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Safe Russian Markets Can't Be Built In A Day

Business Week International International Business


In the best free-enterprise fashion, slick radio and TV advertising in just a few months helped turn MMM, a Moscow-based financial company, into a huge success, with some 10 million shareholders nationwide. In the ads, a fictitious excavator operator named Lonya Golubkov quickly parlays his holdings of MMM shares into a Paris estate, a San Francisco holiday, and a fur coat for his wife. "And why not?" chortles Golubkov to his brother Ivan.

The "why not" is now painfully evident. Taking advantage of Russia's virtually unregulated securities market, MMM's managers did pay a lucky few investors fantastic returns of up to 1,300%. But in late July, the government issued warnings about MMM's financial health, and the bubble burst as investors scrambled to cash in their shares. With the savings of millions of Russians apparently wiped out, critics charge that MMM was a classic pyramid scheme--money from new investors was being used to pay off earlier investors. The company's managers deny such charges, insisting they put money into such solid investments as the AutoVaz car factory that makes popular Zhiguli sedans.

CRACKDOWN? The costly fiasco is souring popular support for Russia's three-year-old experiment with free-market reform. It's putting enormous pressure on the Yeltsin government to crack down hard on Russia's fledgling private-investment schemes, including the hundreds of new funds--many of them legitimate--that have sprouted in Russia.

It will be too bad, however, if Yeltsin overreacts. Russia has a tendency to swing back too hard and snuff out what it's trying to correct. The fact of the matter is this: For Russia to achieve its transition to a new economic model, it must develop ways to channel capital so that new factories can be built and old ones revitalized. In the first stage of the country's vast privatization effort, all Russians were given vouchers to exchange for shares in companies. For cash itself, the main outlet for investment was limited to startups such as MMM.

Now, despite the MMM crisis, a crucial transition is under way. The voucher sell-off program ended in July, and a second phase has started that allows investors to buy shares for cash. Its obvious flaws notwithstanding, MMM was actually a pioneer by accepting direct cash investments and setting up an extensive sales network.

There's plenty of cash floating around the country. And there's capital flight overseas, perhaps as much as $40 billion, that could start flowing back if economic conditions improve and honest market mechanisms are


One promising sign that the Russians are learning their lessons about capital formation involves a plan to upgrade Magnitogorsk Iron & Steel Works, one of the world's largest such facilities, about 1,200 km east of Moscow. Built in the 1930s, the complex is now an unproductive dinosaur whose toxic fumes bring about dusk-like darkness at noon. The project could herald a trend in which Russia's capitalists park their money in real projects rather than in secret bank accounts on Cyprus or in get-rich schemes such as MMM.

QUICK RETURNS. A group of mostly private Russian investors is ready to put more than $650 million into Magnitogorsk. Auto makers, including UralAz, a truckmaker in nearby Miass, and AutoVaz, for example, will help fund a new $500 million cold-rolled steel plant. Four Russian banks are also participating, kicking in $1 million each. These banks used to invest for quick returns, says Alexander Petrovsky, deputy head of the development section of the former Ferrous Metallurgy Ministry. "Now, the attitude is changing," he says. "They're investing in industry for the long term."

Some of the legitimate investment funds are using Russian cash to buy stakes in such newly privatized companies as communications giant Rostelekom and oil producer Lukoil. Taken together, the market value of Russia's 11 biggest energy and communications companies is $7 billion. While many Russians still are lured by MMM-style promises, savvier ones are putting their money into more solid investments.

The message is that you can't expect Russia to have in a mere three years a sophisticated, well-regulated securities market. There could even be new MMMs in the future. But the broader trend is a search for mechanisms to get the cash to where it's really needed. If the Russians can keep their eye on that goal, they could turn their nation into an economic powerhouse. And why not?Commentary/by Peter Galuszka and Patricia Kranz

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