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. Last Updated: 07/27/2016

Insider Banks Rebuild the Soviet Monopolies

Slowly but surely, after several generations of state planning, the monopoly is coming back to Russia. According to the state committee on industrial policy, 30 so-called financial-industrial groups, which combine industrial interests with those of a bank, have been registered with the government.

Some of these groups are said to exist only on paper, but there are many more which remain unregistered.

A number of Western commentators find the trend alarming and think that the impact on the economy will be negative.

Jeffrey Sachs, a Harvard economics professor who has previously advised the Russian government, says "the second stage of privatization appears to have delivered literally tens of billions of dollars of state assets in the oil, gas and metals sectors to powerful insiders in the government and the commercial banks."

Boris Jordan, chief executive of the Moscow investment bank Renaissance Capital, said in a recent presentation that the rise to prominence of FIGs could imply not only the re-emergence of monopolies, but a lack of transparency in business dealings in both the financial and industrial sectors in Russia.

Charles Blitzer, chief economist for the World Bank in Moscow, calls the growth of the new quasi-monopolies simply "worrisome."

Western observers can be expected to be critical: FIGs are, by definition, nationalist and protectionist, and most certainly bad news for foreign investors. In fact, their place in industrial development may be to substitute foreign investment.

The Asian Model

The development of financial-industrial groups puts Russia on a path to an Asian economic model, rather than to an Anglo-Saxon one of stockmarket-fueled capitalism, which Western reformers have seen as going hand-in-hand with the progress of democracy.

While in Germany banks have high equity stakes in industry, there are generally not groups of companies clustered around a core bank, all with inter-related shareholdings. This model, which Russia is emulating, is based instead upon Japan's keiretsu groups and South Korea's chaebols.

The rise of the FIGs has come about rapidly. The mass privatization of Russian industry was intended to break up many of the country's largest industrial conglomerates into small pieces. The privatization process split shareholdings, in some cases, among tens of thousands of individual holdings. Yet within a couple of years, renewed industrial agglomeration -- and what is more, a fusion of banking and industry -- has become one of the most important themes of Russian business.

The rise of the new groups should not come as much of a surprise: The liberalizing centrifugal forces within the Russian economy may have been strong, but they were short-lived. Now traditional centripetal tendencies prevail, increasing industrial concentration.

One of the surest ways to make money in Russia since 1992 had been to be on the receiving end of an interest-free loan from the Central Bank. During the years of high inflation, it was an almost effortless process if one had the right connections -- as many banks did -- to float Central Bank credits on the interbank market at significant profit.

As a result, banks are among the only institutions in Russia with money to spend. So it can hardly be news, now that inflation has tumbled, and with windfall profits from loans and currency speculation harder to come by, that it is banks that are buying up industrial assets while they are still going cheap.

Another way to make money as the borders began to open was as an importer and exporter. Here too, groupings of trading companies have coalesced into larger and larger units.

Nor should it come as a shock that Russian companies in the same industry should be aligning themselves. In a situation where credit risk is almost impossible to ascertain and insurance mechanisms are dicey, part-ownership of and cross-holdings with one's business associates makes sense.

Moreover, the coming-together of companies in the production chain in the same industry smooths input flows in a market where delivery can be highly unreliable. Such arrangements allow long-term investment projects to happen despite the inadequacies of Russia's financial institutions.

Also unsurprising has been the rise of industrial groups centered on old Soviet lines of influence to the government. When Russia's credit squeeze began to bite during 1992 and 1993, a common tactic used by enterprises looking for state credits was to form "trade associations" and lobby the government collectively. "Holding companies" also emerged -- large umbrella firms used by apparatchiks to grab shares in subsidiaries, preventing "outsiders" from gaining a look-in. Some of these holding companies were in effect privatized branch ministries, the most notable case being Gazprom, the state gas monopoly.

All these structures and groupings are widely being labeled as financial-industrial groups. In fact, the term is a coat of many colors.

Horizontal and Vertical

FIGs can be separated into two basic groups: horizontal and vertical. Trade associations and holding companies can be labeled "horizontal" FIGs, as they combine firms engaged in similar production activities.

There are "vertical" financial-industrial groups, which link the production processes in a single industry -- in mining, for example, a FIG might extend from extraction of raw materials to the production of finished metal and even to products manufactured therefrom.

A second way of defining FIGs is to look at whether they come from new or old structures. There are those connected to old Soviet companies who clubbed together to lobby the government for credits.

The new "zero-bank" FIGs, on the other hand, are related to banks that were founded in the early 1990s. They typically have at their heart not a set of "red" enterprise directors, but a private bank holding considerable equity stakes in a number of related commercial activities.

Many of this new set can also be viewed as vertical FIGs -- they are not simply production groups, but often bring together many aspects of commerce, including distribution, retailing and finance. Bank Menatep, for instance, has extensive interests in metallurgy, chemicals and food processing. Similarly, Alkor links metals companies from ore extraction to production of finished goods.

The highest-profile FIGs are both vertical and new, but have also diversified themselves horizontally into financial empires.

Uneximbank, the best-known and best-connected within the government, was formed only in 1993, but closely connected with the old Soviet Vnesheconombank and Soviet external trade structures. Inkombank, which brings together 29 companies, is also a new player, as is the Rossiisky Kredit group of 32 companies.

These industrial empires alone are a huge potential force on the Russian market. Of the top four private FIGs, Uneximbank and Menatep are definitely the two frontrunners in terms of share ownership. However, Rossiisky Kredit and Inkombank are on their heels.

Added to their ranks should be MOST-Bank (42 companies), which is usually thought of separately, due to the particular political links of its president, Vladimir Gusinsky. MOST is traditionally seen to be pro-Yabloko: The other FIGs, while they diversify their political portfolios, are generally pro-government.

The government recognized the emergence of FIGs in December 1993, with a decree that attempted to register them and limit the activities of those linked with the state.

The purpose of this and later decrees was apparently not to limit the growth of FIGs, but more to institutionalize and channel the means by which they could receive state assistance.

Advantages conveyed by the legislation included the ability of such conglomerates to consolidate accounts, thereby allowing a company to cross-subsidize activities and reduce profit tax. Another advantage is that FIGs are first in line for any state investment credits.

The extent of these advantages is not clear. It is at the government's discretion whether any tax breaks are given to any individual financial-industrial group, and there are certain limits on how these concessions can be applied.

Meanwhile state investment credits are becoming scarcer and scarcer. Many de facto FIGs are not officially registered.

Nevertheless, the means exist for the government to encourage FIGs.

But should it?

The proponents of financial-industrial groups in Russia argue that a cartel-like industry structure will foster growth, not strangle it. They look approvingly toward the role such groups have played in the Japanese, and more recently Korean, industrial renaissance.

Corporatism in Japan

At first sight, there are many parallels. The circumstances of the re-forming of the pre-war industrial zaibatsu groupings in Japan under the new term of keiretsu has many similarities with today's Russia.

In war-ravaged Japan, as in modern Russia, the bureaucrats who controlled industry were afraid that well-financed foreign companies would take advantages of Japan's weakened circumstances to buy up its few promising industries. The bureaucrats picked a few key sectors, nurtured them, and protected them from foreign competition. They channeled funds to their chosen industries via the banks which lay at the heart of each keiretsu group. Favored companies could be assured of financial backing to carry them through market troughs and macro-economic squalls, and were left to concentrate on growth.

The rest is history. Japan's momentous economic rise, possibly the most dynamic economic transformation ever, was undoubtedly due in major part to the keiretsu policy. Moreover, it was achieved without foreign assistance: While foreign technology was frenetically imported via licenses, or sometimes just imported, until the 1970s the door was nearly always kept shut on foreign firms.

If the overseas expansion of Japanese industry has slowed, the Korean chaebols are still repeating the model. Their preparedness to take risks in difficult markets is everyday in evidence as they increase their presence in a host of Eastern European countries.

The keiretsu industrial structure has permitted a focus on market share rather than profits, on long-term position rather than short-term gain. It has driven success in such fast-growing industries as consumer electronics, which demand both heavy capital investment and large-scale international presence.

But all this does not necessarily imply that such economic success can be repeated in Russia. It was largely built on advantages which Russia does not possess.

The keiretsus and chaebols had strong foundations in the extremely high practical technical education of their work force, and on its remarkable manufacturing dexterity and efficiency.

Anyone who has visited a Japanese factory and seen the spotlessness and the smiling staff doing aerobic exercises in a tropical lunch break will know that this is no normal workforce. Its productivity supports all the excesses of the expense account quarter of Ginza in Tokyo and the corruption from which Japan is far from immune.

A lesser-known aspect of the keiretsu groups, which has no doubt contributed to their success, is that they are much less monolithic than might be imagined. Kenichi Miyashita and David Russell, in their book "Keiretsu: Inside the Hidden Japanese Conglomerates," explain that though the structure of keiretsu appears to be one of large vertically integrated companies, in fact they are not at all.

Japanese big business, particularly in the electronics business, is normally built upon a myriad of subcontractors. These firms, often family units and crammed into narrow lanes in city centers, are pushed hard by the layers higher up the pyramid, and have been pushed harder in the recent slump in Japan. Sub-contractors are key to Japan's remarkable productivity and just-in-time manufacturing supply systems.

One of the most interesting aspects of the keiretsu phenomenon is how they have maintained relative dynamism in a protected environment which, all things being equal, would naturally tend toward complacency and inertia.

Their external focus on export opportunities in highly competitive markets must be an important reason. This does not explain in its entirety how Japanese manufacturing has become a worldwide model for the speed with which it brings new products to market. The reasons for this must be quite largely cultural.

Russia, in comparison, has a lacklustre industrial tradition. The country's biggest car plant still produces a version of a '60s Fiat model in the guise of the Zhiguli. In Japan, a new model would have been introduced every year or so.

If one applies management analyst Michael Porter's theories of the competitive advantage of nations to Russia, the country must play not to manufacturing, but to its national wealth in raw materials.

Is further consolidation necessary in the raw materials business? In oil, arguably yes. The capital, lobbying clout and exploration and production expertise of the "seven sisters" give them global power. After privatization, the Russian oil industry is splintered.

To make bigger oil groups it is not necessary to let oil companies fall into the hands of banks, as happened when Menatep bought a controlling stake of Yukos. According to oil industry analyst Stephen O'Sullivan of MC Securities in London, in the global context oil companies tend to have a diverse shareholder base.

It so happens that the sole Russian oil company to throw off provincialism and emerge as a major energy player on the international stage is a company which has remained outside a FIG -- LUKoil. Big energy companies sitting on major quantities of natural resource assets should be able to raise substantial amounts of capital internationally -- as LUKoil plans to do -- and so should not need to recourse to a close link with a rich bank.

In many other industries away from the consumer sphere, size is not essential to success. The German economic renaissance during the 1950s was driven by smaller and middle-sized companies, the so-called Mittelstand sector. Italian export success, too, is heavily dependent on smaller, family-owned firms.

Half-way Monopolies

Some economists say that Russia has a long way to go before it has keiretsu-like domination of its economy.

In fact, the common image of the Soviet Union as a land of vast monopolies is a matter of some controversy among economists. In his book "How Russia Became a Market Economy," former economic adviser to the Russian government Anders ?slund quotes statistics showing that monopolies and oligopolies actually accounted for an unusually small share of national employment and production in Russia, and that Russia's largest enterprises were actually smaller than in many OECD countries.

The total number of employees in the top 20 enterprises in Russia was less than in the top 20 biggest enterprises in the U.S, Japan, western Germany, the U.K. and France, even in absolute numbers. ?slund argued there are extremely few natural monopolies in Russia.

If the power of the FIGs is not yet pronounced, most Western observers believe their impact on the economy will be negative.

Alex Goodwin, the chief executive of Sector Capital, says "I don't think banks per se are good managers of industrial assets."

Renaissance Capital's Jordan said in a recent presentation that FIGs have often been created to preserve the existing power base of corporate managers, as well as to cement banking relationships.

The rise of the FIGs has yet to run its course. Goodwin sees FIGs at present mainly in the role of "promoters" -- putting together packages of industrial assets into which others may also invest, rather than having the financial resources to swallow them whole. Jordan comments that most FIGs at present are "underdeveloped in strategic perspective, capital and know-how."

Jordan is not alone in believing that the FIGs' day in the sun may not last very long. He thinks that in the long-term, financial-industrial groups will be difficult to finance, potentially leading to their break-up. Goodwin also believes they may be a phenomenon "with a time and a place." One argument is that banks will cash in their stakes when the doubt goes out of the Russian market.

Blitzer of the World Bank sees their development as one of the major long-run concerns in the economy.

Even if FIGs are not here to stay, how they are controlled, or not controlled, will be a key issue in Russia's political and economic agenda until the end of the century.

Next: How Russia is failing to get to grips with the key economic issue of anti-monopoly policy.