Rotary Club Speech
Robert Skidelsky
Rotary Club | Sunday, January 07, 2007

How solid is Russia’s economy? How solid is its political system? How reliable is it as a partner? .My remarks will be analytic, not imperative. That is, they will not consist of exhortation. We know what Russia should be doing (ie., what we want it to do). The Financial Times tell us almost every day. The point is to understand the structural tendencies of the Russian system.
Let’s start with the economy.
Headline figures of Russian economic growth under Putin tell a spectacular success story. Real GDP growth between 1999-2005 has averaged 6.7%. GDP at market exchange rates was $200bn. in 1999 and $800bn. now, making Russia the tenth largest economy in the world. GDP per capita in PPP is $12,500, or double that of 1999, about the same as Chile’s. Russia has been catching up with wealthier economies.
Stock market capitalisation has increased from $74bn. in 2000 to more than $1 trillion today. The benchmark RTS index rose 71% in 2006, the fourth year under Putin when market has returned more than 50%’. The Wall Street Journal of 22 January had a headline ‘Investors Credit Putin as they Pile Up Profits’.
Russia runs a huge annual budget surpluses, it has almost no foreign debt, and has the largest foreign exchange reserves outside Asia.
However, the point to emphasise is that the Russian boom is driven by rising energy and commodity prices. The Soviet Union was described as a single track superpower. Today Russia is a single track economy, floated off the rocks of 1998 by soaring oil prices –which have increased threefold since Putin came to power. From before collapse of the Soviet Union, oil has been the backbone of the Russian economy. By 2006 it accounted for 60 per cent of exports, and 30 per cent of government revenue. Oil, gas and related industries made up 40 per cent of GDP, energy stocks 80 per cent of the RTS. The inflow of oil dollars has lifted stocks and real estate to new heights. Non-tradables-construction, retail - have taken an increasing share of investment.
By 2006 the economy was more dependent on the export of oil and natural natural resources than it had been ten years before.
Is this good or bad? In short run Russia has benefitted hugely from the commodity boom. The long-run effects are quite possibly dire.
I want to draw your attention to the phenomenon known as the ‘oil curse’, or more generally, the ‘natural resource curse’. There are several reasons, obvious and not so obvious, why being resource rich may blight a country’s economic –and political - prospects.. First, commodity prices are more volatile than industrial prices, so a country which depends on commodity exports is exceptionally vulnerable to terms of trade shocks. Secondly, there is the ‘Dutch disease’, named after Holland’s experience in 1970s, whereby large foreign cash inflows from commodity exports destroy the competitiveness of non-oil industry by forcing up the exchange rate. Thirdly, natural resource abundance diverts economic and political energy from creating wealth to fighting over its distribution. The wealth is already there: the question is who is to control the rents from it? Fourthly, natural resource abundance decreases the demand for democratic representation, as governments don’t need to rely so much on income tax to finance expenditure. This promotes authoritarianism. Finally, the uneven distribution of resources within a resource-rich country can either encourage resource-rich regions to try to break away, or encourage resource-poor regions to establish control over the whole country by dictatorial means. I emphasise these are tendencies rather than inevitable outcomes. They can be offset by good policies.
Both Russia’s economics and politics have been rendered less solid by the oil curse. On the economics, I would make just three points.
First, Russia is highly vulnerable to any downturn in commodity prices.
This is most obvious in its energy-dominated stock market. A fall in price of crude oil has helped push RTS down by 5.7% this year. One analyst said he wouldn’t be surprised to see the market trading at around 1200, or a third down from 2006 high, if price of oil fell to $45 a barrel.
Thus a large fall in the oil price would hit the Russian economy through a personal wealth effect; but also through the reduction in revenues from its crude oil pipeline exports. . Both would cause a cutback in domestic spending. If the price falls below $20 the country’s development might be thrown back by 10-15 years.
Secondly, there is the familiar ‘Dutch disease’story. The November OECD Policy Brief on Russia states baldly that ‘the main factors underpinning current growth are transitory’. By this it meant that the gains from ruble devaluation of 1998 are exhausted; and that growth due to higher commodity prices will slow as the economy becomes less competitive. Rising oil prices have driven up the exchange rate which impedes efforts to widen the export base. Efforts to limit nominal ruble appreciation make it harder to reduce inflation. Productivity growth is lagging behind the appreciation of the real exchange rate
Thirdly I would stress the effect of the petrodollar inflow in reducing incentives to reform, innovate, and make both the oil and non-oil economy more efficient.
The fundamental point is that energy-fuelled growth has stalled structural reforms and impeded diversification of the Russian economy. The reform programme-tax reform, social security reform, land privatisation - has dried up in Putin’s second term. The inflow of oil dollars has enabled the Kremlin to ignore the schoolmasterly lectures of the Financial Times. The arrest of Khodorkovsky and the partial re-nationalization of Yukos, which in other conditions would have frightened off foreign investors, hardly registered on their radar screens. Nor have they yet been unduly put off by the trend towards renationalization and/or direct intervention in ‘strategic’ sectors like oil, aviation, power-generation, automobiles, finance –partly led by the state’s feeling of vulnerability in relying on such a narrow economic base.
Like all natural resource economies, Russia’s is highly monopolised. This means that the SME business sector has played a much smaller part in economic growth than in resource poor countries. It is the smallest of all emerging economies: Employment in small business sector is below 20%, the lowest in emerging market economies. Over-regulation and corruption are still formidable barriers to entry. There has been little incentive to reform the banking sector so as to lower the cost of credit. Sberbank the state savings bank, still dominates the market. The central bank has done little to close under-capitalised banks. There is a dearth of venture capital. (This is 2001. CHECK HOW TRUE TODAY.)
Finally, Russia has been slow to exploit its comparative advantage in human capital. India and China not Russia have been favoured locations for outsourcing. Comparative rarity of joint partnerships like Boeing –Luxoft.. The government is now paying more attention to this, but too little, too late.
The government has taken an important step to insulate the economy from volatile oil prices. Since 2004, the government has sequestered 90% of any tax revenue above $27bn a barrel into an oil stabilization fund. This now has accrued over $80bn.
This fund can protect the budget –and thus the economy - from declines in oil prices for several years.
So one would say the economy is prosperous but not stable. That is to say, the cyclical character of its prosperity appears more marked than in other emerging markets and certainly than in developed markets.
Let me now turn to politics
The stability is very impressive. There is hardly any political opposition, and Putin enjoys an approval rating of 70 per cent –beyond the wildest dreams of any western leader. Stability is a crucial element of the political predictability which investors crave. However, there is a problem looming up which I will call the ‘problem of the succession’. Who or what after Putin?
To understand why the transition from Putin is likely to be so fraught one has to understand that political power in Russia carries property rights. A highly monopolised economy becomes a prey of politics. The connection between property and power has existed in one form or other throughout Russian history. It has been reconstituted in a particularly striking form under the Putin system.
We can draw Putin’s vertical structure of power as two pillars whose arch is the Presidency. The political pillar is completely controlled by the Kremlin. Putin has suppressed or neutralised all the independent centres of political action and expression-the opposition parties, most of whom are creatures of the Kremlin, the media, and the NGOs. These are all fake, like Potemkin villages. The other pillar is the economy, dominated by the monopolised strategic industries. Yeltsin left a system of oligarchic control of Russia’s wealth which was independent of the Kremlin. Though corrupt it was the start of a separation of power from wealth. Putin restored the connection. He has dislodged the three most ambitious magnates, Berezovsky, Gusinsky, and Khodorkovsky, has taken back under state control parts of the oil industry, and has created a giant gas conglomerate Gazprom.
Putin’s most striking innovation has been to integrate the political and economic pillars into the vertical system of command. The new regime is dominated by a web of Kremlin staffers who also head the largest state-controlled companies. The two deputy prime ministers are chairmen respectively of Gazprom and Russian railways. Other key officials run the second largest oil company, a nuclear fuel giant, an energy transport system and Aeroflot. The minister of industry is chairman of the oil pipeline monopoly; the finance minister of the diamond monopoly and second largest state bank, and the telecoms minister of the biggest mobile phone operator.
The transfer of power in such a system involves not just the replacement of one lot of politicians by another but the transfer of property entitlements and the patronage that goes with them. Putin’s political appointees face being dispossed not only of their offices but their rents. This is why property rights in Russia remain unclear, and why no one can quite face up to ‘life after Putin’. The obvious scenario is that he handpicks his successor under an agreement which secures the property rights of his own entourage –as well as his own – in the new regime. But this will not be easy.
If the new president is to satisfy his own followers he will either have to seize control of property which is currently private in the western sense, or will have to dislodge some of the Putin appointees, as Putin did with the Yeltsin family. But unlike Yeltsin, who was sick and discredited when he left office, Putin is still relatively youthful, healthy, and popular. The constitution does not allow him to stay on; but the system he has created does not allow him a safe departure. The added twist is that, under the Russian constitution, he can stand for a third term after one interval. He may nominate a fake successor –someone to keep his seat warm for four years. But then who governs? So this supposedly highly stable system depends on Putin’s continuance in power, by one means or another.
The great advantage of democracy is that it allows the orderly transition of legitimate power. This mechanism is blocked in Russia by the fusion of power and property. There is bound to be a period of great uncertainty, which may last several years, until a successor regime is established. Security of property rights is incompatible with the Putin system.
Reliable Partner.
This question can be asked about the whole range of Russia’s relations with the external world. Americans wonder about Russia as a strategic partner; Europeans are chiefly concerned with it as a reliable energy partner.
Natural resource abundance encourages monopolisation of the economy. Huge corporations and conglomerates have powered Russia’s growth. Many built their strength in foreign trade and financial markets before moving into natural resources in the mid-1990s, using loan for shares program and other non transparent privatisation schemes. Then they expanded into services, agriculture, manufacture.