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. Last Updated: 07/27/2016

Turnaround Year?

Last year brought foot-dragging on key business legislation and saw a group of financiers build an empire at taxpayers' expense. But 1997 will also be remembered for post-reform Russia's first economic growth and a profitable stock market ride. Jeanne Whalen looks back on the year in business. And on Page 3, a look ahead to '98.

Russia's chances for economic reform never looked better than they did in March 1997, when President Boris Yeltsin returned to the Kremlin after a seven-month illness and cleaned house.

Dissolving his old Cabinet and installing at the helm the men who would become known as "young reformers," Yeltsin vowed Russia would stop "floundering in a stream of problems."

Newly appointed first deputy prime ministers Anatoly Chubais and Boris Nemtsov were challenged with righting the economy, and they were to begin with restructuring the tax system and Russia's unwieldy state monopolies.

A mild euphoria ran through the business community as observers hoped for stable, insightful leadership, said Sergei Kolmakov, deputy director at the political research group Fond Politika.

"[Prime Minister Viktor] Chernomyrdin's government before the reconstruction had a lack of energy, a lack of well-defined purpose," Kolmakov said. "Chubais is known as a very good strategist, so there was a very good feeling he would shake up the government and do something new."

Economists agree the year was a macroeconomic success. Inflation hit its lowest level since 1990, hovering around 11 percent, while Russia registered its first year of economic growth since the collapse of the Soviet Union, said World Bank economist Alexander Morozov. Preliminary figures place GDP growth for 1997 at 0.4 percent.

Foreign direct investment in Russia doubled in 1997 to $4 billion, although it remained disappointingly low, said Neal Parison, the director of the European Bank for Reconstruction and Development's Moscow office.

Most fantastically, Russia's stock market ended the year up over 100 percent, despite an October fall in Russian and world markets.

"From a macroeconomic point of view, the year of 1997 was the most successful since the beginning of reforms," Morozov said.

But the positive numbers were overshadowed by glaring shortcomings. Many of the Yeltsin administration's economic goals went unfulfilled. Russia's new tax code, considered one of the last major stumbling blocks to reform, was mired in legislative squabbling. Nemtsov's restructuring of the state monopolies Unified Energy Systems and Gazprom was rebuffed by old-school leaders like Gazprom boss Rem Vyakhirev.

Foreign businesses continued to struggle against bureaucracy and corruption in Russia, which was ranked in one 1997 survey as the third-most corrupt nation on earth.

In the first half of 1997, the government continued to sell its enterprises at giveaway prices as a small group of well-connected financiers capitalized on 1995's loans-for-shares deals.

The summer auction of Svyazinvest marked a turning point in privatization, bringing market prices for state assets and establishing what many called fair competition. For some, it was the auction Yeltsin's young reformers had been promising since taking office.

But allegations that privatization officials had fixed the auction led Yeltsin to fire three privatization heads and forced another to resign. The only survivor, Chubais, remained in office but ended the year tainted by scandal.

The fallout from 1997's privatizations may finally have convinced the government to distance itself from the group of bankers who have gobbled up most of the state's prized assets, Kolmakov said.

"Despite all the setbacks, the state realized that the interests of the state and of big corporations are not in common all the time," he said, pointing to the few auctions in late 1997 that brought the budget top dollar for state enterprises.

Kolmakov said he expects Yeltsin to make some bold remarks about the government's relations with business in his annual state-of-the-union address in February.

"1998 will be a very interesting year because it is the last year when we can expect some measures from the government to do something with the economy," he said. "After that, 1999 will be a year of parliamentary elections and 2000 will bring the presidential elections, and it will be very difficult to expect something from the state because they'll be too occupied with political games."


Russia's powerful bankers have been consolidating their grip on the country's economy since the beginning of the decade, but 1997 was the year they came out into the open. A small group of regent bankers increased their control over key industries and their influence in the Kremlin, and used their holdings in Russia's print and broadcast media to their strategic advantage.

Financier Boris Berezovsky closed 1996 with the bold claim that he and six other bankers -- Uneximbank's Vladimir Potanin, Most Group's Vladimir Gusinsky, Alexander Smolensky of SBS-Agro Bank, Bank Menatep's Mikhail Khodorkovsky and Alfa Group's Mikhail Fridman and Pyotr Aven -- controlled half of Russia's economy.

Many of them had close ties to the government. Potanin had served a brief tenure as a deputy prime minister, for example, and Berezovsky spent much of 1997 sitting on the government's influential Security Council.

"Most likely," the newspaper Argumenti i Fakty wrote at the time, "the majority of those businessmen will exercise considerable influence on the economic policy of the state in 1997 as well."

Indeed. The so-called Group of Seven bankers entered 1997 stockpiling more state enterprises at bargain-basement prices. But unchecked ambition led to mayhem as the year wore on, and infighting broke a unified front into camps of bitter competitors.

In early 1997, the bankers benefitted from a privatization scheme that allowed them to purchase stakes of enterprises they had controlled in trust since 1995's loans-for-shares program, when the government handed over management of Russia's top industries as the collateral for desperately needed loans.

The banks holding the stakes in trust were allowed to organize the auctions and in all cases emerged as the winner. Abuse was particularly acute in auctions for Yukos, Sibneft and Sidanko and metals producer Norilsk Nickel, all of which were sold for a song.

Competition among the bankers grew more fierce as the year wore on and the state's supply of unclaimed jewels began to shrink. The fever peaked with the summer sale of a stake in Svyazinvest, Russia's huge telecommunications holding company.

The winners of the 25 percent stake in Svyazinvest -- a consortium that included U.S. financier George Soros, Western investment banks and Uneximbank -- were reviled by their opponents, who alleged privatization officials had passed the group privileged information allowing it to place the highest bid.

Two high-profile losers in the auction, Berezovsky and Gusinksy, were swift to call foul: Gusinsky used his NTV television station and Segodnya newspaper, and Berezovsky called on his ORT television and Nezavisimaya Gazeta newspaper, unleashing a brutal media attack on Uneximbank's Potanin and his main ally in government, First Deputy Prime Minister Anatoly Chubais.

Privatization chief Alfred Kokh, who had overseen the Svyazinvest auction, resigned under pressure in August. Yeltsin blasted Kokh's leadership, saying, "The scandal around Svyazinvest and Norilsk Nickel is connected to the fact that a number of banks are closer to Kokh's soul."

Kokh's replacement, Maxim Boiko, fared no better. Boiko, Kokh, Chubais and two other officials received generous advances -- $90,000 apiece -- for an unwritten book on privatization from a publishing house connected to Uneximbank. Four members of this "Writer's Club" found themselves out of work, but Yeltsin spared Chubais, choosing to strip him of his finance minister title.

Although it was tainted by scandal, the Svyazinvest auction also brought the first fair price paid for a piece of valuable state property -- $1.875 billion. Another summer auction, for Tyumen Oil, also fetched a fair market price.

"Svyazinvest was a much greater price than we've seen paid before -- it was a turning point," said Dan Lubash, managing director of emerging Europe at Merrill Lynch in London. "Assets commanded a much higher price after that, and we'll see it continue with VNK [Eastern Oil Co.] and Rosneft," he added.


The year started out as the Roaring '20 on Russia's stock market, with equities across the board moving faster than a flapper's knees. Through mid-October, Russian shares had grown 185 percent as foreign investors poured into the market, emboldened by Yeltsin's 1996 re-election, growing signs of macroeconomic stabilization and the inclusion of Russian stocks in an increasing number of global stock indices.

But the band stopped playing Tuesday, Oct. 28, when the Russian equity market took its steepest dive ever, losing 20 percent of its value in one day.

Prices on Russian treasury bills, or GKOs, tumbled along with equities as fearful foreign investors fled the market, raising the government's cost of borrowing and putting downward pressure on the ruble. Analysts believed the crash might prove fatal to smaller banks and brokerages that were overextended in Russian debt and stock.

The stock and GKO markets began rebounding in early December as efforts to stabilize the ruble took root. Although the crash took the bubbles out of the champagne, it was unable to completely sap Russian shares of their momentum, and The Moscow Times Index of 50 top shares closed the year 110 percent higher than it started.

The market slide had a positive side: It helped convince the Yeltsin administration to get serious about tax collection to keep the budget deficit in check and the ruble strong.

"The crash highlighted that for Russia to be able to withstand this type of shock, it has to show that the systems are in place for collecting taxes and keeping the budget deficit under control," said Petru Vaduva, head of equity research at Renaissance Capital.

The crash aside, one of the most noteworthy moments in Russian markets last year was the stellar growth of second-tier stocks. The ASP index of 190 shares, which includes less-liquid stocks than the MT 50, beat Russia's blue chips to rise 210 percent for the year.

"The stocks that really outperformed others last year were the smaller, newer stocks," said Tom Adshead, director of research at United Financial Group-Paribas. "These companies which were being completely neglected by the market and were significantly undervalued were being discovered and being brought up to their realistic value."


1997 proved a paradoxical year for foreign investment: While big international oil companies continued to promise unprecedented billions to Russia's energy sector and a number of consumer-goods companies opened new factories, a slew of high-profile foreign ventures were falling apart.

From multinational Exxon to Moscow-based Kosmos TV, foreign investors had a rough go of it in 1997, battling the very same bureaucracy and outright corruption the Yeltsin administration has promised for so long to conquer. Western diplomats and heads of state appealed to the highest echelons of government for help, but it was often a regional governor or circuit court judge who brought a multimillion-dollar venture to its knees.

In Exxon's case, Russian officials abruptly pulled the company's right to develop an arctic oilfield after the U.S. oil major had invested $10 million in preliminary production. While Russian officials said the tender competition that granted Exxon the license had not been conducted properly, the foreign oil community saw the revocation as a glaring example of damaging Russian whimsy, and suspected the government would eventually award the project to a Russian company.

U.S.-Russian cable venture Kosmos TV and German building materials manufacturer Knauf spent a good part of the year battling for control of their companies against general directors they'd hired to run those enterprises. Both foreign investors reported their executives had turned into Frankensteins, kicking the owners out of their offices, dipping into the company till and wreaking havoc on business in general.

Working through official channels hasn't helped either party. A series of court rulings have upheld the right of Kosmos TV's general director to continue running the company. Although two federal courts have empowered Knauf to take back its factory and fire its general director, the Germans have been unable to enforce the decisions.

New investors continued to enter the market, however. The year's direct foreign investment of $4 billion included noteworthy activity in the consumer products sector, with Cadbury Schweppes and Germany's Stollwerck opening chocolate factories, and General Motors' first Russian-made Chevy Blazers rolling off the line at a plant in Yelabuga, Tatarstan.

A trend among foreign investors in the oil industry may offer a more attractive and safe model for investors in the future. As Exxon struggled against the Russian government, British Petroleum and Royal Dutch/Shell signed multibillion-dollar partnerships with well-connected Russian oil and gas companies Sidanko and Gazprom that surely will shield them from many of the blows suffered by other foreign investors.


Taxes bore the blame for a multitude of Russia's ills this year: No one seemed able to pay them, collect them or explain the byzantine turns of either the existing or proposed tax policy. The government's failure to pass its proposed tax code was one of its biggest failures in 1997.

"It's pretty pathetic, really," said Scott Antel, a tax partner with Arthur Andersen in Moscow. "I just find it unconscionable that you have a prime minister, a president and others referring to a tax system as disgraceful and disgusting, and saying it drives valid businesses into the ground. ... They talk about the [new] tax code as the panacea, but then they dump the thing."

Tax reform looked like it was off to a good start when the Duma, under intense pressure from the Kremlin, passed the draft code in a first reading in June. But in November, Yeltsin appeared to back away from the code, paving the way for the Duma to draw up alternatives to the original version. Deputies have submitted some 3,000 amendments for consideration.

Lawmakers' original intent was to streamline the code by cutting the number of taxes from 200 to 30, and to increase the number of taxpayers by lowering rates. But what will emerge when the next version is presented in February is anybody's guess.

In the meantime, each day that passes without a proper tax system forces the government to borrow funds to meet its obligations, weakens investor confidence and angers the International Monetary Fund and credit rating agencies that at year's end lowered Russia's rating from stable to negative.

Another key moment in 1997's legal wrangling was the passage of a historic land privatization bill in the Volga region of Saratov. Impatient with the federal government's waffling on the issue, Saratov's legislature in November passed a bill allowing the sale of land. Russia's conservative State Duma condemned the bill and vowed to quash it, while Yeltsin, a supporter of land privatization, applauded the bill.

While land privatization is permitted under Russia's Constitution, there are no laws that clarify how it may be done. Yeltsin last year vetoed a land code passed through parliament that banned the buying and selling of land; the president and parliament's opposition leaders sat down in December to discuss a revised code, which is expected to be presented within three months.

In December, Yeltsin passed his own decree that allows land to be purchased and sold in cities and towns, and will remain in effect until the Duma passes its code.