Interview with the Dean of the International Institute of Business, Alexander Savchenko

October 13, 2014

Which companies and state organizations are making money off of the military conflict taking place in the eastern part of Ukraine?

The main principle of war is that all of society and the economy are losers in a war. I would measure the scale of losses from war at 3% in 2014 without even factoring in capital flight. If we were to take into account capital flight from Ukraine, then the losses would increase by $10-15 billion. This is the overall loss for society and the economy.

But, of course, there are those who make out quite well during a war. First and foremost these are enterprises which undertake military supplies. Frankly speaking, no one supplies the military at a loss; any supply entails a profit. In such cases, however, the usual profit is not very high. Right now, all honest businessmen would be happy with a profit margin of 5-6%. It is interesting to note that such a profit margin is considered good for western companies under the conditions of a growing economy.

I concede that some supplies of military uniforms, food, weapons, etc. have a bit more profitability. The level of profitability depends on the honesty and transparency of the procedures. The government is absolutely correct in permitting short-term supply (without tenders) and, therefore, control over such supply can be executed via a post-sale audit of all significant agreements with the army.

 

Should violators be penalized?

Yes. For example, penalties should be imposed if a profit margin of over 10% is discovered in times of war. You can require that a return of such excessive profit margins to the state budget is mandatory. Both, the civil servants who poorly check and permit the purchase of goods at unsubstantiated prices, as well as companies that receive excessive profit from such purchases, should be penalized.

Foreign auditors can be hired to undertake these audits. For example, we can announce a volunteer movement amongst auditors.

Of course, all individuals by nature strive for maximum earnings. Only the government can limit these ambitions. Therefore, there is nothing reprehensible in such control; on the contrary, it is a must.

 

How do you evaluate the damage on the regions involved in the conflict?

There are several types of damage. The first type is current damage, which involves a decrease of production, services, etc. It is quite simple to measure such damages: in the first half of 2014 production in the Donetsk and Lugansk regions fell by 10-15%. This is an extremely high indicator, but it will be even higher in the second half of 2014. There are also capital damages, which entail the destruction of infrastructure. This type of damage is easy to calculate, and right now I can say that these damages are already very significant – we are talking billions of dollars.

A third type is the infliction of damage on the reputational risks of businesses, which are located in these regions. Both suppliers and buyers will exclude their counteragents from Eastern Ukraine for some time. They will search for substitutions wherever possible, in the Russian Federation and on the territory of Ukraine. The level of such damage may only be evaluated after the war comes to an end. The experience of World War II shows that post-war pressure on GDP will be greater than in the beginning of the war.

A fourth type of damage, which is direct and extremely painful for Ukraine and a clear win for Russia, is the migration of the workforce into the territory of the Russian Federation. We are talking about children and young parents. If they leave for Russia, then this is a direct hit to the economy of Ukraine. You can call these damages the reduction of work and social capital.

 

How much value do you place on one Ukrainian?

The production of one Ukrainian, taking into account all expenses from child birth, kindergarten, schools, higher educational institutions to the workplace, costs about $100,000 under the present conditions in Ukraine. This value may already be applied even to a child, because in all countries children today are worth their weight in gold. Indeed, they improve the demographical balance of the country.

I have very disturbing predictions for the outflow of people from the eastern regions. By my calculations, around 100,000 Ukrainians have left or are planning to leave to work in the Russian Federation, including in the Far East and Siberia. They will take their families with them. This is a strategic loss for Ukraine. I estimate it to be approximately 10 billion dollars. Another 200,000 people from the East will move to other regions of Ukraine, and they will most likely remain there.

As a consequence, we will not only have an economically depressed region in the East, but the region will be practically left without a generation of youth. Its restoration will require much more money than the 9 billion hryvnias estimated by the Cabinet of Ministers. A new economy will need to be built under the post-war demographic structure of the Donbass.

 

In evaluating the damage for enterprises in the East, do you take into consideration the conditions of such enterprises on the eve of conflict? In fact, many of these enterprises require repairs, modernization, etc.

The damages for any enterprise will be determined based on the level of production loss, infrastructure damage, deficit of the workforce and the post-war effect of excluding such enterprise from the list of reliable business partners.

 

At whose expense should the process of restoration of the region be undertaken?

I believe that many enterprises procured insurance. However, insurance companies cannot cover all losses. In my estimate, only up to 100 million hryvnias can be compensated by insurance companies. We are talking about a handful of insurers who reinsured their risks in Munich Re, Lloyds and other international reinsurance groups. The rest of the risks were simply not reinsured. In other words, enterprises obtained insurance de jure, but de facto the funds under insurance went through their “own” structures, and this was fictitious insurance. Therefore, for the majority of enterprises, the price of restoration will come at the expense of the owners without the participation of insurers.

 

From time to time in business circles the word “nationalization” comes up. How do you evaluate the prospects for the nationalization of a number of Russian assets?

It is too dangerous to rush into something like this headlong. Let’s look at the possibility of nationalizing banks with Russian roots. What would this practically mean? In practice, a bank, as a valuable asset, cannot be nationalized because within one minute from the nationalization of a bank any assets that have a value, for example, of one billion dollars will turn into a liability of minus one billion.

Moreover, this would be a precedent when ownership rights will be violated. You will notice that Ukraine right now in relation to ownership is still behaving in a proper manner. And, the Russian Federation in relation to private property in the Crimea is also behaving properly. If Ukraine creates a precedent of illegal nationalization, then both the EU and the US will start talking about such nationalization, and Ukrainian-owned property abroad may be negatively affected.

I realize that from time to time people say that Ukraine should defend its rights. But, Ukraine has these rights! And, the international court system must be used to submit claims.

For example, $0.5 billion was stolen from the National Bank of Ukraine in the Crimea. The National Bank shouldn’t wait – it should immediately submit an international claim for compensation of losses. Or, gas and drilling rigs were stolen from Neftegaz in the Crimea. The balance value of these assets is available. So, go submit a lawsuit!

 

Why do you believe that Ukraine has not yet submitted an international claim against the Russian Federation with a demand for compensation and coverage of losses, for example, connected with the Crimea?

Everyone is waiting for a law on the basis of which a claim can be substantiated. One big lawsuit for a trillion hryvnias! But we are talking about international law here. The damages incurred by Ukraine will be determined namely by international law. International legal claims could have been submitted several times already, and they could have even been won. There should be several lawsuits and they should be very carefully and correctly submitted by good legal advisors.

Ukraine will only obtain the right to Russian property located in Ukraine or in other countries if it wins some kind of legal claim against the Russian Federation and the Russian Federation refuses to compensate the damages assessed by the court. Do you remember when a Swiss company arrested the Russian Federation’s ships? There are other examples. Airplanes, sea vessels, securities, bonds, etc. can be arrested.

Delays with international courts may lead to the situation where the Yukos matter for 50 billion dollars could be successfully resolved quicker than Ukraine winning its international claims against Russia. In this case, the Russian banks in Ukraine can transfer into the ownership of Yukos shareholders.


Of Counsel, Frishberg & Partners

Professor Alexander Savchenko

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Frishberg & Partners 2012