All That Glitters

Three years ago, British Petroleum retreated from Russia. In the wild and woolly days of post-communist euphoria, it had invested $480 million in a Siberian producer called Sidanco with rights to 2 billion barrels' worth of oil reserves. In short order it lost nearly half its money through a financial sleight of hand of the sort that has long made multinationals wary of doing business in the country. But now BP is back. Just last month it invested $375 million for an even larger stake in the very company that burned it. "Sidanco is a company that we know extremely well, and it's now a profitable company," says a BP official. "It's an ideal vehicle to get more involved in Russia."

What's changed? From BP's perspective, everything--and not just boom times in the international oil markets. "There is a general feeling of confidence in Russia," says the BP official. For when it comes to Russia these days, it's easy to be an optimist. While Europe and the United States stalled out in recession, Russia could look back on three years of growth, topping 8 percent in 2000. Meanwhile the formerly rocky ruble is enjoying a new and enviable stability. The budget is balanced, and Moscow's stock markets have been shooting the moon. Most promising, an energetic president has been pushing aggressively pro-business reforms at a pace unthinkable in the corrupt and chaotic days of Boris Yeltsin.

You'd think that the man steering this train would be pleased. But apparently not. At the moment that BP was celebrating its re-entry, President Vladimir Putin was dashing cold water on the party. In his annual State of the Nation address last month, he projected a bleak future. "The economic growth of recent years has sufficed merely to prevent us from falling even farther behind other countries," he complained. At current rates, it will take decades for giant Russia to catch up with tiny Portugal today. Bureaucracy, inefficiency and corruption are stalling progress. Russia needs more fresh thinking, he added, and it can't look abroad for help in solving its very serious problems. No one, he concluded, will "make a special effort to come to our assistance. It is we ourselves who have need to fight for our own place in the economic sun." There was only a smattering of applause. "The country has not heard anything as cheerless as this in years," remarked the Communist Party boss, Gennady Zyuganov.

So, what's going on here? What does Gloomy Vlad know that upbeat BP doesn't? For the better part of a year now, a new conventional wisdom has been taking hold: that Russia has finally become a "normal" place to do business, or at least as normal as you can get in a post-communist economy struggling to shed 80 years of Sovietism. And it's true that Russia has made great strides. But amid the good times, the president has raised an important warning flag, especially to be noted by foreigners investing in Russia. Beware, it says.

Things are not as good as they seem. Russia has always been a great temptation--all the more so recently, partly because of a run of good luck. For nearly four years, rising oil prices have buoyed its economy, spurring a surge in production that has catapulted Russia to No. 2 in the ranks of the world's leading oil producers, right behind Saudi Arabia. And Russian oil companies--most now in private hands--have been well positioned to cash in. They've spent years importing new Western technology and management know-how. Instead of siphoning profits into private bank accounts in Switzerland, they've been reinvesting the money. Rather than trying to figure out ways to rip off state assets, they've focused on maximizing production and revenues, just like oil-industry execs elsewhere in the world.

Russia also owes a lot to the financial crisis of 1998, in retrospect one of the best things that could have happened to the country. Investors may have lost heavily when the ruble tanked, but the drop made Russian industries more internationally competitive overnight. Pricey imports, from beef to booze, disappeared from the shelves, giving Russian producers a chance to move in. The biggest winners: the automobile industry, light machinery, pulp and paper, and local food industries, especially beer and dairy. Before 1998, for example, stores were full of Dannon yogurt. Now Russian brands like Wimm-Bill-Dann have taken their place. The crisis also forced Russian businesses to discipline themselves. Previously, state-owned utilities and large companies limped along in a cozy but hugely inefficient system of bartering. Companies would pay their tax bills with the products they made--a complicated system that left plenty of room for corruption at both ends of the transactions. That's changing, often dramatically. Big industrial companies that used to trade their finished products for raw materials from their suppliers are also moving away from such barter deals. Before the crisis, the national electricity utility RAO UES collected only 17 percent of its receipts in cash; now the amount is more than 90 percent. Factories that once paid their workers with their output--everything from coffins to condoms--pay them rubles instead.

Most important was Putin's program of reform. He drew up a national budget and more or less made it stick. That has helped keep inflation in check (despite the new flood of oil money) and kept the ruble steady. After the profligacy of past years, Russia is now running a budget surplus of almost 3 percent of GDP. Most impressively, Putin has made some line items in the budget contingent on whether there's money in the till to finance them. As World Bank economist Christof Ruhl notes with a wry smile: "He's almost like a good German."

Putin has also proved that his countrymen will obey rules that are reasonable and straightforward. After his government introduced a flat 13 percent personal income tax in 2000, payments by individuals surged by half. He's pushed through measures to streamline Russia's notorious bureaucracy and to try to bring corruption under control. For the first time since 1917, a new Land Code allows individuals to buy and sell nonagricultural land. (Similar laws for farmland are expected to follow soon.) He has also curtailed the political power of the oligarchs, the once omnipotent tycoons who controlled major media outlets and could get ministers hired or fired. Now it's Putin who determines what the press can say and who can serve in his cabinet. The oligarchs can still pursue their business interests, but only as he sees fit. That may be a mixed blessing, but many Russians applaud his I'm-in-charge style.

The bad news is that, for all its progress, Russia remains deeply vulnerable to shocks and setbacks. Its public-health system is in appalling disarray, and widespread poverty and a sense of hopelessness continue to grip entire regions. The economy, however improved, is anything but stable. And that makes the country a less than normal place to do business. Begin with Putin's concerns. Economic growth has slowed dramatically in recent months, stalling out completely between October and January before turning modestly upward again this spring. That's partly the effect of the world recession, but it's more because the easy gains of the ruble's devaluation and surging oil prices have already been realized.

Add to this another hard fact: ambitious as the president's reforms may be, they will take years (as in the case of the new land laws) to show real effect. Putin's Russia is still a place where few Russians would dream of applying to a bank for a mortgage to start a small business, or go to court to resolve a dispute rather than pay the customary bribe to corrupt officials or an underworld protection racket. For all the talk of fighting corruption, Russia remains a highly criminalized society. Just last week another journalist was killed in a gangland-style hit--this time a newspaper editor in the central city of Togliatti who published articles on local corruption, criminal groups and the automobile industry there.

In this perilous climate, people like Andrei Slavtsov, 29, are the foot soldiers in a Russian Revolution II. Not long ago, Putin's government crafted--but hasn't yet introduced--a new set of liberalizing rules and tax exemptions for businesses employing fewer than 20 workers. That should help the likes of Slavtsov, who four months ago took the plunge and opened a tiny commercial self-service laundry. It's a cheery place, with bright blue walls and orange piping, hidden away in the huge Stalinist expanse of Moscow State University. So far he's attracting plenty of customers, most of them students like himself. He's already thinking about expanding into the dry-cleaning business, or maybe opening an Internet cafe. But he's afraid of attracting attention--not from the mafiosi so much, since he's too small-time for most of them, but rather from the hungry legions of tax policemen or health inspectors who can reduce any business to bankruptcy unless they get their cuts. "If a lot of people know how much you've invested in something, then you can be in danger," he says. Fear of profit? That may be Russia's real disease.

Many of Putin's upcoming reforms are also destined to make people angry. These changes include a series of mounting cuts in state housing subsidies. That has hit people in their wallets--and 20,000 responded in the southern city of Voronezh recently by staging noisy street protests. Russia's good fortune on the oil markets is also a big vulnerability. "Our dependence on oil and raw materials limits our possibilities for growth," says Andrei Kuznetsov of the Higher School of Economics in Moscow, stating rather cautiously a problem that is the country's de facto Achilles' heel. This involves more than the inevitable cycle of oil prices. (From a low of $10 in 1998, prices have hit a high of $27--and may have no place to go but down despite uncertainty in the Middle East).

Equally important is the way Russia's oil addiction has skewed industrial development. Understandably, cash-flush Russian oil companies have tended to invest only in their own industry, leaving other sectors of the economy starved for capital. Foreign investors have done the same. Following British Petroleum, the giant French conglomerate TotalFinaElf recently disclosed that it is considering a $2.5 billion investment in a west Siberian gas field. And last week Shell announced that it's close to finalizing a similar $1.5 billion venture. All this is good news for Russia's oil industry, but it also casts a spotlight on the scarcity of investments in other realms, such as high-tech industries or telecoms. It's not quite Saudi Arabia with snow, but the danger is clear. If the world oil industry catches a cold, Russia might get the flu.

Aside from oil, foreign investors are still putting most of their money into the lower end of the economy--logging, metals and food. As the World Bank's Ruhl points out: "This is an economy in desperate need of diversification"--of more diversified investment, and more investment, period. It doesn't help that all of Russia still attracts far less foreign investment than does the tiny Czech Republic.

No wonder Putin is out of sorts. No one knows better than he how far Russia has to go, and how vulnerable it is to unpredictable global economic cycles. For all his efforts, the bulk of the country's industrial assets are in the hands of the oligarchs--by some estimates, as much as 80 percent. They may be acting more like businessmen than crooks these days, but that doesn't solve the problems of excessive economic concentration. "This isn't modern capitalism," says Yuliya Latynina, one of Russia's leading business journalists. "It's more like medieval feudalism." Couple this with weak rule of law, the absence of functioning courts and virtually no real banking system, and it's hard to imagine the development of the broad-based, diversified economy that Putin knows Russia needs to achieve his goals.

To become "normal," Russia must have entrepreneurs and an explosion of small- and medium-size businesses. It must create a new middle class, the very bourgeoisie that Lenin and his successors sought to eradicate. Above all, it needs to give its citizens the feeling that their laws make sense and are applied equally to all, that they both punish the wrongdoers and protect the innocent. Despite progress in that direction, Putin hasn't yet delivered on that most essential prerequisite for the kind of accelerated growth that his country so desperately needs.