How Will Medvedev Handle Russia’s Oil Money?

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Moscow may seem an odd place to host a major international boat show—not least because Russia's capital is nearly a thousand kilometers from the open sea.  But over the last few years, a heady combination of easy oil money and a taste for excess has worked strange miracles in this, Europe's brashest capital. Earlier this month, wealthy Russians snapped up gleaming motorboats lined up in front of a swish shopping mall; the price tags ranged from $3.8 million to $20 million for a 47-meter "transatlantic mega yacht."

Across town, dominating the city's skyline, the skyscrapers of the Moskva-City business development are springing up like mushrooms after the rain. By 2015, Moscow will boast the 10 tallest office buildings in Europe—and already prime office rents in Moscow are going above $2,000 a square meter, 50 percent higher than the most prestigious skyscrapers of midtown Manhattan. According to a recent study, Russia now boasts 103,000 dollar millionaires and 55 billionaires, whose lavish spending has fueled a boom in everything from construction to retail.

On paper, Russia's basic economic indicators appear quite healthy: growth has averaged 7.5 per year for the last eight years, the country's massive debts have been replaced with a $150 billion stabilization fund, and its trade balance shows a healthy surplus of $72.5 billion last year. The Russian stock market's RTS index has grown by a staggering 1,922 percent between 2000 and 2007.

But in truth, the Russian economy as a whole is an edifice with feet of clay. The bling and glitter of the capital obscures a harsh reality: the architecture of Russia's economy is no more solid than that of an inflatable children's castle at fairground, with energy and commodity prices the wind that keeps it inflated. Yes, the Russian economy has been growing fast. But little of that growth has spilled over into the real Russian economy. Rather, the boom has, in many ways, held back Russia's non-commodities economy from growing: rampant inflation, spiraling real-estate prices and higher labor costs, bureaucratic corruption, expensive credit and bad governance have combined to stifle the competitiveness of many Russian businesses.

"Russia's macroeconomic performance has been stellar," says economic analyst Anders Aslund. "But Russia's oil surplus is so huge that it hides flaws in economic policy; the longer oil prices remain high, the worse economic policy will become. Booms breed complacency and corruption."

For evidence of this systemic inefficiency, compare Russia's apparently healthy GDP growth with that of its neighbors. Seven-to-8 percent sounds robust—until you look at Ukraine, or Turkey, which have enjoyed nearly 7 percent annual growth since 2004, yet none of them have oil, gas or significant mining industries. Plus, they have had to take the knock of much higher energy prices. "Russia has underperformed in relation to the other former Soviet republics," says Aslund.

Indeed, by some estimates, Russia's GDP growth should have been closer to 14 percent—after all, Russia is the world's largest energy exporter at a time when prices have tripled during the last half decade. So where did the difference go? "Russia's elite still believes that what they have can be taken away at any time, so they spend like mad, or hide their money abroad," says Professor Igor Turkhansky, who studies elites at Moscow's Russian State University for the Humanities. "The idea of reinvesting your money to grow your business, or to saving your salary in a Russian bank for the future—all these ideas are very new."

The underlying reasons for Russia's underperformance are more political than economic. Though in fairness the Putin government has, over the last eight years, pursued some wise macroeconomic policies—most notably, setting up a "stabilization fund" into which $157 billion of oil revenues have been placed for a rainy day. That will certainly help to avert the kind of financial crisis that toppled Russia's last truly reformist government back in 1998—which was caused by a broke government accumulating vast debts, both domestic and international, which it couldn't service. A full-scale default ensued—something that Putin's stabilization fund will prevent.

But on a deeper level, the policies of Putin's Kremlin—which will doubtless be continued by the Medvedev administration—have considerably worsened Russia's economic situation. At base, the most fundamental economic problem is that the Kremlin has grossly undermined basic property rights. Put bluntly, "the state uses the law selectively to expropriate the property of its enemies—or of any business which individual bureaucrats want to steal," says Sergei Filatov, an activist for the United Civic Front opposition group.  

Last December, for instance, the Russian government temporarily shut down the operations of a natural-gas development on Sakhalin operated by Royal Dutch Shell, Mitsui & Co. Ltd. and Mitsubishi Corp. And last month a campaign of harassment against the TNK-BP joint venture was stepped up a notch when the Federal Security Service, or FSB, successor to the KGB, raided BP's Moscow offices and arrested a Russian-American executive and his brother on spying charges. The reason for the pressure? Gazprom has long been negotiating for a bigger share of TNK-BP's Kovytka gas field in Siberia. "We're quite used to this kind of behavior," says the company executive, who was not authorized to speak on the record. "In West Africa, for instance, and Venezuela." 

The result is a kind of state-sanctioned extortion. And by extension, that every businessperson in Russia knows that his or her business is only safe from being raided and stolen by bureaucrats or police to the extent that they have powerful allies in the police or administration themselves. The system "is essentially feudal," says Elena Panfilova, head of the Moscow office of Transparency International, an anticorruption watchdog. "Every business pays a tribute to the local holders of power—from the police to the fire inspectors to the regional governor." If they do not pay, then the business—whether it's a multi-billion-dollar offshore gas project or a hairdressing salon—can be closed for any of a dozen technicalities. 

Not surprisingly, given the fact that it is more profitable to be a bureaucrat than a businessman, that the size of Russia's bureaucracy has risen by 50 percent in the eight years of Putin's rule—from 522,000 to 828,000. More, a survey last year of 16-to-24-year-olds by the Moscow-based Levada Center found that nearly 70 percent of young Russians aspired to work for the state rather than become entrepreneurs.

In 2007, Transparency International ranked Russia 143rd out of 180 countries on corruption, putting it on par with Gambia, Indonesia and Togo (in 1998 it was in 76th place.) Even Alexander Buksman, Russia's deputy prosecutor general, estimates that scale of kickbacks and corruption comes close to equaling entire annual revenues of the Russian state. "The scale of bribes has reached such a level that within a year a midranking corrupt bureaucrat can buy himself a 200-square-meter apartment," complains Buksman.

This systemic insecurity is really the root cause of Russia's instability. Small wonder, then, that and the reason that the number of small and medium scale business is actually going down in Russia—while they account for over half America's GDP. In Russia, firms employing fewer than 100 people account for just 15 percent of gross domestic product.

Tackling corruption has been a major theme of president-elect Dmitry Medvedev's rhetoric over the last few months. Calling corruption "a key threat to modernization and social stability," Medvedev even announced that he would ban law-enforcement and local inspection bodies from entering business premises without a warrant from a court. Medvedev also ordered the government to review legislation to protect small companies from being forced to enter into "security" or "consultancy" contracts with local authorities.

But while Medvedev at least seems to grasp the seriousness of the problems facing small businesses—and the importance of creating a real, non-oil dependent economy to secure long-term prosperity—critics charge that it's impossible to expect local administrations and local law enforcement to reform, when they themselves are the main problem. "Corruption is not an aberration from the system," explains Panfilova. "In Russia today, it is the system."

More, the state-centered economic system that Vladimir Putin has created favors giant, fully or partly state-owned behemoths like Gazprom or the oil company Rosneft over small, private businesses. Indeed, the Kremlin has been the fastest-growing Russian corporation of all, extending state control into almost every sector of the economy from energy and metals to the defense industry, car and aircraft makers and the media. These giants are grossly inefficient by any Western corporate standards, yet the flood of oil money coming in obscures their fundamental unsoundness in a deluge of cash.

Russia's Ministry of the Economy found in a 2007 study that Russia's average industrial productivity was just 1/30th of the United States and European Union; AvtoVaz, for instance, the maker of Lada cars, utilized 27 times more man-hours per unit of profit than the average European manufacturer. And workers in the Russian aerospace industry produced an average of $14,800 per person—in the EU's aerospace industry, the average is $126,800.

"The driver of the economic growth has been the private sector, but Putin is endangering that growth through his renationalization campaign," says Aslund. According to the European Bank for Reconstruction and Development, Russia's private sector generated 70 percent of GDP in 2004 but by 2007 that fell to just 61 percent. And renationalization continues, by fair means and foul, as TNK-BP, Domodedovo airport in Moscow and other private companies singled out for "soft renationalization" by the state are finding out, to their cost.

Most worrying of all, the nationalization and inefficiency have led to a decline in the most important sector of all, oil production. Private investment transformed the old Soviet oil industry into something more modern, drilling new wells when old ones were exhausted and opening new fields. By 2004, production was up to 1991 levels—but without continued investment, that level will soon sag again.

Indeed the future supply of Russian oil is threatened by a likely decline in production levels, one of the country's top oil executives has warned. Leonid Fedun, CEO of Lukoil, Russia's largest privately owned oil company, said last week that $1 trillion would have to be spent on developing new reserves if current output levels were to be maintained—meanwhile the most recent figures show that Russian oil output fell 1 percent in the first quarter of 2008. 

Another problem is an underdeveloped financial system, which makes credit for small businesses expensive and hard to find. Over the last two years, consumer credit has boomed nearly fourfold, with companies such as Russky Standart making small- and medium-scale loans to middle-class Russians to buy cars and apartments. But on a larger scale, Russian businesses are finding it hard to finance their debt or attract real investment.

Again, the macroeconomic figures are deceptive: foreign direct investment into Russia was $28 billion last year, and net capital inflow into Russia reached a record $82.3 billion in 2007, almost double the previous year's figure. But the vast majority of that money went into the energy and mining sectors: the Moscow-based small businesspeople's association Opora reports that banks remain unwilling to make long-term loans at reasonable rates because of the instability in the real economy and uncertain property rights.

Shareholders' rights are systematically ignored, as Russia's largest portfolio investor Bill Browder discovered a year and a half ago when he was banned from re-entering Russia after he complained about the management of Rosneft, a company in which he was a shareholder. Without shareholder rights, there's little hope of delivering shareholder value. High fuel and fertilizer costs and lack of investment have put many of Russia's farms out of business, and many of the country's factories have suffered from underinvestment, high fuel and raw material costs and a flight of labor to boom cities like Moscow.

Russian plans to join the World Trade Organization in 2008 or 2009 may ultimately do Russia's beleaguered agricultural and industrial sectors some good by opening them up to competition from abroad—by forcing them to reform. But that promises to be a painful process, with an uncertain result.

Small wonder, with so much stacked against the growth of small business—the most potent and flexible system of wealth creation in developing economies—that little of the oil boom has trickled down to the lowest rungs of Russian society. Nearly one fifth of Russians live below the World Bank's poverty line of $410 per month.

For sure, the Kremlin claims it's made social spending to improve the country's chronic housing problems and improve health care and make education a priority; indeed, last year's budget saw spending rise by 20 percent in real terms. But the state bureaucracy and law-enforcement agencies seem to be more of a priority: spending on them has doubled as a percentage of GDP over the last five years.

Dmitry Medvedev has made "improving the living standards of every Russian citizen" a key part of his political message as he takes over Russia's presidency this week. But redistributing oil money won't do the trick—the only real way to deliver stability and prosperity to most Russians is to get Russia's real economy working. That's won't happen until the state itself realizes it's the problem, not the solution.

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