Alternative Scenarios for Russian Economic Development

Russia is a very complicated place and each year gets more and more so, and I want to try and play out some general ideas. This is a very exciting week for Russia watchers because we have the final stage in the YUKOS affair, and any day now YUKOS could be declared formally bankrupt and broken up. At the same time, there was yet another bank crisis in Russia with people lining up at the banks to get their money out and Sodbusinessbank and Alfa Bank are the targets. It does not look like a major financial crisis like 1998 but it shows how unstable Russia is and how much lack of trust there is in the system, especially the financial system.

Outside Russia this week, we have seen the publication of two very thorough reports on the Russian economy: the Organisation for Economic Co-operation and Development (OECD) published its Economic Survey of Russia and the World Bank released its Russia Report #8. So we have two very thorough analyses of the trajectory of the Russian economy over the past five years. I will try to incorporate some of those reports and findings into my points. I will try to go briefly in three sections. First, I will give some general remarks about how I see the economy and system, secondly a speculative exercise of future scenarios and thirdly a discussion of some features of the energy sector in Russia.

The Russian economy really went through three stages in the 1990s. The first stage until 1995-1996, was a naive belief that Russia would integrate into the Western economy, on the West's terms; that Russia would open, join international organizations, play by the international rules, and that there would be privatization, transparency, corporate governance, and foreign investment would bring in global norms and practices. But that did not happen. Russia had too many specificities in history and geography and the Russians themselves did not want to integrate into the global economy on the West's terms. They wanted their own terms and they were big enough and powerful enough to pull that off.

So the second phase was the phase of the oligarchy panic with the reelection of Boris Yeltsin in 1996 thanks to the political and economic support from these powerful new capitalists who appeared from nowhere to become major business figures in the Russian economy. Russia, according to Forbes magazine, has 36 billionaires and together the assets of those billionaires amount to about 20% or 25% of Russian gross domestic product (GDP). In the United States, 275 billionaires account for less than 7% of the GDP. The emergence of this oligarchy capitalism obviously affected the political system. The relationship between the oligarchs and Boris Yeltsin became a very intimate one. Western observers were divided about the oligarchy capitalism because they saw it as corruption but they hoped that it would evolve into an effective capitalism. In fact the state continued to play a very powerful role and many of the oligarchs were in fact state officials. So it was never a case of separation of business and state.

Then we move on to the third phase after the August 1998 crash. The devaluation, default on debt and crash of many banks seemed to signal the disability of the oligarchy capitalism system; that the oligarchs had gotten rich by looting assets from the state and by basically bleeding the state budget dry. The 1998 crash showed the limits of the oligarchy capitalism, but we did not know what would come next. Would it be a return to a communist-type centrally planned economy? People were taken by surprise by the appearance of Mr. Putin.

Mr. Putin, like the oligarchs, came from nowhere. He is a 17-year KGB veteran who wants to be nice to the West, who wants to embrace capitalism, who seems to understand that power in the modern world rests on economic prosperity and that the market is the best way to economic prosperity. So Mr. Putin is a very paradoxical figure - half powerful politician of the ruthless sort and half convert to liberal capitalism. Even more surprising, Mr. Putin was able to win the election and became extremely popular. Not only is this a strange combination of authoritarian and market economy beliefs, he was able to be a successful politician in a rough democratic sense and actually win elections and maneuver against his political opponents inside the Kremlin, in the Duma. So he transformed the Russian system into this third phase of which the shape is still not clear.

Some of this disagreement and confusion has become clearer over the past 12 months since the arrest of Mikhail Khodorkovsky, because taking down the richest man in Russia and threatening the bankruptcy of YUKOS, which is pumping more oil than Iraq, is a remarkable development. It shows the limits of Mr. Putin's lead in liberal capitalism. My own conclusion is that our previous perception of Mr. Putin as a person among equals no longer applies. It seems clear that Mr. Putin is intent on a vertical power structure and not a pluralist one. These are very bad indications for democracy and the implications for economic prospects are also rather gloomy and I am not convinced that this pyramidal power is flexible enough to make the decisions Russia needs.

Looking at the scenarios in the second part of the presentation, what comes next? One scenario is that of the early 1990s and the transition to the market democracy, where Russia will conform to global practices and the YUKOS affair is an exception. The World Bank president, head of Moody's Rating Agency and everyone wants to believe that Mr. Putin will go back to a hands-off relationship with business, but I do not see the end of this. Mr. Khodorkovsky was not an exception. Mr. Putin closed down the MOST Agency of Vladimir Gusinsky, who controlled the NTV television channel, and took down Boris Berezofsky, who owned another television channel. So Mr. Khodorkovsky fits into the pattern that if any oligarch steps out of line, he is crushed and this sends a chilling signal to present business leaders. So I am not terribly optimistic about the first scenario.

The second scenario, what Mr. Putin seems to want is a "modernization from abroad." His favorite politician is Peter the Great who embraced Western values to the extent of technology and often rammed them down the throat of the Russian people with mixed success. Mr. Putin seems to do a selective adoption of certain modern techniques of the West and adapts them to the Russian environment, which he has done over the course of his leadership. I am not sure this model will work in the 21st century with the global economy. I am not sure Mr. Putin really understands what modernization can do for Russia and I am convinced that the Russian elite state officials and the Russian people do not agree with the program. So Mr. Putin is alone in this. He has been using his international links to increase his prestige for pressing along with reforms.

The third scenario would be a return to Soviet-style authoritarianism and a return to aggressive, entitled bureaucracy and this is happening. The Russia that I am seeing now is the Russia I saw in the 1980s. There are official youth organizations, lenient media, police questioning academics, journalists and so on, people becoming scared of talking to foreigners. I hope it is only temporary but it has a certain logic and once that machinery gets going, even Mr. Putin himself, if he wants to stop it, may not be able to change the course.

The fourth scenario would be Russia as petro-state driven by energy: production of energy, battles over rents on energy, international politics associated with energy. This is a very important dimension and it may be the best scenario for Russia because of all the contradictions and problems, if the state is driven by the logic of energy, it is better than having the state driven by the logic of power construction. It is probably also better than having the state driven by Mr. Putin's "modernization from abroad" idea and corresponding to the reality at least of Russia's natural resources and the realities of the global economy and Russia's role within the global economy. So I am more of an advocate for Russia as a petro-state, saying this is an objective frame.

The fifth scenario is a package of what we call wild-card scenarios or the unknowns that we cannot predict. So by definition, this is a pointless exercise. One of the things that could happen which could change the game is what happens after 2008 because Mr. Putin is limited by the constitution to two terms in office. The whole system that he has built now rests on him and it is very hard to imagine somebody else coming in and having the same mix of attitudes and skills. Maybe he will not go and they will change the constitution. The second wildcard is some kind of a social upheaval. It may not sound very likely because there are very few strikes and there are very few social organizations. But you cannot rule out social upheaval because a large part of the population still lives in poverty and inequality is massive and you have a lot of unhappy political leaders and unhappy soldiers in the military and Mr. Putin may not be able to contain that kind of endeavor. Also it is possible that there will be some kind of conflict with the West through the Baltic countries, through Ukraine; various things could happen and Russia could get dragged in.

Finally, to sketch some points about the energy sector, which is now driving the Russian economy, oil and gas accounts for 20% of GDP, 50% of Russian exports and 50% of the federal budget revenues. It is not the entire economy, but the economy is dominated by the energy sector. The World Bank and OECD estimate that even though the oil price went up 20%, stimulating growth, only about one-third of that growth has come from the oil price. The average GDP annual growth has been about 6.8% over the past four years and about 2.5% has come from the oil price. We have seen growth in manufacturing and in many oil-related manufacturing and service sectors. Telecommunications, food processing and retail have also grown. There has been some benefit in manufacturing from the devaluation of the ruble but that effect is now being eroded by real appreciation. So growth over the past two years has come from productivity improvements and not from trade benefit.

The OECD and the World Bank are seeing considerable prospects in the growth of the service sector, which is immune from exchange rate effects. So their overall assessment is that despite this dependency on oil and gas exports for big cash, the Russian economy is evolving to a slightly more diverse economy and is not dying from the Dutch disease. That said, on the negative side, there is an investment problem. The chaos of the past ten years has not seen much investment in this infrastructure. Now investment is up to about 20%. But if you look specifically at the oil and gas sector, a study shows that after 2000, private as well as state-owned companies were investing quite heavily to boost production by drilling extra wells in existing fields. So this investment recovery that we have seen does not look very sustainable. There may be another period of lack of investment and certain infrastructure will start breaking down. So this investment cost may spread from 10 years to 15 years and you wonder what time the economy will simply start seizing up.

The other political puzzle of the energy dependency is the subsidy problem with a gap between external prices and internal prices. Energy is sold abroad and the price is five times that at which it is sold domestically; not oil but natural gas and electricity. This works to the benefit of some companies like aluminum smelters and the steel industry although the main beneficiary is the Russian public. The challenge is to increase these prices to give a stimulus for more efficient use of resources and to encourage further export of the energy resources. The political obstacles to ending this cross-subsidization on domestic consumers have proved very high and even Mr. Putin has been having problems dealing with these. They are postponing increasing the prices until restructuring is completed. The government is constantly worried that angry people will pour onto the streets and refuse to pay electricity and regional governors are worried because they are elected and can lose elections, and a utility price rise can be political death for them.

Q: In your second part, especially with the first and second scenarios, how do you evaluate the possibility of World Trade Organization (WTO) entry and if you take these two scenarios, what is the effect on the possibility of WTO-entry? The second question is that from May 1 Russia has a direct border with the European Union (EU) but I understand that at the same time, among Belarus, Ukraine and Kazakhstan, there are some discussions of a future economic integration. How do you estimate the future framework of the economic integration with a deeper relationship with the EU or among this Commonwealth of Independent States (CIS) coalition?

A: There seems to have been a breakthrough with the Europeans on the question of WTO-entry at a meeting last month. By coincidence, Mr. Putin said he would approve the Kyoto Accord and the EU said they would drop their objections to Russia's entry to the WTO. The main issue for the Europeans was energy price difference but they realized they would not persuade Russia to reform Gazprom. On the American side, I think the Bush administration wants to award Mr. Putin for being an ally in the war on terror. So although there are some objections, it was a political decision. Kazakhstan is waiting for WTO-entry and I think it will happen in two or three years. Since the tariffs in Russia are below WTO levels, the barriers to entry are not as severe as imagined.

On economic integration, the hope for Russia to become an integral part of the EU has faded for political reasons and because the EU is having problems in absorbing new members. The relationship with Europe is focused on energy. With Belarus, Ukraine and Kazakhstan, there has been talk about integration but no action. The CIS economies have started growing faster than Russia but are drawing in imports from Russia. So the CIS has been a major contributor to the steady growth there and there may be more integration. But the political barriers to integration are severe and the countries are suspicious of Russia.

Q: Although Mr. Putin's meeting with EU leaders was positive in regards to the Kyoto Protocol, his reaction in a meeting with Prime Minister Koizumi last month was negative. What do you think of the Russian position on the Kyoto protocol in light of Russian politics and economics?

A: Part of the problem is the lack of a clear decision-making process in the Russian government. It is a mess and there is no coordination. After Mr. Fradkov was appointed prime minister in March, there was government reorganization and this explains part of the confusion. To be specific, we can refer back to Mr. Illarionov, the economic advisor who makes outrageous statements which go against academic opinion and the government's own opinion. For some reason Mr. Putin tolerates him but I do not know the extent to which he listens to his advice, but Mr. Illarionov has a large impact on Western media. On the Kyoto Protocol, I think the Russians realized that emissions-trading was not where the money was to be made, but in joint implementation of investment projects. There was some opposition from nationalists in the Duma and Mr. Putin would not push the Protocol before the Duma election in December, which produced a Duma loyal to Mr. Putin. So the political barrier has disappeared and support for the Protocol has expanded. This is one of the weaknesses of the Putin-centered political system where everything is chaotic and order is imposed through loyalty. It does not produce a very rational policy discourse where the costs and benefits can be carefully weighed.

Q: My question about the Japan-Russia relationship. What do you think about the possibility of issues like the Northern Territories and peace treaty being solved during the period of Mr. Putin's presidency? Can he do this by himself or will he need to consult with others? How do you think it is different from the past?

A: In general, power with any dictator is more formal than real when it comes to implementing policy, especially in a country as complicated as Russia. The more Mr. Putin is on the pedestal, the further he is from actually running things. He has had some success in building institutions to implement policy, but in the economic sphere, I do not see many successes. In foreign policy, Mr. Putin has more discretion and he has been able to enforce his own particular views of cooperation in the West and so on. On the Northern Territories issue, I think it is not that Mr. Putin cannot do it; it is that he does not want to. I think he is nationalist-minded on it and he sees the Northern Territories as geopolitically valuable. In the Russian Far East, geopolitical thinking is more important than economic, whereas policy with Europe is economic. I think it is a bad policy, but that is the mindset.

Q: Over the past five or six years, has the state been getting stronger? Is it better at raising taxes, better at doing what it wants to do or is it still essentially a weak state?

A: The quick answer is yes. But the longer answer is that I am not sure the strong-weak dichotomy is always appropriate. It has always been strong in some things and weak in others. The Russian state and even the Central Asian states are strong, particularly in the sphere of police, military, control of the media, control of the opposition; they are too strong. With regard to economic regulation, taxation and so on, they are quite weak. The regulatory systems are not developed, but taxation has gotten better with a lot of it coming from oil and gas. That was easy to fix but they did not have the political will to do it. But their ability to collect income tax and apply social welfare wage payroll tax has not improved much. There is a political contract that the state will leave the black economy alone and in return people will not challenge the state. So when it comes to break a barrier and raise utility prices, it causes a reaction from society.

Q: First, could you please explain a little bit about the fourth scenario about the petro-state? Second, what is Mr. Putin's major interest? Is his concern to improve the standard of living of the people or to get superpower in international politics or to get stability in Russia?

A: First, about the scenarios, each is a kind of mixture of economic and political elements. With the petro-state scenario, the economic development strategy is clear but I am not sure of the political institutions. A petro-state could be compatible with a democracy or a dictatorship but they key thing is that each of the scenarios has a certain Russian identity. The market democracy is Russia as part of the global civilization; the Soviet model is Russia living in its past; the modernization model is Russia as different. The major barrier to the petro-state scenario is that Russians reject it as an identity. Communists, liberals and nationalists all are not comfortable with that idea that Russia has oil and gas. So it is an identity barrier and if Russia embraced this reality, this is where the strategy would be driven to design political institutions to make the petro-state work for the benefit of Russian society.

Mr. Putin was clear about his goals in the beginning but is getting less clear having achieved the first goals. He said his first goal was to unite Russia and he did that. The second was to make Russia a respected power in the world and he achieved that. When you come to economic goals, he is less convincing and his goals like "double GDP by 2020." They sound like empty slogans of Soviet planning. So what does Mr. Putin really want? I do not know. I do not get the impression that he is a driven leader like other modernizers like Ataturk and President Park of Korea. He is not that kind of a leader who has a very strong set of economic goals that he worries about achieving. He has political goals which he has achieved.

Q: I think the shadow economy remains as one of the major problems in the Russian economy. How do you evaluate the effect of the shadow economy to the real sector, and in the future, how will the shadow economy affect the real sector if the oil price becomes lower and GDP becomes smaller?

A: The shadow economy is a permanent feature of the system. So it is not getting better or worse. You can argue that it is functional to the system. Some people argue that the shadow economy is useful to political stability and survival in the 1990s because people kept their families going through shadow economy activities. So it has provided a kind of social safety net that the corrupt central government budget could not provide. But in the long term, I agree that the shadow economy is a problem. In the industrial sector, barter and non-cash transactions have gone down. Turkey and Italy have big shadow economies and are prosperous societies. I do not expect any radical breakthrough and the government is not really talking about it. The same could be said for corruption or organized crime and although Mr. Putin has been more active than Mr. Yeltsin in tackling corruption at top levels, there has been no real assault on it.

Q: I would like to have your view on the efficiency of the U.S. policy towards Russia. Lately we have seen a lot of development between the U.S. and China, but I do not see those same developments between the U.S. and Russia. Could you explain why and the reason for this development?

A: The U.S. policy toward Russia turned very negative at the end of the Clinton administration as Russia had a terrible image because of corruption and the Chechen war. When the Bush administration first came in, they kind of ignored Russia, but after September 11, this policy swung around due to Mr. Putin's call to President Bush and Russia's willingness, after some reluctance, to cooperate in Afghanistan. American policy now is very unstable and could easily flip back to an anti-Russian policy. On the other hand, the war on terror and energy security issues are pushing the U.S. to maintaining cooperation with President Putin. But Mr. Putin saying that al-Qaeda was involved in Iraq is an attempt to get President Bush reelected because the Russians prefer to deal with the Bush administration than a new one. But Russia does not have many friends in the U.S. now, which makes the government a bit nervous.

Q: If Russia is moving back to a Soviet-style system, presumably that will lead to a decline of Western investment in Russia. Could you give me your thoughts on the relationship with Western businesses in Russia in general?

A: I would say that Russia is not going back to a Soviet past; I just had that as one scenario which I do not think to be the most likely. Foreign investment has been minimal in Russia through the 1990s and the reason is that the Russians did not want it because they did not want to give up control of their assets. So the foreign investment was allowed to come into chocolate factories and the tobacco factories but not into the oil and gas industries. The second point is that Russia is a capital exporter. It is running a $60 billion a year current account surplus and has been exporting capital both legally and illegally at a massive rate throughout the 1990s. So it does not need the foreign investment as capital. Having said that, Russia needs foreign investment for the managerial skills, the transparency and the technology that come with the capital. Western companies are not really interested in providing that expertise unless they are in control and can reap more rewards. The Russians figure that sooner or later the Western energy companies will come to them on their own terms, so they can wait. The YUKOS affair seems to strengthen that interpretation because YUKOS was looking for foreign partners and that was one of the factors that pushed the Russian government to crack down on them. So this trend seems to be continuing, with Russia trying to keep the foreign investors at a distance and trying to dictate the terms of the relationship.

Q: What is the reason for listing Russia as the number one country for foreign direct investment (FDI) retail sales, but that it lags in the manufacturing sector? What is the difference? I think it relates to the Russian government's attitude to FDI. Do you think there are other factors why they do not want to have any modern technology for durable consumer goods?

A: Oil and gas were the big money earners and they were the big politically visible sectors, whereas retailing and food was not visible at the national level, so regional governors were open to bringing foreigners in. It is in those sectors that we see self-made Russian oligarchs. In oil and gas, they are not self-made; they took over existing industries. The auto sector is interesting because it was protected by tariffs and it had political connections. If you look at all the manufacturing sectors, auto has the smallest drop in production compared to 1990s. It was easy for the auto industry to bargain with the national government and keep foreign cars out of the Russian market. Even foreign investment was not particularly welcomed. So I think the auto industry is different from the other manufacturers, but I do not know how long that will continue.