Editor: Russia Arms Trader Becoming Central Kremlin Instrument

[this article was compiled and written by the editor of this website] When we talk about the notable trend of Russia “reasserting state control of the economy,” generally the debate goes straight to the energy sector and never comes back. Meanwhile there have been more quiet developments in other sectors of the economy such as metals and the arms trade, the latter of which has significant geopolitical ramifications – not entirely unrelated to the diplomatic relations shaped by energy agreements. tor_m1.jpg The TOR-M1 mobile surface-to-air missile system, to Iran from Russia with love Last Thursday, a major announcement was made by the Russian government to make the state-owned defense giant, Rosboronexport (Rosboroneksport, ROE), the sole weapons exporter – a monopoly by decree. Many privately run, successful defense firms in Russia such as the MiG Russian Aircraft Corporation and KBP will be forced to hand over $624 million of export sales to the government. The news, which was largely ignored by Western media (perhaps due to the tap dancing show put on by Gerhard Schroeder last week), is cause for concern for several reasons: 1. Like Gazprom, Rosoboronexport’s corporate structure is almost indistinguishable from that of the Kremlin. 2. Similar quasi-legal tactics, including (literally) hostile takeovers and allegedly bogus investigations, have been used to pressure private competition and consolidate state control over defense businesses and other heavy manufacturing. 3. Thanks to innovative deal making, defense transactions are helping Russia cement closer relations with several leading energy exporters and strategic manufacturing centers – often raising diplomatic tensions with Western Europe and the United States. Kremlin Inc. in the Arms Trade It is possible that less attention is paid to Russia’s arms industry because of the disproportionate income from exports of oil, gas, timber, and metals, yet between 2002 and 2005 arms exports increased by 15 fold, and with sales of $5.3 billion in 2006, Rosoboronexport just completed a “banner year.Identified by President Vladimir Putin many years ago as a critical source of revenue for the state, the administration initiated a series of moves to bring these businesses under tighter state control. The most important move in achieving executive influence in Rosboronexport was the installation in 2004 of CEO Sergei Chemezov. Chemezov has a long, personal history with Vladimir Putin, dating back to their KGB days in Dresden. There are even credible rumors that Chemezov could be considered as a dark horse presidential candidate. A recent Le Monde article listed Chemezov, along with Dmitri Medvedev of Gazprom and Igor Sechin of Rosneft, as one of Putin’s top-ten closest allies, and a Wall Street Journal article titled “Kremlin Capitalism: Russian Car Maker Comes Under Sway Of Old Pal of Putin” (published May 19, 2006) goes a bit further in describing the relationship:

Until recently, Rosoboronexport was barely known, an operation with a few hundred employees headquartered on a quiet Moscow boulevard. It was, and remains, one of Russia’s most opaque companies: Its business activities are largely a state secret. With Mr. Chemezov at the helm, however its profile began to grow. According to Mr. Chemezov, he and Mr. Putin met when both were KGB intelligence officers in Dresden, East Germany — a claim the Kremlin won’t comment on but one published in a government-controlled magazine. Mr. Chemezov says the two lived in the same apartment block and their families socialized. They kept in touch after their return to Russia. In 1996, when Mr. Putin got a job as a mid-level Kremlin bureaucrat, he made Mr. Chemezov his deputy. … After Mr. Putin became Russian president the following year (2000), he took control of the trade. He formed Rosoboronexport as a state monopoly to squeeze out freelance arms salesmen and root out graft, staffing it with old comrades. Mr. Chemezov became its deputy head and then, in 2004, its chief. … As Mr. Chemezov’s influence expands, the line separating his different roles — civil servant and entrepreneur — is increasingly blurred. “You know, we’re not really the state, we’re businessmen,” he says of Rosoboronexport. “Call it state commerce.”

Chemezov’s proximity to the Kremlin gives the company an overtly political dimension to its decision-making process – which is a negative development for both market competition and Russia’s foreign relations. chemezov_deal.jpg Chemezov signs one of many deals with India Yukos-ification of Defense, Automotive, and Metals Companies Since the appointment of Chemezov, Rosoboronexport has exhibited very aggressive tactics in regards to competiting exporters and other industry acquisitions, with full Kremlin support. For example, Sergei Tsivilev, the first deputy director general of the privately held Russian Aircraft Corporation MiG, has earned the wrath of the Russian procuracy, accused of mass fraud for allegedly attempting to sell counterfeit aircraft parts to Poland (although Polish representatives have come to his defense and stated clearly that they have no complaint against Tsivilev). MiG representatives say that the probe is a baseless, politically motivated gambit to prevent him from inheriting Alexei Fedorov’s position as CEO. Kommersant quotes lawyer Tatyana Protsenko saying the following: “This criminal case has no judicial future, it was initiated illegally, and the charges were brought to Tsivilev illegally as well, because the prosecution story does not disclose what is the precise fault of my client.” Ruslan Pukhov of the Center for Analysis of Strategies and Technologies says that many groups in the Russian defense sector are aiming to limit the expansion of Alexei Fedorov’s group. Another case of Yukos-like tactics has been Rosoboronexport’s ham-handed takeover of the AvtoVAZ, the manufacturer of the Lada. In December of 2005, Mr. Chemetov, whose company had no experience in cars, was accompanied by 300 heavily armed men to forcefully seize control AvtoVAZ, in what some have called a “creeping nationalization.” In order to force out the old management and install Kremlin loyalists, the government had to assist Rosboronexport with force. The Wall Street Journal reported the following on the takeover:

“To impose order . . . the state had to bring in 300 policemen from outside,” says Mr. Chemezov. “Over the next few months, we had to replace virtually the entire police force, both in Togliatti and in the factory itself.” Soon, three of Avtovaz’s senior accountants found themselves facing charges of theft and tax evasion. The charges were dropped a few weeks later.

Perhaps the clearest indication that Russian state had regained control of the automotive sector via arms proceeds was the proposed plan to manufacture the Lada “Kalashnikov” – a jeep to be sold to the military. The renewed state influence in the company began to cast serious doubts on a $340 million joint venture General Motors signed AvtoVAZ in 2001. Last summer, GM announced plans to construct its own assembly plant in Russia after their new Russian partners decided they wanted to be paid more for the parts they supplied to the Americans – and unilaterally decided to shut down production for 10 days. A similar “creeping nationalization” has occured with the takeover of 66% VSMPO-Avisma, the company resposible for manufacturing almost one-third of the country’s titanium. According to the blog ZheZhe, government pressure may have been applied to get two major shareholders to sell their stakes in the firm at reduced prices – apparently days before the negotiations VSMPO-Avisma was hit with a huge tax bill with penalties of 2.45 billion rubles. (last summer the titanium firm signed an major joint venture with American aerospace giant Boeing). In light of the government conduct in each of these three cases, it is clear that Rosoboronexport has quietly become a central instrument of the Russian government’s attack on the private sector. These examples of baseless lawsuits, unilateral contract violations, and inflated tax bills bear the trademark of a singular line of thinking – the same tactics used against Yukos and other companies. From a business perspective, these creeping nationalizations and bogus investigations from the procuracy augur very poorly for investor’s perceptions of risk, and also do much to damage Russia’s weak rule of law. kalash.jpg After taking over AvtoVAZ, Russia’s arms leaders debuted a new jeep called “The Kalashnikov.” Weapons, Energy, and Foreign Relations Another disturbing trend of Russia’s new arms monopoly is where these weapons are going. While both China and India are Rosoboronexport’s top customers (making up two-thirds of sales), the company has also recently closed deals with a number more controversial states, including several critical energy exporters. Just this week, it was announced that Russia has completed delivery of 29 TOR-M1 short-range missiles to Iran, and is in advanced talks with Syria for a deal on Strelets missiles (apparently the negotiations have been “difficult” as the Syrians would like the missile system to be equipped with Igla rockets). In the past we have covered the major arms deals Russia has carried out with Venezuela, and they also count Algeria as a significant customer (and natural gas partner). After news broke last year that Russia would consider trading oil and gas rights in exchange for arms, speculation opened up as to what extent Gazprom’s licenses in the Orinoco basin and Russian energy agreements with Algeria were due to favorable weapons deals. Russia has been able to use its arms deals to help cement stronger relations with nations that share its “vision of a multi-polar world” – and consolidate cooperation in energy and other geopolitical issues. For example, a report by the Congressional Research Service for the US Congress found that by 2005, Russia had beat out the United States to become the leading arms supplier to developing nations:

Russian leaders have made important efforts, in recent years, to provide more flexible and creative financing and payment options for prospective arms clients. It has also agreed to engage in counter-trade, offsets, debt-swapping, and, in key cases, to make significant licensed production agreements in order to sell its weapons. The willingness to license production has been a central element in several cases involving Russia’s principal arms clients, China and India. Russia’s efforts to expand its arms customer base have been met with mixed results. In the early 1990s, Russia developed a supply relationship with Iran, providing that country with Mig-29 fighter aircraft, Su-24 fighter-bombers, T-72 Main Battle Tanks, and Kilo-class attack submarines. Although new Russian sales to Iran were suspended for a period from 1995-2000 in accordance with an agreement with the United States, Russia now asserts its option to sell arms to Iran should it choose to do so.

The fact that Russia participates in the arms trade is not in itself a point of controversy. Just like any other nation, they have a legitimate right to pursue their interests in this field. However, the problem comes with some fundamental corporate governance issues. When a company lacks transparency to such an extent, and when the executives hold such integral relationships with the highest levels of government, many of the organization’s decisions will seek to fulfill political, not business objectives. This is extraordinarily damaging in terms of efficiency, discouraging to the business sector, and capable of causing enormous friction in diplomatic relations (for example, it has been discovered that Russian weapons were used by Hezbollah against Israel in last year’s conflict). The illegal tactics used by the Russian government to position the state-owned defense firm into a monopoly status erode rule of law, and underscore the current administration’s disregard for rules, agreements, contracts, and corporate rights.