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. Last Updated: 07/27/2016

Should the Russians Give a FIG?

As Russia's centrally planned economy was dismantled, enterprises intent on salvaging their bargaining power with the state clung together. In an attempt to extract credits from the federal government, firms engaged in similar production activities formed "trade associations," which as early as July 1992 accounted for 25 percent of Russian enterprises and 40 percent of tle labor force. "Holding companies" subsequently emerged, which grabbed equity stakes in subsidiary firms, discouraging outsider share-ownership. Such trade associations and holding companies picked up the pejorative label FIGs, or financial industrial groups.


The relative merits of FIGs depend very much on whom you ask. Since the adoption of a presidential decree on FIGs in December 1993, they have been a hot topic. Many analysts view them as a hindrance to true privatization. Others see FIGs as a positive development, which avoid the "short-termism" of Anglo-Saxon capital markets. In fact, much of the reason for the lack of consensus about FIGs is that the term is so loosely used.


Specifically, one can distinguish between horizontal FIGs and the vertical FIGs. Horizontal FIGs, combining production units from one industry or from several, emerged when largely state-owned enterprises clubbed together. Vertical FIGs, in contrast, are owned mainly by private shareholders. More fundamentally, FIGs are vertical when the are not just production groups, but bring production together with other seeds of commerce: distribution, retail and particularly finance.


Given that federal subsidies are now scarce and enterprises are beginning to respond to shareholder pressure, Russia's horizontal FIGs are beginning to fade. Meanwhile, the vertical FIG is blossoming. Granted, there is often a gray area between the two models as several of the old horizontal holding companies have transformed themselves. But the typical vertical FIG has at its center a young and dynamic private bank which commands considerable equity stakes in a number of related commercial activities.


Vertical FIGs can be undiversified. An example is ALKOR -- the Aluminum Corporation of the Urals -- which is linked to Russian Credit Bank and covers the entire production process from smelting aluminum through to the production and distribution of finished products. But the most high-profile vertical FIGs are strongly diversified and have become commercial empires in themselves. Interros, set up around Uneximbank, combines Energia, an investment banking arm, with Microdin, a distribution and retailing entity, and deals in everything from automobile manufacture to food processing. The activities of Menatep, another vertical FIG, include pulp and paper, textiles and metallurgy.


Vertical FIGs in part reflect the ambitious nature of the new wave of Russian managers. Moreover, in a situation where credit risk insurance mechanisms are not sufficiently developed and contract law is ropy, part-ownership of one's business associates and even cross-holdings are a logical move. Vertical integration similarly ensures a sure flow of capital and other crucial inputs. Low liquidity and a tradition of barter relationships have also added to the trend. Vertical FIGs have allowed companies to make progress with long-term investment projects despite institutional inadequacies.


So should FIGs be encouraged, or discouraged?


Vertical FIGs may be more able to cross-subsidize the development of high-tech production techniques, encouraging industrial restructuring. More generally, lending decisions made within FIGs on nonmarket criteria may avoid the short-termism of British and American banking systems. In the U.K., where bank equity stakes are low, only 19 percent of lending in 1992 was for more than four years. In Germany, where banks have large equity stakes, the comparable figure was 50 percent.


British and American banks themselves have private shareholders who demand very high rates of return. Within a vertical FIG, though, lending can take place which takes a favorable view to infrastructure investment and worker training, activities which are not immediately profitable, but are crucial to contemporary Russia. Moreover, Russia's vertical FIGs are currently forming interregional networks that spread commercial vitality.


But should banks take such large equity stakes? It is not as if they are experts at restructuring enterprises. And given the legal and political doubt currently weighing down Russian stocks, well-connected banks currently benefiting in government sell-offs will make huge medium-term gains on their holdings without lifting a finger. This spreads skepticism toward the market mechanism, undermining reform.


Legislation may be required that separates Russia's stock market from its money market. In an environment of low liquidity, while depositors remain jittery about the ruble and skeptical about banks in general, heavy equity exposure is dangerous, even for the most well-established FIGs. Very few of Russia's banks currently have the capital base to manage long-term investments while meeting their short-term call liabilities. In addition, vertical FIGs will lead to a heavy degree of medium-term market concentration, hindering small firms from entering the market and encouraging competition.


The bottom line is that the current high equity holdings by Russian banks have more to do with the race for asset accumulation than anything else. In some senses, there is currently no time in Russia for the subtleties of western competition and industrial policy. The policy of the government should be to push state assets into the private sector to strengthen the pro-reform lobby.


It is still not clear whether the emergence of the vertical FIG in Russia will lead to a high degree of bank equity holding in the long term, with the government picking winners in sectors with "genuine market advantage according to transparent criterion" in the same vein as the German-Japanese model. In fact, it could be argued that the current predominance of vertical FIGs will lead to a trust-busting culture such as that which swept the United States post-Rockefeller and continues to shape the American corporate psyche today, resulting in a relatively deregulated financial environment.


What is clear is that highly diversified vertical FIGs will continue to exert considerable political clout to maintain and strengthen their market advantage for several generations. The fusion of money and politics is indeed a messy, immoral and unmeritocratic process. But it is the basis of liberal democracy the world over.