Russian President Vladimir Putin appears intent on reviving the KGB in ministerial form. Reports are circulating that a new Ministry of State Security (MGB) is being set up based on the existing Federal Security Service (FSB) plus some other security services, producing a new security monolith along the lines of the old Soviet secret police.

With the new ministry, Putin – a fomer KGB officer himself – hopes to recapture some of the $300bn a year lost to corruption. The Russian economic model is now broken following the collapse of high oil prices, and there appears no other way he can keep intact the system he has built over the last 16 years and at the same time cover the budget deficit without implementing austerity measures, which could provoke social unrest and cause his regime to collapse. Putin’s revenue-raising plan could have been lifted straight out of a KGB MBA textbook.

The new ministry is the latest in a string of initiatives that Putin has been introducing for years that increases his grip on power. It began with tough anti-money laundering rules in 2000, through de-offshorisation rules for Duma deputies and corporates, up to the creation this year of National Guard elite police forces under direct presidential control. But the MGB will take the game to a whole new level, institutionalising Putin’s control of the security services.

Why is Putin doing this? The answer for Russia’s detractors is easy: the creation of the MGB slots very neatly into the “Russia is evil” narrative, and “Putin wants to recreate the Soviet Union” meme. The point critics miss is that the Soviet ideological battle is over. Socialism lost. Putin is a committed capitalist and needs the Russian economy to flourish. The problem is his lack of understanding of how best to do that.

Cash caught up in corruption is the only pool of money in the country left that Putin can effectively go after to cover the RUB2 trillion ($30bn) budget deficit Russia will run for at least the next three years, according to the new budget that will be submitted to the Duma in the autumn. And as oil prices are expected to stay low for years to come, Russia Inc is in real trouble, as it’s no longer a profitable business and won’t be again for the foreseeable future. Something has to change.

Pathetic politics

Clearly, the MGB does have a political dimension. Putin has not exactly been accommodating of the opposition. But the Duma elections on September 18 graphically showed there is almost no opposition left. Obviously, Putin has successfully crushed most real dissent using his monopoly on “administrative resources”, but at the same time the opposition has failed to offer the people a viable alternative.

Grigory Yavlinsky’s Yabloko failed to close the deal in the 1990s thanks to bickering with the other leaders of the time. Former prime minister Mikhail Kasyanov is fatally flawed thanks to his corruption while finance minister, and he has just acknowledged the fact by withdrawing from the 2018 presidential race. As a former oligarch now living in effective exile from Russia, Mikhail Khodorkovsky only appeals to Western pundits and is also unelectable – and also just took himself out of the 2018 race. Ilya Yashin is from the new generation, but so far he has managed to annoy his colleagues more than the Kremlin, with his Parnas party cohorts disowning a corruption report he brought out ahead of the Duma election. And the star power of Alexei Navalny has also faded. Since his conviction for fraud, Navalny has been unable to find a toehold on the slippery face of Russian domestic politics. He is now at best a thorn in the Kremlin’s side. The Kremlin may have made it hard for the opposition to function, but the opposition is as much to blame for its own failure.

So if the opposition is so weak why does Putin need a security service that is as powerful as the old KGB used to be? It looks like overkill.

If you were president today looking forward to 2018, what would you be most worried about? Putin will walk the 2018 presidential election, as the leading Yeltsin-era oligarchs were cowed after Khodorkovsky was jailed in 2003, and the new breed of ZAO Kremlin oligarchs such as Oleg Deripaska and Mikhail Prokhorov have been sidelined. Indeed, most of the Yeltsin-era oligarchs have already left the country and the Putinite oligarchs are now clearly starting to pull out. The latest victim in the crackdown on oligarchic malfeasance is Viktor Vekselberg, who saw his telecommunications company Vimpelcom raided earlier in September. The only oligarchs left operating freely are the ‘stoligarchs’ – the handful of businessmen in Putin’s immediate circle. Putin faces few threats from this quarter.

Putin’s biggest headache is not politics; it is economics. For almost all of his decade and half in power the state coffers have been overflowing with petrodollars. The collapse of the oil price in December 2014 has not only turned the oil money spigot off, but as oil will stay “lower for longer” the Russia’s economy has changed fundamentally. There is no amount of cost cutting and rejigging that Russian Finance Minister Anton Siluanov can do to put the current company back into profit. The obvious solution is to put in place those deep structural reforms we have all been calling for to spur domestic investment and encourage small and medium-sized enterprises (SMEs) to flourish. Raising retirement ages, and hiking income and profit taxes can close some of the gap, and both of these initiatives are now on the docket.

But to do all this would mean breaking up the ZAO Kremlin system that Putin has spent 16 years building. These reforms would destroy his hold on power, as both the people and the elite could turn on him. However, he believes there is an alternative that would allow him to keep ZAO Kremlin intact while also fixing the economy: tapping the massive pool of corruption money that has always plagued Russia since Tsarist times.

Endemic graft

Russia is regularly described as a kleptocracy, but since Prime Minister Dmitry Medvedev launched the latest anti-corruption drive in 2008 the levels of graft have begun to fall, albeit slowly. Russia is currently ranked at 117 on Transparency International’s index of 176 countries, up from 143 in 2011.

The government currently needs about RUB2 trillion ($31bn) of extra revenues to cover the budget deficit and will need the same amount for several years.

According to official government statistics from Rosstat, the shadow economy is equivalent to about 15% of Russia’s GDP, or $180bn at today’s dollar equivalent value for the economy. However, other experts put the value of corruption in Russia much higher at about 25% of GDP, or $300bn at current exchange rates. In other words, cutting corruption by one tenth would comfortably cover the budget shortfall for years to come.

And recapturing corruption flows is not a new idea; the anti-corruption theme runs through Putin’s reign from the very start. He has, correctly, identified corruption as the single biggest drag on economic growth.

It started in 2000 when Putin began his tenure by tackling money laundering, which is synonymous with corruption. That year Russia was added as a money launderer on the black list of the Financial Action Task Force (FATF), an international group established to crack down on illicit cross-border money-laundering operations.

Then-finance minister Alexei Kudrin was rapidly dispatched to a G8 summit in Genoa in 2001 to get Russia off the list. By 2002, a new “Law on Combating Money Laundering” that copied the FATF recommendations almost verbatim was put in place, and later that year Russia was removed from the list.

The new law did not just pay lip service to a watchdog, as Moscow followed up with the ratification in 2001 of the Council of Europe Convention on Laundering, Tracing, Seizure and Confiscation of Proceeds from Crime. That led to a new money-laundering law and a raft of amendments, including the Criminal Code, which defines money laundering as a crime, the Banking Law and the Securities Law, which all went into effect in 2002 and 2003.

In October 2004, Russia launched the Eurasian Group on Combating Legalisation of Proceeds from Crime and Terrorist Financing (EAG), which in addition to Russia has as its members Belarus, China, Kazakhstan, Kyrgyzstan, Tajikistan and Uzbekistan. These initiatives have since been coopted into the Eurasian Economic Union (EEU) rules.

More recently, this attack on money laundering and corruption has been extended to the banking sector. Just before he stepped down, the former head of the Central Bank of Russia (CBR) Sergei Ignatiev gave a shocking speech to the Duma where he said “one group” is responsible for “half of all capital flight in the country”, leaving the Duma deputies with little doubt who he was referring to.

Since then, the new CBR governor, Elvira Nabiullina, has been closing one bank every three days on average for several years and capital flight plunged. The majority of small banks are at best glorified treasury departments for businessmen and at worst illegal money chutes for sending cash offshore.

 

The banking reform has been accompanied by a raft of legislation targeting both Duma deputies and companies, such as the clumsily named de-offshorisation laws that ban deputies from owning foreign assets and are now forcing Russian companies to bring their tax domicile back onshore.

At the same, Russia has for years had an e-declaration system like the one that Ukraine just set up and it is continuingly being refined. All government officials and their families must declare their assets, a rule that lead to rash of marital divorces in the Duma. Vladimir Zhirinovsky, the leader of the Liberal Democratic Party of Russia (LDPR), divorced his long-standing wife, but declared, “We are still married in the eyes of God”.

These are not toothless measures. Three regional governors have already been arrested for corruption and former defence minister Anatoly Serdyukov was sacked in 2012 on graft charges. And an ever-widening circle of senior Russian officials is being arrested and paraded on TV for taking hundreds of millions of dollars in bribes. The head of the Customs Service Andrey Belyaninov was one of the most recent.

On a more mundane level, Russia’s tax service has been comprehensively reformed to reduce fiddling. Thanks to Russia’s flat taxes, the system is already high on international rankings for its efficiency. Most of the new revenue gains made this year have come not from cutting budget spending but a new tax IT system that was introduced.

And on top of all this, the powers of Boris Titov, the Kremlin's ombudsman for business, have been vastly expanded so that he can tackle individual corruption cases. Titov now can stop any court case suspecting of being a sting by a corrupt official and answers only to the president. But even Titov admitted to bne IntelliNews that the amount of progress he can make is limited.

But of course the crackdown on corruption is selective. The Kremlin doesn’t use the rule of law to run Russia. It is not even the rules of the game that Yeltsin used to run an unruly Russia in the 1990s. Putin’s system is the rule of the reward: the allocation of fat state contracts to the stoligarchs, as these men enjoy de facto exemption from investigation. Increasingly, everyone else is expected to get a job.

The introduction of the MGB is the next piece in the puzzle. Putin is clearly going to take the game up to a new level and the new ministry is perhaps designed to create an irresistible force to bring the corrupt officials and top powerful top businessmen into line.

But it is the wrong model. The goal should not be to get officials and businessmen to stop stealing by using fear, but to set up a level playing field with the rule of law and strong property rights so entrepreneurs are encouraged to go into business.

Russia’s problem is not the lack of revenue to fund state-backed enterprises, but the lack of investment. Falling corruption should be the by-product of a good business environment, not the goal. The new system may reduce corruption and bring in more money to the budget, however, the sword of the MGB hanging over the head of entrepreneurs will also kill off their desire to invest in Russia, and the result will be stagnation.