Outlook: Investors vote with their feet as Russian bear turns nasty

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The confiscation, impounding, call it what you will, of Mikhail Khodorkovsky's controlling stake in Yukos marks a dramatic escalation in the Putin regime's assault on Russia's richest business oligarch. Up until yesterday's court action, it was possible to see Mr Khodorkovsky's arrest as a politically motivated, pre-emptive strike against an enemy of the Vladimir Putin government. But as is so often the case, what may have started as a matter of politics is fast becoming an issue of economics as well.

Russia has been one of the major beneficiaries over the past two years of the recovery in appetite among international investors for emerging markets. Only two weeks ago, Moody's, the debt rating agency, pronounced that Russia was sufficiently rehabilitated to be assigned investment grade once more. The foreign money that has been pouring into the country is one thing; Russians that removed their wealth in the run up to the debt default of 1998 have also been repatriating it in ever increasing quantities. Now that process risks going into reverse.

Vladimir Putin undoubtedly wanted to teach Mr Khodorkovsky and other oligarchs with political pretensions a lesson in moving against Yukos. What he did not want to do was provoke another flight of capital, yet despite the soothing noises he was making to international bankers and business leaders yesterday, that's precisely what he seems to be achieving.

So frightened is the regime of the consequences that Russia's finance minister, Alexei Kudrin, last night suggested that the courts may have overstepped the mark in seizing the Yukos shares. The prosecutor's office was at pains to stress that this was not an act of sequestration, just an impounding of shares, similar to a British court order to freeze assets. Yet for already unnerved capital markets, the distinction might seem a fine one, and many investors are already voting with their feet.

The developing political and financial crisis has occurred in the middle of a visit to Russia by a delegation of British business leaders, led by the president of the CBI, Sir John Egan.

When he suggested at a function that the Khodorkovsky affair was a passing political skirmish unlikely in the long term to impact on Russia's transition to a liberal free market economy, he was told by his Russian counterpart in no uncertain terms that the situation was much more serious than he realised. The Russians know all about financial and economic crises and from bitter experience they know that the clamp down on Mr Khodorkovsky is all too likely to provoke one.

The situation is further inflamed by the lack of answers as to motivation. Is this a full frontal attack on big business, as Yukos would have us believe, or is it as the prosecutor's office insists just the legitimate pursuit of an outsized crook and tax cheat. If it were the latter, then half of Russian business would be behind bars, for to a greater or lesser extent all the Russian oligarchs robbed their way to riches during the lawless 1990s.

Is the crack down Vladimir Putin's policy, or is it that of more hardline elements in the security services and the judiciary? And if it is the latter, what does that say about Mr Putin's grip on power. Why were the Yukos shares sequestrated? To stop Mr Khodorkovsky selling them to Exxon and Chevron, or as a precursor to renationalisation of Russia's biggest oil company? At every level, the questions multiply, yet Russia seems quite incapable of giving the capital markets the answers they need.

For investors, the bottom line is that despite all the progress that has been made these past twenty years, the state machine is beginning to act as if returned to the bad old days of Stalinist Russia. Power is being exercised in a dictatorial, authoritarian and arbitrary manner. Mr Putin cannot seriously want to return the economy to state control. Nothing he has done since becoming president would suggest that. To the contrary. Russia today has a more liberal economy with less state interference than most of the capitalist west.

Yet the markets are right to fear that Mr Khodorkovsky may be just the start of a wider purge of business leaders, for there is nothing to reassure them otherwise. In the end, dictatorial government is incompatible with a dynamic free market economy. The evidence of China might seem to indicate otherwise, but China is in truth not a free market economy. Foreign business locates there as part of a contract with government planners.

Mr Putin insists he wants the rule of law, but capital cannot trust itself to a country where the law is exercised in an arbitrary fashion by a one party state. For all Russia's political and economic progress since the fall of communism, it is still very far from being a liberal democracy on the western model, with the requisite protections for individual liberties and property rights.

Lord Browne of Madingley, chief executive of BP, claims to be entirely comfortable about the billions he's invested in Russia. But then Big Oil is well used to dealing with unsavoury regimes and difficult dictatorships. President Putin was at the signing ceremony and is said to have dictated some of the terms, so it hardly seems likely that BP will be turned on any time soon. In any case, growing world demand for oil in combination with a finite quantity of reserves means that the oil majors must invest in ever more risky, dangerous and inhospitable places in their search for new sources of supply. It comes with the territory.

The same is not true of international capital, where billions can be moved at the click of a mouse. Mr Putin needs to act fast if he is to undo the damage he's causing his economy.

Baku Pipeline

Still on BP, in another part of the former Soviet Union, an altogether different controversy looms. BP is the main backer of the planned $4bn oil pipeline that will eventually link Baku on the Caspian sea with Ceyhan on the shores of the Mediterranean. The pipeline has for long been a bone of contention with environmentalists. Yet as environmentally damaging construction projects go, this one comes a long way down the scale, and were it not for the involvement of the World Bank, it probably wouldn't be much of an issue at all.

The World Bank will next week formally announce whether to grant the project approximately $300m of backing. There's not much doubt about the outcome given that the US controls 25 per cent of the votes at the World Bank and no one outside the environmentalists and some Kurdish groups fundamentally objects to the plans. The decision has none the less provided a rallying point for what opposition there is, leaving some members of the pipeline consortium to wonder why the World Bank is being involved at all.

The purpose of the World Bank is to provide cheapish finance to projects in the developing world that the markets wouldn't otherwise back, either because they are perceived to be too risky or because the returns are not worth the bother. The theory is a good one. The implicit guarantee of the US allows the World Bank to borrow at rates as advantage as those of the US Treasury and then lend it on to development projects where there has been market failure.

However, the point about the Baku pipeline is that the participants were quite happy to finance it without anyone's help. The involvement of the World Bank, with its politically correct guidelines and procedures, has only delayed the project and in all probability made it more costly. The World Bank was brought in only to give an international stamp of authority to a project that involves some of the most politically sensitive areas of the world, as well as to enable Azerbaijan to gain a rather larger equity participation than it would otherwise have had. It is not at all clear that this is an appropriate application of the World Bank's largesse.