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. Last Updated: 07/27/2016

THE ANALYST: Defaults Are Dangerous, Renationalization Is Fatal

Now that the government has defaulted on its domestic debt f a development that, as it turns out, the president himself was unaware of f the next zone of danger will be the "N-word." A nightmarish prospect, and one that could potentially isolate Russia from the global investment community for decades. For if a default is an admittance of complete macroeconomic failure, then nationalization is outright confiscation.

In the weeks and months ahead, this will be the new Russian risk. At this point, as horrible as it seems, nationalization cannot be excluded from the realm of the possible considering the rapidity with which the country is unwinding. Unfortunately, analysts have underestimated this risk by focusing on the wrong level; when and if nationalization appears, it is likely to be not on the federal, but on the regional level.

Two weeks ago, the government of Bashkortostan, an ornery, somewhat recalcitrant republic, announced that it was merging all the region's oil and energy companies into one holding. Bashkir Fuel Company will have an estimated annual turnover of $3 billion by combining Bashneft, Bashkir Petrochemical, Bashenergo and a number of other downstream enterprises. The republic has long wished to create such a regional "budget-maker," but continually met resistance from directors. Now, in the post-crisis world, finding finances will be the key to survival, and the republic's president decided notto bother with corporate dissent and just signed the necessary decree.

Which is why this is alarming. Directors of several of the affected companies found out about the merger in the newspaper. There was no consultation. (Can there be any in a time of acute crisis? a governor may retort.) More alarming still is the fact that in every company the republic owns stakes insufficient to carry out such a transaction; the law on joint-stock companies says that a shareholder must own at least 75 percent of a company's stock to approve this kind of merger. Apparently, the republic, intent on forging a steady flow of funds to the regional budget, could care less about shareholders. (The Bashkirs are proud about doing things their own way. After the privatization voucher expired in July 1994, Bashkortostan continued conducting voucher auctions.)

The Far East, not a tad bit surprising, provides a finer, more insolent example. In April, Primorye region Governor Yevgeny Nazdrantenko said at a news conference that his administration was considering measures to increase the region's stake in Primorsk Elektrosvyaz and Far East Shipping at the expense of foreign shareholders, who, as collective owners of 22 percent and 39.3 percent of these respective enterprises, were infringing upon the interests of Russian shareholders. Or so the governor implied. If nationalization is to occur regionally, then Nazdrantenko is one person (read: dictator) capable of it.

The central issue here is cash flows. Governors need money, and will go to any length to obtain it. Like nearly all of Russia's financial-industrial groups, which arose by sucking onto a lucrative enterprise with a reliable stream of cash (normally an exporter), regional governments need to find assets that will assist budget execution. More than ever, governors are itching to build business empires. The quicker they can achieve this, the sooner independence from Moscow will be attained. Such is their ultimate goal.

The likeliest form "regionalization" will assume is a version of the legendary Government Order 254, an offspring of one of the oligarchs, Vladimir Potanin. Pursuant to this document, all companies with outstanding tax arrears must issue a controlling equity stake to the government as collateral against current payments. Miss two monthly payments in a row, and the government has the right to liquidate the stake on the open market. Or just confiscate it. Bashkortostan, by the way, has already pioneered this method with shares of three local oil refineries, much to the indignation of shareholders, whose subsequent appeals in Bashkir courts were about as likely as golf on the moon.

Unfortunately, the fuse on this nationalization powder keg was shortened by about a mile last week when Dmitry Vasilyev resigned as head of the Federal Securities Commission. Vasilyev was practically the only person in government who cared about shareholders' rights and made a respectable career by defending them. He is the only man in the country who locked horns with the oligarchs f men who normally spit on shareholder value f and came out unscathed. (A man named Sergei Kiriyenko also tried once.)

Now Vasilyev is gone, and economic power is seeping from the center to the regions. What the governors will do with these new levels of control over their regional economy, the devil only knows.

The investor should beware: Nationalization could take place in an instant, just like default and devaluation did, and neither the president nor anyone in government would know anything about it. We could be reading about it in the paper after it's long over.