Originally Published on September 10, 2017.
Corruption happens in every country and every industry. For example, Transparency International gave The United States a score of only 74 out of 100 with 100 indicating little to no corruption in the public sector. Emerging markets, in general, have higher rates of corruption than developed economies. For investors focused on emerging markets, rampant corruption can increase the level of risk of a portfolio and can lead to significant loss of revenue. So, how can investors mitigate corruption in emerging markets? In this article, I will demonstrate one step investors can take to protect their portfolios from corruption risks. I will use Russia as a case study.
The most important step to mitigating corruption risks is to know the major players. In countries like Russia, for example, there is a de jure political structure and a de facto political structure. Understanding how these two layers of government work together is vital to uncovering the real power players in a country. For me, it is helpful to think of the de jure political structure as the constitutionally outlined government. In the United States, we have three branches of government with different powers and are designed to check the power of the other two branches. However, just understanding the political structure of the U.S. ordained by the constitution would not give an investor an accurate picture of U.S. politics. So, the other component is the de facto political structure. I think of this layer as the shade government of a country. For example, in the United States lobbyists are influential in shaping policy and pushing agendas, but are not explicitly given any authority by the Constitution.
Russia, for example, has one style of government outlined by the Constitution, but there are players with significant influence, who have been empowered by Russian President Vladimir Putin. Russia is a semi-presidential Federation with the president designated as Chief of State and the prime minister acting as head of government. The Constitution of the Russian Federation established the parliament, which is composed of two houses. The Federal Assembly is the upper house of parliament and comprises 166 members. The State Duma is the lower house of parliament and is made up of 450 members. These houses have specific powers designated by the Constitution, such as the authority to confirm deputies and ministers appointed by the government. The president nominates all members of Russia’s three highest courts and appointed by the Federation Council. President Vladimir Putin has manipulated this de jure political system to concentrate more power in his hands. For example, Putin extended the term length of the president from four years to six years.
In Russia, the shadow government, composed of Russian Oligarchs and childhood friends of Putin, holds the real power in Russia at the pleasure of the President.
Putin and his “cronies” have consolidated control over the media through intimidation; they have silenced political opponents through violent coercion. The courts in Russia have been used to punish individuals for political reasons. Russia has a history of false charges being brought against Putin and Putin’s inner circle. Some examples include Mikhail Khodorkovsky and Sergei Magnitsky.
Understanding the players in Putin’s Russia can help investors identify the interests at play. The major players in Putin’s Russia include Igor Sechin, Gennady Timchenko, Dmitry Medvedev, Nikolai Shamalov, Kirill Shamalov, Sergei Roldugin, Vladislav Surkov, Vyacheslav Volodin, Sergey Chemezon, Yury Kovalchuk, Arkady and Boris Rotenberg. Several of these men have a connection with Putin from his time in St. Petersburg, and several men have been longtime friends of the Russian President. The majority of the men in Putin’s good graces are businessmen. Igor Sechin is the head of Rosneft, the Russia oil company. Gennady Timchencko is a long time friend of Putin, and the owner of a private investment group called the Volga Group. Dmitry Medvedev has been in both the public and private sector as chairman of Gazprom and as the current Prime Minister of Russia. The complete list of Putin’s inner circle and their connections to the President can be found here.
While monitoring the decisions of the State Duma and the Federal Assembly should not be ignored, important political decisions can be made behind closed doors in Russia at the behest of Putin and his supporters. All of the men around President Putin have interests, and they protect the interests of the President. Since the majority of Putin’s inner circle are businessmen, investors need to keep abreast of political changes in the country. Investors can begin to mitigate risks from corruption by first understanding the power players, and, consequently, knowing what industries and/or sectors (natural gas) are politically-charged. However, this is only the first step to ensuring client portfolios are not negatively affected by corrupt practices.
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