CHAPTER 9

Russia and the CIS

PAINFUL PROSPERITY—REINVENTING A SOCIETY

I knew that I would be in for a wild ride when I boarded my first Aeroflot flight. The plane was decrepit to put it kindly, with seatbelts that were torn. The pilots, former military flyers, taxied down the runway, and before I knew it I was looking straight up as the jet went vertical until we reach cruising altitude. Flight attendants dressed in what looked like nurse uniforms walked down the aisles handing out apple juice from rickety carts. It was 1982.

Russian language was one of my minors in college and I was fortunate to have been taught by two dedicated professors: Edward Danowitz, who taught the Apollo astronauts basic Russian for their meeting in space with their Soyuz counterparts; and Sasha Boguslavski, who led my first trip to the former Soviet Union. In retrospect, as enjoyable as Russian was, I should have studied Chinese!

I was fortunate to first visit Russia when it was still in the throes of communist rule. Yuri Andropov, the premier, had just died. I knew that, it was all over the news. But, the majority of Russians and Soviets had no idea. They were told he was ill. And, like a nation spoon-fed everything else, they believed it.

By the time I returned home after more than a month, I had lost 15 pounds. The only other country where I can lose weight so fast is China. My diet consisted of Tuc crackers and Fanta or Pepsi Cola. There was little to eat that was appetizing unless borscht is up your alley or some strange fish covered in a layer of jelly. We could buy bread at Bread Store Number 7 down the street from the Pribaltiyskaya Hotel or some bruised apples if they were available. Once in a while, we’d be treated to some shashlik—shish kabobs—but even they were gristly and mostly inedible. I was so hungry one night that I went to the best hotel in Moscow at the time, the Metropol Hotel, thinking I could get some real food. You must remember that at the time the ruble was basically worthless against the U.S. dollar and everything was cheap. I looked at the menu and ordered a whole chicken. It arrived promptly. I have never seen a chicken that had no meat on it until that night! It was back to my hotel for some cheap but filling beli hleb (white bread).

Moscow, St. Petersburg, and Kiev (in Ukraine) are spectacular cities. Their wide avenues were so well lit at the time that taxicabs would leave their lights off at night. The architecture with the gilded onion domes of the Kremlin and the museums like the Pushkin and the Hermitage were beyond compare—a little shabby but spectacular, nonetheless. Everyone had a job. Elderly women—babushkas—were sweeping the streets, veterans wearing all their war medals manned the coat checks everywhere we went. The country was poor, but it was functioning and the government’s welfare state was in full swing.

On each floor in the hotel there was a matronly character sitting in front of a desk opposite the elevator 24 hours a day to make sure we were not bringing contraband, human or otherwise, to our rooms. They would also make us hot tea whenever we wanted it. Drinking water was not potable and tea was the best option to avoid getting sick. Getting sick was quite easy. Some of my fellow travelers experienced this firsthand when they drank the water a few hours prior to taking an overnight train from Moscow to St. Petersburg in the dead of winter. While we slept in cozy bunks, they spent the night sitting on splintered wooden toilet seats buffeted by subzero temperatures. I always wonder why people don’t take the simplest precautions when traveling.

St. Petersburg is a beautiful city, one of the most beautiful I have ever seen. Nevsky Prospekt is one of the grandest streets in the world, lined with nightclubs, restaurants, and shops. It’s the main thoroughfare in the city. What struck me most about St. Petersburg, and the Soviet Union in general, was the unbelievably beautiful architecture and statuary to be found everywhere. It was a testament to both the love of arts of the former tsars and tsarinas, and also a reminder of the days of oppression and serfdom that led to the Bolshevik Revolution. The masses were better off in 1982, but sadness was the order of the day.

As Westerners we stuck out like sore thumbs. It was hard not to. We wore clothes with colors that weren’t gray, seemingly the national color. It seemed that somberness was celebrated and happiness a rare commodity. The prevailing mood stood in sharp contrast to the background. Imagine traveling down hundreds of feet on an escalator to a subway platform so deep in the ground that it was doubtless designed to be a bomb shelter. On the platform you were surrounded by artwork and massive ornate chandeliers—a testament to the wealth accumulated by the country. But all around you were silent, gray ghosts resigned to a life of melancholic anonymity. They were prisoners of their own making, living life ignorant of what was occurring in the outside world. If they stepped out of line, they faced harsh punishment. Visitors often commented on the number of bread trucks they saw on the streets of a country where food was scarce only later to find out that many of the trucks were used to transport dissidents and others that the ever-present Big Brother wanted to silence or send to the Gulags.

People were scared. Everyone whispered so as not to attract attention either from the plain-clothed KGB fops or from listening devices. At a party in our room, our guests pointed immediately to the ceilings as the preferred place for listening devices. When I stood at the airport in Minsk, Belarus, taking photos, my camera was stripped from my hands and the film removed. The airport was also a military air base. If I were not a tourist, I would have certainly fared much worse.

Propaganda was the order of the day. The secondary purpose of the trip was for a group of us to do interviews with members of the Russian television media about a book that we worked on called the Best of Pravda, a compilation of translations of the politically charged anti-Western cartoons that appeared daily in the major newspaper, Pravda. Pravda in Russian means “truth.” We joked that there was little truth in Pravda. During the interviews we invariably talked about the lack of free speech, the views of dissident author Alexander Solzhenitsyn, and the overall perverse view of the West that the Russians held. None of it ever appeared on the program when it aired.

When we weren’t interacting with the media we spent time shopping. There was nothing to buy in the stores, of course. The big shopping center, GUM (goom), was replete with shops carrying nothing but poor-quality clothing. But on the streets and in the back alleys there was a treasure trove to be bought, and bought cheaply. The U.S. dollar was king and the exchange rate on the street, if you didn’t get ripped off first, was three times that of the official rate. We bought everything from beautiful Russian lacquer works to fur coats, fur hats, balalaikas, chess sets, you name it. Often we didn’t use cash, but traded blue jeans (we knew ahead of time to bring several pairs) and packs of Marlboro Reds. I even traded a reversible belt for a beautiful lacquer box with a troika painted on it—one of my prized memories from the trip. Since the belt was reversible, I got my counterpart to throw in a fur hat as well! The biggest problem was getting everything out of the country. The Soviets did not turn a blind eye to anything. Fortunately, airport pat downs were rare back then and some of us strapped the wares to our bodies—it was winter and bulky was the fashion!

Out of the Frying Pan and into the Fire

The former Soviet Union came into being in 1991. After a period of liberal thinking prodded by Mikhail Gorbachev, the official dissolution was orchestrated by Boris Yeltsin in 1991. Unlike popular revolutions like the one that led to the formation of the Soviet Union, this revolution was created by the state apparatus out of desperation. The Soviet Union had to break up or Russia, the biggest country, would not survive. It was a financial decision and a tacit admission that 74 years of communism was a failure beyond measure. It caught the people off guard completely, and to this day a vast majority of the population in places like Russia, Ukraine, and Belarus pine for the days of communist rule—not because they enjoyed the lack of freedom, but because they knew the certainty of a welfare state where everything was provided for them, albeit sparsely. Health care was free, pensions were worth something, jobs were created, food was on the table, housing was cheap, and excellent educations were attainable by the masses. There was only one problem. And the problem could not be foreseen by a population that was ill prepared for a seismic shift in its way of life. The problem was that the state was broke: massive military overspending, little in the way of surplus capital, obsolete factories, massive public debt burdens, and a population that produced little in the way of exportable goods for hard, valuable currency. Add to this massive corruption at municipal, state, and federal levels and the recipe for failure was mixed many decades ago.

For the average Russian, Ukrainian, Kazakh, Uzbek, or Lithuanian there was only one truth: No country in the world was more powerful, richer, and fairer than the U.S.S.R. They learned the hard way that nothing they had heard or read for decades was true. In fact, aside from a strong military, the U.S.S.R. was nothing but a ragtag collection of republics that, for the most part, did not get along with each other prior to the formation of the union, and all of which learned to hate Russia the most after the collapse.

Each country was on its own. Each had to develop new governments, new currencies, new social institutions, new trade agreements, new everything. Today the result of the collapse is still being felt in many parts of the former U.S.S.R. Pensioners beg for food, health care is outrageously expensive as is decent food and clothing. Energy costs are extremely high, and threats of shortages due to unpaid bills to the producers are common. The only thing that remains the same is corruption, and that has been taken to new heights.

Today, the former republics of the U.S.S.R. are firmly entrenched in the second and even the third tier of emerging market status. The rule of law in places like Russia can change overnight. Overt strong-arm tactics once practiced by the government are now covert tactics practiced by former members of the KGB, who have basically usurped power. In poorer Republics, despots have taken over power and control vast resources of oil and other commodities. In the Baltics, efforts at European-style commercial activity and government are perhaps the only shining light left from the shell of what was once considered a massive and powerful empire.

It’s not an easy task to invest in the former Soviet Union. There are a few options, however. And, as with any emerging market, the options are very volatile and, for the most part, investing in the former Soviet Union is perhaps best reserved for professionals and not for individual investors. So mutual funds and exchange-traded funds are the rule. It’s best to break the region into three categories: the Russian bloc of Russia, Ukraine, Belarus, Moldova, and Georgia; the Baltic bloc of Lithuania, Latvia, and Estonia; and the Asian bloc comprising Kazakhstan, Uzbekistan, Turkmenistan, Kyrgyzstan, Tajikistan, Azerbaijan, and Armenia.

Beneath the Amber Curtain

My first investment in Russia was a parking garage in Moscow in the mid-1990s. It turned out to be a bust. Not because the garage was not successful but because it was impossible to track the investment and property rights were fuzzy at best. My next investment was through two highly volatile investments. One was the closed-end Templeton Russia Fund and the second was in a cellular company called Vimpelcom. I invested in both after the Russian financial crisis, which began in late 1997, triggered by the collapse in the Asian markets earlier in the year. They were both excellent trades as I recall and set the stage for future trades in Russian equities, all of which were made during times of crisis.

If you’re going to invest in Russia, go small and wait for the inevitable crises that occur with regularity. There is nothing kosher about stocks or companies in the region. All are subject to the whim of government meddling. The place is corrupt from the top down, and knowing this fact makes Russia the worst of the BRIC (Brazil, Russia, India, and China) countries as far as transparency goes.

Let’s step back for a minute and look at the structure of the Russian and Ukrainian story. The other countries, Belarus, Moldova, and Georgia are not worth spending much ink on, as they are barely economically viable countries.

When Yeltsin took power Russia was an economic mess. Huge debts—internal and external—a crumbling currency, obsolete factories, overemployment, and massive inefficiency and corruption were the rule of the day. Some businessmen were making money though by smuggling goods into Russia—things like computers, blue jeans, and cigarettes were in huge demand. They were able to sell their wares because of their connections to the power brokers in the Russian government, who took a healthy cut of the profits to look the other way.

As a cornerstone of the transition from state-run enterprises to privately held businesses, Yeltsin and his advisors embarked on a course to privatize Russian state-owned enterprises. To understand the scope of this, think about all the companies in the United States—from trash collection to steel mills to bakeries—being owned by the U.S. government and then given to the public at large. Prior to this time it was illegal to own a business in Russia.

The intention was right but the results were disastrous for the vast majority of the population. Vouchers were distributed to everyone, including minors. But the masses did not understand what was going on as they had no idea what a nongovernment-run or-owned business was. Most quickly surrendered their vouchers to the management of these businesses for something they did not have: cash. These managers and the few black marketers who had money bought everything on the cheap, thereby shutting out almost the entire population from future benefits of the businesses. Much of the non-black-market money came directly through the Russian governmental connections. In effect, what happened was the very government officials who privatized the companies ended up owning these companies for themselves, their cronies, and their friends.

What ensued was concentrated ownership of the entire complex of businesses by a small group of individuals who came to be known as the oligarchs. What the oligarchs knew was that their new businesses would have support from the government, as they were still the biggest spenders on goods and services. In return for this bargain, the oligarchs would pad the coffers of individual government officials for decades to come. If they didn’t, the government officials would use their enforcement mechanisms to either jail, kill, or confiscate the wealth from the oligarchs at will. This process repeated itself in the other Commonwealth of Independent States countries, as the former republics were called, with varying results.

The Baltics

The Baltic countries of Latvia, Lithuania, and Estonia have never identified with their former Russian overlords. They shared neither language nor culture with them. More European (Germanic/Nordic) in descent than Slavic, the Baltics were forced to embrace Russia and the Russian language, but only by military threat and occupation. You would be hard pressed to find a single non-Russian individual who harbored anything but resentment toward the former Soviet Union.

I knew from the moment I set foot in Tallinn, the capital of Estonia, that it was a different place completely from any of the Soviet cities I had visited. The people were friendlier, the buildings more colorful, and the food was actually edible. It was the first time on my trip, after almost three weeks of the worst food I had ever eaten, that I actually enjoyed a meal. I remember it vividly—chicken breast and French fries . . . I think I ate three servings!

The three countries are part of the European Union with Estonia adopting the euro currency in 2011. The other two will follow in the coming years. While fast growing, the economies are quite small as are the populations, which when combined would be fewer than that of the New York metropolitan area.

What the Baltics offer, as my friend Kevin Kerr, a successful commodities trader who resides there part of the year, has discovered, is a great standard of living for those who earn Western salaries but spend in Eastern countries. The countries sport slightly higher per capita income relative to their Russian and Asian counterparts, averaging just over $10,500 per year. The relatively low cost of living and strong European feel of the countries and especially their capitals, Tallinn, Riga, and Vilnius, make for an interesting second or primary home proposition—especially for those seeking backdoor entry into the EU.

The Asian Republics

These former Soviet republics border Russia to the south. They have more in common culturally with countries like Turkey than those of their former brethren to the north. I remember vividly standing in an elevator of a Moscow hotel when an Uzbek walked in. I felt as one might have felt in the old American South when segregation was in effect. The cultures clash in every possible way. But, these republics are rich in natural resources, especially places like Kazakhstan. Few people realize that Kazakhstan is a real place and not some made up place from a Borat movie. Boasting the largest reserves of oil in the Caspian Sea region, Kazakhstan is the size of Western Europe—it’s massive.

However, one other similarity that is shared by most of these pseudo Asian countries is that they are ruled by a cadre of benevolent dictators with relatively low levels of freedom for the people and relatively poor distribution of wealth. Most of the countries are Islamic nations, as well, which has allowed for expanded ties to the countries to the south like Turkey and Iran.

The only real investment opportunities here are in the oil/gas/resource sector. But, my experience has been that most of the companies, and a couple have listed on U.S. and London exchanges, have been pretty sketchy. News releases are often short and not timely and there are significant credibility issues when dealing with countries that are small and ruled by pseudo dictatorial regimes, which are more tribal and familial. They operate much like the oligarchies of Russia and Ukraine.

Strengths

The region has massive natural resources. Russia produces more oil daily than Saudi Arabia, but its reserves are a third of those in Saudi. The Baltics allow for easier entry into the European Union with an educated, low-cost workforce and less corrupt parliamentary democracies. Russia has a strong military force and there is a vast infrastructure developed in the Soviet times as well as extensive port systems.

Weaknesses

It is difficult to invest in the former Soviet republics. There are ETFs and country funds like the Templeton Russia Fund (NYSE:TRF) and a host of mutual and hedge funds, as well. A former intern and colleague of mine runs a fund for Firebird Management (www.fbird.com/). They have extensive experience in investing in the region and have proved to be quite resilient. But as is the case with any other fund or investor, money is only made in Russia and the region during boom periods and can easily be lost overnight. It’s not for the faint of heart. Other problems include currency controls, a lack of transparency in accounting and government, and poor social safety nets; they are nonexistent in many of the countries. The Russian bloc has high rates of alcoholism. There is little spending on infrastructure other than for natural resource pipelines.

Opportunities

This is not China, India, or Brazil. Russia is fraught with risks beyond those of economic cycles. Opportunities are available in the natural resource sector in the Asian countries, but contracts are very hard to enforce. The Baltic bloc offers great opportunities for expatriation if the climate is not an issue.

Threats

There is a huge divide between the mega rich and the poor. Oligarchs and government operatives in the Russian bloc thrive on chaos. There is a Russian mafia, which has close ties to the government. Asian countries have poor popular representation and are prone to violent coups in the future. Russia itself could face major political, popular, and economic issues in the future as the poorest in the society, an educated mass, reach the point of desperation. As a nuclear superpower, Russia will always possess a bigger bark than bite, impeding global progress in the Middle East and Asia where Russia holds significant commercial interests.

Russia and the former Soviet republics have never recovered from the collapse of the U.S.S.R. There are questions about rule of law, distribution of equity, and transparency of markets. Until those are resolved, the region, minus the Baltics, will face significant problems for years, if not decades, to come. Unless you are an adept trader with a high tolerance for risk, the region is not a place that I would recommend for investment.