Ben Aris in Moscow -
Walk down Oxford Street into Knightsbridge and the signs "we speak Russian" are pasted inside the windows of many high-end shops. Bishops Avenue in north London has become one of the world's most expensive addresses and is home to several oligarchs in exile. The lingua franca in the Novikov restaurant in Mayfair, belonging to Russia's most famous restaurateur, is Russian. And most of all, the City of London is replete with clever young Russian bankers bringing in billions' worth of business for their firms. London is awash with Russian money.
It seems that every Russian oligarch who has made his fortune aspires to a house in London and a place in one of the UK's exclusive public schools for their children. London has become to modern Russia what Paris was to the princesses and grand dukes of the Tsarist times.
But there is a dark side to the Russians’ love of London: since the 1970s, London has attracted an estimated £133bn of "dark" money and a big chunk of that is Russian cash looking for a new home. "There is strong evidence that a considerable chunk of the UK’s £133bn of hidden capital inflows is related to Russian capital flight," say Oliver Harvey and Robin Winkler, authors of a Deutsche Bank report, "Dark matter: the hidden capital flows that drive G10 exchange rates", published in March, who add that London has become the preferred destination for money launderers due to its extremely light reporting touch on many transactions. "Inflows have accelerated in recent years, tracking at around £1bn per month since 2010… While not significant for the overall balance of payments, hidden inflows may have been marginally supportive of the pound in recent years, and are another factor behind the UK’s extremely large current account deficit."
Hidden flows that are sufficient to skew the value of the pound or distort the current account should be more than enough reason for the authorities to tighten up the regulations and force more of the inbound capital through proper channels. But the sheer volume of inbound money raises the broader question: Are British banks and lawyers ignoring the apparently criminal way that some Russians have earned their millions for the sake of the fat fees on offer?
London has become an attractive destination for flight capital for everyone and not just Russians, so not all the "dark money" flowing in is Russian. "[The Deutsche Bank report] shows that it is not just Russian dark money that is coming into the UK, but also from Qatar, Saudi Arabia and China," says Ben Judah, author of ‘Fragile Empire: How Russia Fell in and Out of Love with Vladimir Putin’. "This money is definitely undermining British corporate governance and the legal system, but even more important is that it is an untaxed flow of money at a time when the government is imposing tax and austerity."
Deutsche Bank analysts focused their study on the net errors and omissions (NEO) line in the national accounts that is there to account for rounding errors or incomplete and imperfectly measured factors like real estate deals. However, if the NEOs were really just mistakes, then over time the numbers should sum to zero, as sometimes economists overestimate a number and other times underestimate it. The problem is that this line is not zero, but actually represents a positive inflow of money of such a magnitude that it is affecting the national accounts, so has to be taken into account by currency traders trying to forecast exchange rates.
The chart from Deutsche Bank shows quite clearly that the UK's NEOs track Russian capital flight pretty closely since the fall of the Soviet Union in 1991. But also Russian money cannot explain all of the UK's hidden cash flows, as Russia's annualised NEOs are less than half those in the UK.
No one doubts a lot of Russian money in London got there by questionable means. But how much of this is actually criminal money remains an open question. As the Bank of New York scandal in the late 1990s showed, where the bank was used by Russians to launder billions of dollars, a large part was simply cash escaping Russian taxes. However, some of this money was linked to Semion Mogilevich, a famous gangster also known as the "Brainy Don", who ran prostitution rings in Germany amongst other things, and is now wanted on murder charges by Interpol, but lives free in Moscow.
In light of the heightened political tension between Russia and the West, and the sanctioning of dozens of allegedly corrupt Russian individuals, the calls to "do something" about the dark Russian money flowing into the UK have risen in volume.
The problem has become so bad that a "Nemtsov law" is needed to keep Russian "funny money" out of the City, wrote Jim Armitage, city editor of The Independent in an editorial in March. This law would parallel the US' Magnitsky law that imposes sanctions on Kremlin officials linked to the death of anti-graft lawyer Sergei Magnitsky. The US Congress also proposed in March to add names associated with the investigation of the assassination of opposition leader Boris Nemtsov in February to those listed under the Magnitsky law. "Nemtsov was a huge admirer of Margaret Thatcher, and the Anglo-Saxon capitalism she represented. So it must have been all the more galling for him to have seen Britain, and particularly London, becoming a willing enabler of the corruption he deplored," said Armitage.
The most obvious signs of Russian money in London are the gorgeous houses. It is de rigueur for any self-respecting Russian oligarch to own the most spectacular property in London and Chelsea FC owner Roman Abramovich is as good an example as any. In 2011 he bought a house on Kensington Palace Gardens for a reported $90m, adding to his growing collection of luxury homes. After taking possession, Abramovich planned to add a new underground floor, a tennis court, a spa and a car museum – all of which were given planning approval by the Kensington and Chelsea Council.
One of the biggest items in the net errors and omissions line of national accounts is real estate deals, as there is no centralised registrar for deals and so data is extremely hard to gather. And because London property prices are so high, real estate is a gift for would-be money launderers. "Billions of pounds of corruptly gained money has been laundered by criminals and foreign officials buying upmarket London properties through anonymous offshore front companies – making the city arguably the world capital of money laundering," corruption watchdog Transparency International (TI) concluded in what it says is the biggest survey into the origin of funds invested in the London property market, released in March.
The flow of corrupt cash has driven up prices, but also led to a “widespread ripple effect down the property price chain and beyond London,” the report says.
That is not to say that all deals are dodgy: when the Azerbaijani sovereign wealth fund was given permission to invest in more than foreign treasury bills, the first thing it did was to acquire property in London. But, TI claims, a big chunk of real estate deals is likely to be money-laundering schemes.
The Metropolitan Police Proceeds of Corruption Unit found that 75% of UK properties owned by people under criminal investigation for corruption are held through secret offshore companies, TI said. Companies House records show that about a third of corporate-owned properties, some 36,000 London houses, are owned anonymously by legal entitles in the BVI, Jersey, Isle of Man and Guernsey, according to TI. However, again this is not just Russian money – everyone who wants to clean cash is doing it. "We estimate that Russian buyers accounted for an average of 7% of total sales of properties over £1mn in prime London. Given that overall sales in Prime Central London in 2012 was around circa £8bn, the proportion of sales to Russian buyers would be some £560mn," says Tom Mundy, head of research at Jones Lang LeSalle.
While this is large in absolute terms, house buying is still relatively small compared to the total volumes of cash moving through London. However, Deutsche Bank's study also backs up the link with dark capital showing there is a correlation between London house prices and the British NEO, and even though Russian money accounts for a 16th of London's high-end real estate market, given there are just under 200 countries in the world, then that is an extremely big share of the market.
Sin of omission
Property in London is only the most obvious and simple entry point for black money looking for a home in the UK, but Deutsche Bank shows the problem is much wider and includes other asset classes across the G10 countries, but especially in the UK, Sweden and New Zealand. "Systematic trends in NEOs occur in half of all G10 economies. At some point, Switzerland, Norway, the UK, New Zealand and Sweden have all displayed cumulative NEOs above 5% of GDP," Deutsche Bank reports. "In the case of Sweden, measurement errors are vast, with NEOs having reached nearly 40% of GDP when cumulated from the early 1990s. In the US, Eurozone, Japan, Canada and Australia, by contrast, cumulative NEOs have not reached above 5% of GDP."
Sweden is prone to large NEOs partly because it has such a high proportion of rich people; Deutsche Bank shows there is a correlation between millionaires and large NEOs. In other words rich people are prone to cheat on their taxes. Unfortunately, the report didn’t produce a similar analysis for Russia's rich and Moscow, which has more billionaires per square kilometre than any other city in the world.
The rich have been moving their money out of Russia. In the 1990s hundreds of billions of dollars left Russia, but in 2014 alone a record $150bn fled Russia. Again, not all of this is illegal or even unreasonable: as Russia's banks and companies are cut off from the international capital markets they cannot refinance their debt and paying down debt accounts for around $50bn of this money. The outlook for this year is about $90bn is expected to leave.
Another source of dark money is the common practice of underestimating the value of export goods and overestimating the import value. Such "transfer pricing" is a (technically legal) scam that is well known to the Russian authorities. In the 1990s Russian oligarchs routinely exported oil priced at $1 per barrel only to sell it on the international markets at over $25, booking the profits in some offshore tax haven. Deutsche Bank speculates that the UK is increasingly being infected by the same practice and other related schemes. "One possible source of such a discrepancy is a systematic reporting error of inflows by financial institutions. Another is that increasingly sophisticated tax avoidance and accounting methods make it difficult for reporting bodies like banks to trace the true beneficial owner of portfolio securities. UK equity securities are increasingly held in multi-ownership pooled accounts, making it impossible to precisely determine the nationality of the owner," Deutsche bank said.
Incongruously, the Kremlin would agree with the substance of its Western critics that dark money fleeing Russia for London is a bad thing. With economic growth in a tailspin, the Russian government is suddenly hungry for revenue and looking for ways to increase its tax take without raising the rates. Cracking down on all the tax scams is the obvious place to start.
While Russia has a poor reputation for reforms – it is amongst the hardest place in the world for getting a company connected to the power grid or obtaining a construction permit – the same is not true for financial reforms. It is a reputation the Kremlin is keen to preserve because both state-owned companies and oligarchs need to access the international financial markets to move their massive wealth about without restriction.
In 2000, Russia was placed on the Financial Action Task Force (FATF) black list as a money launderer, an international club 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 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 kicked off the Eurasian Group on Combating Legalisation of Proceeds from Crime and Terrorist Financing (EAG), which has as its members Belarus, China, Kazakhstan, Kyrgyzstan, Tajikistan and Uzbekistan in addition to Russia.
The point of all these reforms is that Russia, like the West, is battling a nasty terrorist problem and is as keen to cut them off from their funding as Washington is to throttle Al Qaeda financially.
All these changes were steps in the right direction, but as has so often been the case in the past, the problem in Russia is not the ideas or the laws, but the implementation. Russia remains on the UK’s Financial Conduct Authority (FCA) list of "high risk" countries, which is any country that scores less than 60 on Transparency International's ranking, (Russia scored 27 last year, one point better than in 2013 and is ranked by TI in 136 place out of 175 countries).
Russia simply has too many banks for the regulator to police them efficiently. While the central bank has been actively closing banks in the last two years as part of its financial sector reforms, there are still just under 800 in a country that needs only about 200-300. Stiff competition and a lax inspection regime mean smaller banks are tempted to make big profits from doing shady transactions.
Since Putin returned as president, he has taken the fight against money laundering and dark money flows to a new level, targeting companies.
Despite the conventional pessimism and characterisation as a "Mafia State", Russia is trying to deal with its problems, of which corruption is the worst. The previous central bank governor, Sergei Ignatiev, caused an uproar in 2013 shortly before the end of his tenure when he told Duma deputies that $49bn a year is routinely laundered from Russia via banks and sham companies, half of it by a "single group of money launderers".
No one misunderstood the reference: he was talking about government officials. In his last speech to the Duma, he described one scam that used 1,173 shell companies to channel $24bn to foreign banks. Before the end of the same year Putin introduced a ban on any government official holding offshore banks accounts or foreign assets. Since then, the law has been expanded and extended to cover state officials, managers of state-owned companies and most recent to the top tier of the regional administrations.
Last year this campaign took another direction when the de-offshorisation campaign was applied to companies – both public and private. In Russia it has been standard practice to own assets using a "non-dom" holding company domiciled abroad (typically Cyprus). Putin, like every leader in Europe, is keen for companies that make their profits based on physical assets and production in Russia to actually pay their profit taxes there too.
Since January 1 this year, companies now have to declare to the Russian authorities all their Controlled Foreign Companies (CFC) and have until the end of March to complete the process (although there is likely to be an extension as so many companies are not going to meet the deadline, say lawyers).
Without getting into the technicalities, the goal is to make all Russian companies confess to owning CFCs and find out who the ultimate beneficial owners are, so both the company and the owner can be taxed and prevented from hiding profits overseas. "The new law places an obligation to Russian tax residents to disclose by notifying the Tax Authorities, of any direct or indirect holding in foreign entities that exceeds 25% or 10% if such foreign entity is by more than 50% controlled collectively by Russian Tax residents. For 2015 there is a relaxation in the law and the percentage of control is set at 50% during this one year transition period," the Klnanis law firm said in an explainer to clients.
In this sense, the de-offshorisation law is not an anti-money laundering measure, but its effect will be to greatly reduce the amount of dark money on the move so the effect will be the same. The main question is: will it work? Will oligarchs declare all their myriad offshore companies? "It will work – eventually. But not now, because if you cheat, how are they going to find out?" points out Stephen Konigsberg, a legal advisor and former council to investment bank Renaissance Capital. "Everyone is making this risk assessment now. It’s a mess, as the old law overlaps with the new one and there is not a lot of guidance."
Clearly a lot of oligarchs and super-rich businessmen are going to ignore the law and as the Russian authorities have little experience of investigating financial flows overseas, it will be extremely difficult for them to check if anyone is lying. On top of that, the showdown with the West over Ukraine means it is even easier for Russian businessmen to hide money abroad. "Before all this started [in Ukraine], the US was pushing Russia to improving its anti-money laundering effort, but now the tables are turned: Russia wants to track oligarch flight capital, but no one, least of all the US, wants to share information with the Kremlin."
And even before that, the UK was not known for being particularly helpful. The French investigating magistrate Eva Joly has complained in the past that the City “has never transmitted even the smallest piece of usable evidence to a foreign magistrate.”
Author Ben Judah damns the government saying the British political elite are also beneficiaries of this system of dark money inflows and have little motivation to do anything about it. "The British political elite are richer than they appear, and the British elite are both the creator and beneficiary of this system."
The geopolitical standoff has created the perfect fog for oligarchs to move their money and avoid the scrutiny of the Russian taxman. And it is happening when the political chaos has stoked capital flight to a record $150bn in 2014. Where will all this money go? Well, you can be sure that London is on the top of most people's list.
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