For Russians, Crime Isn’t What Fuels Capital Flight

Of the estimated $7 billion in suspicious Russian funds that have flowed through Bank of New York, $10,000 belonged to Alexei N.

Alexei does not run casinos or prostitutes. He imports prescription medicine. For the last 10 years, as Russia’s pharmaceutical industry crumbled, Alexei has kept dozens of Moscow pharmacies stocked with remedies for ailments ranging from angina to zymosis.

He lives a comfortable life, but he is not rich. He drives a foreign car, but it’s only a used Volkswagen. And he breaks the law to stay in business.

“If I did everything legally, I wouldn’t make a profit and no one would be able to buy the medicines because the price would be too steep,” he says. “People here don’t have much money, but they need good medicines just as in any other country.”

Even as FBI investigators work to determine how much of the Bank of New York money might have been laundered, experts and businesspeople in Russia think they already know the answer: not much.

Instead, they say, most of the money is probably simply capital

flight--funds sent abroad by businesses both scrupulous and unscrupulous to circumvent high taxes, punitive customs duties and Russia’s bankrupt banking system.

“The vast majority of the capital that leaves Russia is not mafia money,” says Irina M. Khakamada, director of Moscow’s Business Development Institute. “It’s normal money that wants to work in normal, effective conditions. It would rather stay here. But in the meantime, it goes where it’s safer.”

According to official Russian figures, about $1 billion a month bleeds out of Russia’s anemic economy--a sum many analysts consider conservative but which, in the course of a year, still adds up to 6% of gross domestic product and about half the federal budget.

“This is a scourge for Russia,” says Mikhail Zadornov, a former finance minister and Russian representative to the International Monetary Fund. “The money is not invested in the economy, new technology isn’t bought, and new jobs are not created. Capital flight is the reason the economy is not growing and the national currency is so weak.”

It’s also a big part of the reason that tax collection remains low, wages don’t get paid, and there’s little capital to rebuild the banking sector.

Although the damage is extensive, Khakamada points out that in Russia, capital flight is also, strangely, a sign of economic progress.

“We’re now living in an open country,” she says. “Capital flows where it must in order to thrive. In the Soviet Union there was no capital flight because it was a closed system. In this sense, [capital flight] is a positive symptom.”

If capital flight is the symptom, instability is the disease.

Russian banks are unreliable, the entire banking system having gone bankrupt twice since the collapse of the Soviet Union. The political situation is volatile. Laws and regulations change constantly and are enforced inconsistently. High inflation eats away at the ruble’s value. The stock market is moribund. You can own buildings but usually not the land underneath.

In short, safe investments in Russia are as rare as flamingos in Siberia. Most people think that the only smart thing to do with their money is to keep it in U.S. dollars under the mattress--a form of “internal” capital flight--or to try to get it out of the country.

“I don’t know why anyone would be bringing their money back here right now,” acknowledges Scott Blacklin, president of the American Chamber of Commerce in Russia. “There are a lot more attractive places to invest.”

One Country’s Loss Is Another’s Gain

Blacklin points out that while capital flight may be unfortunate for the country affected, it’s only illegal if it evades taxes or other duties. And then it’s only Russia that considers it illegal: Most countries, including the United States, don’t consider it a crime to evade other countries’ taxes.

“For Russia, capital flight is a bad thing. But for the countries to which the capital is fleeing, it’s a good thing,” Zadornov notes wryly.

Stemming the flow is not an easy proposition. Laws that hinder capital flight also hinder the free trade of goods and currencies.

“The United States told us we needed to liberalize trade, to liberalize the financial system,” says Russian Tax Minister Alexander P. Pochinok. “Excuse me, but that’s what we did. You have to realize that liberalization is what makes capital flight possible.”

Pochinok complains that Russia’s tax authorities get little help from the West when it comes to stopping illegal capital flight.

“The United States boasts of its good system of controlling payments and money transfers,” he says. “So I just have one question: If money has been flowing to the United States from Russia for years already, why hasn’t there been a single case when U.S. officials told the Russian tax service so we could check on whether taxes were being evaded?”

Despite the large outflow, Russia still keeps a tighter grip on currency transactions than most other countries. Travelers cannot take more cash out of the country than they bring in. Banks must be licensed by the government in order to wire funds into and out of Russia. And Russians are not allowed to have foreign bank accounts without special permission.

For all these reasons, it takes a lot of ingenuity to get money out of Russia. Consider what Alexei N. had to do last fall to pay for a shipment of medicine, and why some of the funds passed through Bank of New York. He described the deal to The Times on the condition that his full name not be used and that some details be omitted.

‘I Don’t Feel as if I’m Cheating’

In November, Alexei placed an order with a Western European company for $50,000 worth of medicine. Russian customs duties for the types of medicine he ordered amounted to 14% of the declared value, which would raise Alexei’s costs to $57,000. He knew he could sell the medicine for $60,000 and that after transportation fees he would be lucky to break even.

So Alexei’s supplier agreed to declare the value of the shipment as only $10,000. Alexei paid the official price for the goods through a wire transfer, which happened to be routed legally through Bank of New York.

He used a variety of back-channel tricks to pay the remaining $40,000. Part of it he paid for “consulting services” to an offshore firm, which passed on the sum to the pharmaceutical company. Another portion was paid through a fictitious contract with a subsidiary of the company in a second European country for goods that were deliberately never shipped.

In the end, he spent only $1,400 in customs duties instead of $7,000. After about $2,000 in shipping fees and other taxes, he made a profit of about $6,000.

“I don’t feel as if I’m cheating,” Alexei explains. “What I do is natural. Everybody does it to stay in business.”

Bigger businesses have more options. Some have foreign partners or offshore subsidiaries to which Russian firms sell their goods at a below-market price. The offshore firms then sell the products at market prices and keep the difference.

Such money avoids Russian taxes. But it isn’t lost to the Russian economy altogether. In Alexei’s case, money in his European bank account is used to buy more medicine. Sometimes, Russian firms will pay for a deal through their offshore accounts; the money changes hands outside the country but the work is done inside. And sometimes, cash returns through Russian companies’ foreign subsidiaries, but by then it’s usually labeled “foreign” investment.

Khakamada estimates that only 20% to 30% of the capital that flees Russia stays out for good. And much of what does come back is from the kind of offshore accounts that raise suspicions in the West. Zadornov, the former finance minister, says the countries with the biggest outflows of money to Russia last year were Cyprus, Ireland and the Benelux countries--Belgium, the Netherlands and Luxembourg--all popular offshore destinations for Russian money.

“These are countries where offshore banking is well developed, so it’s clear that as the situation improves in Russia, this money will start coming back,” Zadornov says.

Indeed, government officials and businesspeople agree that there is only one cure for capital flight: political and economic stability.

With hotly contested parliamentary elections in December and a presidential election scheduled for June, Russia’s political future is unlikely to be settled soon. Meanwhile, business owners say, the government could take a number of economic steps to ease the situation.

The first item on their list is lowering taxes and customs duties. They argue that as long as these rates remain high, so will the incentive to cheat.

Such demands rankle Pochinok, the tax minister. He insists that Russia’s rates--35% profit tax, 20% value added tax--while higher than in the United States, are on a par with Western Europe, and that lowering them would only reduce revenue, a view supported by the International Monetary Fund.

Khakamada of the Business Development Institute takes a different tack. She says that as long as business remains riskier in Russia than in Western Europe, tax rates have to be lower to compensate.

“Businessmen want to pay taxes,” she says. “But they want to pay into a transparent system at a level that doesn’t stifle their business.”

Alexei agrees. He doesn’t like the hassles of double bookkeeping and worrying about the tax collector. But he does it because he considers his business not just a livelihood but a vocation that helps sick people.

“First and foremost, Russia should change its tax and customs policies,” he concludes. “Then people like me will gladly do our business officially. Everyone will profit from it, even the state.”

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Sergei L. Loiko of The Times’ Moscow Bureau contributed to this report.