Can Russia's state-managed, network capitalism be competitive?

Journal of World Business 42 (2007) 1–13 www.socscinet.com/bam/jwb

Can Russia’s state-managed, network capitalism be competitive? Institutional pull versus institutional push Sheila M. Puffer *, Daniel J. McCarthy College of Business Administration, Northeastern University, 319 and 313 Hayden Hall, Boston, MA 02115, United States

Abstract In the fall of 2005, former chairman of Yukos Oil, Mikhail Khodorkovsky, was sentenced to prison, after being found guilty of fraud and tax evasion. Many viewed the trial as the government’s attempt to gain control of the energy sector which Putin had declared as strategically crucial to the country. This article examines the role of the state and the type of capitalism that is evolving in Russia. We view this system as consisting of three forms of network capitalism that coexist in this transition economy – market, oligarchic, and siloviki – and the relationships among them, all existing within the pervasive environment of the Russian state. We argue that the Russian economy will continue to be based for some time on the cognitive institutional pillar rather than the regulative pillar. The article concludes with implications of government policy decisions for the various forms of capitalism, for the country’s competitiveness and attractiveness for foreign investment, and for Russian managers. # 2006 Elsevier Inc. All rights reserved.

1. The Yukos trial: a watershed for the Russian economy Yukos, Russia’s largest and most successful oil company, originated during the country’s privatization program of the early and mid-1990s. In 2005, its chairman and major shareholder, Mikhail Khodorkovsky, and his partner, Platon Lebedev, were found guilty of defrauding the state during the 1995 privatizations of an insecticide research institute and a fertilizer factory. The court also concluded that the company owed $28 billion in back taxes. Khodorkovsky and Lebedev were given long prison sentences, and the company’s major assets were broken up and sold at auction. The assets formed the basis for the newly created state-owned petroleum company, Rosneft. * Corresponding author. Tel.: +1 617 373 5249; fax: +1 617 373 4758. E-mail addresses: [email protected] (S.M. Puffer), [email protected] (D.J. McCarthy). 1090-9516/$ – see front matter # 2006 Elsevier Inc. All rights reserved. doi:10.1016/j.jwb.2006.08.008

Some saw the Yukos trial as the government’s retribution for the excesses of the 1990s privatization program that resulted in the country’s major industries ending up in the hands of a small number of powerful businessmen who used highly questionable methods to accumulate these industrial gems at a fraction of their true market value. But the Putin administration also seemed to have another motive for going after Yukos and Khodorkovsky – to squelch his political ambitions. In any case, the trial created great uncertainty about the future of the Russian economy and the state’s role in it. 2. Assessing Russia’s economic system The Yukos-Khodorkovsky case called into question the role of the Russian government in business and the economy, the type of economic system that was emerging, and the implications for Russia’s global competitiveness. We examine these issues in the context of institutional theory, and develop the concepts of institutional pull and push. We also draw upon the work

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of Boisot and Child (1996) who examined the government’s role in the transitioning Chinese economy and the type of capitalism that has been emerging there. 3. Institutional pull versus institutional push The dissolution of the centrally planned economy also saw the dismantling of institutions, including the state central planning system with its ministries that had controlled virtually all economic information, causing chaos throughout the entire economic system. New institutions needed for a successful transition (Peng, 2003) have not developed enough to support a codified market-oriented system of information, such as laws, regulations, and their enforcement, as well as business practices and values. The lack of institutional development was a major cause of the country’s unstable environment and the resulting reliance on informal relationships and traditional values that existed before the tenuous attempts at transition to a market economy. Additionally, the government’s efforts to diffuse important economic and business information have been limited and confusing, and enterprise managers thus have traditionally provided low transparency of company information. Institutions have been defined as ‘‘the humanly devised constraints that structure human interaction’’ (North, 1990: 3), and include formal rules and laws as well as informal influences like cultural norms. Scott (1995) classified North’s formal and informal aspects of institutions into three pillars: regulative, cognitive, and normative. The regulative pillar consists of formal rule systems like laws and regulations as well as enforcement mechanisms that are sanctioned by the state (North, 1990; Scott, 1995). The cognitive pillar includes accepted beliefs and values, and the normative pillar refers to legitimate means to pursue valued ends. We focus on the regulative and cognitive pillars since they comprise the institutional dichotomy we observe in Russia. Peng (2003) noted that most attention in the market transition literature concentrates on state-level policies rather than firm-level strategies. He added that international organizations, like the World Bank and United Nations, hope that firms themselves behave as reformers. We conclude that they have not done so in Russia until recently, and what has emerged is primarily the cognitive pillar of beliefs and customs that supports clans and networks. All of these circumstances in Russia set the stage for the recent phenomenon that we call institutional pull, whereby companies, in pursuing their own self-interest, are imposing pressure on authorities to create formal

institutions. These moves strengthen the regulative pillar. This is in contrast to the more commonly studied approach that Peng (2003) noted, which we refer to as institutional push, where authorities first initiate formal institutions to support and regulate the business environment. We view institutional pull and institutional push as being analogous to the marketing concepts of pull and push. Demand for a company’s products and services can be created or pulled by customers’ actions, or by a company’s pushing its products and services through advertising and marketing. We believe that more such institutional pull is required in Russia to help strengthen regulative institutions and alleviate the current heavy dependence upon the cognitive institutional pillar of accepted beliefs and values. The absence of a push orientation to develop institutions, after some years of sporadic development, is due primarily to the federal government’s insufficient and inconsistent efforts, particularly in developing the judicial system. This situation, as well as the growing institutional pull phenomenon in Russia, is consistent with the nature of institutional change, which North (1990) noted is overwhelmingly incremental. We see this incremental evolution as being the typical form of change. Yet the transition has at times been characterized by discontinuous change or punctuated equilibrium (Gersick, 1991), such as the government’s promulgation in 2002 of the Code of Corporate Conduct for companies having more than 1000 shareholders. We also view the emergence of institutional pull as being consistent with the notion of institutional relatedness. That concept is defined as ‘‘the degree of informal embeddedness or interconnectedness with dominant institutions’’ (Peng, Lee, & Wang, 2005: 623) that provides resources to a firm and increases its legitimacy (Granovetter, 1985). These conditions have created a situation of companies pulling institutions into the setting by putting pressure on the government to develop them. Some positive initiatives are occurring in the areas of capital markets, regulation, and laws, all of which are beginning to strengthen the normative pillar. One result is to support an increasing level of transparency and interest in corporate governance that has developed not out of altruism, but from business owners’ quest to increase personal wealth. A major impetus for the pull phenomenon of companies creating pressure for authorities to build institutions has been the vastly increasing number of initial public offerings planned for 2006 and 2007. Compared to the 13 initial public offerings in the entire period from 1992 to 2004, 2006 was expected to see nearly 30 such offerings raising $25

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billion. This level of activity would place Russia fourth globally in such issuances. The dearth of institutions that led to the institutional pull described above can be explained in part by utilizing Boisot and Child’s (1996) classification of economic systems according to how information is codified and diffused. Codification refers to ‘‘the selection and compression of data into stable structures’’ (Shannon, 1948, cited in Boisot & Child, 1996: 602). Diffusion refers to the degree to which transactionally relevant knowledge is dispersed within a given population (Boisot & Child, 1996). Based on our nearly two decades of experience analyzing the Russian economy, we consider information to be essentially uncodified and undiffused. This situation can be attributed to the break-up of the Soviet centrally planned economy, and the dismantling of its supporting institutions during privatization, that in turn led to the decentralization of managerial decision making, as reported by managers in the early 1990s (McCarthy & Puffer, 1992). Russia’s increasing political stability has still not produced a codified or diffused system of information nor a system of supporting institutions. Thus, the country still depends upon a clan organizational form of capitalism with its related reliance on networks. 3.1. Clans and networks In clans, transactions, including economic exchanges, are based primarily on personal relationships rather than formal rules. According to Boisot and Child, clans arise under conditions of low codification and weak diffusion of transactionally useful information in the absence of more formal institutions. In contrast, information in the more formalized, market economic form is highly codified and widely diffused. The information conditions that give rise to clans lead to the use of networks, rather than rule-based mechanisms, to accomplish business objectives. These networks are characterized by reliance on personal relationships, goal setting by negotiation, and coordination by mutual adjustment (i.e., informally without formal rules), all conducted among a moderate number of participants in an atmosphere of high uncertainty. Such developments are consistent with the cognitive institutional pillar described earlier, as well as with the assertion that firms prefer relationship-based strategies during the early stages of a transitioning economy (Peng & Heath, 1996). However, a market-centered strategy would emerge during a late phase and would be supported by more formal, market-supporting institutions (Peng, 2003). Peng emphasized the necessity for a

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time-based view for transition economies: ‘‘focus on the longitudinal process to move from a relationship-based, personalized transaction structure calling for a networkcentered strategy to a rule-based, impersonal exchange regime suggesting a market-centered strategy’’ (Peng, 2003: 276). We see Russia as still being in the early stages of its transition. 3.2. A distinctive institutional form: Network capitalism Clans permit a local and personalized cognitive type of institutional order, which led Boisot and Child to conclude that in China ‘‘decentralization from the former state command system is giving rise to a distinctive institutional form – network capitalism’’ (Boisot & Child, 1996: 600). Russia is also transitioning from a centrally planned system, with ‘‘the historical and continuing power of the State over enterprises’’ (Buck, 2003: 311) much in evidence. Additionally, Russia exhibits ‘‘deeply embedded patterns and rules that still continue to regulate the business environment’’ (Randall, 2001: 10), and are engrained in Russian culture and values (see, for example, McCarthy & Puffer, 2002; May, Puffer, & McCarthy, 2005). For instance, svyazi (connections), refers to a strong reliance upon personal networks in conducting business, and trust is typically generated only within such networks (Schrader, 2004). Such cultural embeddedness of networks dates from tsarist and communist times, when networks were imperative for most people to accomplish virtually anything in their everyday lives (Ledeneva, 1998). The enduring importance of networks was confirmed in a late 1990s survey in which managers ranked connections (and dishonesty) as the two most important factors for business success (Taylor & Kazakov, 1997). A study of Russian entrepreneurs found that network connections reduced uncertainties and risk in financial transactions, provided access to resources and loans, and helped increase sales and profits (Batjargal, 2003). Networks are also used extensively by the state to influence companies’ activities ‘‘through its personal contacts with industry and links with the media and banks’’ (Buck, 2003: 309). 4. Russia’s state-managed, network capitalism Institutional theory helps explain why Russia has developed a system of state-managed network capitalism. The economy operates primarily on a cognitive institutional pillar, rather than the more formal, rule-based

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Exhibit 1. Russia’s state-managed, network capitalism.

regulative pillar, that allows networks to thrive. These in turn are socially embedded in Russian culture, and agents of the state have traditionally played an integral role in such networks. We view Russia’s system of state-managed, network capitalism as consisting of three forms of network capitalism that coexist in its transition economy – market, oligarchic, and siloviki – and the relationships among them, all existing within the pervasive environment of the Russian state. We have not included wholly government-owned companies like those in the defense sector, nor organizations in the shadow economy or black market, since neither group is considered to operate according to capitalistic mechanisms. The system of state-managed, network capitalism is depicted in Exhibit 1. Members of all networks attempt to exert influence not only internally, but also externally in other networks. Although the circles are depicted as approximately equal, as are their intersections, in reality, they vary in size and importance depending upon the criteria employed, such as contribution to GDP, number of companies, or influence upon other sectors. Each form of capitalism and their intersections are discussed below. The large, outer circle depicts the pervasive role of the Russian state in all areas of the economy, leading us to the conclusion that the entire economy is one of state-managed, network capitalism. 4.1. Market capitalism Russia has evolved well beyond the centrally planned Soviet economy, and President Putin, like

President Yeltsin before him, has repeatedly stated his commitment to a market economy. In fact, by 2003 the country had been designated as a market economy by the United States and the European Union, and was poised for accession to the World Trade Organization (WTO) in 2006. Still, Russia is far from having a true market economy, a situation that has raised concerns among WTO and G8 (group of eight industrial nations) leaders about the country’s suitability for membership in both organizations. The government’s privatization program initiated in the early 1990s eventually resulted in a market-sector that is growing and operates for the most part as a competitive free market, particularly in the consumer sector. Hundreds of thousands of small and mediumsized private firms have sprung up in various areas of the economy. Notable successes in the private sector are found in retail, wholesale, financial services, food processing, and manufacturing. At the foundation of the entire market capitalism sector is a network-based mechanism that is a response not only to the lack of codified and diffused information in the current environment, but also to centuries-old traditions. In summary, market-sector managers rely heavily on a cognitive institutional pillar for making business decisions. The state, however, retained an ownership position in thousands of enterprises that were privatized, giving it the ability to influence or block important strategic decisions within those firms. Because of the myriad bureaucratic obstacles that impede starting and growing private businesses, the leaders of market-sector firms rely on networks to deal with these obstacles as well as to exchange information and develop supplier and customer relationships, in traditional Russian fashion. Additionally, because information on changing regulations is not well codified or diffused, and therefore not readily available to managers, a 2004 World Bank survey found that 75 percent of Russian firms worried about the unpredictability of the interpretation of laws. In summary, the regulative institutional pillar has not yet developed enough to guide decisions, and business people thus have relied upon the cognitive pillar for decision rules. Also, many business people in the private sector started businesses after careers in academe, the military, the Communist Party, the Communist Party Youth Organization (Komsomol) and the like (Puffer & McCarthy, 2001). They continue to deal with others from similar backgrounds, since they are known and more likely to be trusted, two crucially important attributes in the development of networks among Russians (Ayios, 2004).

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Private Russian firms compete among themselves as well as with foreign multinationals including CocaCola, Gillette, Danone, Caterpillar, and General Motors. Unfortunately, the manufacturing sector is desperately obsolete and is in dire need of investment to modernize, as noted by many critics including members of the World Economic Forum (Belton, 2005a). Few such firms are able to compete with international companies that have invested in local production facilities, or that export to the country. Additionally, managers of Russian companies must embrace a new management style if they are to compete domestically as well as outside the country (McCarthy, Puffer, Vikhanski, & Naumov, 2005). Still, the consumer sector is vibrant and fundamentally operates in a market-oriented, competitive fashion, with many growing Russian companies and an increasing number of foreign competitors. For instance, in competition with foreign firms like the German giant Metro/Real and France’s Auchan, Russia’s leading retailer, Pyatyorochka, recorded a 23-percent increase in sales for 2005. The luxury goods sector is also very active, with such familiar brands as Cartier, Armani, and Louis Vuitton along with the major Russian chain, Arbat Prestige, which raised $80 million in a spring 2006 initial public offering to fund expansion. Russian companies succeeding in the fast-growing telecommunications sector include VimpelCom and MTS. The automotive sector also operates in a market-oriented, highly competitive environment, with Russian companies facing increasingly severe competition from imported and foreign vehicles assembled in Russia. The great progress in the consumer sector is reflected in the marked growth of GDP, which essentially doubled, to $712 billion, from 2002 to 2005, with GDP per capita reaching $5000. In the still undeveloped financial services sector, some organizations have begun to provide the foundation for capital markets, a critical institutional underpinning of market economies. Russian investment banks have emerged, such as the highly regarded Troika Dialog Bank. Some market-sector companies have begun to pull formal institutions into the financial arena, creating a growing but nascent regulative institutional pillar. Constrained by the fledgling domestic capital market, a number of large Russian companies have successfully turned to international capital markets, primarily for debt, while some have listed on foreign stock exchanges. In early 2005, for instance, the information company Sistema became the fourth Russian firm to be fully traded on the London Stock Exchange, raising 1.2 billion pounds ($1.6 billion). And although Russia’s two stock

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markets have relatively few companies listed, they have succeeded in attracting foreign investment, and were among the world’s top performers in 2005. 4.2. Oligarchic capitalism Oligarchic capitalism refers to the economic activities of a small number of very large and powerful financial-industrial groups operating in highly concentrated industries in the private sector, predominantly in natural resources. The firms operate globally, with limited competition due to the nature of commodity markets. This form dominated the Russian economy in the second half of the 1990s and early 2000s, and remains an important but less dominant component of the economy. Each financial-industrial group includes an oligarchowned bank, including Menatep, Alfa Bank, and Stolichny Bank, that amassed fortunes by securing privatized natural resource-based firms at a fraction of their value. Most of these empires are owned by one or a small number of extremely wealthy and powerful individuals, many included on Fortune’s billionaires list. These men came to be known by the unflattering term, oligarchs, since they had obtained ownership and power of much of the nation’s natural resources through highly questionable privatization auctions. Among the oligarchs who were still powerful more than a decade later, Anatoly Chubais, Roman Abramovich, Vladimir Potanin, Mikhail Fridman, and Oleg Deripaska were ranked by journalists as being among the 15 most influential Russian businessmen in 2005 (Ekonomika i Zhizn’ survey reported in Economic Newsletter, December 19, 2005). In the 1990s, the Yeltsin administration had adopted a relatively laissez-faire approach to the economy, but became indebted to, and embedded with, various oligarchs in the notorious loans-for-shares scheme connected to Yeltsin’s 1996 reelection campaign. The country’s 1998 financial crash triggered a radical rethinking about this type of economy, and Putin’s election signaled a vastly increased role for the government in the economy and business (McCarthy, Puffer, & Naumov, 2000). The ownership of some companies acquired by the oligarchs became the subject of challenges, like Yukos in the courts, and others in the arena of public opinion. Olga Kryshtanovskaya used the term, financial oligarchy, to describe the ‘‘emerging clan structure’’ reflecting the rise of the oligarchs with their huge financial wealth, as well as their enormous political influence (Kryshtanovskaya, 1996, cited in Hoffman, 2002: p. 321). Her insight was a recognition

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of the traditional prevalence of clans in Russian society. Some analysts have referred to this economic form as oligarchic capitalism (Hoffman, 2002: 367). The clan structure of oligarchic capitalism operated through network-based relationships, with oligarchs having created the Club on Sparrow Hills in the 1990s to informally discuss issues of mutual interest regarding business and the economy. The oligarchs’ network had an incestuous relationship with the Yeltsin government, which became very clear when the president’s chief of staff tried to get two oligarchs to divide the spoils of a privatization plum 50–50 rather than fighting their ‘‘Bankers’ Wars’’ (Hoffman, 2002: 379). The infighting among the oligarchs and the power they exercised, both financial and political, turned back the clock of economic reform in Russia by at least 3 years. Oligarchic capitalism had taken a major toll on Russia’s road to a market economy and a more legitimate form of capitalism (Hoffman, 2002). When Vladimir Putin became president, he reportedly struck an agreement with the oligarchs to leave them and their property alone if they kept out of politics. Mikhail Khodorkovsky evidently violated that agreement by signaling his political ambitions, challenging Putin, and presumably setting off the government’s attack on Yukos. A question that remained was whether Yukos-type vendettas would proliferate to other oligarchs, in spite of Putin’s pronouncements to the contrary. The conflicts evident in the Yukos case raised the more basic question of whether oligarchic capitalism would continue to exist as a major segment of the Russian economy. A signal may have been given by Putin’s deputy chief of staff, Vladislav Surkov, in December 2005. He warned that a return to a government heavily influenced by the richest businessmen, the oligarchs, would be a catastrophe (Moscow Times, December 22, 2005: 7). 4.3. Siloviki capitalism In contrast to the market and oligarchic, private capitalistic sectors, the growing government involvement in business has led to a condition that Harvard Russian economist, Marshall Goldman, and others have termed siloviki capitalism. This economic form encompasses various ways in which the government exerts influence over the economy by controlling major corporations in which it has majority or significant ownership. The term siloviki is rooted in the Russian word for power. It traditionally referred to heads of ‘‘power ministries’’ like Defense and Interior Affairs, as well as the military and security forces. Some former security and military siloviki had joined the Yeltsin

government in the 1990s, but the silovikis’ influence in promoting a ‘‘statist ideology’’ became much more pervasive under the Putin administration, with their number estimated to have been more than 6000 people in 2005 (MN-files, 2005). The trend toward siloviki capitalism appears to lie at the heart of increased government involvement in partially state-owned companies, as well as some that had been primarily in private hands. Implications of the state’s expanding presence were noted by the director of the Russo-British Chamber of Commerce, who declared that ‘‘the State is back,’’ and advised companies to find ways to do business under this constraint (Cromwell, 2004: 16). A growing number of siloviki have been appointed to key positions in major corporations with majority government ownership, and some that were essentially private companies. Such appointments are reminiscent of tsarist-era practices of imposing influence and monitoring activities. Tsars would appoint aristocrats to key positions in private businesses, including those with foreign owners (Economic Newsletter, November 2004). Putin’s siloviki appointments include administration deputy head, Igor Sechin, as chairman of the board of state-owned Rosneft, an official seen as ‘‘an increasingly powerful proponent of statist economics’’ (Belton, 2005b). Others include former top Putin aides Alexei Miller, who is board chairman of Gazprom, and Viktor Ivanov, chairman of the boards of the airline Aeroflot and the defense enterprise Almaz-Antei. Six others, including Vladimir Artyakov as chairman, were appointed in late 2005 to the 12-member board of privately owned AvtoVAZ, after a state-owned defense firm acquired a controlling stake in the leading but ailing Russian automaker. The entire process is a vivid example of how members of Putin’s inner circle are using their network to take over private companies, amassing personal wealth in the process (Chazan, 2006). The development of siloviki capitalism supports broader forms of government influence, such as industrial, fiscal, and monetary policies, and other methods. As members and former members of the government, particularly the presidential administration, these influential siloviki have a natural network in the political sphere, with the president at the center. The increasing influence of siloviki capitalism seems to be a threat, particularly to oligarchic capitalism, and potentially to market capitalism. The growing siloviki capitalism sector has also weakened the regulative institutional pillar that had begun to emerge in the earlier years of President Putin’s administration, and has

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strengthened the cognitive pillar which is characterized by networks.

in protest against its policies toward business and the economy.

5. State-managed, network capitalism

5.2. Siloviki-oligarchic intersection

The three forms of Russia’s capitalism discussed above are not only networks within themselves, but they overlap with one another, creating additional networks. These intersections are depicted in Exhibit 1 as the siloviki-market network, the siloviki-oligarchic network, and the oligarchic-market network. Additionally, a three-way intersection, at the center of the exhibit, occurs as a result of the state’s actions through deployment of siloviki to achieve certain goals that affect both the oligarchic and market networks. These relationships are also reciprocal networks, with the oligarchs and market-oriented business people attempting to influence the government, and each other, to achieve their own objectives. And more broadly, the Russian state, the pervasive environment for all three forms of network capitalism, is depicted as the large background circle in Exhibit 1. This network of interactions, including interactions with the state, results in a system that we call state-managed, network capitalism. The interrelationships within this system are discussed below.

One result of the Yukos-Khodorkovsky case was the fear instilled in many oligarchs that their empires would be dismantled like Yukos and reconstituted as silovikicontrolled, state-owned enterprises. Oligarch Vladimir Potanin of Interros called upon Putin to ensure that the Yukos affair was a one-time occurrence. Still, in late 2005 he sold his 26-percent stake in the largest Siberian oil field to the state-controlled oil company, Rosneft. In a similar move that year, oligarch Roman Abramovich sold his substantial holdings in oil firm Sibneft to the majority state-owned energy giant Gazprom. Perhaps both anticipated that the state would inevitably find a way to gain control of their oil holdings in a consolidation of the energy sector. Additionally, they were likely trying to build alliances with the increasingly powerful siloviki who were expanding the intersection of siloviki and oligarchic capitalism. Another sign of this growing intersection was the state-owned defense firm Rosoboronexport’s announcement in early 2006 of its plans to form a state minerals holding company. Russian think-tank analyst, Konstantin Makiyenko, noted that this reflected the government’s objective of gaining control of strategic sectors of the economy, which began with oil and gas (Pronina & Humber, 2006). And economic minister German Gref announced in February 2006 that the government intended to gain majority control of Alrosa, the Russian diamond monopoly, the chairman of which was Finance Minister Alexei Kudrin.

5.1. Market-oligarchic-siloviki intersection The Yukos-Khodorkovsky case is an extreme example of the state’s intervention in the economy in whatever way it chooses. The government’s actions instilled increasing fear and uncertainty in business people who were already suspicious of vacillating government policies. It raised additional doubts about institutions like private property and the court system, potentially resulting in serious damage to the country’s economic future. In this case, the government’s actions seemed to threaten the future of both oligarchic capitalism and market capitalism. The situation also promoted the prospect of increased siloviki capitalism by deploying Putin loyalists to key positions in the former Yukos operations which were reconstituted as the state-owned Rosneft, a new oil powerhouse. This increase in siloviki power seemed to threaten the future of the oligarchs and oligarchic capitalism. State involvement was being pursued by members of what Andrei Illarionov has called the new corporatist order, noting that these officials [siloviki] joined state and private companies, which effectively turns them into state firms (Levitov, 2005: 2). He made these remarks several days before resigning from the Putin government at the end of 2005,

5.3. Siloviki-market intersection This network intersection is illustrated by the appointment in January 2006 of six siloviki – progovernment directors and managers from state-owned enterprises, including two from the state arms enterprise Rosoboronexport – to the board of directors and senior management of AvtoVAZ, the country’s largest domestic automobile company. Although that company had majority private ownership, it was included on the state’s list of strategic enterprises, and thus the government appointed state-friendly executives to the troubled company. The new management denied that the state’s objective was to take control, but few analysts agreed. Another instance of the siloviki-market intersection occurred in February 2006 when former finance minister, Boris Fyodorov, started a private equity fund

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after the last 60 percent of the privately owned United Financial Group, which he cofounded, was purchased by Deutsche Bank for $400 million, giving it complete ownership. As one of UFG’s largest shareholders, Fyodorov had already made tens of millions on the sale of the initial 40 percent. His new private equity fund, UFG Asset Management, planned to invest $250 million focusing on 5000 to 10,000 Russian companies worth $10 million to $100 million and having no government ties. Fyodorov concurrently served on the boards of directors of majority state-owned Gazprom and Sberbank, while his new company would compete with Western private equity investors and Russian oligarchs (Clark, 2006). 5.4. Market-oligarchic intersection Although most oligarchs started their empires in the natural resource sector, many have diversified both within and outside Russia. Some of their newer businesses operate in the more competitive marketsector, creating an intersection of oligarchic and market capitalism. A prime example is oligarch Mikhail Fridman’s Alfa Group, which entered the telecommunications industry through its extensive ownership of NYSE-listed VimpelCom. That firm became a major competitor not only within Russia, but in early 2006 was also attempting to extend its reach into Ukraine by way of a major acquisition. Additionally, aluminum industry oligarch Oleg Deripaska of Basovyi Element diversified his holdings to become a major force in the competitive Moscow construction industry. Such diversifications appear to be a growing trend among the oligarchs to utilize funds flowing from their natural resource-based companies that have ready markets at world prices in the global arena. These diversifications also provide a potential refuge for the oligarchs if the government should decide that their natural resourcebased firms are strategic to the government’s interest as discussed in the siloviki-oligarchic intersection. 6. Pervasive power of the state The state’s power pervades all three networks and their interactions, and is depicted as the large background circle in Exhibit 1. We thus designate the entire system as state-managed, network capitalism, and note that in dealings among networks, parties on all sides attempt to influence others to achieve their objectives. Members of the market and oligarchic sectors attempt to influence the siloviki and the state. Not surprisingly the state has prevailed, as evidenced not only by the

Yukos-Khodorkovsky trial, but also by the sale of valuable natural resource assets by some oligarchs to state-owned companies. Additionally, the state has used many other methods to exert its influence on the economy. These include regulating and restricting entry of firms, controlling the use of land and real estate that private businesses occupy, taxing businesses to suit its own ends, inspecting firms and sometimes closing them at will, and exercising control over international trade and foreign exchange transactions (Shleifer, 2005: 102). The state has also used these methods to support politically friendly business people and punish unfriendly ones. Many of these methods have involved the use of networks that include state officials, administrative operatives, and business people. Although also found in Western countries and elsewhere, it is essential in Russia where such networking is fundamental to conducting business. Specific instances of government intrusion into other networks abound. In December 2005, the Kremlin’s major supporting political party, United Russia, invited four senior executives from industrial and consumer companies into its ranks to develop closer associations with important, non-oligarch business leaders as ‘‘the pro-Kremlin party continues its drive to win over the country’s business elite’’ (Pronina, 2005: 7). Also, many members of the Duma (legislature) have their own businesses or work in other companies, while many bureaucrats in the state establishment have enriched themselves through bribes. And long-time Moscow mayor, Iurii Luzhkov, wields such power and influence over business in the critical Moscow region that some have included him among the oligarchs (Hoffman, 2002: 54–77). In early 2006, for instance, his policies continued to prevent investors and business people from owning land in Moscow, even though federal law had legalized private land ownership in 2001. 7. A legacy of the Yukos trial: Russia’s network capitalism at a crossroads One expert on the Russian economy at the Institute for International Economics concluded: ‘‘Three of Russia’s greatest recent reforms have been tax reform, judicial reform and the reinforcement of property rights. Through the Yukos case, Putin has effectively jeopardized all these achievements . . .. The worst long-term effect is that property rights in Russia have been severely undermined’’ (Aslund, 2005). The same expert in mid-2006 decried what he described as the Russian government’s ‘‘folly of renationalization’’ (Aslund, 2006). Yet, because of the attractiveness of

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the Russian market and the potential for substantial returns from the oil sector, foreign direct investment more than doubled in the first half of 2005 to $9.3 billion compared to the same period in 2004. After annual increases in the early 2000s, oil production grew at only 2.2 percent for 2005, the lowest growth rate since 1999, while annual industrial output increased only four percent, compared to 7.3 percent in 2004. Industrial output was greatly affected by low growth in the oil sector. Analysts attributed that slowdown largely to the government’s dismantling of Yukos and selling off its major production unit, Yuganskneftegaz, to the new state-owned oil company, Rosneft. While many speculated on the government’s objectives given its strong moves into the oil sector, President Putin tried to reassure Russian business people and foreign investors that Yukos was a one-time event. His government passed a law in 2005 that seemed to support his statements, reducing from 10 years to three the statute of limitations for contesting alleged company wrongdoings during privatization. It appeared that Putin succeeded. A Business Index survey noted that negative views resulting from Khodorkovsky’s sentencing were short lived (Walters, 2005). And late in the year, increased retail sales and a higher RTS index were seen as indicators that the Yukos trial was ‘‘a fading concern’’ (Economic Newsletter, November 2005). The Yukos case had clearly resulted in mixed signals and dealt a major blow to the development of the regulative institutional pillar that had begun to emerge earlier in the Putin administration. The uncertainty, confusion, and fear among many business people reduced their trust and willingness to be transparent about their companies, a major setback to the country’s nascent corporate governance system. Until the Yukos case, substantial progress had occurred in the corporate governance system, particularly among large corporations with more than 1,000 shareholders, which made them subject to the 2002 Code of Corporate Conduct. The Yukos setback convinced many of these companies as well as many not so large firms to decrease transparency and deemphasize sound corporate governance. They began instead to rely more upon their established networks and a cognitive institutional pillar for guidance. 7.1. Uncertain state role The Yukos-Khodorkovsky trial was not only a highprofile example of the state’s interference in business and the economy, but it also raised the more important

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question of the state’s objectives for the private sector, given the Putin administration’s ambivalent signals. The president, however, has consistently voiced his support for a market economy, and in his late January 2006 annual press conference, emphasized that the state was not planning a major renationalization of key industries. He added that the state welcomed private investors in the oil sector, noting that there were about 10 large private oil companies in Russia. It seems clear that one reality of the fallout from the Yukos case is that the country has moved beyond oligarchic capitalism that had dominated the economy during the second half of the 1990s and early 2000s. After nearly two decades of a tortuous road toward a market economy, Russia’s form of capitalism still continues to be somewhat of an enigma. Still, advances in the market-capitalism sector, and its intersection with other sectors, suggest that Russia is developing its own form of network capitalism. Various forms of capitalism coexist, but with uncertain futures given the mixed signals from the Putin administration. The YukosKhodorkovsky trial was a watershed in the evolution of Russian capitalism since it was an early indicator of the move to state-managed, network capitalism, coming at a time when free-market capitalism and transparency had seemed to be on the rise. 8. The future of Russia’s state-managed, network capitalism: policy, investment, and competitiveness Recognizing the pervasiveness of the state’s influence in many sectors of the economy, we conclude that the Russian economy is and will continue to be one of state-managed, network capitalism. We base this conclusion not only on our analysis of the current system of networks that constitutes the Russian economy, but also on the country’s enduring cultural tradition of relying heavily upon networks to accomplish goals and objectives, as well as the traditional key role of the state in the Russian economy. We believe that the economy will continue to rely primarily upon the cognitive institutional pillar rather than other more formalized institutional foundations. This situation will continue to exist until the state strengthens the regulative institutional pillar, especially the ineffective legal-judicial system and the banking system. There is little evidence that information is becoming more codified or diffused to move beyond dependence on networks to conduct business within the Russian economy. The state and related institutions, like the judicial system, have not succeeded in making

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information available in an organized fashion to the business community. The dearth of stable economic institutions has exacerbated this situation, and information continues to be inconsistent, confusing, contradictory, and incomplete. The Yukos-Khodorkovsky case motivated many business people to fall back on their cultural tradition of distrusting those outside their networks, and led them to carefully guard their own company information. The codification and diffusion of information necessary for the development of a Western-type market capitalism, reflective of the regulative institutional pillar, is clearly not sufficient in Russia. 8.1. Policy issues The most crucial policy issue is whether the state will become even more deeply involved in business and the economy. The state’s economic policies will determine not only the extent of state-managed, network capitalism itself, but also the size and extent of intersections among the three forms of network capitalism within that system. These relationships will in turn affect the country’s competitiveness and investment attractiveness. The state’s attention to strengthening the regulative institutional pillar by such actions as reforming the judicial system and ensuring the enforcement of laws would be a very positive step for both competitiveness and attracting investment. The future of the market capitalism sector will depend on whether economic policies create a supportive environment, or continue to make it extremely difficult for private companies to be created, grow, and be profitable, a weakness consistently noted by Putin and other top officials. Small business, for instance, which is the economic engine of most developed economies, employs only 20 percent of Russia’s economically active population in contrast to over 50 percent in Europe and 80 percent in Japan. Supportive policies would encourage entrepreneurship by reducing the bureaucratic requirements for starting businesses, and also reduce opportunities for bribery and corruption that business people face at every turn. Prime Minister Fradkov and Economic Development and Trade Minister Gref both called for reforms in mid2006 to prevent such abuses. Developing codified, clear, and consistent information, and diffusing it widely, would go far to dispel such negative practices and the reigning confusion. Conversely, increasing government involvement, by continuing the trend of more siloviki capitalism, could come at the expense of market capitalism, and certainly

that of oligarchic capitalism. But even if market capitalism prevails, it will still be a unique form, with networks at its core for some time. Oligarchic capitalism is even more vulnerable than the market capitalism sector to increasingly intrusive state involvement, either directly or through the extension of siloviki capitalism, a lesson learned from the Yukos-Khodorkovsky affair. State policies could further threaten the existence of other oligarchic empires through quasinationalization, or outright nationalization as occurred with Yukos. Alternatively, the state could decide to break-up oligarch-owned enterprises, but ensure that they operated in the market capitalism sector rather than in the siloviki capitalism sector. Thus far, however, the state’s policies and actions seem to forecast more nationalization and quasinationalization. 8.2. Investment attractiveness Unfortunately, uncertainty has prevailed for investors. At a time of relatively high instability in Russia, siloviki capitalism might have been justified by President Putin and others as a way for Russia to exercise control over strategic industries like energy and defense. The extension of that form of capitalism into the automotive and precious gem industries, however, could be an indication that the state is unwilling to allow those attractive consumer sectors to become the province of foreign companies through imports or direct investment, or even private Russian companies. Like energy, if the auto industry were to become statedominated and provide substantial state revenues, it could reinforce the state’s already lukewarm attitude toward foreign investment, which in the longer run would be detrimental to Russia’s economic growth. The lack of consistent policy and institutions to strengthen the state’s credibility is detrimental to securing new foreign investment, especially in areas that are politically salient (Henisz & Zelner, 2005). The issue has become very serious as political officials have overturned or reinterpreted agreements for reasons of political expediency and outright greed. An additional concern is that the energy industry managed by siloviki has already become less efficient than major global competitors. The inherent inefficiency of state-managed companies could well extend to the automotive and aircraft industries where siloviki capitalism has already taken hold. An additional concern for investors is that this inefficiency, and decreasing investment attractiveness, could creep into other areas like the remainder of the 39 industries on the state’s list of strategic industries.

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A positive development on the investment and capital markets front, however, has been the increasing interest of foreign financial institutions in the opportunities available in Russia. The growing need of Russian companies for debt and equity capital has attracted major Western financial firms including Renaissance Capital, UBS-Warburg, Merrill Lynch, Dresdener Bank, and Deutsche Bank. But this positive institutional development, an example of what we call institutional pull, came about as a result of the state’s failure to provide sufficient institutional push. A prime example is that most companies still have little access to bank debt since the lion’s share of loans is made by Sberbank, the government-owned bank. It lends primarily to businesses with connections to the bank or the government, a situation brought about by the mass privatization process (Kogut & Spicer, 2002). Russian industry, including the highly profitable oil sector, is desperately in need of modernization, which in turn will require substantial infusions of new domestic and foreign investment. But unfortunately, the Russian state has shown relatively little interest in attracting foreign direct investment, since the country is awash in hard currency inflows resulting from oil exports. 8.3. Competitiveness Not only the size and growth rates of each form of capitalism, but also the size of their intersections, will be determined largely by government policy, and these policies will affect the competitiveness of Russian companies both domestically and globally. The state could allow the market and oligarchic sectors to grow unencumbered by restrictive government policies, leading to growth of the private sector, with greater prospects for global competitiveness. Conversely, state policies could result in larger intersections of siloviki capitalism with both market and oligarchic capitalism. This would reflect an increasing role for the state, and would likely result in more enterprises being less competitive, unless such policies were to support an open and competitive environment in the market capitalism sector. The increasing role of the state, primarily through siloviki capitalism, is inherently inefficient and noncompetitive since the siloviki have a bureaucratic rather than a competitive business mindset. Clearly, government policies alone do not produce either national nor firm competitiveness. As Michael Porter, a leading authority on the subject recently noted, such a top–down approach must be complemented by a bottom–up or microeconomic approach that focuses on individual firm performance (Snowdon & Stonehouse,

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2006). We have seen the latter process result in the institutional pull phenomenon described earlier. Undoubtedly, some top–down policies and actions are needed to create a stronger institutional push. However, if misapplied, such policies can undermine an economy by reducing corporate profits, which in turn discourages entrepreneurial activity and economic growth (De Soto, noted in Shleifer, 2005: 102–103). In mid-2005, senior presidential economic advisor, Andrei Illarionov, charged that the state’s trial against Yukos had diverted portfolio investment from ‘‘the most effective and fastest growing companies into ineffective nontransparent ones seen as close to the state’’ (cited in Belton, 2005b). 8.4. Implications for Russian managers and owners Implications for Russian managers and owners will depend primarily on the capitalism sector in which they operate, as well as the other capitalism sectors with which they interact. Those in the oligarchic sector currently face the greatest risk of negative actions on the part of the state, as evidenced by the Yukos case. Some oligarchs seem to have received a clear message and have strengthened ties with the siloviki sector and the Kremlin. For instance, Roman Abramovich and Vladimir Potanin sold valuable energy assets to the state, and Oleg Deripaska’s cooperation was rewarded with large state infrastructure contracts for the construction arm of his diversified empire. Oligarchs who do not cooperate may find their holdings threatened or confiscated by emerging firms in state-declared strategic industries. Managers in the siloviki capitalism sector would seem to enjoy favorable conditions under the current Putin government’s economic policies. Government decisions during Putin’s second term have led to an expansion of government into private business, and the siloviki became beneficiaries being appointed as managers and board directors of the newly expanding quasi-state firms. However, in mid-2006 Putin began weakening the siloviki who he evidently saw becoming too powerful. So although current policies generally support the position of siloviki managers, their future is uncertain and will remain so at least until the 2008 elections. Although their future is far from certain, managers and owners operating in the market capitalism sector have reason for optimism. The Putin government has consistently maintained its commitment to a market economy, and a number of influential members of that administration are clearly committed to that direction, including a potential successor to Putin. Still, the

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ambivalence of the administration is evident in its increasing involvement in some key, strategic industries as well as its apparent unwillingness to make badly needed changes that would make it easier to start and grow private businesses. Progress has been and will likely continue to be uneven. While managers and owners in the manufacturing sector need substantial assistance and incentives if their businesses are to attract investment and become truly competitive in Russia and globally, those in the retail and supply chain sectors will likely continue to prosper, as will those private companies in the natural resource sectors. 9. Conclusion Russia’s role as a key player in global energy markets, and its potential as a burgeoning market for consumer and industrial goods and services, makes the country increasingly important to Western and domestic companies. State policies will determine whether this situation continues, as well as whether more private Russian companies will attract foreign investment and take their place among major global competitors. The country’s competitiveness and investment attractiveness require a strengthening of regulative institutions rather than the current heavy dependence upon cognitive institutions. We believe this requires substantial institutional pull on the part of (mostly market-sector) companies to pressure the government to create more formal institutions. We also conclude that Russia will continue to develop its state-managed, network capitalism. The specific direction of the economy, however, will depend upon government policies that determine which types of network capitalism are strengthened and which are weakened by those decisions. Our analysis leads us to conclude that policies which strengthen the market capitalism sector will have the most positive effects on the competitiveness of Russian companies and their attractiveness for foreign and domestic investment. In any case, Western investors, international agencies, and Western governments will need to recognize that, whatever the outcome, it will not be the Western market capitalism they are familiar with, and they will need to find ways to work with Russia’s state-managed, network form of capitalism. References Aslund, A. (2005, May). Kangaroo court costs. Moscow Times, 18: 10. Aslund, A. (2006). The folly of renationalization. Moscow Times, 23: 10.

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