Who’ll invest in a country that 'sways in the wind’?

CORE CASE

The risk inherent in the political system that has developed in Russia under Vladimir Putin has been laid bare by the 4 December parliamentary election: a sharp one-day sell-off in Russia equities on 6 December was triggered by street protests in central Moscow organized by social networks in response to the official results of that ballot. The severity of the market reaction signifies a sudden awareness – but not necessarily an accurate assessment – of previously ignored risks.

Making sense of these risks requires, above all, a clear view of the causes of the recent chain of events: the sharp loss of support for Putin’s United Russia (UR) party in the State Duma election and the evidence that the real UR vote share was well below the official result of 49 per cent (which, in turn, was down 14 percentage points compared with the 2007 election). In other words, the falsification of the vote count may well have made the difference between UR having an overall majority of 13 seats in the Duma (the official result) and losing outright control of the federal parliament. The resulting demonstrations in Moscow and St Petersburg by the young liberal opposition – which met with the familiar heavy-handed police response – have sparked loose talk of the Arab Spring coming to Russia. The reality is much less dramatic, but no less interesting and important.

The doomed ‘big tent’

These political events stem from the inevitable entropy of the “big tent” style of political organization. A typical phenomenon in countries recovering from humiliating collapse (and seen in the post-World War II period in several countries that are now mature and stable democracies), the “big tent” envelops a country’s entire mainstream elite into a broad front for national revival. Real political competition is confined to the interior of the “tent”, with opposition either marginalized or – where formally participating in the system – assigned the function of safety valve for protest votes rather than the authentic opposition role of constituting an alternative government. Recovering living standards consolidate public support for the ruling establishment, hence its legitimacy.

Indeed, legitimacy has been just as important to the Russian version of this system as the more obvious authoritarian features. In short, Russia’s “big tent” regime – which emerged in the late 1990s and has since been “perfected” under Putin – has amounted to a mild form of authoritarianism legitimized by the consent of the ruled.

By its very nature, such a system is transitional, since the popular consent on which it is based will erode over time. The 2007 election coincided with the peak of an economic boom that had seen Russia’s GDP in dollar terms rise approximately tenfold in less than a decade. So it was inevitable that at the end of a political cycle that, in economic terms, centred on the deep 8 per cent recession of 2009, UR’s vote would fall from its 2007 peak of 63.4 per cent. The key point, however, is that not even sustained economic growth can preserve public support for the “big tent” establishment. That is because expectations will always tend to rise faster than real incomes, leading to disenchantment among the electorate.

Until now, the Russian ruling establishment has weathered this disenchantment, not least because a majority of the public feels the benefits of stability and improved welfare achieved during the Putin era and thus has no wish to see those gains placed in jeopardy. Were it take place against this background alone, the decline of the Putin system in its present form, though inevitable, could be fairly gentle.

But there is an additional factor weakening public support for the establishment and, at election time, its vehicle – UR. This is the extremely high level of corruption that pervades all of society but is felt most keenly by citizens through the stealing and extortion carried on by bureaucrats. While the corruption problem has deep social and cultural roots, the very successes of the Putin years – stable and legitimate power combined with economic growth – have accentuated the greed and arrogance of the “state mafia”. During Dmitry Medvedev’s presidency, the political leadership has sensed the threat posed by corruption to the stability of the establishment and hence to its power. But various initiatives to combat official corruption have most likely helped make the problem worse in the short run, by creating an incentive to maximize rents while the opportunity still exists (this argument is set out fully in our June 2011 report Russian corruption revisited).

The resulting widespread public alienation is particularly acute among the educated urban young – especially in Moscow and St Petersburg – who are appalled not only by corruption but also by the authoritarian features of the regime, including the control of the central television networks, which contrasts so starkly with the free speech on Russia’s internet. This more purely political form of discontent remains a minority phenomenon – although, as many commentators have long pointed out, the growing middle class will wish over time to supplement material gains with a greater voice and accountability on the part of the authorities. But the minority in question – the most dynamic and creative part of society with the greatest potential to contribute to Russia’s economic and social development – has obvious importance for the country.

Political risk management options

Dictatorship is not an option

It follows that unless Putin’s “big tent” system is modified, there will be increasing risk of below-potential development (including the economic growth performance underlying the investment case) and destabilization. One option in theory might be to replace popular consent as the basis of the regime’s legitimacy with a harder and more repressive version of authoritarianism. But Russian society is too educated, open and wealthy for a straightforward dictatorship to succeed in imposing anything but the most brittle stability – one that would be undermined soon enough by resistance and upheaval. It is thus no surprise that Putin’s clear strategy is to preserve the ruling establishment in its present form founded on democratic legitimacy.

New faces

Perhaps the simplest and most effective way to implement such a strategy is through periodic personnel changes at all levels of government and administration, above all including the rotation of the top leadership itself. Ordinarily, this straightforward gambit goes a long way towards accommodating the public’s natural desire for change and renewal – a breath of fresh air – while simultaneously maintaining the existing order intact. Indeed, the effectiveness of this approach is exemplified by the success of the politically bankrupt Yeltsin administration in generating fresh political capital by choosing, in August 1999, the unknown Vladimir Putin as the new leader.

Putin created the option of heading in a similar direction when he handed the presidency to his protégé, Dmitry Medvedev, in 2008. Despite dissatisfaction at the gulf between his rhetoric of radical renewal (“modernization”) and the stubborn realities of Russian life (especially the bureaucracy), many hopes were placed in Medvedev. To some extent, those hopes were justified: aspects of his presidency relevant to the present situation include his championing of the internet and gradual liberalization of the political system, which resulted in much easier campaigning conditions for opposition parties in the latest election, as acknowledged by Sergey Mitrokhin, the leader of the liberal opposition party Yabloko, among others. And those hopes – along with their stabilizing effect – would have grown if Medvedev were now heading for a second presidential term and hence a freer hand (with Putin continuing to ensure bedrock stability).

Putin’s decision to reverse this whole approach by returning to the Kremlin for what, under the amended constitution, could be two six-year terms is therefore counter-productive to what he claims is his motive: namely, to provide a stable environment for the country’s development. As explained in our August 2011 note Russia’s tandem heading for a second term, the 2008-12 version of the Putin-Medvedev “tandem” has been politically productive since Medvedev can supplement Putin’s still solid support among the Russian public by appealing to the important younger and more educated constituency. This appeal has been largely, if not wholly lost, as a result of Putin’s decision to head back to sole leadership with Medvedev demoted to subordinate status. UR’s vote share in the Duma election would have been higher if he had not opted to do so.

Fighting corruption

Besides personnel rotation, another fundamental way of halting the natural erosion of legitimizing popular support for the ruling establishment is a more credible fight against corruption. As far as political risk is concerned, this is particularly important as regards the formal electoral process through which legitimacy is established. In short, blatantly rigged votes and falsified vote counts undermine the system at its heart. The extent of the falsification in Moscow revealed by an active civil society monitoring campaign has duly triggered the unrest seen in the capital in the days following the election.

Short-term outlook: No ‘Russian Spring’

This brings us to the question of short-term risks, which are now the natural focus of attention in Russian financial markets. At the time of writing – with further large-scale demonstrations planned during the second week of December in Moscow (and elsewhere) – it is not surprising to see widespread speculation about severe political instability even to the extent of “regime change”. In our view, such speculation is mistaken – for three main reasons.

1. Flexible management from the top: Demonstrations permitted

Faced with a more serious situation than they bargained for, the authorities are raising their game. In practice, this means that decision making is being taken out of the hands of bone-headed lower-level officials (including those in the Moscow Electoral Commission, City Hall and police department, who reacted to the first protests on 5 December by imprisoning the popular anti-corruption blogger Alexey Navalny). Senior Kremlin officials and the sensible Mayor of Moscow, Sergey Sobyanin, are in direct crisis management mode. As a result, demonstrations are being authorized in such a way that demonstrators can comply with the regulations; and the demonstrators, for their part, hail from the relatively law-abiding middle class (as opposed, for example, to the nationalist football fans who staged a pogrom in central Moscow in December 2010).

2. Electoral abuse: Concessions

At the same time, it is clear that at least some of the more flagrant abuses of the Moscow vote count will be investigated and acknowledged in the courts. This is exactly what happened in response to protests about similar corruption by Moscow electoral officials in the City Duma election in October 2009.

3. Fundamental legitimacy: Eroded but not lost

The formal goal of the protests is to ensure that falsification is recognized and corrected. This is not to say that the protest movement will necessarily fizzle out quickly (although the upcoming New Year holiday season will provide a natural dampener). The opposition parties will demand a full re-run of the Duma election, and this will be rejected by the authorities. So the stand-off will continue. But the substance of the dispute is much more specific and limited than an uncompromising demand for regime change or the 2004 “Orange Revolution” in Ukraine, which sought to ensure that the presidential election was not stolen from the real (opposition) victor. The most important point here is that the Duma election was not stolen in any fundamental way.

This can be shown by making the most conservative assumptions about the real level of support for UR from the voters on 4 December. We start by taking the four most populous “national republics” (non-ethnic Russian regions), where paternalist traditions always lead to a higher turnout and voter support for the government. In Table 1 below, the official turnout and UR vote share in these regions are adjusted down from the officially declared levels of, respectively, 75-99 per cent and 70-99 per cent, to 70 per cent and 66 per cent.

Sources: Central Election Commission data, TS Research.

Table 2 below further reduces the nationwide turnout number (on the assumption that there was similar artificial inflation of that number in other regions) and then applies an assumed real UR vote share to that normalized total number of votes cast. Alongside the 66 per cent vote share in the major “ethnic” regions mentioned above, we assume that the party’s actual performance in the rest of the country – that is, before electoral abuses – was 40 per cent. This assumption balances, on the one hand, the official UR result in several major cities in the range of 30-35 per cent (while in Moscow, exit polls gave United Russia 28 per cent versus the official result of 46.5 per cent) and, on the other hand, the more conservative smaller centres and rural areas (which still contain around half the electorate), where the party’s share may be conservatively estimated at 50 per cent.

Sources: Central Election Commission data, TS Research.

Putting all these assumptions together, the bottom line is that UR’s real vote share was most probably above 40 per cent but below 45 per cent. This fits with the reality check of the exit poll result of the independent Public Opinion Foundation, which predicted a score for UR of 45.5 per cent.

Although this lowest likely real score for UR is not too far below the official score of 49 per cent, the gap between the two does represent the difference between an overall majority of 18 in the new State Duma and loss of overall control (around 200 out of the 450 seats). But in practical political terms, this does not mean that the election was stolen, since the dominance of UR remains genuine; and even with 200 seats, the party could pass all legislation with the support of a few deputies from the other parties – Vladimir Zhirinovsky’s traditionally pro-Kremlin “Liberal Democrats” being the obvious candidates. In short, although the legitimacy of Putin’s rule has been eroded, the decline comes off such a high base that the new lower level of support – even after allowing for vote-rigging – remains easily sufficient to govern.

Our prediction is that from January onwards, protests against falsification of the Duma election result shift into a campaign for an honest presidential election. If anything, the combination of an enthusiastic monitoring effort and greater caution by electoral officials will marginally enhance the legitimacy of Putin’s inevitable victory in that election. Attention will then turn to the formation of the new Medvedev-led government and the identity of the promised new faces (at this level at least, Putin has grasped the benefits of rotating personnel). Against this background, political calm will return.

The main risk to this forecast would stem from violent provocations this month during protests in Moscow – and possibly other major cities – on the part of the authorities and/or the demonstrators, which could lead to a formal state of emergency and the postponement of all elections. We see this as unlikely. Since, for the reasons just argued, adequate legitimacy remains in place, the authorities clearly have no incentive to retain power by the much more risky means of hard repression. As for the demonstrators, while some leading opposition activists make a point of seeking confrontation with the police, the large middle-class crowds – as we pointed out above – will always tend to disburse peacefully (as seen even amid the tensions and arrests accompanying the first explosion of street protest on 5 December).

INVESTMENT CONCLUSION

No ‘political’ trade for now

Despite our expectation that tensions surrounding the Duma election will be successfully contained, the political risk premium in Russian equities and debt would look attractive only if the market were to experience more down days on a scale similar to that seen on 6 December (the major blue chips, Gazprom and Sberbank, lost around 6 per cent of their value on that day). Unless and until the scare deepens, we would not recommend a “political” trade in Russian equities.

Longer term: How to price political risk

Looking out to the medium and longer term, investors would be justified in requiring an additional political risk premium in Russian asset prices until the flaws in the present political set-up start to be corrected. Such corrective measures would lead to high-quality stability based on solid legitimacy, in turn facilitating the country’s dynamic development. As things stand now, the political risk laid bare by the Duma election will be likely to inhibit the reversal of capital flight and increase in foreign direct investment that could ordinarily be expected at the start of a new political cycle.

Failure to modify Putin’s “big tent” establishment in the coming years would create a real risk of its disorderly disintegration. The key driver of any such scenario is loss of public support – the basis of legitimacy – although this could be accompanied, in a mutually reinforcing process, by the defection of mainstream elites. That, in turn, would strengthen the incentive to hold onto power by illegitimate means (such as the total theft of elections and repression of the resulting protest), spelling chronic destabilization.

This leaves the question of what would signal to investors that this political risk is, on the contrary, being controlled or even reduced. As discussed in the “Core Case” section above, the two most practical and effective strategies would be rotating office holders and much more vigorous action against corruption. As regards the first of these tests, Putin has missed the main opportunity by choosing to return to the presidency; that mistake could be corrected, or at least mitigated to some extent, only if Putin indicated that he would stand down at the end of the next political cycle in 2018.

Another positive development would be a readiness to accept UR “defeats” in routine regional elections – that is, the party’s loss of overall control of regional legislatures while remaining the largest party, as happened in the St Petersburg regional election on 4 December. This would be a harbinger of transition from the “big tent” to a more mature pattern of coalitions and ultimately alternations in power – all within a framework of systemic stability.

Leaving aside such long-term imponderables, in the shorter run (where predictions are inevitably easier), we expect that President Putin will give Prime Minister Medvedev ample scope to pursue an active reformist agenda that will be supported by a line-up of new faces in senior ministerial positions. Although Medvedev’s political potential is much reduced, he will have every incentive to make the strongest possible mark as head of government. The fundamental political incentive – that is, for Putin himself – will be to prove that he is not a “busted flush” (a response that would be in line with his track record of counterattack in times of adversity). Hence we would not agree with the widespread view that the tandem’s diminished political capital precludes constructive policies. While some necessary and unpopular reforms (such as raising the pension age) may be ducked, most market friendly policies – notably privatization and capital market reform – do not involve social sensitivities. Moreover, continued tough anti-corruption action would be welcomed by the public.

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