by an infusion of 30 per cent of the capital gains, with the rest going to the government. At the time, the banking sector in Russia was very unstable¹¹ and had begun to expand into insurance and real estate, rather than providing resources to the real economy.

The consortium of banks also seemed likely to be useful for political and policy objectives. Support by powerful bankers could help overcome arguments for renationalization. By pitting the weight of the banking sector, whose owners had interests in the media, against the opposition, the government may have hoped further to secure their political backing for the presidential election, although bankers would scarcely have promoted Communist candidates (Treisman 2010).

Reformers diverged in their views about whether to accept the proposal. Some were not convinced.¹² Privileges in the economy being offered to a small group of bankers, writes Dmitry Vasiliev, then deputy chairman of the Federal Commission on Securities and Capital Markets, are not “helpful for Russian economic transformation… . Monopolization is what we’ve been fighting for a long time” (Kaban 1995). Chubais took a similar position. From the affected sectors and regions, also came a vigorous and effective defence of preserving the state sector as it was: industrial ministers strongly opposed the proposal, laying a foundation for their refusal to participate, firm by firm.¹³

In the end, from a list of 29 firms to be pledge auctioned, the bankers in the consortium obtained mostly minority tranches of shares in 12 large, state-owned corporations in return for loans to the federal budget of about $800 million. By 1 January 1996, 12 pledge auctions were completed. Besides Surgutneftegaz, the companies included oil corporations Lukoil, Yukos, Sidanko and Sibneft, as well as nickel producer Norilsk Nickel, and Mechel and Novolipetsk Steel Works. Notably, UES and Gazprom were taken off the list of companies in the LFS programme.

In its final form, the government decree of 31 August 1995, together with further amendments, showed, at least on paper, that the government had listened to some of the criticism in the months after it was proposed. The banks would not be allowed to sell their shares until after 1 September 1996, and the auctions were opened up in principle to include other bidders – both foreign and domestic – with the assurance of a transparent, open and competitive process (Lieberman and Kopf 2007: 303). However, there was a huge gap between any notion of a fair process and what actually took place.

The historical context

1994

In October 1993, Yeltsin won the showdown with parliament. But in the subsequent elections for the Duma in December, the Communists, the Agrarians, and Zhirinovsky’s anti-reform party received 50 per cent of the list vote.

In theory, the agenda of the reformers was straightforward. As Vladimir Brovkin, a historian of the Mensheviks, described the task in principle:

What the democrats must do is to reshape economic policies in accordance with the wishes of the electorate. This means, in practical terms, to put an end to corruption, stop mafia control of retail trade, create a functioning banking and credit system and regulate privatization in the interest of common people rather than mafia bosses.

(Brovkin 1994)

Realpolitik was much more difficult. There was little consensus on what to do; even the views of Prime Minister Victor Chernomyrdin, who had once compared voucher privatization to Stalin’s forced collectivization of agriculture in the 1930s, were shifting. At that time, in December 1992, as Chernomyrdin was chosen to take over the government, there was the real possibility that the programme would be halted. In fact, the reformers were strong enough to maintain the voucher programme, which Chernomyrdin endorsed, choosing to work with the reformers. However, in January 1994, Yegor Gaidar and Boris Fedorov, two of the key reformers, both resigned. Gaidar’s replacement as first deputy prime minister was metallurgist Oleg Soskovets, who “lobbied unabashedly for state credits, bailouts, and tariff barriers” during the next two years that he worked under Yeltsin (Colton 2008: 336). Chubais was the only reformer in a senior government position, as deputy prime minister in charge of privatization.

In March 1994, Chubais announced that some of the country’s largest companies from the energy sector and once top-secret military factories would be made available to investors. Hoping to encourage the use of vouchers before they expired at the end of June before the start of cash privatization, he declared: “In an unprecedented move, we will present the super-effective, super-profitable firms for the final stage of privatization” (Tolkacheva 1994). But later, the cash privatization plan met with resistance from parliament, which rejected it on first reading in July 1994. The programme thus went into effect by decree, but, effectively, privatization became voluntary (Liesman 1994).

Moreover, the pool of small investors threatened to shrink throughout 1994 amidst numerous scandals and schemes.¹⁴ The most spectacular of these scandals, and one which perhaps serves as a metaphor for the state of the capital markets in Russia at the time, was the collapse of MMM, which turned out to be a Ponzi scheme. A Ponzi scheme is an investment operation in which depositors’ money should be protected but is instead used to pay dividends to earlier investors. Of course, it all ends in tears when new investors cannot be found and depositors realize their money is lost. It is estimated that MMM resulted in losses for at least five million Russians. It had advertised on state television channels, its advertisements featuring one Lyonya Galubkov, who claimed that, with MMM’s investment returns, a “common man” had bought a Paris apartment. MMM sponsored the Russian football team, provided free travel on the Moscow underground, and encouraged its share certificate to be used like cash. The price of MMM shares had risen from 1,600 roubles in March to 115,000 roubles in July. But the authorities either had little legal recourse or chose not to use it. As numismatist Peter Symes points out: “Although the Russian authorities had investigated [MMM] on several occasions, they had done nothing to alert people to [its] activities. Simply put, a pyramid scheme was not illegal in Russia.”¹⁵

MMM’s fantasist director, Sergei Mavrodi, was eventually brought to book on tax evasion charges in August 1994. However, he successfully shifted the blame, at least in the eyes of the populace, claiming that the government had “provoked the panic among MMM investors to eliminate what had become a powerful political force”.¹⁶ The government, for other reasons, had indeed failed investors in its ineffective watchdog, the Commission on Securities and Stock Funds (Gustafson 1999: 152). The collapse of the scheme thus boosted Mavrodi, now a household name, and he gained a seat in special parliamentary elections in October.¹⁷

Meanwhile, the Russian economy was weak. To be fair, inflation was declining, but from 839 per cent in 1993 to just over 410 per cent in 1994. But export revenues were weak. The government cancelled tax exemptions for oil exporters in May, and discussed through the summer the critical step of scrapping oil export quotas and licences to improve the budgetary situation. The summer ended, however, with continued support for the agricultural lobby in large credits going to agriculture. Output and investment continued to fall.

Nevertheless, even during this period there were some promising developments. In the summer, the State Committee for Statistics declared that one million new businesses had been created in Russia since 1992. Gazprom announced its intention to sell 9 per cent of its shares to foreign buyers to pay for pipeline upgrades (OADB, 11 August 1994). But more critically, the Duma passed a new Civil Code, which, in theory, as McFaul (2001: 253) remarks, “established the legal and economic institutions to guarantee both private property rights and the enforcement of contracts”. He goes on to suggest that “progress on this monumental code suggested that the agenda of parliament had changed fundamentally … the question was no longer whether but rather what kind of market economy would develop”.

That said, by the end of 1994, prospects for privatization looked bleak (Treisman 1998: 245). In October, the rouble collapsed in the panic of Black Tuesday, raising risk for strategic investors. In the same month, the state had reached only one-quarter of its privatization target (Barnes 2006: 115). The number of mid-sized and large privatized enterprises actually declined in 1994 (Blasi et al. 1997: 189). Some 40 per cent of Russia’s enterprises had not yet been privatized, with the state still holding large stakes in those that had (Barnes 2006: 114–15).

October also brought strengthened calls in the parliament for renationalization, leading in November to the removal of Anatoly Chubais as head of privatization. He was promoted to deputy prime minister for economic affairs, but was saddled with Vladimir Polevanov, an unknown, as head of the GKI. Polevanov had formerly served as the acting head of the Amur region and was a geologist with no previous experience in Moscow and no economics education.¹⁸ His first public remarks alluded to privatization as a threat to national security (Kokh 1998:74).¹⁹ He proposed a Federal Nationalization Law, for example, to enhance the role of the state in strategic sectors and attacked voucher privatization as having “weakened national security”. He proposed to reverse privatization in oil and aluminium.²⁰

Then, in December, Yeltsin approved the invasion of the breakaway republic of Chechnya: “A military disaster”, one observer called it (Durden Smith [1995]). Russian forces moved against Grozny from December 1994 to March 1995, destroying the city. The Russian forces became demoralized when the Chechen populace threw their support behind their own leader, Dzhokhar Dudayev (Lapidus 1998). In the Duma, Russia’s Choice, Gaidar’s reformist party, generally opposed the invasion, thus distancing itself from Yeltsin.

1995

Nevertheless, in early 1995, reformers succeeded in getting Polevanov dismissed, and a privatization programme of sorts continued. In April, the IMF approved one of the largest loans it had ever given, a $6.8 billion stand-by credit. Approval came with Russia’s commitment, as Michael Camdessus pointed out, to “a strong program, which, if fully implemented, will achieve macroeconomic stabilization and accelerate structural reform”.²¹ However, the terms of disbursement were stiff. The IMF imposed a monthly, instead of a quarterly, review for disbursement of tranches of the loan, and among conditionalities were the reduction of the deficit from over 10 per cent to 8 per cent of GDP and a fall of the monthly inflation rate to 5 per cent.²²

The uncertainties about outcomes of the 1995 privatization programme grew, as the investment environment worsened. The attraction of Russia as an investment target was fading with continued inflation, uncertainties over the disbursement of the loan, news of the war in Chechnya, the collapse of the Mexican peso and parliamentary enthusiasm for renationalization. At the beginning of 1995, forecasting a seriously weakened economy, Jeffrey Sachs and one of Yeltsin’s own analysts, Mikhail Deryagin, felt it was possible that Russia was no longer on a steady course towards stabilization (Treisman 1998: 245).

Privatization slowly continued. Little cash was being raised, and according to Blasi et al. (1997: 74), “‘auctions’ were wide open to domination by insiders and back room deals”. In May, due to pressure on the federal government, Yeltsin issued a decree that diminished the proportional amount that the regional governments could take from sales. This only decreased incentives for regional governments to participate. The sale of some 136 large companies had to be postponed (ibid.: 73–4). Numerous problems arose in this new phase of privatization: the setting of excessive minimum prices for large stakes, which discouraged buyers, and the reverse – the selling of smaller stakes at excessively low prices – which promised to lead to no capital investment. The one instance when the government chose to display a careful and transparent approach, the attempted privatization of 25 per cent of Svyazinvest, a holding company that held over one-third of the stock in 85 regional telecommunications firms, carried out by Maxim Boycko, then head of the Russian Privatization Center, with the assistance of N. M. Rothschild & Sons, failed when Stet of Italy, the winner of the tender, wanted to put its $640 million in an escrow account and the Russian government broke off negotiations.²³ The government proceeded with the sale only in 1997.

By autumn 1995, privatization targets looked less and less achievable. By year’s end, block sales had produced only 1.5 trillion roubles, instead of the expected four or five trillion, from the sale of valuable enterprises. In 1995, only 6,000 enterprises in all were privatized (5 per cent of the total number privatized) and most of these were small (fewer than 200 employees). Only 20 per cent of them were in industry (Radygin 1996: 5). Only in August 1995 did the private sector surpass the state sector in regard to total number of enterprises, and the share of the state in manufacturing still exceeded that of the private sector.²⁴ The bond market was active, but Russia’s deteriorating assets were not attracting strategic investors. Foreign direct investment in 1994 totalled $1.2 billion, one-sixth of the IMF loan, and by August 1995, in view of the continuing deterioration of the country’s “legal and tax mess”, the situation looked far worse, with only $500 million invested from abroad.²⁵

The bankers’ LFS proposal, first made in March 1995 and effected by decree at the end of August, was therefore timely, and it was accepted in a period when the government believed privatization to be failing. The reformers, some of whom initially opposed LFS, as noted above, had little alternative. At the end of 1995, the pro-reform party was defeated in the December parliamentary elections, with opposition parties winning a greater share of the vote. In other words, the new parliament was even more conservative than the 1993 parliament. Gaidar’s party won less than 4 per cent of the vote, down from 15.5 per cent in 1993. Chernomyrdin’s party, Our Home is Russia, was the main beneficiary.

In this context, again, the presumed political rationale of LFS – that is, the threat that privatization might be reversed if Yeltsin lost – emerges. In February 1996, Zyuganov had declared his intention to undo the “criminal” sales, should he become president, thus doubtless putting further offside the influential group of bankers.

Indeed, by 1996 the presidential election campaign was the political priority. But Yeltsin signed a land decree, confirming private property rights to arable land. This was a major step towards rural markets, and it was possibly designed to appeal to rural voters. But at the same time, he criticized the Chernomyrdin government for “focusing on financial stabilization and forgetting about people living on wages and pensions”.²⁶ He indulged in giveaway economics with promises ranging from the payment of pension arrears to the fixing of church roofs. Indeed, so perilous was the financial situation that the government had to pass an emergency law in June 1996 to “raid” the resources of the Central Bank.

In political terms Yeltsin’s campaign, which was run by Chubais, was a huge success. He won the first ballot narrowly, but then proceeded to bring the nationalist, General Lebed, into his coalition and won the second round handsomely. He now had a coalition, which was generally supportive of market reform. Indeed, Potanin, the architect of the LFS, was brought in on 14 August as one of the three first deputy prime ministers under Chernomyrdin. In the meantime, Chubais was appointed as the head of the presidential office. So a banker who had organized the LFS was now inside the government as loans were defaulting and the shares were being put up for auction.

Whether or not Potanin used his power during late 1996 and early 1997, shares pledged under the LFS were sold to the banks that had extended the loans, despite the clear presence of a conflict of interest. Moreover, the purchase prices, at market prices at that time, were certainly regarded as low.²⁷

Following Yeltsin’s victory, further privatizations by auction took place under the leadership of Alfred Kokh, the new head of the GKI appointed in September 1996. On his appointment, he reflected that he “saw a space wide open for maneuver” and he “used it to the fullest extent possible” (Kokh 1998: 161).

However, the continuing privatizations brought new friction with the Duma; a Duma Commission even recommended the abolition of the GKI in April 1997. Nevertheless, in July of that year, the government and the Duma seemingly agreed on a new privatization law. It stipulated that there would be an agreed privatization plan each year. By that time, the principle of privatization seemed no longer to be in dispute. However, as regards the law itself, no agreed plans emerged and while privatization continued, the law itself was not fully enforced. The sales of shares also generated conflict between the banks themselves, particularly when Oneximbank won the Svyazinvest auction in the summer of 1997. Indeed, disputes within the government might have been increasingly interpreted as squabbles between contending oligarchs (Sakwa 2008: 188; Rutland 2009: 164).

For example, when Kokh resigned, he was replaced by Maxim Boycko, who had a reputation as an honest broker. Boycko, together with his mentor Chubais, was soon under attack over purportedly illegitimate advances for a book. The newspapers publicizing the story were associated with Boris Berezovsky, implying a feud between Berezovsky and Oneximbank’s Potanin, Chubais’s colleague.²⁸

The apparent warring between different business elites within the government was cited as one of the reasons why Yeltsin removed Chernomyrdin from his post as prime minister in March 1998, replacing him with Kiriyenko, a young reform-minded technocrat. Whatever the motivation, privatization continued, but there was little sense of a proper separation between financial interests and those of the government, which was supposed to regulate them.

The year 1998 ended with Russia defaulting on its debt, as tax revenues dried up. The rouble was devalued, and Kiriyenko was removed as prime minister. The pace of privatization slowed. But the relationship between private business and government remained unhealthily intertwined.

The period in perspective

McFaul (2001: 246) describes the period 1994–96 as “the end of market romanticism and the beginning of oligarchic capitalism”. In the first four chapters we described why the reformers might have been described as “romantic”. The objectives set for the Privatization Programme were well beyond what it could ever achieve within the reality of Russian political and economic institutions. As the programme moved to cash privatization, the stakes were raised, and the lack of that institutional infrastructure became ever more apparent. The demand for more cash to finance the government budget became a shuttlecock between the Duma, which wanted to spend but objected to privatization, and the government, which wanted privatization.²⁹

Yet it would be wrong to see privatization as uniquely responsible for the way in which industrial and political power developed during that period. The level of insider dealing was noted throughout Russian industry. However, like most activities of this nature, such dealings were often kept obscure. Insider dealing is encouraged when those who have control of an enterprise do not themselves own it and therefore have little incentive to manage it well, and instead direct it in a way that enhances their private advantage. This was what was happening in Russia. Indeed, one aim of privatization was to help reduce such mismanagement. We have already noted these practices being apparent at Norilsk Nickel, prior to Oneximbank’s intervention. Another example would be Gazprom, a company that Marshall Goldman focuses on in his book The Piratization of Russia (2004). Most of the scandals he describes at Gazprom are the result not of its privatization, but rather of the “lack of government ownership and lack of outside directors [which] allowed the management to treat the company as a cash cow for their personal projects” (Goldman 2004: 95).

During the period, opposition to the principle of privatization lessened. The key objections raised by parliament and others concerned the wrong-doing in its implementation. For example, in February 1996, parliament announced a full-scale investigation into privatization practices from 1992 to 1996.³⁰ Favarel-Garrigues (2011: 241–4) cites cases of corruption in the cash privatization era, including information about auctions conveyed only to a single interested party, assets negotiated before the auction process, fraudulent bankruptcy not covered by criminal legislation at the time, managers ostensibly acting as outsiders buying shares and benefiting from conditions normally reserved for workers’ collectives (ibid.: 243). Such instances were common throughout the privatization process.

However, the response to the inquiry was not to stop privatization, but rather to pass a new law requiring binding conditions for those who won the bidding and transparent procedures.³¹ Indeed, since parliament did not approve the privatization programme for that year, in fact the new law did not go into effect, and opposition to corrupt practices continued. So, at a time when markets were becoming accepted in Russia, privatization became symbolic of increasing abuse of power. Note that abuse in the privatization process may have actually required no more contravention of law than would be natural in other spheres of life. Khodorkovsky, for example, talking to Frontline about how he made his money, observes: “I made a choice for myself: I said that I will not break the law … I did not break Russian law, but everything else wasn’t my concern. If I saw a loophole I’d take advantage of it.”³² Without a proper legal or even cultural framework, the enterprises of Russia, state or private, offered a cornucopia of loopholes, which could be exploited by those who had the power to do so.

What went wrong with privatization in Russia was the absence of appropriate laws, routines and embedded culture required for well-functioning auctions in market economies. Blasi et al. (1997: 172) write:

The leading industrialized nations focused on privatization with the intensity of a laser beam and ignored the wide-ranging institutional development Russia sorely needed… . Much more should have been done more quickly to accelerate the development of stock markets, private bank lending to enterprises, mutual funds for citizens, investment banks, and clear and coherent reforms in Russian law, taxation, domestic and foreign investment, and trade unions.³³

In many senses, Blasi et al. are right; privatization was not “an end in itself”. To make sense in policy terms, changing the ownership of an entity will only create beneficial results if other conditions about governance, law, labour, goods and capital markets are met. But, in another sense, they are wrong. Western aid may have focused particularly on privatization, but advisers from the West were at pains to point out the need for corollary reform, and Russians in government committees were exhaustively working on building draft laws for many other reforms. And no western policy adviser suggested adopting the LFS programme or designed or oversaw its execution; and Russian reformers initially rejected the idea. There is scant evidence that private companies and privatization were unique in nurturing the improper practices that blighted this period. Rather, such practices, often more openly displayed in the privatization process, were apparent throughout commercial life in Russia. The laws, the institutions, the culture and the morality needed to sustain a market system were simply not in place.

What did cash and pledge privatization accomplish? In a limited way, in regard to selected pledge auctions, they brought much needed finance to the government and, subsequently, to a key export sector that had previously experienced a serious lag in productivity, deteriorating financial conditions, and infrastructure starved of investment. Coordinated with major reforms, opening the export sector to competition was a key positive outcome of the 1995 deals. In regard to the rest of the firms struggling with bankruptcy and the need for capital, policies of this period gave increasing support to the FIGs, which extended their influence over regional authorities and transformed regional politics in varying ways.

It cannot be said that Russia’s fragile market institutional development was ignored by lawmakers: Russian budget practice rapidly improved (Sinel’nikov 1995); a remarkably western Company Law was passed in 1995 (Black and Kraakman 1996). However, in Russia, as in other countries of the CIS, institutional transformation was slow. This was largely because the scale and complexity of the newly required institutions and structures were enormous. Finding legal “transplants”, and getting them to be accepted, in law, in enforcement and in practice, was an enormous task. Even if, as Blasi et al. (1997) suggest, foreign aid had focused first and most effectively on Russia’s market institutions, it is not at all clear that Russians would have been willing, for example, to adopt an equivalent of the EU framework that assisted transformation in accession countries of Central Europe. The Russian legal expertise that Russian reformers relied on had a strong base in imperial Russian and Soviet legal codified tradition. Informal arrangements based on legal understandings from the past, in extremely difficult conditions for Russian enterprises, contributed to the spread of shady practices, just as formal privatization procedures provided much of the opportunity for using such practices to advance.

Perhaps what is most important is that despite these problems, despite Russia’s history, and despite the strength of the opposition parties during this period, the fact that there was to be some sort of market economy in Russia became less and less an issue of political contention. McFaul (2001: 267) sees this taking place immediately after 1993. One might argue that the consensus was already building before that, and that those “defeated” in October 1993 were not advocating a return to the planned economy. Indeed, consensus might have been reached earlier had relations between the government and the Duma been better, had there been a clearer view of how policy would develop, and had there been a leadership more focused on what good enterprise management involved. But such was not the case, and it is not our purpose here to discuss counterfactual history. Rather, we would note that even with cash privatization, whatever its faults, money was raised, ownership was changed, and the political consensus did swing further away from any thought of a return to the planned economy of the past.