Recent reports of Kremlin-infighting are partially accurate. Expect sharp swings in investor sentiment, creating good opportunities to make money, but no radical changes to Russia’s economic & political system.
Although the mass-media remain sceptical, in-depth analytical sources and business intelligence groups – such as Stratfor – have begun reporting of a new battle underway in the Kremlin. They claim that the crisis has given rise to a new political group, the civiliki, which is headed by President Dmitry Medvedev, and aims to unseat the hard-line siloviki group, responsible for much of Russia’s policy in recent years.
If true, this may mean that Russia faces a near-term period of upheaval, as political groups jostle for power. It would also test the joint president-prime minister leadership path. Understandably, given the classical lack of transparency governing everything that happens in Russia, the mainstream media are more reticent to decree political change underway. What is really going on? What are the ramifications for Russia investors?

First, let’s remind ourselves of these political groupings. The siloviki is by now a well established and universally recognised political force in Russia. The moniker derives from the Russian word for “force” or “power.” Many of the siloviki have security service backgrounds, when this political group first emerged, the perception was of a group of people powerful enough to bring order to Russia, and patriotic enough to do so without pursuing corrupted personal interests. The attack on Yukos and the continued power grabs that took place thereafter undermined belief in the latter characteristic, both domestically and abroad. Attacks on Shell and BP further muddied the siloviki’s image, although they seemed not to care, since they were so well politically entrenched as to be able to effectively defend their interests.

By contrast, the “new” group quickly becoming known as the “civiliki” is considered to be more internationalist and to favour more open economic policies, with less government involvement and fair competition for all. This group has essentially co-existed with the civiliki for years, and counts as its members, some of the most powerful politicians in Russia – Finance Minister Kudrin has proven one of the most effective and resilient politicians in post Communist history.

Now, the balance of power looks to be shifting. First, the selection of Dmitry Medvedev as Putin’s preferred presidential candidate enhanced the strength of the civiliki, while weakening the position of the siloviki (whose candidate of choice was the hard-lined Sergei Ivanov).

If the election of Medvedev shifted the balance of power, then the financial crisis took it further. The meltdown of the Russian financial system exposed the inefficiency and mismanagement of many assets ostensibly controlled by the state, but in fact dominated by the “people of force.” I have long argued that the culture of corruption, which flourished under Vladimir Putin, starts at the top; and the financial crisis exposed exactly how the siloviki had undermined effective development in the pursuit of government assets and power.

By contrast, the civiliki consists of a group that has differentiated itself by not openly pursuing assets, but rather focussing on responsible economic management. The shift of power away from the siloviki has led Russia commentators to contrive the civiliki moniker and to begin to view this group as a cohesive force, directly supported by President Medvedev.

Balancing Power

Throughout his time in power, both as president and prime minister, Putin has invested considerable energy to balancing the interests of various power groups. Thus far he has talked like a silovik and allowed this group to accumulate assets, but kept civiliki in economic management roles. Those civiliki that became too public in their disagreement with the siloviki were removed, but replaced with less vocal members of the same political group.

Medvedev, by contrast, has always sided with the civiliki – many of whom have been in senior government longer than he. The president projects an interest in sustainable economic development, directly aligned with the civiliki’s goals.

For the most part, these two groups easily coexisted during economic boom times. The civiliki were able to maintain steady economic growth, albeit with higher inflation than would be ideal. The siloviki were able to acquire and consolidate control of assets and wealth ostensibly under state control. Russia’s trend rate of growth, underwritten by a one-way oil market, left room for both parties to pursue their independent interests.

Crisis Pits Silovik Interests Against Civilik Economic Effort

The economic crisis changed that, laying bear the mutually exclusive nature of the two groups’ interests. As Russia struggled through the worst period of its economic crisis early this year, President Medvedev began to pursue policies that challenge the entrenched position of the siloviki, including:

- A critical review of state-owned companies, consolidated by the siloviki in the last days of Putin’s administration.

- A long-term campaign to raise the issue of corruption in the public spotlight, if not to actually address is it.

- Efforts to expose the extent of Russia’s economic dependence on oil.

As global liquidity tightened and economic demand plunged, Russia clearly decoupled from its BRIC peers, as the only major emerging market at the forefront of the economic collapse. China, Brazil and India have all continued to expand in 2009, while Russian GDP remains down approximately 10% YoY.

Chart 1: BRIC GDP Change, YoY

Notably, siloviki assets fell under severe liquidity pressure: loan repayments remained high, but income plunged and refinancing options evaporated. The technical bankruptcy of a partner of United Aircraft Corporation may have been the tipping point. Investors should have known better than to treat all state-owned enterprises equally as sovereign proxies (to do so arguably puts Russia back below investment grade status). But, the default brought home to the government the breadth of its market-implied economic responsibility.

For a state that had invested so heavily in improving its debt structure and fiscal reputation post-1998 default, this was too much to bear.

Tipping Point?

The key point of concern to foreign investors is where does this shift in balance lead? Will the president continue to dismantle the siloviki structures of the Putin era, further increasing the power of the civiliki?

Successfully executed, such a strategy could greatly enhance Russia’s investment case, leading to the country’s rapid integration into the global economic system and rapid inflows of capital.

Unsuccessfully executed, such a strategy would lead to acute political turmoil, probably leading to the (premature) return of Vladimir Putin to the presidency, and the strengthening of the siloviki within the government system.

In short, this battle has the potential to either turn Russia into an efficient 21st century power, or send it back to the alienated days of the cold war.

Don’t Expect A Revolution

The most likely outcome is far less extreme. The reality is that the mainstream media, which are very hesitant to identify a division between Putin and Medvedev, have the right idea. Even in the face of Medvedev’s letter on gazeta.ru, which implicitly accused Putin of abject failure to develop the Russian economy, mainstream press were reluctant to suggest a political division.

In part, this hesitancy is based on the realistic assumption that Putin is the most powerful figure in Russian politics. Personally, I question the extent of his ability to control the country, but his relative power is unquestionable. It is logical then, that Medvedev is severely limited in his freedom to criticise or pursue independent policy.

In reality, I find it implausible at this stage to believe that Medvedev would even want to. His “liberal” reputation precedes his presidency, but has always been kept in check. The war in Georgia, although led by Putin, strengthen Medvedev’s domestic position vis a vis the hardliners, but also reflects the limitations of his liberal ideology.

Ultimately, I agree with one of the most experienced journalists in Russia, who recently (privately) described Medvedev as a member of the Putin clan who’s “special powers” focus around projecting transparency, modernity and liberal economic interests. Not as an independent thinker willing to break-up the status quo in pursuit of the greater good.

Medvedev will continue to challenge the siloviki, and for a time he may appear to weaken them. But he will not defeat them, for they are deeply historically entrenched and supported by Putin. In the final analysis, a decisive victory over the siloviki is not possible without the exit of Putin from power. As things stand, Medvedev has no interest in destabilising the system that exists.

The case of Rosneft is perhaps the best demonstration of this point: It has received no political criticism despite finding itself so economically stretched as to turn to the Chinese government for a $20 bln loan, on undisclosed terms. The Russian government remains the dominant shareholder of Rosneft (despite possible plans to sell-off treasury shares). The company’s over-expansion was caused by its accumulation of Yukos assets at the onset of the silovik ascension. It is utterly untouchable by the strongest of the civiliki (and caused several leading members of this group to fall out of favour and into opposition), and beyond reprehension. A definitive marker of the limits of reform potential.

The best we might hope for is that Medvedev will pursue political liberalism wholeheartedly and tenaciously – up to such limits. The shady state-owned companies will change their status, becoming joint stock companies, but they will remain under silovik control, and provided that the price of oil doesn’t collapse long-term, they will remain entrenched and inefficient.

False Dawn – But Brighter Skies Nonetheless

Incremental development has long been a Putin policy. Optimists point to the success of China in pursuing such a strategy. Pessimists and democrats see it as an effort to project economic growth without challenging vested interests – both economic and political.

That said, Medvedev’s campaign to modernise Russia has the potential for great impact. If it continues to gain traction, it will increase capital flows and initiate a new era of “openness.” It may even bring marginal improvement in real economic terms. Russia has become so economically dysfunctional that it would be hard not to improve from here.

However, it will not lead to an elimination of the core problems. Investors in Russia would do well to continue demanding fast returns for the high risks they are taking. Things may look very rosy in 2010 as liberal themes emerge, and yes there is money to be made. But the fundamental issues are unlikely to change.