Rags-to-riches surprise for Russia’s power engineering industry

Graham Stack for Russia Profile

The flood of investment in expanding Russia’s power generation capacity has taken most people by surprise – not least the power engineering companies who will build it.

Russia’s huge and unanticipated success in raising 150$bn investment to expand its power generation capacity has taken power equipment producers largely by surprise, causing bottlenecks in production, soaring prices for equipment, and oligarch acquisition of engineering plants.

“No one anticipated the success of the UES spin offs in raising investment funds,” says Alfa’s Alexander Kornilov, “and so the power generation machinery sector was caught unprepared for the huge surge in demand.”

Caught unprepared

St. Petersburg based Power Machines, a conglomerate of several large power engineering plants which took shape in 2004, has 60% of the Russian market, so is taking a lion’s share of the capex. But according to Kornilov, Power Machines is facing a “severe shortage of qualified personnel and manpower.”

It was only in 2007, as the sell-off of the state’s stakes in power generation companies started, that the scale of the coming investment boom became clear. Power Machines announced February 2007 that its sales revenue could jump to $1.5bn in 2010 from $680m in 2006, as the result of $1bn in investment through 2010.

This abrupt change in fortune turned loss-making Power Machines into a hot property – with strategic importance.

Both electricity utility UES (25%) and financial-industrial group Interros (30%) announced they would sell their stakes to a strategic investor, promptly unleashing a bidding war between metal oligarchs Oleg Deripaska and Alexei Mordashov that resulted in the latter consolidating a 55% stake in the company for close to $1bn.

With a strategic investor in the driving seat, new management, and an additional share issue having raised $275m, Power Machines’ plans to more than double generation capacity of machinery produced from 8-17 GW annually looked more realistic.

But it was still running to catch up, with new demand exceeding current output fivefold. Moreover, construction of new generation capacity is on an extremely tight schedule: mandatory investment programmes stipulate 280 turbines to be built by 2011.

This bottleneck it does not just relate to turbine producers. A whole range of further industries engineering services, construction materials and construction work are coming up short.

It is not only lack of capacity. Russian produced-technology still lags far behind western counterparts.

Luckily for Power Machines, but unluckily for Russia’s electricity generators, foreign giants such as Siemens and Alstom are also running at full capacity.

“The world’s largest producers of generating equipment, such as General Electric, Alstom, Siemens and Mitsubishi, are just as overloaded as Russian Power Machines, leaving no room for an increase in their production,” says Alfa’s Kornilov.

Freedonia market report puts global electric transmission and distribution equipment demand to rise 4.4% annually through 2011, and International Energy Agency forecasts at least around €140 billion per year to be invested in power generation until 2030

As a result Russian power generators have to queue to place orders. Mosenergo reportedly paid a $54m booking fee for a $500m equipment order from a foreign producer, according to Russian Today.

The surprise guest at the feast has thus been no-name Chinese producers. OGK-2 invited Harbin Power Equipment was chosen as equipment supplier for the Troitsk HPP and at the end of April announced it was inviting a project developer from China to take part in the construction of new generating units at the plant.

These steps awakened alarmist fears of flood of cheap Chinese power station components and companies flooding the market. However, according to Alfa’s Kornilov, Chinese manufacturers still lack the quality to make real inroads.

Chubais vs. Chemezov: How to kick-start engineering

The upshot is that Anatoly Chubais – the godfather of 90’s economic reform, scourge of industrialists and idol of free-marketeers – has succeeded magnificently where the government’s interventionist silovik faction has little to show: By kickstarting a revival of the ailing machine-building sector.

For much of Kremlin economic policy in Putin’s second term was focused on reorganising the machine-building sector – including ‘deprivatisation’ where necessary.

The culmination of this policy was the establishment December 2007 of the Russian Technologies state corporation, dedicated to supporting and developing machine-building, and excercising direct control over upwards of 300 companies, and headed by Putin’s old friend Sergei Chemezov.

Chemezov argues – with some justification – that turning the sprawling machine-building sector around is the key to achieving economic diversification.

“In any country, and especially in ours, machine-building is the key sector of industry,” Chemezov told Nezavisimaya Gazeta in an interview May 28th.

And this is what Chubais has achieved with the rags-to-riches tale of power equipment producers – without a ruble of state support, and without infringing on property rights or creating opaque structures as the siloviki are wont to do.

On the same day, 21st May, that headlines were full of the maiden flight of Russia’s new regional jet, the Sukhoi Superjet 110, a product of state-owned holding United Aircraft-building Corporation, Chubais opened the first Russian-produced, combined-cycle power unit in Komsomolsk, the work of private companies and private investment, saying “a breakthrough for the country’s heavy-machinery sector.”

One company had double cause to celebrate: Yaroslav-based turbine producers NPO Saturn built the engines for the Superjet, and also the turbines for Konsomolsk power plant.

The case of NPO Saturn also perfectly illustrates the very different approaches between the ‘industrialists’ Chubais and Chemezov.

Chubais, in his speech opening the power plant, congratulated Russia’s power engineering managers, but warned them they had to stay internationally competitive to keep winning tenders:

“I’m for Siemens as well, and I’m for General Electric. If you fail to produce the 10 new units, I’ll strangle you with my own hands,” he warned them playfully, as quoted by Interfax.

Chemezov’s threats towards NPO Saturn, on the other hand, are far less playful: Russian Technologies holds a 37% stake in the company and is pushing for the company to be merged into a state-controlled conglomerate, effectively renationalizing it. Company director, Yury Lastochkin, who controls 57%, is bitterly resisting this.

Deputy Industry Minister Denis Manturov, a Chemezov ally, has publicly called Lastochkin’s position ‘destructive’, adding in a Kommersant interview, ‘I advise Mr Lastochkin to read what is set down black on white in the presidential decree about who is to do what and when,” and stating Russian Technologies would ultimately require 100% control over Saturn.

Lastochkin responded in Vedomosti that “to hand over assets we have been developing and structuring for over 10 years to complete nobodies would be beyond a laughing matter.” Asked if he feared pressure from law-enforcement agencies forcing a management sell-out, he said he hoped the state was clever enough to realize that any such ‘games and experiments’ would have a disastrous effect on such a finely-tuned technological enterprise.

Which of these two battling paradigms – Chubais vs. Chemezov, unbundling of UES vs. snowballing of Russian Technologies, competition and private investment vs. state control – wins out, is one of the first things that new president Dmitry Medvedev will have to decide.

Oil field services: The market’s answer to Russia’s stalling oil production

With Russian oil production beginning to fall, the new and growing Russian oil field service (OFS) sector (specializing in oil exploration and production services, solutions, and technology) could hold the key to turning this trend around — by cutting costs, increasing competition, and introducing new technologies.

Russian oil production in April of 2008, at 9.72 million barrels, was 1.8 percent below the production peak in October, despite world oil prices having soared to $126 per barrel (compared with $12 ten years ago).

In an interview with Smart Money, Vagit Alekperov, CEO and largest shareholder of LUKoil, Russia’s second largest oil company, called the drop in production “a trend.” His colleague, LUKoil CFO Leonid Fedun went even further, telling the Financial Times on April 15th that last year’s 10 million barrels per day peak was the “highest he would see in his lifetime.” The Russian government has been swift to respond with the promise of tax cuts to stimulate new production.

But another market-driven development will also be crucial to kick starting production growth: the ongoing emergence of an independent oilfield service sector in Russia.

Emerging from the shadow of oil majors

Global market leaders in oilfield services, such as Schlumberger and especially Halliburton, are household names, not least due to the latter’s controversial role in Iraq and links to U.S. Vice President Dick Cheney. Although what OFS companies sell are technologies for extracting oil, and not the oil itself, they constitute a trillion-dollar business. Schlumberger, the market leader, has a capitalization of $110 billion, a turnover of $23.28 billion, 80,000 employees worldwide, and holds 8.9 percent of the Russian market.

Characteristic of Russia’s capitalist energy field, only in the last three years have Russian OFS companies crystallized as a sector independent of integrated oil companies, mostly by spinning off from the latter. In 2008, the process is snowballing. The global practice is for oilfield services to be independent of oil companies, but the Soviet industrial legacy means that in Russia, over 50 percent of the market is still dominated by in-house services, not directly exposed to competition or shareholder scrutiny. Yet this is set to change and competition to increase.

“In the West, very few oil companies have their own oilfield service departments. You only find this in Russia and in China,” Andrew Gould, the president of Schlumberger, told the Vedomosti business daily on April 23rd. Gould added that the current trend for spinning off oilfield services is “excellent for competition,” and spoke highly of Russian technological expertise–Schlumberger itself employs 15,000 Russians worldwide, constituting almost 20 percent of its workforce.

“Oil companies are going to keep spinning off their non-core assets,” said Aleksandr Dzhaparidze, president and owner of Eurasia Drilling, also interviewed by Vedomosti in January. Eurasia Drilling and Schlumberger both possess just under nine percent of the market share in Russia.

Eurasia Drilling was formerly “LUKoil Burenie,” the OFS division of the LUKoil oil giant. Now it is the largest Russian OFS company, with market capitalization of $3.4 billion, having raised $450 million through an IPO in November of 2007.

Russia’s largest oil company, the state-owned Rosneft, also confirmed its plans to float its three OFS divisions following fundamental restructuring: the restructuring of Rosneft Service, uniting all regional service subsidiaries, was completed in April. Rosneft Service along with RN Drilling and RN Energy IPOs are slated for 2010-211.

TNK-BP, Russia’s third largest company by output, is also restructuring its 12 OFS units into one division, with the aim of either selling or floating it, or, alternatively, running it as a profit center. The service units earned $500 million in 2007, and Timothy Summers, Chief Operating Officer of TNK-BP, told journalists in April that he expects a profit of $700 million in 2008, along with a market capitalization of about $1-2 billion. The Siberian Services Company (SSK), a former YUKOS OFS arm, currently enjoys a market share of 2.5 percent.

A number of smaller operations are also being set up in the sector. Britain’s Imperial Energy announced early February that it is mulling an IPO of its freshly-consolidated oil services arm Rus Imperial Group (RIG). In March, Russia’s TMK, one of the world’s top three oil and gas pipe producers, announced the launch of the TMK Oilfield Services division.

Other investments in the sector include Geotech, conducting a $100 million private placement to institutional investors in preparation for an IPO in 2010, and in March, the leading Russian OFS company Integra announced a joint venture with America’s Smith International Inc., another global leader.

In contrast to the increasingly restrictive investment environment for foreigners in the oil sector per se, the OFS sector is very much open to foreign competition, which tends to focus on the high-end hi-tech niche. According to Rencap’s Roman Eleagin, this means that within five years, majors will outsource 70 percent of oil services to independent companies, in contrast to the current 50 percent.

Government tax break will further boost OFS

This change in the sector will go hand in hand with a double-digit growth of the OFS market, that will grow from approximately $11.5 billion to $15 billion per year. Driving the coming boom is the challenge posed by oil production, due to field depletion and greenfield development, combined with soaring oil prices. Analysts and executives agree it’s getting harder and costlier to extract oil in Russia.

“One of the most important global trends is the increasing challenge of maintaining the level of oil and gas production,” said Schlumberger’s Gould in March. “This is the fundamental reason behind the rise in costs. The second global trend is to replace reserves by conducting exploration. In Russia, this is being done mostly in Eastern Siberia. But infrastructure there is underdeveloped.”

Oil field services do make a difference, by employing state-of-the-art technologies to get the most out of depleted oil fields and by cost-efficient exploration. “We all know about high global energy prices,” Vladimir Putin said, addressing the Duma as prospective prime minister on May 8th. “Revenues of oil companies are not small. However, we are taking a large chunk of these revenues (about 75-80 percent) into the budget in the form of taxes and export duties. To a large extent, this leads to an increasing number of idle, low-debit wells. Exploration and development of new deposits take place slowly.” Putin concluded that “In order to stimulate production and refining of crude oil, it is now time to make a decision to reduce the tax burden on this sector.”

On Monday May 26th, the first meeting of the new Presidium of the Russian government approved a reduction of the mineral extraction tax (MET), by increasing the non-taxable base rate from $9 per barrel to $15 per barrel. It also approved seven-year-long tax holidays, for developing new regions such as Yamal, Timano-Pechora, and the continental sea shelf (in the Russian Arctic).

This is music to the ears of OFS companies. As analysts at the UralSib investment bank said, Russia’s OFS companies such as Integra, Eurasia Drilling, and C.A.T. oil, are now set to “benefit handsomely from the expected wave of capex growth that integrated companies will pour into exploration and development

Russians gobble up European companies

Graham Stack for business new europe

It is hard to get alarmed by investors buying into tour companies, however big, but Germany’s influential Der Spiegel nonetheless rang the alarm bells when Russian steel oligarch Alexey Mordashov recently bought 10% of tourism giant TUI. But while a spate of acquisitions in Germany and Switzerland by Russian oligarchs is triggering paranoia about attempted political influence, Russian firms are more focused on conquering their domestic market – by buying up Western expertise and technology.

“What do the Russians want? Profits or political influence?” screamed Der Spiegel, before going on to accuse Russian investors of running a “simple plundering scam.” Describing in lurid tones the “fairytale riches” of Mordashov and his colleagues, the magazine concluded that, “they cannot find any profitable investment opportunities in Russia, so they are coming to Germany. The ruble is rolling towards the West.”

Fears that the Kremlin might gain control over German summer holidays were reminiscent of the quip in 2007 that the Russians were claiming the North Pole to control Christmas. A sense of realism returned days later when TUI and Mordashov’s investment vehicle declared they were founding a joint venture in order to tap into the potentially vast and booming Russian and CIS tourist market. Russian firms, it seems, are interested in acquiring technology and expertise to conquer the booming Russian domestic market by importing best practices on a large scale, they’re not looking to create a fifth column in the West, despite what the headline writers say. So far from reflecting a lack of investment opportunity in Russia, as Der Spiegel alleges, the exact opposite is true: such acquisitions directly reflect the massive investment opportunities opening up in Russia, ranging from an underdeveloped service sector benefiting from booming consumption, to upgrading scanty and crumbling infrastructure through generously sponsored public-private partnerships.

Mordashov’s interest in tourism is a reflection of the potential size of the Russian tourism market, and its current fragmentation. While Western Europe’s tourism market is saturated, Russian outbound tourism is the fastest growing in the world. According to the Russian Federal Agency for Tourism, between January and June 2007 a staggering 13.7m Russians went abroad for their holidays, with destinations such as Croatia, Egypt, and Greece growing 130-150% in 2007. Moreover, Russians, with their two-week compulsory break in January when the rest of Europe is back to work, are a tour operator’s dream – and one that Mordashov’s investment in TUI hopes to turn into reality.

Only a few days before Mordashov became TUI’s largest single shareholder, fellow oligarch Len Blavatnik, valued at $7.2bn by Forbes magazine, snapped up a 19% stake in Air Berlin, Europe’s third-largest discount airline with a market capitalization of €506m. Air Berlin is the only one of Europe’s big three budget airlines currently present on the booming Russian aviation market, with flights from Germany to Moscow and St Petersburg. Budget airlines are in their infancy in Russia, but this is another market ripe for growth.

Retooling Russia with European tech

Outside the tourism sector, on March 26 the Russian holding company FLC West, linked to Russia’s state-owned United Aircraft-building Corporation, bought 70% of the Aker shipyards in the German Baltic town of Rostock for €292m. Again, there was nothing coincidental about this purchase. The Kremlin launched a programme to revive Russia’s moribund ship-construction industry in 2007 by uniting state-owned naval shipyards in a holding – the United Aircraft-building Corporation, sister of the United Shipbuilding Corporation. The declared aim of the United Shipbuilding is to refocus state-owned shipyards from naval to commercial shipbuilding. Hopes are pinned on the niche of ice-class shipping – to serve the Russian energy sector’s growing demand for oil tankers, LNG tankers, pipeline-laying ships and supply ships capable of plying the icebound waters of the Arctic.

The Kremlin wants Russian shipyards to corner this market and win what Putin called in his 2007 parliamentary address, “a decent niche on the global market.” And in February 2008, the then-presidential candidate Dmitry Medvedev called on Russian companies “to acquire foreign enterprises both directly and through participation in joint stock capital [and] help re-equip Russian enterprises, enhance their production, diversify investment and gain new markets.”

This is where the Aker shipyards come in: Russian shipyards lag far behind in commercial-use technologies. The Aker shipyards are already producing ice-class dry-bulk carriers for Russian corporations such as Norilsk Nickel, the world’s largest nickel producer. The shipyards produce double-acting cargo vessels, the sterns of which are designed to double up as ice-breaking bows. A pioneering technology specially developed for Arctic shipping – and one now in Russian hands.

The equation is the same when it comes to uber-oligarch Oleg Deripaska’s investment in German-Austrian construction giants Strabag and Hochtief. In 2007, Deripaska acquired 10% of Germany’s Hochtief and 30% of Austria’s Strabag, both construction and infrastructure giants, in anticipation of Russia transforming “into a gigantic building site,” in the words of Deutsche Bank. A state-sponsored infrastructure building programme will, according to First Deputy Prime Minister Sergei Ivanov, be worth a staggering $1 trillion over 10 years. “This country needs everything: roads, hospitals, schools, airports, cars, trains, airplanes,” Deripaska said in a November 10 interview about his European construction industry acquisitions. “There is huge demand, and supply is not coping.”

Russians not welcome – yet

On April 4, the same day Blavatnik announced his acquisition of a stake in Air Berlin, an old friend from his student days, billionaire Viktor Vekselberg, announced he was increasing his year-old stake in Swiss technology concern Oerlikon, in which he first invested in 2007. That year, Renova also bought into Sulzer, the major Swiss engineering company producing, among other things, state-of the-art equipment for the oil industry. Renova is an energy-focused conglomerate with stakes in oil major TNK-BP as well as power generation assets. In a January interview with Russian business daily Vedomosti, Vekselberg put the total investment in Switzerland at $3bn-4bn.

The unexpected double acquisition raised hackles in Switzerland and was challenged in court. When asked by Vedomosti what his motive for investing in Oerlikon was, Vekselberg answered: “to get access to technology that we don’t have in Russia,” especially in the sphere of alternative energies – wind, solar and biofuels. Vekselberg patiently talked down the hostile response to his investment. “No one anticipated the appearance of major Russian investors in one of the historic leaders of the Swiss economy. They asked: ‘and what do these Russians want?’ You have to laugh, but they saw the Kremlin’s hand behind it all. They’re just not used to us – but given time that will change.”

Hardly had the news of Russian oligarchs’ new business operations in Germany subsided, than a new rumour was doing the rounds on April 11: that Russia’s largest bank, Sberbank was poised to acquire Dresdner Bank’s investment banking arm, Dresdner Kleinwort. However, in this case there was hope rather than suspicion in the German reports: Dresdner Kleinwort has been badly hit by the global financial crisis, is wearing a “save me” sign, but has nevertheless been turned down by potential investors such as the Chinese Investment Corp. sovereign wealth fund.

The Russian side, however, was quick to dismiss the rumours. Renaissance Capital’s banking analyst David Nangle says that while it’s obvious that Dresdner Kleinwort is being touted for a sale and there may have been some contacts in this connection with Sberbank, “I’ve been talking with the Sberbank people and there’s simply nothing behind it.”

“Sberbank are looking to add on an investment-banking wing, that much is true, but it’s going to be in Russia where their corporate clients are, of course. Either they’ll buy into a Russian investment bank, or most likely they’ll do it organically,” he says. “Dresdner Kleinwort might be going cheap, but Sberbank is far from going on a European shopping spree without rationale or strategy.”

Russian shipping and shipbuilding: The league of national champions

Graham Stack, for Radio Free Europe / Radio Liberty

In the 1990s, as the Soviet economy collapsed, the shipping sector was one of the few to bob to the surface, buoyed by international demand for its tonnage. It migrated to offshore tax havens and operated under flags of convenience.

As a consequence, less than 10% of Russian fleets’ business was done in Russia, and a decade of surviving in international waters forced Russian shipping companies to become lean and mean.

Now the ‘Kremlin-garchs’ want to change things: they want Russian shipping home again – to increase added value in the energy sector by serving national oil and gas giants. And with the prospect of demand for ships mushrooming due to giant offshore energy projects and Arctic shipping lanes opening, they also want Russian shipping companies to buy Russian-built ships.

Actors in the Sovcomflot-Novoship merger

The vehicle for state policy in maritime shipping a new ‘national champion’, created by merging the state’s 50.3% share in Novorossisk-based Novoship, the world’s twentieth largest carrier, into 100% state-owned Sovcomflot, the world’s sixteenth largest. The result is the world’s fifth largest shipping company.

The driving force behind this policy, of which implementation started in 2007, is the former Minister of Transport Sergei Frank, himself originally from the shipping industry in Vladivistok, moving to the Ministry of Transport in 1995, and becoming minister in 2000. Frank had advocated such a merger while in office. In 2004 he left the ministry to become CEO of Sovcomflot, evidently tasked with implementing the merger and effectively renationalizing Novoship.

2004 can be considered the birthyear of the new era of industrial restructuring of state-owned assets and related private assets in Russia, including renationalisation of the latter through ‘market methods’ – a term that however in Russia traditionally has a very broad meaning, including use of legal and extralegal coercion. In the first Putin term, further privatization of state assets was formally on the agenda, but a lack of political will meant that state-owned assets remained in limbo.

In 2004, as a result of Putin’s administrative reshaping of government, a powerful Federal Agency for Industry under Boris Aleshin, an industrialist, emerged with a remit to restructure state assets to create large merged companies or sectoral holdings that could compete internationally. Instead of being privatized, these were to remain under state control, but take on (foreign) strategic investors or conduct IPOs and enter international alliances to attract funds and technology.

Moreover, the Yukos case and the post-Beslan transition to appointed governors in 2004-5 strengthened the Kremlin against big business and regional lobbies.

Alongside the appointment of Aleshin and Frank, 2004 also saw Sergei Chemezov, often regarded as the mastermind behind this plan, and an old friend of Vladimir Putin, take over as head of state arms intermediary Rosoboronexport, and launch a programme of restructuring the defence sector through renationalizing privatised companies. The reshaping of government 2004 also led to the corporatisation and connected restructuring of industrial giants Ministry of Railways and Ministry of Atomic Power, pushing industrial policy firmly to the fore, for the first time since the collapse of the Soviet Union.

Despite this ‘sea change’ in 2004, the Sovcomflot-Novoship merger has been a work of compromise, in particular regarding the regional component: Sovcomflot is registered in St. Petersburg, of which the governor Valentina Matvienko has influence in the Kremlin. Novoship, in its turn, is the largest tax payer in the southern region of Krasnodar territory, the governor of which, Alexander Tkachev, is an influential pro-Putin nationalist whom pundits occasionally tipped as a Putin successor. In addition, Sochi, successful Winter Olympic candidate, is located in Krasnodar. Tkachev was particularly active in lobbying against any reregistration of Novoship away from Krasnodar as a result of a merger, and partly as a result, Novoship will remain an independent affiliate of Sovcomflot registered in Novorossisk.

Frank himself is not overtly aligned with any Kremlin groups. As CEO of Sovcomflot he replaced Dmitry Scarga, appointed to Sovcomflot in 2000 at the age of 30. Scarga was linked to the Petersburg group around the Baltic Pipeline System that includes Alexei Miller, who in the same year became head of Gazprom. In 2005, Sovcomflot filed a lawsuit in Britain against Scarga, by then a ‘senator’in the Federation Council, due to financial manipulations uncovered at Sovcomflot’s British subsidiary causing damages of $200m. Scarga moved to London ostensibly to defend himself. Criminal charges in Russia were subsequently opened against him, and an extradition request filed in early 2008. Scarga is now claiming political asylum in Britain – alongside former Novoship CEO Tagir Izmailov (see below). Both these cases indicate at the very least that Frank can count on support from law enforcement and justice organs.

During Putin’s first term, the supervisory board of Sovcomflot was chaired by Dmitry Kozak, a close Putin aide and reformist liberal with a law background. After the Beslan hostage-taking, Kozak moved to become presidential representative to the Southern Federal District, and was replaced by Igor Shuvalov, also a Putin aide on economic matters and a liberal. Neither of them, nor Frank, are closely associated with the silovik faction of former and current KGB / FSB members – showing that the ‘national champion’ industrial policy launched 2004 currently enjoys consensus support among government groups, and can rely on the backing of law-enforcement agencies irrespective of whether siloviki are directly involved in running the business or not.

Implementing the merger

Such backing from law enforcement and legal organs soon proved necessary, since Novoship management resisted the merger from the start. Despite the state’s 50.3% stake retained, Novoship management exercised de facto control over the company through cross-ownership with subsidiaries and influence over financial flows. The company was growing strongly and expanding its fleet rapidly. But state officials and Sergei Frank argued it was doing nothing to reduce exposure to the volatile spot market, and was suspected of shifting assets offshore.

As in many other cases, the complex financial structures set up by insider management in order to control their companies ultimately proved to be their Achilles’ heel: When company president Tagir Izmailov openly expressed opposition to the proposed merger in 2005, he found himself charged with abuse of position and money laundering, and fled to London. In December 2006, ex-chairman of subsidiary Novoship-Invest, holder of 6.5% of Novoship, shot himself after being summoned for questioning. Days before the merger was finalised, management tried to offload a 14.41% stake held by Novoship’s Liberian-registered subsidiary to Gazprombank – to retain some independence from the new bosses – but Moscow blocked this at the last minute.

Kremlin mistrust of management or ‘insider’ ownership for important companies – such as titanium producer Avisma, car giant Avtovaz, plane manufacturer Irkut or Novoship – appears to be one of the driving forces behind current restructuring. Kremlin officials suspect management ownership – often through cross-ownership of companies by their subsidiaries – of restricting companies’ growth prospects, because insider owners risk losing control of the company, and thus their position, if they take on badly-needed strategic investors. The state then proves its point about vulnerability by coercing management into selling up.

Nevertheless, for all the charges brought against former Novoship management, analysts regarded Novoship as – at least formally – more transparent than Sovcomflot. Novoship disclosed its results on a quarterly basis. Sovcomflot disclosed very little and there is an ongoing criminal case against former manager Dmitry Scarga and other management members, who are accused of defrauding the company.

The league of national champions

What does the Kremlin want of its new national champion? Now that state companies Gazprom and Rosneft have secured control of development of offshore gas and oil reserves (specifically the massive Shtokman and Sakhalin projects), the idea is to create linkage to other domestic sectors to increase added value generated in Russia. Shipping services are the obvious next step. Next in line are the shipyards. Ideally tripartite alliances of Russian oil and gas giants, Russian shipping companies, and Russian shipyards should emerge. Sovcomflot management talk of the merged company acting as a catalyst for the development of maritime clusters similar to the role played by Maersk in Denmark, NYK in Japan, Stena Bulk in Sweden or COSCO in China.

Sovcomflot is moving rapidly in this direction, specializing in energy and ice-class shipping, placing orders home and abroad, and rapidly expanding its fleet of LNG carriers, with large orders placed at Korean and Japanese yards – no Russian shipyard currently produces LNG ships, although Baltic shipyards plans to start in 2011.

Supporting offshore projects is however seen to be only the first step. With the Arctic ice melting due to climate change, the Arctic is opening up both for more energy exploration – the US Geological Survey estimates that 25% of the world’s undiscovered oil and gas reserves are located in the Arctic – and also for shipping route: the North-East passage, if sailed from Hamburg to Yokohoma – is almost 40% shorter than passing through the Suez canal.

The offshore developments are expected to put in place a lot of the shipping infrastructure needed for the Arctic to become a main shipping lane, if present climate change trends continue. Sovcomflot estimates that over the next ten years, Arctic shipping will quadruple in connection with Shtokman alone. Currently there is almost no shipping in this area at the moment, and so there is little current competition.

Sovcomflot is not the only Russian shipping company to be thinking along these lines. The smaller, private Vladivostok-based Primor’e Shipping Company (PRISCO) is also an oil carrier currently increasing deadweight at 18% pa and looking to expand into the LNG market. Prisco is well placed for Sakhalin oil shipping and the company has won contracts to ship oil even against bigger players such as Sovcomflot, with a $150mn contract to ship oil for Exxon in Sakhalin. As the relationship with Sakhalin develops, Prisco expects half of its business to be domestic.

The question for PRISCO is whether Sovcomflot’s status as national champion will not jeapardise its ability to win contracts for Sakhalin, after national champions Gazprom and Rosneft having taken leading roles in these projects. Furthermore, if shipping sector consolidation were to continue, PRISCO, or other private shipping companies, might find itself under pressure to sell out to the state-owned shipping giant.

Meanwhile, having merged into a national champion, rich pickings also loom for Novoship in connection with the planned Burgas-Alexandropolis oil pipeline, in which the Kremlin is involved. According to Renaissance Capital, the company is set to become a preferred partner for shipping Russian oil to Burgas.

In early 2008, the advantages of the merger for Novoship became more evident.
Sovcomflot management outlined significant synergies in both revenue generation and on the cost side, including attracting new clients with, for instance, right of first refusal contracts, and savings potential through joint purchasing, cheaper debt financing and the reduction of administrative expenses.
Despite the fierce resistance from Novoship management, minorities and investment banks were mildly positive about the merger – pointing to the chances to increase liquidity and create economies of scale. The merger should produce both synergies and diversification: Novoship is a classic tank oil carrier working the Black Sea routes, while Sovcomflot concentrates on the ice-bound Arctic and hi-tech transport of liquid natural gas.

Analysts argue that size does matter when it comes to international competitiveness, and that the new company will enjoy considerably more pricing power. One of the tenets of the state shipping doctrine has been to move away from the spot market and time charters – where everything is short term and subject to oil price fluctuations – towards establishing long term contracts with direct customers.

Most importantly, in January 2008, Sovcomflot signed a cooperation agreement with state-owned oil pipeline monopolist Transneft for oil shipping to the Burgas-Alexandrupolis pipeline. The January 2008 agreement envisages Novoship becoming the seaborne carrier linking the Transneft pipeline ending in Novorossiysk with the new Burgas-Alexandrupolis pipeline in Bulgaria and Greece that bypasses the Turkey-controlled Bosphorus.

The agreement is very positive for Novoship, since it will support the targeted shift from the volatile spot market towards more sustainable pipeline-like utilisation. However, this deal also showed that the Sovcomflot merger was by no means purely a case of industrial restructuring. It was also a key component in the Kremlin’s pipeline policy looking to expand and diversify its oil and gas pipelines to Europe, while crowding out other competitor pipelines bypassing Russia. This means that the company is of strategic interest to the Kremlin, which could in the future run counter to commercial considerations.

The merged company is correspondingly emitting contradictory signals in terms of its interest in boosting shareholder value and internationalisation.

The new Novoship board appointed in January 2008 is positive sign in this regard, including three independent directors, a rarity in Russia, with two of them non-Russian: Marlen Manasov, managing director of UBS Securities and Robert Sasson, an investment banker, former Head of EBRD Mission in St. Petersburg. Analysts agreed this indicated Sovcomflot was intent on boosting Novoship capitalisation in preparation for an IPO of the entire group.

However, in February 2008, this policy experienced a significant set back, as state interests prevailed over commercial. Inside sources reported that Sergei Frank had been lobbying for independent directors to join the Sovcomflotboard, specifically Morgan Stanley’s Elena Titova and Deutsche Bank’s Charles Ryan. But instead, state officials supported Andrei Kostin, CEO of state bank VTB – and most significantly the new CEO of Transneft, Nikolai Tokarev, a probable former KGB man. Tokarev’s inclusion instead of an independent director indicated that strategic state interests would prevail over commercial considerations in running the company as a member of the league of ‘national champions’.

Uniting Russia’s struggling shipbuilders

The Novoship merger was the prelude to a sweeping overhaul of the shipbuilding sector, the cornerstone of which was the presidential decree of March 9th, 2007, “On the Establishment of the United Shipbuilding Corporation” (USC). This decree provided for consolidating all state-owned assets in the shipbuilding branch, totalling around 40 companies, into a holding with 100% state ownership.

The Sovcomflot-Novoship merger was child’s play in comparison to setting up the USC. The template for the USC was the United Aircraft-builders Corporation (UAC) established in 2006. However, here there are also substantial differences: the aircraft industry consolidation came initially ‘from below’, with considerable consolidation between Irkut, Sukhoi and MiG already underway. Moreover, the Russian aerospace industry includes some very internationally competitive production, such as the MiG and Sukhoi fighter jets, around which a successful company might be built.

Government officials seem, in contrast, to have made decisions about the USC at speed and without consultations. The USC bundles all existing state shareholdings in maritime shipbuilders. There was a strong political flavour to its launch, with much telegenic championing of ‘national shipbuilding’ by at that time potential presidential sucessor Sergei Ivanov. At the same time, relatively efficient fully privatised outfits, such as Petersburg’s Baltiskie Zavody and Northern shipyards, both owned by oligarch Sergei Pugachev’s United Industrial Corporation group, were not invited to join.

The formation of the new holding is not to be completed until 2009, and is already well behind schedule. In its final form, the USC will unite 40 odd companies from Kaliningrad to Konsomolsk-on-Amur, ranging from federal state unitary enterprises (FGUPs) to joint stock companies where the state is only a minority shareholder. Alone the process of inventorying FGUP’s assets and converting them into joint stock companies is, Sergei Ivanov has himself admitted, extraordinarily laborious. The need to facilitate integration influenced the decision to structure the company along regional lines, instead of functional roles; there are to be regional centres in Petersburg, Severodinsk and Vladivostock.

In fact the operation has already run into considerable difficulties, reflected in personnel turnover in top positions. There was initial confusion over who would head the supervisory board. Originally it was expected that Sergei Ivanov would do so, then defence minister Valery Serdyukov was tipped, and finally deputy prime minister Sergei Naryshkin got the job in July 2007.

The difficulties in putting together the corporation were even more apparent regarding the crucial position of CEO. Alexander Burutin, first head of the USC and charged with swift implementation of the presidential decree, resigned in September 2007 after three months of fruitless negotiations with shipyard managements about the terms of their integration. It took over a month to find a replacement for Burutin, with the first choice candidate for the job, Andrei Dutov moving instead to head the State Industry Agency. The next best candidate, retirement age Yury Yarov, a former cabinet minister, in the 1980s boss of current prime minister Viktor Zubkov, was finally appointed October 23, with six months having lapsed since the presidential decree.

What does the Kremlin expect from USC?

The declared goal of the USC is to strengthen commercial, not military, shipbuilding in Russia. To cite Vladimir Putin’s annual address to parliament 2007, the modest goal of USC is ‘for Russian shipbuilding to occupy a decent niche on the world market’.

Currently, Russia basically has zero market share in the global commercial shipbuilding industry. Whereas Japan and South Korea each produce 70m tonnes deadweight per year, Russia turns out only 1m, lagging behind Vietnam, Iran and Turkey. But Russian companies place orders worth $1bn for ships each year, 80% of which go abroad. In fact, 80% of Russian ship-building output is for naval procurement. The imbalance is a legacy of the Soviet era, where naval shipyards were concentrated on Russian territory, with merchant fleet ships being built in Poland, Finland and East Germany, and Ukraine.

As a result, even now that state defence procurement is soaring, Russian yards are on average only working to one third of their capacity. This makes the idea of Russian commercial shipping companies placing a higher proportion of orders with Russian shipyards so alluring.

However, Russian shipyards largely fail to compete even on the domestic market. They suffer from productivity levels far lower than South-east Asian countries. They are also unable to achieve turnaround times anything like the Asian countries, on average half as fast, which is critical, or reliable. Furthermore, Russian shipyards lack the capacity to build the ships with over 80,000 tonnes deadweight that enjoy wide global demand. One major problem here is the location of major shipyards, such as the Admiralty and Baltic shipyards in the historical heart of Petersburg, where there is simply no room to expand

The call of the Arctic

Despite this seemingly hopeless position, Russian planners have identified a market niche they believe Russian shipyards could fill. The grand plan for the ship-building sector is to build vessels to service the Shtokmann gas field and the Pacific shelf projects, as well as for the Arctic shipping routes expected to increase fourfold over the next 10 years.

Government estimates put the number of platforms needed for offshore oil and gas production by 2030 at 40, the number of 85 specialized ships at 80 with more than 140 support ships needed. Demand is set to boom for atomic icebreakers, hydrographic craft for exploration, ice-class oil tankers and LNG carriers, as well as platforms for oil and gas drilling, and pipeline-laying and transport ships

The policy is realistic in looking for Russian shipping to occupy a specialist niche – ships specially suited for Arctic operations. Thus the USC does have a vision going beyond the next elections: an alluring vision of Russia’s twin evils – dependency on budget money and dependency on the resource sector – cancelling each other out – with military shipbuilding diversifying into commercial, and the economy as a whole beginning to put added-value on its resource base.

However international competition still has a head start in tackling these new challenges. Japanese and Korean yards dominate global production of LNG carriers. Even in ice-class shipping, the pioneering role is held by Norwegian Aker-Kvaerner producing double-acting icebreakers (with a stern that can be deployed as an icebreaking bow). Aker-Kvaerner is already supplying freight ships to Norilsk Nickel for year-round shipping between Dudinka and Murmansk. Russian shipbuilding is going to need the sort of hidden protectionism the national champion policy implies, but the costs will be borne by the projects they supply.

In November 2007, the Ministry of Energy and Industry authored a federal target programme to support this technological transition, called “Development of civil marine technology 2009-2016”, which envisages R140 investment for this time period, of which around R100bn will come from the federal budget. The programme focuses on financing R&D and modernising testing and design bureaus. The funding is also sufficient to purchase foreign licences especially for LNG tankers. However, the programme does not foresee direct budget investment in upgrading the shipyards themselves.
The Kremlin’s grand plan thus hinges on creating a chain of ‘national champions’ to increase added-value generated in Russia from the resource sector, comprising Russian energy giants, Russian shipping giants, and a Russian shipbuilding giant. This chain can be extended into supplier sectors. For instance, ice-class shipping requires high-grade steels, of which steel giant Severstal is planning to increase production, launching an investment programme for this purpose worth R850m through 2009, in time for the start of construction of LNG and modern ice-class tankers in 2011.
What use is USC?

An additional question mark over USC is that market forces were already pushing the most efficient shipyards in this direction. Such shipyards are currently either ignoring the intervention of state officials, or regard them and USC as a threat to their efficiency. The most capable shipyards picked up on the new source of demand long before government officials. In recent years, for example, Admiralty shipyards has built five ice-class tankers for Sovcomflot and five for Lukoil. But it is precisely Admiralty shipyard management that has expressed deep misgiving about the corporation – and having to undergo a complex metamorphosis from unitary enterprise to joint stock company, entailing loss of decision making freedom.

Management is particularly troubled about how much freedom the company would retain to conclude contracts independently. In particular, since the USC is to have a two level structure, with separate shipping centres for the West (St. Petersburg and Kaliningrad), the North (Severodinsk and Murmansk) and the East (Vladivostok), united under the umbrella organisation USC, constituent companies are afraid of excessive bureaucracy and loss of the flexibility that is crucial to making effective business decisions.

Two of the most advanced shipyards in terms of producing for offshore projects are Petersburg’s Baltiiskie Zavody and Northern shipyard, both of which are affiliates of oligarch Sergei Pugachev’s United Industrial Group. There has been no attempt to strong-arm these companies into joining, which is in some ways a positive sign, but also questions the rationale behind the project.

Analysts argue that both these shipyards should comprise the core of any Petersburg-based shipbuilding holding. They have also been trailblazers in terms of restructuring, proving that private capital is more effective than government ministers in turning industry around: Baltiiskie Zavody is embarked on a complete relocation from constricted premises in Petersburg’s historical heart to the expanded facilities at out-of-town Northern Shipyards.

Baltiiskie Zavody is Russia’s main producer of nuclear and diesel powered icebreakers, and The UIG shipyards are active in moving into the Arctic shipping business, including preparation to build LNG tankers that are currently not built in Russia at all. Production is slated to commence in 2011, in time for start of operations at the Shtokman offshore gas field in the Barents Sea. In contrast, the state is dragging its heels on holding tenders for constructing shipyard facilities large enough to build ships over 80,000 tonnes, especially large LNG tankers.

Confirming this trend of efficient companies responding swiftly to energy sector demand, the to date largest shipbuilding contract resulting from the Shtokman field development – for two marine drilling platforms worth $2.5bn – went to the privately-owned Vyborg ship-building yard. Vyborg shipbuilding yard that hopes to secure four further such contracts, will also not be part of USC. Vyborg shipyard was recently acquired by influential Petersburg financial group ‘Bank Rossiya’, reputed, as is also Sergei Pugachyov, to enjoy some access to Vladimir Putin.

Further questions were then asked of the efficiency of state-owned yards when in February 2008 the Norwegian shipping concern Odfjell terminated a $500m contract with the Sevmash shipyard, based in Severodinsk, the Russian producer of nuclear submarines. Sevmash called the contract for twelve 45,000 tonne tankers the ‘deal of the century’ when it was signed in 2004.

Odfjell claims that the first tanker was slated for delivery in September 2007, but will not be ready until May 2009, and that the cost of the order has risen from $500 million to $544 million. Following termination of the contract, Sevmash will also be liable for damage claims.

Sevmash for its part argues that the soaring price of steel is to blame for the rise in costs, but in fact this is not Sevmash’s first failure of this kind. The yard also mismanaged a large Indian order to reequip the Russian aircraft carrier Admiral Gorshkov for sale to India. Originally planned for 2008, the handover has now been postponed to 2011, a delay that cost the previous Sevmash management their jobs.

The Sevmash case points again to weak management as a major problem for many state-owned shipyards, and it is unclear how the USC intends to improve this situation.

Conclusions

- The basic goal of boosting commercial production by former naval shipyards is positive, since, if successful, it will increase international economic integration of the sector and hinder the emergence of any ‘military-industrial complex’ lobbying for arms spending increases. The Arctic shipping / offshore niche has some real potential.

- The increase in state involvement should not be exaggerated. In shipping, there remain three major and expanding private shipping companies. In shipbuilding, the state has not yet tried to persuade or pressure private companies into joining the holding – even major ship-building companies with considerable defence significance such as Baltic and Northern shipyards remain in private hands.

- The selective use of criminal charges apparently to pressure former Novoship management into consenting to the merger is extremely disquietening.

- The new focus propagated for shipping and ship-building on offshore projects and the energy sector will add to Russia’s assertiveness in this area, in terms of ‘resource nationalism’. Multinationals are often regarded as reluctant to contract out to Russian suppliers, and the Kremlin is intent on maximising added value in the energy sector as part of its diversification strategy. Moreover, the increasing, and increasingly politicised, focus on the Arctic waters as being of strategic significance for Russia will lessen readiness to compromise on questions of demarcation of territorial waters.

- The developing system of ‘national champions’ is potentially detrimental to competition and the market mechanism, since it is likely that national champions, such as Gazprom and Rosneft, in the energy sector will prefer other (state-owned) national champions in shipping and ship-building, even where private companies are more competitive. Furthermore, state-owned companies that have proved themselves efficient outside of national corporations, such as Admiralty shipyards, or the Sukhoi holding in aircraft construction, risk being shackled to inefficient loss-making companies.

Rosoboronexport / Russian Technologies – Russia’s unofficial ‘Ministry of Deprivatisation’

Graham Stack, for  Radio Free Europe / Radio Liberty

Defence sector restructuring into sector-based holding companies was on the cards right from the start of Vladimir Putin’s presidency. What is striking is that the plan to establish holding companies largely failed to get off the ground during Putin’s first term. Apart from the establishment of the Almaz-Antei tactical missile and Sukhoi aviation holdings, the 2002 project to set up 74 state-controlled concerns and holdings remained entirely on paper due to bureaucratic infighting, conflicting visions, and above all widespread resistance from enterprises. Then even the Almaz-Antei merger plan hit an iceberg when new Kremlin-appointed manager Igor Klimov died in a hail of bullets in Moscow.

Put simply, the reasons for consolidating individual plants into sectoral holdings were also the reasons why there was so much resistance against this happening: the managements of the defence plants, both state-owned and private, feared losing control of ‘their’ companies and the connected financial flows. However, without consolidation, and separation of ownership from management, these enterprises would remain unable to attract the financial resources they desperately needed to develop.

Wholesale renationalisation was still firmly off the agenda during Putin’s first term. Restructuring plans were mostly connected with further privatization – but there was no political will for this.

The stalemate ended abruptly in 2004. Putin’s radical reshaping of government on dismissing the Kasyanov government one week before reelection saw a Federal Agency for Industry emerge with a remit for the entire defence sector, headed by Boris Alyoshin, an ardent proponent of the holding policy with an aviation industry background. The newly-created Federal State Property Agency was run by a contingent of Petersburgers committed to transforming federal state unitary enterprises into joint stock companies.

Moreover, in the course of 2004, federal power was considerably strengthened at the expense of business interests by the Yukos case, and at the expense of regional interests by the post-Beslan transition to appointed governors. In addition, the surge in oil prices, and the start of Putin’s second and final term in office shifted economic policy away from long-term institution building to state-accelerated economic diversification aiming at short-medium term results.

Rosoboronexport: More than just an arms exporter

Most importantly, in mid-2004 Sergei Chemezov took over as head of state arms export intermediary Rosoboronexport (ROE). He had long recognized that the company’s control over arms exports gave it enormous leverage over the defence sector, that could be used to achieve restructuring ‘by the back door’.

Two competing arms export organisations had been merged into ROE right in 2000, immediately following Putin becoming president. By 2004, ROE had a monopoly of export sales, except for four companies with their own export licences – including the aerospace legend MIG. In 2005, ROE sold $5.2 billion worth of arms, about 85% of all arms sales. However, Chemezov set about lobbying for a complete monopoly on arms exports for ROE, which was granted in 2006.

Since the Soviet collapse, arms exports had been the lifeline of the Russian defence industry, the only internationally competitive sector outside minerals and mining. Russian state arms procurement died during the nineties, and only slowly revived under Putin.

Because ROE assigned export orders to defence sector plants, it enjoyed potential leverage over the sector. Adding to this leverage was the Soviet system of internal competition in the defence industry, whereby a number of plants had duplicated production to stimulate competition. This means that ROE often has a real choice between plants when assigning export orders.

In addition, surging defence procurement later in Putin’s second term now provides the state with further means of persuasion for recalcitrant companies. Chemezov has clearly been able to influence defence ministry order assignment to facilitate renationalisation of companies.

Apart from these political levers, ROE takes 5-15% commission on arms sales, which rose from 5.5bn in 2005 to $7bn in 2007, meaning the company has considerable cash flow.

On the other hand, the company is formally merely a federal unitary state-owned company, and as such subject to a large amount of bureaucratic supervision and regulation: answering directly to the Federal Agency for State Property, the Federal Agency for Industry, the Ministry of Economic Development and Trade, the Ministry of Energy and Industry, the Ministry of Defence, and the Military-Industrial Commission.

The Chemezov Code: Back to the future

This is where the person of 56 year old Sergei Chemezov plays such a crucial role. Chemezov is an official Friend of Putin, and has a direct line to the Kremlin. It is this personal relationship, in the final analysis, that allowed ROE to act as an unofficial ‘Ministry of Deprivatisation’ independent of the government.

Putin and Chemezov’s acquaintanceship goes back to the time as KGB agents they lived in the same apartment block in Dresden in the 1980s. When Putin moved to work in the Kremlin administration in 1996, Chemezov moved to work under him, and has worked for him ever since.

Chemezov was involved in industrial espionage against the West, and his interest in industry, and catching up with the West in terms of technology, permeates his activities today: Chemezov is an ardent proponent of developing high tech production to diversify the economy away from its reliance on commodity exports.

“Our mineral deposits,” said Chemezov, in an interview with news magazine Itogi, “are finite. There are few remaining undiscovered gas and oil deposits in Russia. And they are non-renewable. But high tech, including for military use, can be refined without end, and its price is stable and predictable, whereas oil has fluctuated from $8 to $60 a barrel in the last ten years.”

“A state of the art fighter jet costing around 50 million dollars: This is the price of two and half tonnes of gold. Russia produces 166-180 tonnes of gold per year, enough for 65 fighters. Our Irkutsk plant alone will turn out 32 Su-30s in 2007– i.e. worth half of the gold mined in the country in the course of the year!”

“Everyone knows that we have to get away from our country’s dependency on commodity exports. We have to diversify our industrial production. Reforming Russian industry is simply a question of national security.”

Chemezov thus shares with many liberals the view that Russia has to diversify its economy, increase added value, and become globally competitive. However, the means he proposes to use are very different, and potentially mutually exclusive. Instead of long-term institutional reforms, he favours a state-led restructuring and repositioning of the technologically advanced defence sector as being the key – a restructuring based on renationalisation of much of the sector.

Chemezov sees the defence sector as crucial in this respect because of its potential for economic diversification and high tech. Chemezov’s goal is globally competitive Russian high-tech production – both military and commercial, He is not a militarist intent on turning Russia into a military superpower again.

Chemezov does not seem to regard the West as an enemy, but he views Western companies as competitors on global markets, enjoying strong backing from their respective states, which Russian companies should thus also enjoy.

Indeed, Chemezov sees Western markets as a huge untapped potential market for Russian commercial high tech, and the West as a crucial source of both investment and technology. ‘Diversification’ thus also involves diversification from military use into commercial use technology to access western markets closed to Russian arms.

Cutting the Gordian Knot

Chemezov’s political trademark has been to cut the Gordian knot in defence sector restructuring by renationalizing.

Whereas in Putin’s first term, talk of restructuring the defence sector envisaged ongoing privatization, Chemezov has done the opposite: buying back assets privatized in the 1990s from private owners or the stock market. This is partly due to desire to reassert state control over the sector, but also because it is simply the path of least resistance for restructuring the sector.

Inefficient and unstable insider ownership by management, often via complex cross-ownership of companies by their subsidiaries, was clearly throttling the development of the sector.

In many cases, management control of enterprises depended on the state as a minority shareholder playing a passive role.

However, when political will appeared, it was easy for the state to unseat management, simply by increasing the retained minority stake to a controlling one by ‘market methods’: by acquiring free-float shares; buying out private investors and management-owners or implementing asset swaps for ROE assets, especially with regional government stakes.

This is what ROE and its subsidiaries have set about doing, with the cooperation of further state instances, such as the Federal Agency of State Property.

Many of the plants ROE has taken control over had low market capitalization, so relatively small cash payments have been needed, especially where the state retained a share packet. For instance, to reassert state control over the famous Moscow Milya Helicopter Plant, all it took was to acquire the 20% stake held by Interregional Investment Bank for a mere $20m. The Tatarstan regional government was persuaded to simply swap its 30% stake in Kazan Helicopter Plant for 15% in ROE subsidiary Oboronprom.
ROE has acted with a minimum of publicity to avoid driving up prices of assets it wants. Secrecy has been a hallmark of its activities, in keeping with the KGB background of many of its managers, with the ‘unofficial’ nature of ROE’s restructuring activities. This means that the details of many details have remained unknown.
Vertical take-off for renationalisation

Only three weeks after Putin’s reelection in March 2004, Boris Alyoshin, as new head of the new Federal Agency for Industry, submitted a project for ROE subsidiary Oboronprom to unite all companies developing and building Mil-class helicopters in a special holding. This remit then broadened into creating a holding for all Russia’s producers of helicopters.

Oboronprom is the vehicle used by ROE to piece together its helicopter, and aviation engine, holdings, originally 51% state owned, 49% state owned. Its youthful former manager, 38 year old Denis Manturov, promoted in 2007 to deputy minister for industry and energy, enjoys Chemezov’s full trust, and is rumoured to be a former intelligence service colleague, who however had been working in the helicopter sector for almost ten years.

At the start of the process, the state had retained at the most blocking stakes in Russia’s main helicopter producers. The main producer of attack helicopters, Rostock helicopter plant (Rosvertol), was completely private, controlled by its management, and the legendary Kamov holding was owned by financial-industrial group AFK Sistema.

This is where ROE came into play, with the task of creating a holding ‘outsourced’ to the arms trader. In the predominantly state-owned plane-building and ship-building sectors, consolidation into holdings was official government policy. Helicopter sector consolidation, on the other hand, was ‘unofficial’ policy since it comprised large-scale renationalisation.

It was also a test case for renationalisation “by market methods”.

2004-2007 Oboronprom worked hard at gathering the helicopter industry under one roof. It acquired 31% of the Milya Moscow Helicopter Plant, 29.9% of the Kazan Helicopter Plant, 63% of Ulan-Ude Aviation Plant, 60% of the Stupino Machine Production Plant and 50.5% of Vpered Moscow Machine-Building Plant, and bought first a blocking, then a controlling consolidate a controlling stake in Rostvertol. It purchased from AFK Sistema 100% of the shares of Kamov-Holding, including the Kamov Design Bureau and the Kumertau Aircraft Building Plant and Arsenev Plant.

Integrating the major Kamaz Helicopter Plant (KVZ) proved to be the greatest political challenge, due to resistance from management owners backed by Tatarstan’s government. Only after President Shaimiev’s reappointment by Putin, wielding his new powers, in 2005, did Tatarstan cede its 29.92% stake to Oboronprom in return for a 15.7% stake in Oboronprom. It was not until 2007 that Oboronprom finally bought out the management stake, resulting in the abrupt departure of KVZ’s director of 17 years standing, its chief owner, and opponent of Oboronprom, Aleksandr Lavrant’ev.

The icing on the cake was an August 2007 presidential decree transferring the state’s stake in Bashkiria’s Kumertau plant and in the ‘Progress’ plant that produces the ‘Black Shark’ attack helicopters to Obronprom.

The operation was accomplished without any public scandals breaking out or overt pressure applied, and to the general satisfaction of stock market analysts. Oboronprom could thus call itself a model of how to create a state-run holding from out of privately-owned defence enterprises.

Oboronprom’s helicopter assets are now being integrated into a single company called “Russian Helicopters.” A new phase of integration was launched at the start of February, 2008: the management of Russian Helicopters took over running the Moscow Milya Plant, with the same to happen for all other companies in the holding in the course of the year. The goal, by 2010, is a single share, international accounting standards, and an IPO, leaving the state with just over 50%, and bringing in foreign investors.

On the same day in August 2007 that Putin signed a decree transferring the remaining state assets in the sector to Oboronprom, he inked a decree calling for four state-controlled holdings for producers of aviation engines.

This decree specifically tasked Oboronprom with setting up the largest of the holdings. The three other holdings comprises state-owned companies, but Oboronprom’s holding was to integrate the Saturn plant in Rybinsk, Ufa’s UMPO and Perm Motors – all of which are privately-owned companies.

Analysts regard Saturn as an exemplary thriving management-owned company, with large investments in R&D and retooling making it the technologically most advanced company in the sector. Saturn, in partnership with Snecma, a member of France’s Saffran aerospace group, developed the SaM-146 engine to be used for the much-hyped Sukhoi Superjet 100.

However, despite these services, first deputy chairman of the Military Industrial Commission Vladislav Putilin stated unambiguously, commenting the presidential decree: “Oboronprom must take control of companies where there is currently no state control.”

Titanium tempation

ROE has also taken control of plants in the metallurgy and mining sector it believes to be of strategic importance for the defence sector.

In late 2006, ROE subsidiary OboronImpex acquired 66% of Russian titanium producer VSMPO Avisma, which as supplier of 65% of Airbus titanium needs and 30% of Boeing’s has strategic significance for the global aviation industry.

VSMPO- Avisma, the result of a merger in 2005, had a rocky history in terms of ownership, with an ongoing dispute between Renova and Renaissance Capital over a 13.4% share packet. Soviet era management held a controlling stake, with 73 -year old general director Vladislav Tetyukhin and chairman Vyacheslav Bresht each with 30%.

In an interview with Vedomosti in February 2008, OboronImpeks director, the 40 year old Mikhail Shelkov said “ROE entered VSMPO Avisma and (car producer) AvtoVAZ for the same reason. Both companies are strategically important for the economy, and both had problematic ownership structures. At VSMPO there was a conflict between Tetyukhin, Bresht and Vekselburg, and the company was suffering.”
Chemezov has also argued that VSMPO-Avisma’s dependency on Boeing and Airbus meant there was a great risk of the company being acquired by foreign aviation concerns, to the disadvantage of Russian plane producers.
The real reason may have been to increase Russia’s leverage over Boeing and over Airbus producers EADS in order to deepen collaboration and technology sharing. Ultralight titanium components are crucial to the new generation of airliners, such as Boeing’s Dreamliner and EADS’s next generation Airbus – and global titanium supply is stretched. Both companies depend on Russia for supplies – and Russia depends on them for technologies and partnership.

The ROE takeover has thus strengthened the titanium producer’s partnership with Boeing. In August 2007, VSMPO Avisma formalised a joint venture with Boeing, Ural Boeing Manufacture (UBM), to manufacture components for the Dreamliner. Pressed titanium components made by a new UBM plant in the Urals, with startup slated for late 2008, will then be finished at a Boeing factory in Portland, Oregon. UBM will also supply titanium components to Airbus.

Oboronimpeks management claims the new owners have brought order to the plant implementing SAP for most business processes. A $1bn investment programme is intended to diversify production by 2012 and increase its added-value, ending production of titanium sponge in favour of higher-grade titanium ingots and also milled products. Market capitalization has grown following the company’s renationalisation.

In autumn 2007, the ROE acquisition conveyor belt started moving again – into mining. Citing a shortage of carnalite used in titanium production, ROE’s subsidiary OboronImpex acquired Kama Mining Company on parity basis with Silvinit. The JV plans to acquire a licence to develop the Polovodosk potassium and magnesium salt deposit, and to built a $1.5bn plant to supply VSMPO-Avisma on an exclusive basis with 500,000 tonnes of carnalite annually. It was also reported at the end of 2007 that ROE had engaged British-owned mining concern Aricom, a subsidiary of Peter Hambro Mining as advisers to help them develop mining assets.

The move into mining is indicative of the way ROE’s core business of weapons exports seems to effortlessly pan out like spilt beer across a table – from defence export, to producers, to metallurgy, to mining. There was thus little surprise when in early 2008, it was reported that ROE was laying claim to a 49% Russian state stake in Mongolian company Erdenet, Asia’s fifth largest copper producer.

ROE has not just staked a claim on exotic ultra-light materials like titanium. ROE started targeting ‘special steels’, i.e. high grade steels suitable for use in armour and other defence applications, in 2007. The vehicle for this is a specially created holding RusSpetStal holding, 100% owned by ROE. Its first acquisition was 100% of the Krasnyi Oktyabr metallurgical plant in Volgograd early in the year, and a couple of more minor purchases followed

Even Chemezov sometimes loses track of all he is after. Speaking at the Paris Airshow at Le Bourget in June 2007, Chemezov said RussSpetsStal had approached the Kulebaki metallurgical plant, the Volgograd machine-building plant, and Stupino Elektrostal plant. But this, Chemezov said, was by no means an exhaustive list. “In fact, I cannot even remember them all,” he admitted.

Saving private AvtoVAZ

Most controversially, ROE took control over giant car producer AvtoVAZ, based in Tolyatti in Samara region, in 2005, and analysts rubbed their eyes in disbelief at seeing the state arms exporter intervene in domestic car production.

A new ROE management team quickly took over running AvtoVAZ, replacing 65 year old Vladimir Kadannikov who resigned, apparently after a meeting with feared Kremlin deputy chief of staff Igor Sechin. The new management came backed by battalions of police dispatched from Moscow to eradicate of organised crime from the plant.

The car giant AvtoVAZ, valued at $2.270bn, with a workforce of 165,000 producing about half of Russia’s needs in passenger vehicles, was adrift in dire straits, with rapidly receding market share, as imports flooded into Russia.

The AvtoVAZ plant, ever since late Soviet days, has been a feeding trough for organized crime, with a death toll nearing 100. The new AvtoVAZ’s first task, apparently successful, was to put an end this. Chemezov claimed that in one year the new management was able to cut costs by almost a third and increase profit by 40% year on year simply by ending crime and theft.

Furthermore, a cross-ownership share structure crippled management incentives: Kadannikov controlled the plant without owning it. This structure also made it easy, given political backing direct from the Kremlin, for a new management team to come in and take over, with the aim of “unlocking” cross-ownership and attracting external investors.

Two years later, cross-ownership is on its way out, and will be wound up by June 2008, facilitated by the technical expertise of investment bank Troika Dialog, ROE’s partners of choice. Share price has spiralled, but not profits or sales.

In the course of 2007, a number of personnel changes cemented ROE’s role in AvtoVAZ’s future. Most notably, Putin appointed the new AvtoVAZ CEO Vladimir Artyakov, a close associate of Chemezov, governor of the wealthy Samara region. Boris Alyoshin, head of the Federal Agency for Industry, then took over as general director of AvtoVAZ.

2008 will see AvtoVAZ’s reanimation move onto a new level. In December 2007, AvtoVAZ and Renault signed a memorandum of understanding declaring the intention to “to renew the lineup, exchange technologies and promote the Lada brand.” Renault is likely to pay over $1.3 billion for a blocking stake in AvtoVAZ.

In February 2008, it was declared that Carlos Ghosn, CEO of Renault would join AvtoVAZ as chief operating officer, with members of his Renault team becoming CFO, managerial accounting director, product planning director and chief engineer: the same team that turned around Nissan’s operations effectively.

Raiders of the lost rotorcraft

Vladimir Putin signed off November 26th 2007, on a bill setting up a state corporation Russian Technologies, to be headed by Chemezov, Two days later Putin signed a bill transferring ROE and all its assets to the new corporation, and ordering the government to draw up a list of further state assets to be transferred.

One week later, hitherto unknown businessman Oleg Shvartsman gave an interview Kommersant business daily that detailed his role in a dirty tricks campaign that was an integral part of renationalisation “by market methods’.

Shvartsman described the renationalisation crusade as a state-sponsored ‘velvet revolution’ aiming in particular at defence-related enterprises. In language reminiscent of Chemezov’s, he called this “a state task to develop the innovation sector, to transform Russia from a raw materials producer into a progressive innovation power”. He also claimed to have been acting under direct orders from the Kremlin hawks known as ‘siloviki’, to which Chemezov belongs.

Much of the credibility of what Shvartsman said comes its strong fit with observable trends:

“Generally we use voluntary-compulsory instruments to lower market capitalisation, by blocking growth, and using all sorts of administrative methods,” Shvartsman explained in the interview. “But, as a rule, people understand where we are coming from. In fact, usually we are talking about conflicts that are already smouldering somewhere, already the centre of attention for existing companies. They only need to come to an arrangement with our older colleagues and reach some sort of agreement. As a rule, it is the lower rung of the market value. But we’re not talking about another YUKOS case – the people do get reasonable money.”

The impact of the Shvartsman interview was due to its plausibility, as many commentators observed. The ROE deprivatisation campaign features use of ‘administrative resource’ , i.e. law enforcement and tax organs, and courts, to exert pressure on recalcitrant owners – and these are only the rare cases that come to light.

In August 2007, long before the Shvartsman scandal broke, Konstantin Makienko of Moscow’s Centre of Analysis of Strategies and Technologies (CAST) wrote baldly that “basically the story of the nationalisation of VSMPO Avisma and plane producer Irkut and of the helicopter producers shows that if the state takes a fundamental decision to restore control over specific assets, this will happen, sooner or later. Private owners display two reactions to nationalisation. The first is the “Tetyukhin reaction”, the second the “Bresht” reaction (the two former majority shareholders of VSMPO Avisma). The first reaction offers to cooperate with the nationalisation plans, as a result of which the owner retains a management position, a small share packet and financial compensation. (…) The second reaction leads to the private owner or his close relatives finding himself in trouble with the law enforcement organs, and ultimately his share packet reverting to the state and him being forced out of the business without adequate compensation.”

An obvious instance of such pressure while buyout negotiations were under way in 2006, was, for example, that tax inspectors suddenly filed back tax claims against the company. A judge handling the case expressed perplexity at how Avisma might be credited with R10.6m of tax overpayment on March 13, 2006, and then, out of the blue, significant tax arrears all of two weeks later.

However, analysts agree that in the case of helicopters producers, ROE did not employ much coercive pressure, since it already had strong levers of influence through control of export orders and state procurement. According to analysts, not only foreign export orders, but also state procurement orders stopped going to companies with less than 50% state ownership.

Yury Lastochkin, owner-manager of the Saturn aviation engine producer, is publicly resisting renationalization, as demanded by the August 2007 presidential decree on setting up state-owned holdings for engine plants.

As a counter move, Lastochkin is pursuing a voluntary merger with Ufa’s UMPO, while stalling on talks with Oboronprom. He argues that this fulfils the spirit, if not the letter, of Putin’s decree. When, however, Kommersant asked Denis Manturov if he agreed with this interpretation, Manturov called Lastochkin’s position ‘destructive’ and said threateningly, ‘I advise Mr Lastochkin to read what is set down black on white in the presidential decree about who is to do what and when.” He stated Oboronprom would ultimately require 100% control over Saturn, although the state’s current stake is 37%, with management holding 57%.

The conflict escalated in late December 2007 with Saturn’s purchase of 20% of UMPO, and start of buyout talks. Lastochkin told Vedomosti that state ownership was irrelevant. “The state already has all the levers of influence it needs. The main thing is the efficiency of the consolidated companies being created.”

In the same interview, Lastochkin discussed the fact that the Yaroslav regional section of pro-Putin party Edinaya Rossiya ‘only’ took 53% of the vote in the December 2 Duma elections, 11% less than the national average. This caused Yaroslav governor Anatoly Lisitsyn, a Lastochkin ally, to resign days later. Lastochkin is himself a member of the regional party council, demonstrating how entwined the “Putin party”, the economy and the state are becoming.

Saturn is Russia’s largest and most technologically advanced aviation engine maker, with a workforce of 40,000. Lastochkin said stingingly that “to hand over assets we have been developing and structuring for over 10 years to complete nobodies is beyond a laughing matter.”

Asked by the interviewer if he did not fear law enforcement or other state agencies would attack the company’s market capitalisation a la schvartsman, Lastochkin hoped the state would be clever enough to avoid such “experiments” that could disrupt the finely-tuned process of designing and producing advanced technology.

An second major headache for Oboronprom in setting up the engine-producer holding is the case of Motor Sich, the Ukrainian plant that supplies 80% of Russia’s helicopter engines, and 80% of Motor Sich production is exported to Russia. Oboronprom has held acquisition talks with Motor Sich, but they were broken off without results in August 2007.

Referring to Ukraine’s Nato membership bid, on February 5, 2008, Industry and Energy Minister Viktor Khristenko called for future substitution of Motor Sich imports by Russian-produced equivalents. 80% of Motor Sich components come from Russia.

Many analysts agree that the immediate motive here was to attack Motor Sich’s capitalisation and facilitate a Russian buy out: duplication of production would costg $300m-400m and take 5 years.

Immediately following the announcement, Motor Sich shares lost 14% of their value. One week later, Denis Manturov, former Oboronprom CEO, now deputy minister of energy and industry, again proposed that Motor Sich join the future Russian state holding.

Russian Technologies: L’etat, c’est moi

In June 2007, Sergei Chemezov first publicly spoke of fitting ROE a new legal status, “disposing of the full legal rights of an integrated economic subject, plus the rights of state procurement for certain types of military exports. Something between a unitary enterprise and a joint stock company.” He referred surprisingly in this context to the ARKO agency set up in 1999 to restructure banks following the 1998 financial crisis. Specifically for this purpose, a peculiar legal form called “state corporation” was created in 1999 as a non-commercial organisation, and had since fallen into disuse.

Putin, in his state of the nation address in April 2007, mentioned setting up a state corporation for the nuclear sector. However, it was assumed this meant a state-owned joint stock company analogous to the United Aircraft-builders Corporation or United Ship-builders Corporation created 2006.

It turned out that ‘state corporation’ meant precisely ‘state corporation’ as legislated for in the obscure 1999 amendment to the 1996 “Act on Non-commercial Organizations”, and mentioned nowhere in the Civil Code.

‘State Corporation’ (SC) went on to become the hit of the year, with SCs being founded for nanotechnology, Winter Olympics, housing reform, road building, the entire nuclear sector, both military and civilian – and for Russian Technologies (RT), aka Rosoboronexport: with its purpose defined as assisting the development, production and export of high-tech industrial production by supporting Russian organizations on domestic and foreign markets, and attracting investment to different industrial sectors, including the defence sector.

Nowhere in the special law on setting up RT is there any definition of what constitutes high-tech production. In this way, RT has carte blanche to intervene in any sector of the economy.

RT will also perform state functions “in the implementation of the state’s export and import policy and state policy concerning military-technological cooperation with foreign states. The list of functions can be extended by other acts or presidential decisions.”

In fact, the whole ‘state corporation’ concept is riddled with anomalies that create huge accountability and corruption issues:

Bizarrely, a “state corporation”, as laid down in the law, is neither state-owned nor a corporation: it is a non-commercial organization established by the state for a specific purpose – social or “managerial”. It is, however, not owned by the state. Property transferred to the SC belongs forthwith to the SC, and the state has no further claims to it.

An SC is strictly speaking not for profit, but there is a lot of leeway allowed; any profit it makes must be reinvested towards the purpose for which it was created, which however is vaguely defined. Similarly, an SC can act entrepreneurially if this serves the goals for which it was established.

In contrast to federal unitary enterprises such as ROE, SCs have the right to borrow domestically and internationally, to issue bonds and give guarantees. A SC can also establish joint ventures and other partnerships with the private sector.

On February 20, 2008, the Russian Federation Council published a devastating critique of SCs as part of its annual review of federal legislation. Among the points listed were: There is no restriction placed on the purpose and function of SCs; property and funds transferred to the SC become its property and the state has no further rights or claims on them; each corporation is regulated by a separate law, meaning they exist outside any unified legal framework, in a legal grey zone.

Most significantly, according to the Federation Council report: the law contains virtually no control over the activities of SCs. There are no evaluation criteria for SC goal fulfilment; no procedures for medium or long term planning; no sanctions for non-fulfilment of goals.
Astonishingly, considering the ROE story has been all about bring the defence sector back under state control, SCs are explicitly freed from all government oversight and intervention, excepting the power of the president to appoint management and supervisory board.
As stated above, SC assets do even not belong to the state, which makes a mockery of the ROE mantra of ‘bring defence assets back under state control’. In order to transfer ROE to Russian Technologies, it will be de jure privatised. In preparation for this, the state arms export monopolist was removed from the list of strategic state-owned companies in late 2007.
The Federal Council report concludes that SCs create “the perfect chance to transfer state property to the non-state sector with no financial benefit for the state and at the risk of uncontrolled use and alienation of assets.”
Less diplomatically, Kommersant wrote in December 2007, referring to the fact that SCs are formally non-profit organizations, that 2007 had seen “a $20bn donation to charity by the Russian state, the largest ever in human history.”

In fact, the complete lack of government oversight apart from presidential appointment, combined with far-reaching rights of disposal over assets, means that Chemezov’s claim to have restored state control over strategic assets only holds water if he claims ‘l’etat c’est moi’. Given the personalisation of power and property that has taken place under Putin, this claim would not be far from the truth.

There has been no government explanation for such wide use of the SC legal form in the last few months of Putin’s presidency. Chemezov has adduced a couple of reasons: that taking ROE outside the state allows him to pay managers a market-level salary, and that it reduces risk of US sanctions applied to ROE affecting ROE subsidiaries, which will probably now be transferred to direct ownership by RT.
These reasons hardly justify the sweeping and unsupervised disposal of property, and coercive power over whole swathes of the economy, that Chemezov will now enjoy.
However, it could be much worse. Even Chemezov has not seen all his wishes come true. He originally lobbied for ROE to implement the state arms procurement programme, which would have given him control of around $20bn revenues per year, turning RT into a Gazprom of the defence sector, but with even less accountability. This proposal was excluded from the RT bill. However, it is still open for the future – along with the option of transfer to RT of the state’s controlling stakes in the United Aircraft-builders Corporation and the United Ship-building Corporation.
Chemezov has until now worked mostly to nationalise private business, but the establishment of RT indicates he is increasingly set on privatising the business of state. The extent he achieves this under a Medvedev presidency will be a test of whether the incoming president’s public commitment to liberalism holds any water, and whether he can break with his predecessor.

Back to the future: The Kremlin takes control of Russia’s aircraft producers

By Graham Stack, for Radio Free Europe / Radio Liberty

Diversification of the economy has long since been a watchword for Kremlin officials. During Putin’s first term, the path to diversification was seen as the institutional reforms drawn up by German Gref’s Ministry of Economic Development and Trade. The state’s task was to establish an institutional framework supportive of diversification.

During Putin’s second term, soaring oil prices made diversification an issue of concern for Kremlin hawks as well as liberals. The former saw it as a matter of national security, that had twice over twenty years been compromised by sharp drops in the price of oil. However, their commitment to patient institutional reform was less marked than for the liberals.

At the same time, the financial resources accruing to the Russian government encouraged a pro-active policy towards industry and investment. Kremlin power increased respective to business interests as a result of the Yukos affair, and respective to regional interests as a result of the post-Beslan transition to appointed regional governors, expanding policy options.

Kremlin hawks and industrialists argued that Russia was already diversified, possessing a hi-tech defence sector and also civil aircraft construction sector that were still widely state-owned, and only just recovering from the collapse and chaos of the 1990s. The then defence minister Sergei Ivanov and the head of the state arms exporter RosOboronExport, Sergei Chemezov, among others, argued that diversification could be achieved through activating this resource. They advocated state-driven restructuring of the defence / aviation industries in connection with a rearmament programme making good for a decade of minimal arms purchases combined with an aggressive export strategy.

Defence sector privatisation: Disaggregation instead of rationalisation

The privatisation of the defence sector in the 1990s was a major political feat for reformers. There was an intrinsically political element to the way privatisation broke the sector up into its myriad individual component enterprises: reformer saw this as putting an end to the reactionary political lobbying power of the ‘military-industrial complex’.

Privatisation disaggregated the sprawling defence sector, but did not rationalise it. This was partly a result of the structure of the Soviet defence industry: for instance, design bureaus and production facilities were mostly separate entities, and the Soviet system of internal competition meant that many of the new semi-privatised defence companies duplicated each other’s production lines.

Furthermore, due to political backlash against privatisation and increased attention to strategic concerns, privatisation remained only partial, with the state retaining controlling or blocking stakes in almost all corporatised defence companies. Defence companies regarded as strategically vital and / or financially unviable remained in 100% state ownership as Federal Unitary State Enterprises (FGUP).

Combined with the general economic collapse, this meant that the defence and also civil aircraft construction sectors mutated into a sprawling archipelago of companies languishing in a limbo between state and private management. Since the state remained the single main owner of the defence sector, it was predestined to become the main actor driving on its restructuring, as soon as the necessary political and financial resources materialised.

Aircraft builders in post-Soviet Russia

Military aviation, in particular Russian fighter jets such as the Su flanker jet series and the MiG fighter jets, constitute Russia’s only globally competitive hi-tech production. Key enterprises such as Sukhoi, MiG and Irkut survived the 1990s by exporting their planes to non-Western countries. With an economic revival now well underway, the state procurement budget is now starting to play an important role again. But this does not compensate for the fact that Russia’s most technologically sophisticated and competitive production is barred from the enormous Western markets for obvious strategic reasons.

Russian civilian aircraft production, on the other hand, was devastated by the economic collapse of the 1990s, failing to compete even on the domestic market. To the insult of a massive collapse in demand was added the injury of Soviet production being outcompeted by Western models far cheaper to operate and compliant with international requirements. Not only did Russian and CIS carriers stop buying Russian planes, they actively started to phase them out especially on international routes, discarding their Tupolevs and Ilyushins for Boeings and Airbuses.

However, along with economic revival, passenger numbers are increasing 8% per year, generating demand for new, modern planes from Russian carriers. In a huge country like Russia, plane travel is quickly becoming again the dominant means of medium and long range passenger transport, and it is also a matter of national pride that Russian planes fly in Russia.

Setting up the UAC: Policy

Extrapolating from these structural conditions, and manifold policy statements, the Russian government’s goal in setting up UAC was to restructure and rationalise existing capacities in order to leverage this strong domestic demand (commercial and military) to produce globally competitive planes.

A key idea was to combine military and civillian production – separated in Soviet times – in one holding to create synergies and commercial spin-offs of military technology. The focus of the UAC is firmly on creating competitive commercial aircraft. There is thus a double diversification involved – from commodity export to high-tech production, and from military production to commercial.

The presidential decree on setting up the United Aircraft Corporation (UAC) was signed February 2006. The decree called for the UAC to be set up in three stages, the first stage being the establishing of the holding’s capital from the state’s shareholdings:100% of Sukhoi Holding Company (which owns 50.1% of the Sukhoi design bureau, 74.5% of the Komsomolsk-on-Amur KnAAPO plant, 74.5% of Novosibirsk’s NAPO plant, 11.63% of the Irkut Corporation, 38% of Beriev design bureau and 87.9% of Sukhoi Civil Aircraft); 25.5% of KnAAPO; 25.5% of NAPO; 86% of MAK Ilyushin (which owns 81% of Ilyushin Company and 30% of Voronezh-based VASO plant); 90.8% of Tupolev (which owns Tupolev Design Bureau and 73.5% of the Ulyanovsk-based Aviastar-SP plant); 38% of the Sokol aircraft plant in Nizhny Novgorod, 38% of Ilyushin Finance (IFC) leasing company; 58% of Finance Leasing Company; and 15% of the Aviaexport foreign trade company.

38% of the Irkut company was contributed by Irkut management, in return for a stake in UAC. The state was to own 90% of UAC.

Setting up the UAC: Politics and actors

A lot of the groundwork for setting up a consortium of aircraft constructors was performed ‘from below’, by companies themselves, especially by the managers and shareholders of the Irkut concern, such as Alexei Fyodorov, president of Irkut and owner of ca. 18% of the company. Fyodorov’s success in managing Irkut led to his being named head of the state-owned MiG and charged with turning the company around. Closely associated with Fyodorov was another Irkut manager and shareholder, Valery Bezverkhny, who became head of the non-commercial partnership United Aircraft Consortium, set up in 2005 without state involvement to coordinate sectoral activities, and which lobbied for sectoral consolidation through privatisation of the state’s shareholdings.

The subsequent success in establishing an aircraft producers’ holding thus owes a lot to its organic nature. However, these initial efforts were also a victim of their own success. State actors, mainly Defence Minister, and later First Deputy Prime Minister Sergei Ivanov, a possible successor to Vladimir Putin as president, Sergei Chemezov, head of state arms export Rosoboronexport, and Boris Alyoshin, head of the Federal Agency for Industry, hijacked the idea, and turned it into a vehicle not for privatisation of state shares in defence companies, but for consolidation of state assets in a state-owned holding, and, where necessary, deprivatisation of private owners. This move towards governmental creation of ‘national champions’ also fitted telegenically into Ivanov’s heightened profile as potential presidential successor.

This ironically made the position of the Irkut management, who had initiated the push for consolidation, precarious. Irkut was commercially by far the most important company in the sector, with sales figures for 2006 matching those of MiG and Sukhoi combined, and comprising half of the total order book for the entire Russian aviation sector.

Moreover, Irkut was a public company that had even conducted an IPO in 2004. Post-IPO the management stake had dropped from 70% to 44%. 32% was held by institutional and private investors. The state only retained 12% owned by the state-owned Sukhoi holding. A 10% stake in Irkut was held by the European aerospace champion EADS. EADS thus held only a slightly smaller – but more direct – stake than the Russian government did – in Russia’s most successful military aviation company.

Irkut management said as late as July 2006 that they expected to receive as much as 30-40% in UAC in exchange for their 38% stake in Irkut – since their consent was crucial to the UAC going ahead. However, to general surprise, state officials valued the Sukhoi Holding at $2-2.2bn, аnd Irkut at a mere $940m, despite the company’s having a market capitalisation of $1.12bn and outstanding financial results. As a result of what was widely regarded as a deliberately depressed evaluation, Irkut management were entitled to less than 10% of UAC for their 38% of Irkut – ensuring the state would own over 75% of the holding, securing it control.

Irkut management owners consented to this evaluation, since the government coopted Alexei Fyodorov, owner of 18% of Irkut, and Bezverkhnyi by appointing them head and deputy head of UAC respectively. At the same time, fraud charges were brought against another of Irkut’s owners and board members, Sergei Tsivilev who was apparently less willing to cooperate. The charges were immediately dropped on the deal going ahead, pointing to their being politically motivated.

Having acquired Irkut management’s 38%, UAC submitted a binding offer to Russia’s Federal Financial Markets Service (FFMS) on the buyout of Irkut 49.9% of Irkut charter capital, which was finalised in March 2008. Negotiations with EADS, owners of a 10% stake in Irkut, resulted in EADS agreeing to convert its stock into UAC shares (see below). This clears the way for UAC to switch to a single share with Irkut in 2008.
Currently the process of the putting the UAC together is still ongoing – with the corporatisation of MiG and Kazan APO taking longer than planned. On March 19th, 2008, MiG’s transformation into a joint stock company was finally completed.

Plans

The government’s plan for the development of the UAC up to 2025 was presented to President Vladimir Putin for his approval February 20, 2008. The ambitious plan envisages UAC supplying 10-15% of global demand for regional and medium-stretch passenger planes, and 20-30% of global demand for military and transport aviation.
Regarding civil aviation, UAC is to focus on three vectors: modernisation and serial production of Soviet Ilyushin and Tupolev models; development of the Sukhoi Superjet and the new MS21 narrow body passenger jet. Military aviation hopes are pinned on the launch in 2015 of Sukhoi’s 5th generation fighter jet.
The program as presented will require $20bn in investment, of which $10bn will come from the budget. The share of military aviation in profits should drop to 40% from the current 80%.
On the same day the plan’s parameters were announced, Aeroflot’s general director Valery Okulov in an article in business daily Vedomosti criticised the focus on continuing modernisation of Soviet models originally developed in the 1960s. “It is not modernisation of obsolete models that will secure sustainable development of our plane building industry, but the development and launch of competitive new planes tailored to demand on the global market. Modernisation of models currently produced only targets marginal markets. But such markets do not offer steady demand and profits. This is not a plan for catching-up development, but a path to growing backwardness.”
Okulov’s words capture the basic dilemma inherent in the UAC. Is it intended to revive Soviet-era aviation producers such as Tupolev and Ilyushin or to create new, globally competitive products that represent a break with the Soviet aviation legacy? As a state-owned holding cobbled together from companies in very different financial and technological positions, containing both competitive and obsolete technologies, there is an inherent risk of political lobbies prioritising the latter at the expense of the former, and the UAC achieving the opposite of what it was intended to achieve: blocking out new development.
A fresh start: Sukhoi Superjet 100

UAC has, however, received valuable ‘start capital’ towards its strategic goal from the Sukhoi subsidiary, Sukhoi Civil Aircraft (SCA), in the form of the Superjet-100. The Superjet 100, designed and built by Sukhoi Civil Aircraft (SCA) is a regional passenger jet carrying max. 100 passengers with a range of 4,550 km and designed to compete with Brazil’s Embraer E-Jets and Canada’s Bombardier C-series.

In contrast to Soviet-style autarky, the Superjet is the result of extensive international collaboration, in which Sukhoi has played the part of system integrator. The plane flies with SaM146 engines designed and produced by Powerjet, a joint venture between Russia’s NPO Saturn and France’s Snecma. The electronics are supplied by France’s Thales, and Boeing has acted as project consultant. Besides receiving large Russian subsidies, the regional jet has been subsidised by the French (€140m) and Italian governments (€92.3m), and recently took out a 10-year $100m loan from the European Bank of Reconstruction and Development (EBRD).

Moreover, in May 2007, 25% of Sukhoi Civil Aircraft, was provisionally sold to Italy’s Alenia, a 100% subsidiary of Finmeccanica SpA, partly state-owned and also a member of the Eurofighter consortium. Alenia has also founded a joint venture with SCA to provide global after-sales and maintenance support – likely to be the plane’s main weak point. A presidential decree January 2008 sealed the deal and cleared the way for foreign nationals to become members of the SCA’s managing bodies, although only a Russian national can be head of Sukhoi Civilian Aircraft.

Sukhoi’s Superjet represents a completely new departure for Russia’s aviation industry. The plane’s main selling point is ironically – considering the Soviet gas-guzzlers the Soviet Union churned out – its operating costs being 10-15% lower than Embraer or Bombardier. Sukhoi is billing it as the most ecological in its class, so that airlines buying the plane will potentially claim Kyoto carbon credits. Moreover, a wider cabin offers more comfort – another break with Soviet tradition – and priced at $27.8m, it will be 18-22% cheaper than competitors, which could compensate for perceived lack of after-sales and maintenance network.

By mid-October 2007, SCA had 73 firm orders placed. Only ten of these were from outside Russia – placed by Italy’s Itali regional carrier, and a large number were for state-owned Aeroflot. However, at the end of October 2007, new SCA contracts were reported for 128 Superjets, worth $3.6bn in total, including orders from India’s Omega Airlines, Indonesia’s Merpati and China’s S.A.T. 350-400 Superjets must be sold for the project to break even.

The speed and smoothness of the Sukhoi regional jet’s development has surprised and impressed many observers who initially held the project for a pipe dream. Indeed, the the regional jet has proved the continued viability of Russian aircraft production and thus lent impetus to the creation of the UAC.

The EADS dilemma

UAC’S next major new commercial development is MS-21 narrow-body medium range airliner to be built by Irkut. The 130- to 170-seat MS-21 twinjet family is intended to replace the Soviet-era workhorse Tupolev Tu-154s and to compete with Airbus A320 and Boeing 737NG. The MS-21, however, is still very much on the drawing board, with main parameters still unclear and an engine still to be chosen.

Moreover, the plane is slated for serial development not before 2015. This poses a problem in as much as Aeroflot, for instance, plans to retire all Тu-154s by 2010, meaning that a gap in the market will open up inevitably to be filled by Airbus А-320 and Boeing В-737, making life very hard for the MS21 when it does eventually appear.

In fact, the issue of UAC acting as system integrator for any commercial planes larger than the Superjet is tightly bound up with UAC’s future relations with EADS. The main question is whether the EADS will deliver Russia an assembly line for the next generation A320, EADS’ mid-range liner. A320 NG would be a direct competitor of the MS-21. If EADS were to do so, UAC would be likely amend or drop the MS-21 plans.

UAC does not deny how crucial the relationship to EADS is. UAC head Fyodorov is looking to create a long-term partnership with EADS, including cross-ownership. Some degree of cross-ownership looks increasingly acceptable to EADS, despite initial alarm at the purchase of 5% of the company by Russian state-owned bank VTB in 2006. In December 2007, VTB announced it would sell the EADS stake to UAC in 2008. According to Sergei Ivanov, EADS is also ready to convert its 10% stake in Irkut for an approx. 2% stake in UAC.

EADS would then be free to increase its stake in UAC during an IPO in Russia of 10-15% of UAC stock to be held 2009-2010.

Military collaboration with India

In the sphere of military aircraft development as well, UAC is looking to develop strategic international partnerships, with India likely to play the main role as partner in developing the fifth generation fighter jet. Fifth generation fighters combine versatility with new developments such as thrust vectoring, composite materials, stealth technology, integrated avionics. Currently only the US F-22 Raptor is the only fully-fledged fifth generation aircraft operating.

In October 2007 it was reported in the Russian and Indian press that the much-hyped fifth generation fighter would be developed together with India on equal terms in a $10bn project. Indian involvement will initially be financial, but the models will subsequently be adapted by Indian engineers for Indian airforce needs. It is unclear exactly what the time frame of the project is, with estimates varying between 2010 and 2015 for production to start.

The Multi-role Transport Aircraft (MTA) is another important Indian-Russian joint that has currently hit a snag in the Indian demand that Russia reinvest in the project $10bn of Indian debt to Russia. However, both sides have considerable interest in moving on. In March 2008, it was announced that Irkut would withdraw from the project to concentrate on the MS21, leaving the MTS project wholly to Ilyushin.

In early March 2008, the Indian airforce demonstrated its trust in Russian as a strategic partner, placing a nearly $1bn order for upgrades to MiGs, despite the fact that in February Algeria had returned to Russia fifteen MiGs supplied, at a value of around $1.5bn, due to alleged inadequacies.

Backdoor protectionism: State-ownership of passenger airlines

The state has also retained considerable airline assets, including global giant Aeroflot (51.17%), and other large carriers such as GTK Rossiya (100%), Sibir (25.5%) and Krasair (50%). In 2007, it was decided to fold Krasair into a merged company called AirUnion together with four smaller regional carriers, in which the state would retain a blocking stake, and Boris Abramovich, owner of 40% of Krasair, would hold a majority stake, thus effectively privatising Krasair. The merged company would be Russia’s third largest in terms of passengers.

Obviously these extensive holdings give the state considerable leverage in supporting domestic aircraft production – simply by insisting that state-controlled carriers buy a certain quota of Russia-built planes. Of particular concern is that domestic regional carriers provide a launching pad for the Sukhoi Superjet.

In December, 2007, the state corporation Russian Technologies (RT) was established on the basis of state-owned arms export monopolist RosOboronexport, headed by Sergei Chemezov, an old friend of Vladimir Putin’s from industrial espionage activities in Dresden in the 1980s. Chemezov was predictably named head of the corporation, charged vaguely with promoting Russian hi-tech production, both defence-linked and civilian, domestically and internationally.

Russian Technologies has now laid claim to these state-owned airline assets, clearly to leverage them to promote the revival and technological upgrading of the aircraft production industry. It has not yet been finalised what assets Chemezov’s state corporation will get. Although apparently Chemezov requested that the State Property Committee transfer RT the Aeroflot stake, this is unlikely to happen. However, a Deloitte Touche revaluation of the assets of the merged AirUnion company established that the airline assets held privately by Boris Abramovich would not be sufficient to give him a controlling stake in the merged company, as was originally planned, despite Abramovich having placed orders for 20 Sukhoi Superjets.

Instead it is likely that Russian Technologies will end up with a controlling stake, thus preventing the privatisation of Krasair, and instead effectively nationalising the smaller regional airlines Abramovich merged into AirUnion. The method employed – an inflated valuation of state-owned assets relative to private assets when configuring a merger, was also used in the Irkut case described above.

If Chemezov established control over AirUnion, it is likely he will set up a holding for all the air carrier assets transferred from the State Property Agency, buying out Abramovich completely if necessary.

This latest development yet again illustrates how the policy of setting up state-controlled holdings has knock-on effects all down the line. The project of regenerating Russia’s aircraft-building industry under state supervision has prompted renationalisation of assets in metallurgy, especially titanium producer VSMPO-Avisma, as well as now seemingly in regional aviation carriers. Although the consolidation of extreme fragmentation across most sectors resulting from privatisation (there are 173 air carriers operating in Russia) should bring benefits, the fact that this is taking the form of a league of state-owned ‘national champions’ eliminates market elements, and thus stimuli to efficiency – as well as increasing the predominant power of the Kremlin vis-à-vis business and society.

However, there are increasing signs of resistance especially to Chemezov’s seemingly endless appetite for assets. With the Kremlin liberal wing encouraged by the coming Medvedev presidency, there have been sporadic attacks on ‘state capitalism’ and state corporations by policy makers, and indeed Medvedev himself. Moreover, March 18th, Sergei Ivanov himself criticised in front of the Federation Council the idea of Russian Technologies owning producers of finished products, arguing instead that the state corporation should concern itself with restructuring defence-sector suppliers of components and materials. His comments might also indicate that Chemezov had been lobbying for the United Aircraft-builders Corporation and the United Shipbuilding Corporation to be transferred to RT.

Conclusion

- The policy of uniting commercial and military aircraft producers in one holding, with a focus on production of commercial aircraft for international markets, and embedded in a system of international collaborations, is a positive sign for Western policy makers, since it will create important disincentives for Russia to sell military aircraft to internationally isolated regimes – especially as in the case of Sukhoi, when the same company seeks to sell commercial aircraft on Western markets. In the 1990s, with the aircraft sector struggling to survive, there was a policy of beggars can’t be choosers, leading Russia to export to which ever country was able to pay. The UAC’s express focus on developing and producing commercial aircraft is thus to be welcomed.

- Increasing state involvement here should not be regarded as particularly problematic. Many Western countries have or have had state involvement in aircraft production, especially for defence purposes, and the state is to a large extent merely reorganising more efficiently holdings it had retained. State direction is likely to lead directly to increased involvement of risk-sharing foreign partners and investors, and thus the long-term international embedding of the Russian aircraft production industry. This is the policy expressly being pursued. Again, this international context will dictate against the development of an autarkic ‘military-industrial complex’ that lobbies for spiralling defence spending with aggressive militaristic arguments.

- The UAC, benefiting from increases state attention and funding, will probably make more efficient use of resources to create new military aviation models retaining some degree of international competitiveness in Russian military aviation technology. However the role of international partnership (especially with India) is likely to grow here too.

- The apparent readiness of Russian authorities, when engaging in such restructuring, to exert pressure on individual owners to sell up by bringing criminal charges, even if substantiated, to bear against them, undermines the impartiality of the justice system and institution of private property.

- The policy of creating national champions has some justification especially in the aviation sector. However, it looks to be triggering a domino effect all down the line – from airlines to aircraft producers to engine producers to metal suppliers. In each segment, state-owned national champions are being formed, including straightforward cases of nationalisation such as the purchase of titanium producer VSMPO Avisma, supplier of Boeing and EADS, by Rosoboronexport. Not only does this increase the state’s share in the economy, it also squeezes out the market as coordinating mechanism, as, on the one hand, national champions, such as Aeroflot, are leant on to ‘buy Russian’, and on the other, state-owned companies are preferred as suppliers to private companies.