Moscow Stiffs Western Bankers, While Paying Oligarchs And Eurobond Holders: A Sign of Things to Come in Russia?

(Washington, D.C.): According to the 5 June edition of The Economist magazine,
Russia is
seeking to delay by six months its combined debt service payments of $855 million due on 2
June
to the London Club of private commercial bank creditors. This amount represents the interest
payment required on some $30 billion in Soviet-era debt. The London Club is expected to roll
with this latest default, hoping against hope that, by so doing, they can recover a significant
portion of their loans in the future. Such a move would anticipate — and be consistent with —
the G-7 governments’ willingness to ignore Russian proliferation and other predations when
they consider a Soviet-era debt forgiveness scheme at the upcoming G-7 summit in
Cologne.

Such a move is all the more troubling in light of the fact that Russian authorities only
last month
managed to find the hard currency to pay $333 million to service Ministry of Finance bonds held
by Russian individuals (read, oligarchs) and institutions. Moscow is also somehow finding the
means to make payments on its Eurobonds. This sort of selective approach to debt service has
made a mockery of a cardinal rule in global finance –“equal treatment” for all creditors — and
should stimulate both legal action and, if necessary, the seizure of assets. Unfortunately, as the
following excerpts from a recent speech by the Center’s William J. Casey Chair, Roger W.
Robinson, Jr., before the Non-Proliferation Policy Education Center makes clear, to the extent
that the corrupt Russian government is allowed to tap Western funding sources without being
subjected to financial discipline and transparency, it is likely to translate into greater threats to
U.S. security and interests.

Excerpts from

“Can We Prevent U.S. Credit Flows From Fueling Russian
Proliferation”

by Roger W. Robinson, Jr.

May 19, 1999

Regrettably, the recent leadership drama in Moscow will likely produce no meaningful
change in
what I have in the past described as the “Primakov Doctrine,”
which includes a strong
proliferation component to help destabilize the Middle East, the Caspian Sea region, parts of
Asia and beyond in hopes of reasserting Russia’s international standing and influence.

For example, one can basically count on the fact that some 80% of Russian industrial exports
will continue to be comprised of military sales and that proliferation activities will proceed
largely unabated. In short, it will ultimately require the systematic transformation of
Russia’s economy to that of a diversified, civilian one which is governed by the rule of law
to reduce substantially the political, economic and profit-oriented incentives driving
Moscow’s proliferation activities.

In fact, with the sharp decline in Russian hard currency earnings, the role of arms, space and
nuclear exports has undoubtedly increased in importance as has access to various forms of
Western financing. It is this latter subject – both with regard to the lessons of Soviet-era and
Russian experience – that I would like to concentrate on during the balance of these remarks.

It is useful to recount some of the lessons of the Soviet era. It is a fact that, for example,
billions
of dollars of Western government and commercial bank credits were diverted annually by the
Kremlin to fund activities both at home and abroad that were inimical to U.S. security interests.
Indeed, a hard currency cash flow analysis of the Soviet Union showed clearly that Western
public and private sector financial institutions were responsible for funding, on an annual basis,
the equivalent of virtually 100% of the hard currency costs of the Soviet external empire.

This unhappy circumstance largely resulted from a lack of Western discipline, conditionality,
transparency and collateral in financial dealings with Moscow. The bulk of Western credits to
the former Soviet Union took the form of so-called balance of payments or general purpose loans
with no underlying projects or trade transactions. This is still the case today. Then, as now,
transactions were rarely collateralized and the use of disciplined lending techniques were set
aside.

Official credits – including those extended by multilateral institutions like the IMF – were
similarly configured as general purpose loans with no non-economic conditionality
such as
geopolitical behavior and more specific security-related concerns. In short, the results of this
inattention concerning where the money was going and how it was being used by both public and
private sector Western creditors were the squandering of otherwise productive borrowings, the
underwriting by Western taxpayers and depositors of Soviet activities harmful to Western
security interests and the Kremlin’s ultimate default on some $90 billion in Western debt a mere
two days before the collapse of the Soviet Union.

Perhaps not surprisingly, the methods and instruments used by sovereign borrowers to fund
themselves and their global undertakings have changed significantly since the 1970’s and 80’s.
Today, governments with substantial funding requirements — like those of China and Russia —
have largely turned away from financing provided by Western governments and commercial
bank syndicates in favor of tapping the private capital markets. Some reason for this shift are as
follows:

• Relatively inexpensive access to large sums of general purpose cash (i.e. no underlying
  trade
  transactions or projects making it easier to divert these funds for potentially nefarious purposes).

• The ability to recruit a large new group of Western lenders (e.g. securities firms, pension
  funds, insurance companies, corporations and even individuals).

• Continued avoidance of conditionally, transparency, discipline and collateral (e.g. some of
  the
  key origins of the Russian default last August).

• Construction of politically-powerful new constituencies in this country and abroad with a
  vested financial interest in ensuring that, for example, Russia or China are not subject to U.S.
  economic sanctions or other penalties almost irrespective of the gravity of the misdeeds involved
  (e.g. proliferation, human rights abuses etc.).

• Greater confidence that the foreign government will be bailed out by Western taxpayers in
  the
  form of IMF packages and other means should a financial crisis arise.

• The sharply increased use of bonds and other securities has actually compounded the
  problem
  of moving such governments toward disciplined, transparent financing methods and made more
  difficult the rescheduling of such debt instruments during periods of financial distress. Although
  new efforts are underway in Western capitals to make bonds more readily rescheduable — by
  such methods as a dramatic reduction in the percentage of bond holders who must agree to a
  change in the maturity structure — it may be too late for Russia.

It should go without saying that Russia has been expending multi-billion-dollar sums on
strategic
modernization and advanced weapons systems during virtually the entire period of its financial
perils. These might be referred to as “hard” contributions to the proliferation portfolio as they
implicate the components, materials and actual equipment that make up such illicit trade. It is,
however, the “soft” contributions to proliferation which are often the most challenging and least
understood. By soft contributions on the financial side, I mean the facilitation by
would-be
proliferators, or their benefactors, of the means – often in terms of new revenue streams –
to procure and/or supply proscribed materials and equipment.

This point is best illustrated by the case of Gazprom’s effort to debut on the U.S. bond
market, in
an offering led by a major U.S. investment bank in November 1997.

Gazprom was seeking $3 billion to offset some $4 billion it was compelled to pay the
Russian
government in tax arrearages in the summer of 1997.

It was scheduled to come to the U.S. bond market days after signing onto the French-led
consortium to develop the South Pars off-shore gas fields of Iran in violation of the Iran-Libya
Sanctions Act.

This U.S. statute was predicated on the notion that foreign development of Iran’s energy
sector
would bolster Tehran’s hard currency earnings which would, in turn, help provide the means for
Iran to procure components for weapons of mass destruction, ballistic missile delivery systems
and other proscribed items.

Gazprom needed the Western financing to help fund its participation in the Iranian deal.

It struck the U.S. Congress — specifically the Senate Banking Committee — that it was
inconsistent to withhold some $700 million in ExImbank and other taxpayer-funded financing
from Gazprom while the firm simultaneously went to New York for some $3 billion.
Accordingly, the bond offering was vigorously opposed in two Senate Banking hearings within
one week — on October 30 and November 5, 1997, the latter at which I testified — even though
the ILSA legislation makes no reference to the private capital markets.

Soon thereafter, the bond offering was withdrawn from the market making it the first such
foreign bond offering ever derailed on the U.S. market for primarily national security reasons.

Although it is virtually impossible to preclude the use of U.S. credits or aid flows from
funding
activities contrary to our interests because of the fungibility of money, substantial progress can
be made in reducing this prospect as well as effectively deterring or, if necessary, penalizing such
harmful diversions to advance proliferation:

1. Western creditors and investors should steer clear of general purpose, balance-of-
payments
lending. Instead, such lenders should focus on short-term, documented trade transactions and
classic project finance.

2.The requirement that borrowings be collateralized (to the extent possible) would give the
Russian government and its large enterprises like Gazprom pause before borrowed funds were
diverted for non-productive political purposes (e.g. proliferation).

3. The present firewall existing between finance and national security must be breeched.
Security-minded conditionality should properly accompany taxpayer-funded credit and aid flows
to Russia, thus ensuring that Moscow does not achieve “the best of both worlds” at our expense.

4. Wall Street players would be wise to implement immediately a new national security layer
of
due diligence prior to agreeing to manage Russian and other foreign bond offerings to ensure that
the true identity and activities of the borrowers are understood and communicated accurately in
prospectuses.

5. Adopt particularly the establishment of a joint U.S.-Russian legislative commission to
monitor
the disbursement of Western aid flows, the increased channeling of U.S. aid to reform-minded
regional governments (hopefully bypassing Moscow), and ensuring that new aid and financing
follows the implementation of systemic reform, not the other way around.

Clearly, the desire is to make it difficult, if not impossible, for the U.S. to sanction such
entities
once evidence of proliferation is unearthed. In addition, often unsuccessful efforts to generate
multilateral support for such sanctions almost always is responded to by the business community
with the mantra that we are merely “shooting ourselves in the foot” if we proceed to implement
penalties on a unilateral basis.

There is an area remaining, however, where the U.S. still enjoys market dominance and can
act
unilaterally to create substantial, if not intolerable, hardship for larger foreign enterprises or
governments determined to be involved with – or supportive of – these smaller proliferating
entities in Russia, China and elsewhere. Should a company like Gazprom, for example, lose
access to the U.S. bond market on a sustained basis, it would not only pay more for the funds it
raises elsewhere (e.g. in Europe or Asia) but would likely find itself unable to attract the volume
of funds required to meet its development needs.

Another advantage of financial sanctions is in the political arena. Put simply, there are
generally
no underlying exports, jobs or people-to-people contact of the type that leads to substantial
lobbying on Capitol Hill and within the Executive Branch by influential members of the business
community. While it is true that U.S. investment banks and other institutions
could make their
case on Capitol Hill concerning lost profits if a foreign enterprise’s access to, for example, the
U.S. bond market was restricted due to proliferation concerns, it is unlikely that there would be a
great outpouring of political sympathy for generally well-healed Wall Street players.

An alternative method for penalizing proliferators would be to increase the focus on the
respective governments which are obliged to oversee these entities. Such an effort might seek to
link future Western taxpayer-funded credits and aid flows to progress in curtailing in-country
proliferation operations. A “top-down” approach of this kind would serve both to increase
pressure on these would-be proliferators from their own governments as well as to provide
incentives to foreign governments to maintain a clean bill of health on proliferation.

The merits of financial – versus trade – sanctions should be given careful review. In a world
where America’s vital security interests are increasingly being compromised by the lack of
political will and allied support, we would be well-advised to adopt more seriously the old adage
“follow the money.” Clearly, greater U.S. leadership is likewise required in allied capitals and
multilateral institutions. Should the implementation of multilateral sanctions elude us even after
we have identified foreign entities executing or aiding proliferation, the U.S. can still act
unilaterally in the U.S. capital markets and severely disadvantage offenders with relatively little
collateral damage, if properly managed. Naturally, it is important that such steps do not smack
of “capital controls” or other draconian measures that could cast a shadow over our common
desire to preserve the free flow of private capital into and out of the United States.