Weekly Geopolitical Report

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1 November 23, 2009 Clan Wars (NB: Due to the Thanksgiving Holiday, the next report will be published December 7 th.) Over the past month, it appears that a shift in power is developing within the Kremlin. Recent speeches by President Medvedev have called for economic restructuring and reform in ways that would represent a change in policy that has been in place since In this report, we will discuss the Russian power structure and Prime Minister Putin s role in maintaining that structure, recent signals of changes and their geopolitical implications. As always, we will conclude with potential market implications. The Russian Power Structure Although Russia is nominally democratic, in reality, it is an authoritarian state. Power resides with Prime Minister Vladimir Putin. The current power structure has evolved over the past decade with Putin playing the role of allocating influence. When Putin took power as president in 2000 (officially, December 31, 1999), he had several powerful entities to control. The major groups were the intelligence agencies, the oligarchs (CEOs of various companies), the market liberals and the Yeltsin family. With precision, he neutralized those clans that didn t fit his vision of Russia. The Yeltsin family was emasculated, the oligarchs found themselves either in jail or in exile, and the market liberals were discredited by the collapse in the economy in the late 1990s. Putin, a former KGB agent, threw his lot in with the intelligence agencies. There are two primary intelligence groups in Russia, the FSB (formerly known as the KGB) and the GRU, which is the military s intelligence apparatus. The KGB and GRU were holdovers from the Soviet Union. Although the former is better known, the latter was larger and had a more global reach. During the Soviet era, these two intelligence agencies competed for influence, a situation that has persisted even after the fall of the Soviet Union. Putin holds power by balancing power between the leaders of these two intelligence groups. The current leaders of these two clans are Vladislav Surkov and Igor Sechin. Surkov represents the GRU clan and Sechin the FSB clan. Sechin s clan has been dubbed the siloviki which translates into the strongmen. This clan yearns to a return of the authoritarian Soviet days, minus the ideological baggage of communism. They want a highly centralized economy and long to return Russia to its former superpower status. Although we doubt they expect such status could be attained in the near term, regaining control of Russia s near abroad would be an excellent start. In contrast, Surkov s clan is known as the civiliki or the civilians. However, this is something of a misnomer. Surkov gets 1

2 his power from the GRU s intelligence apparatus, who are very much strongmen. The civiliki is really another clan which represents the economic liberals, technocrats with business skills. The early technocrats were a group of St. Petersburg lawyers and economists that grouped around Anatoly Sobchak, the mayor of St. Petersburg. This early group was discredited by the disastrous privatizations that occurred during the Yeltsin era. The privatizations, started by the economic liberals, were co-opted by the oligarchs, who were former government officials or Soviet state firm managers. The oligarchs enjoyed a financial windfall by purchasing state assets at well below market values. As Putin took control earlier in the decade, he viewed the civiliki, the economic liberals, as tied to the oligarchs. Thus, for the most part, he sidelined the civiliki as they moved against the oligarchs. Putin replaced the oligarchs with the siloviki; retired KGB agents were given control of important enterprises. Most of the siloviki took control of natural resource or defense companies, and laws were changed to seriously discourage foreign investment into these industries. The commodities boom from 2002 to 2008 allowed the siloviki to expand their control. They aggressively borrowed from abroad to expand operations and buyout competitors. Often, these mergers would be on very unfavorable terms for the target company as the siloviki would use the levers of state power to force the sale. In many cases, these mergers made little business sense. Instead, they were done to expand political power. Commodity prices peaked in July The subsequent decline put pressure on the Russian economy. When the financial crisis hit in the autumn of 2008, the siloviki were faced with collapsing commodity prices and a rapidly depreciating currency. The collapsing ruble was a particularly adverse circumstance because most of the foreign loans were denominated in foreign currencies. The siloviki were forced to petition the state for aid; the Medvedev administration was forced to bail out the siloviki at great cost. Russia: Spot Exchange Middle Rate, NY Close Ruble/US$ Russia: Official Reserves exc Gold EOP, Mil.SDR, NSA Sources: WSJ, OECD /Haver This chart shows Russia s foreign reserves with ruble exchange rate. During the commodities boom, reserves rose strongly and the ruble appreciated. The global financial crisis led to a sharp drop in the ruble and a plunge in foreign reserves. These reserves were used to bail out siloviki who faced default on foreign loans. 0 2

3 Even though the civiliki had become discredited in the 1990s, Surkov recognized their talents and offered some of the leading figures protection. Over time, civiliki have adjusted to the more nationalist tone of Russia, becoming less free-market ideologues and instead adopting a purely technocratic mindset. Unlike the siloviki, the civiliki want to develop an economic system open to foreign investment, less dependent on natural resources with a robust private sector. The civiliki have mostly abandoned the desire for power and political intrigue. Instead, they want to build a Russian economy that is more normal. Putin and the Clans Although Putin leaned toward Sechin s siloviki when he restructured the government earlier in the decade, he didn t give them complete power. Surkov also gained some ministries as well. Sechin controls the defense and interior ministries, along with Rosneft (the state pipeline company), Aeroflot and Rosoboronexport (defense industry export company). Surkov controls the finance, natural resource and economic ministries, along with Gasprom and Sherbank. Surkov has been dubbed a gray eminence. His ethnic background is unusual for a Russian leader, being half Jewish and half Chechen. However, he has been very loyal and useful to Putin. He brought down Chechen President Dzhokhar Dudayev and oil oligarch Mikhail Khodorkovsky. As mentioned previously, he has offered protection to the civiliki in return for helping undermine Sechin. The civiliki economic plan was developed by Alexei Kudrin, the current finance minister. Kurdin is respected by Putin because of his finance skills. In addition, he appears to lack political ambition, which makes him a reliable consultant for the prime minister. Kudrin s plan is to wrest control of major companies from the siloviki, replacing them with trained civiliki technocrats. Surkov intends to use special legal authority, recently granted by President Medvedev (also a civiliki), to go after the siloviki-controlled firms. In addition, Surkov wants to oust some highly placed Sechin allies in the Kremlin. When Putin appointed Medvedev president, Sechin was incensed that the new leader came from Surkov s civiliki. To quell dissent, Sechin was able to place numerous allies in key advisory positions in the Kremlin. Thus, Sechin can easily monitor Medvedev (and Surkov). Recently, a number of high profile resignations have occurred at the Kremlin, all members of Sechin s clan. This would suggest that Surkov is moving to consolidate power and reduce Sechin s ability to monitor his actions. So far, Putin has agreed to these moves. Although Putin has a vested interest in keeping both clans roughly equal, it appears that the problems in the economy have become severe enough to bring the Russian prime minister to lean towards the civiliki. Putin has indicated that all changes must be personally approved which could mean that Surkov probably won t be able to 3

4 completely eliminate the siloviki. But, it appears very likely that Surkov will gain power at the expense of his rival. Potential Policy Changes Kudrin s economic plan is much more foreign investor friendly. Under the siloviki, foreign investors were treated poorly; contracts were often adjusted without compensation and the courts offered no recourse. This would change under the Kudrin plan. Russia plans to court foreign investment as a way to build the private sector. Even oil and natural gas industries would be open to foreign investment, although there is a clause that would force reciprocity. In other words, if an oil company made an upstream investment in Russia, a Russian company would be allowed to invest in a downstream operation of the foreign company investing in Russia. This would increase Russian foreign influence. We would also expect that Russian foreign policy would become less aggressive. Although we have no illusions that Russia still intends extend its influence into its near abroad, it would like try to expand its power through diplomacy and investment. It is possible that changes are already being felt with Russia s Iran policy. President Medvedev has, on more than one occasion, suggested that if Iran remains unwilling to transfer its enriched uranium out of the country, that sanctions might be inevitable. Other figures (primarily from the siloviki camp) have indicated that Russia doesn t favor sanctions. However, it does appear the civiliki have Putin s ear. This apparent shift has clearly rattled the Iranians, who have been making very harsh statements about Russia s behavior, complaining that it still hasn t fueled the nuclear power plant at Bushear and haven t sent the S-300 antiaircraft weapons system as promised. Iran seems to sense a significant change in Russia and clearly isn t pleased with it. Overall, we don t expect Russia s foreign policy aims to change significantly. We still expect the goals of expanding influence into the near abroad and to build Russia s global power to continue. The fact that Putin is allowing the civiliki to gain power suggests the Russian economy is in bad shape. To some extent, Putin is changing course and wouldn t be doing so without a good reason. Ramifications In the short run, the changes we are seeing in Russia are bullish for supermajor oil companies. If these companies can get access to Russian oil reserves, it would give them the chance to boost production. It could be bearish for oil prices, although we doubt Putin will allow production to rise so much as to upset the oil markets. It is still unclear how Iran would act if it comes to believe it cannot rely on Russian support. Given recent behavior, we would expect that Iran would become increasingly belligerent. It appears that Iran is spoiling for a conflict, intending to show that the U.S. is weak and Israel won t attack without 4

5 American approval. We believe this is a serious miscalculation. Of course, Russia benefits if a conflict develops in Iran. On the other hand, a normalization of relations between Iran and the U.S. could be a problem for Russia. Russia could find itself competing with expanding Iranian oil output. However, if Russia follows through on the Kudrin plan, it would probably see a deal with Iran as less of a threat. From a geopolitical perspective, the changes being seen in Russia would tend to dial back recent tensions the West has had with Russia. A desire to bring in foreign investment and present a more technocratic face would be a major improvement over the siloviki. However, we don t expect major changes in Russian foreign policy goals to develop from these changes. Instead, this is a different way to accomplish the same goals, which, at some point, will be a source of conflict with the West. Bill O Grady November 23, 2009 This report was prepared by Bill O Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security. Confluence Investment Management LLC Confluence Investment Management LLC is an independent, SEC Registered Investment Advisor located in St. Louis, Missouri. The firm provides professional portfolio management and advisory services to institutional and individual clients. Confluence s investment philosophy is based upon independent, fundamental research that integrates the firm s evaluation of market cycles, macroeconomics and geopolitical analysis with a value-driven, fundamental company-specific approach. The firm s portfolio management philosophy begins by assessing risk, and follows through by positioning client portfolios to achieve stated income and growth objectives. The Confluence team is comprised of experienced investment professionals who are dedicated to an exceptional level of client service and communication. 5