Russia: Risks and Challenges in 2002

Oil politics

Soviet-era oil politics were predictable and boring; the oil sector was 100% state-owned and prices were set by OPEC. The post-communist system now in place is more flexible and thus more complex. The oil sector is now largely in private hands. The state still owns the pipelines and thus still retains considerable leverage vis-`a-vis the entire sector, but there is no doubt that there is a rapidly emerging oil market. Furthermore, the interests of the oil companies vary widely. Some are keen to boost production and exports, having invested heavily in recent years in new oil fields and in modernizing their capital stock. These companies favour an aggressive stance vis-`a-vis OPEC and lobby the government to support a major medium-term expansion of Russia’s market share. They argue that by boosting exports in a major way the government will be able to generate broadly the same dollar revenues for the budget at lower prices and thus reduce Russia’s energy dependence. Other companies either are unable to boost production in the short term or have other strategic interests – horizontal diversification for example.

The interests of the government are not easily characterised either. On the one hand, ceteris paribus, higher prices are always good for the budget. At the same time, Russia would like to become not only the world’s largest energy exporter (it already is the world’s largest gas exporter, by a wide margin), but a reliable supplier to the West as well, a goal the achievement of which would likely bring other strategic benefits. One school of thought in Moscow favours playing along with OPEC in the second quarter of 2002, when the present understandings on export cuts agreed last December expire. A price war would not benefit anyone and could put undue pressures on the budget, already operating with an oil price assumption ($23.5/bl) well out of date. Others argue that since the budget is fully financed even at $15/bl (although some previously agreed expenditure cuts would have to kick in) and since the largest OPEC producers’ budgets are even more dependent on oil revenues than the Russian budget, no price war is likely and thus the government should support a major boost to production and exports. Those in this camp remind the government that even though production has grown by some 15% in the last two years, it has not yet returned to the peak levels of the mid-to-late 1980s, given the dis-investment seen during much of the 1990s.

How the above debates play out will have tangible implications for oil prices and hence the budget and growth. One possible outcome is that some suitably ambiguous arrangement will be reached that allows OPEC to save face and that, de facto, makes it possible for Russian output to grow by some 5% in 2002. With a fledgling US recovery underway, steady oil prices would facilitate this outcome.

Political risks to President Putin?

President Putin’s very constructive approach vis-`a-vis the West after 11 September has been the subject of considerable scrutiny and commentary in Moscow and elsewhere. Depending on who makes the assessment, it has been variously characterised as a brilliant diplomatic move, ultimately intended to strengthen political and economic links with the developed world or, at the other end, a sell-out of Russia’s key strategic interests with no apparent rewards in return. The fact that he did not explicitly attach a “price tag” to Russian cooperation is seen by some as setting the right tone for a new phase of relations with the US and the EU, in which Russia is increasingly perceived as a reliable political and economic partner. Ironically, the greatest reservations about Mr Putin’s approach have come from his traditional centers of support: the military, the security services, Communist deputies in the Duma. Liberals, having expressed in the past reservations about some of Mr Putin’s methods, have now rallied around him convinced, apparently, that Russia’s future lies in further integration with the G7 and countries in the industrial world and that he is the man to push this process forward.

Although we are of the view that Mr Putin’s approach was quite appropriate, highlighting a clear break with the adversarial tone which has been the subtext for superpower relations during the Cold War period, it is too early to assess whether the gamble will end up silencing his opponents or rather strengthening them. Much will obviously depend on the US and the EU as a number of foreign policy issues come to the fore in the months ahead. Three issues are likely to figure prominently in this agenda:

Russia’s relationship with Nato: A formal partnership that would give the Russian government a say in areas of common strategic interest, such as the fight against terrorism and the use of peacekeeping forces, would go a long way toward mitigating the adverse impact of Nato expansion, which is scheduled to take place by year-end and which has been consistently opposed by Moscow.

Arms reductions treaty: Russia would like to enshrine agreements with the United States on cuts in stockpiles of nuclear weapons in a formal treaty, rather than the informal arrangements favoured by the US administration. Such an approach is strongly opposed by the Russian military who seem to regard “informal” understandings on such issues of limited value and, in any case, an inadequate basis for pushing forward with a restructuring of the military.

Iraq: The coming expiration of the interim regime of UN sanctions against Iraq and the possibility that Iraq might become the next target of the war against terrorism is a source of concern in Moscow. Russia has benefited from the UN’s “oil for food” programme and emerged as a key trade partner for Iraq. Even if sanctions were lifted (in the unlikely event that UN weapons inspectors were readmitted by Iraq), Russia would likely benefit from future trade deals. US strikes against Iraq, however, would disrupt trade and lead to a chorus of protest among Mr Putin’s opponents, who would accuse him of having yielded too much to the US without due regard for national interests.

Table 1: Selected economic indicators		Chart 1: Federal budget execution (In billions of rubles)

There is clearly a risk that, with the military campaign in Afghanistan rapidly coming to an end, the US government will now move to the next stage of its war on terrorism, one in which Russian cooperation could potentially be less central, with Mr Putin thus being sidelined and with not much to show in terms of substantive gains as a result of his accommodating stance post 11 September. Were this to happen, the argument goes, his popularity would suffer, his critics would be emboldened, and his adeptness at co-opting the Duma and the bureaucracy into supporting his push for economic reforms would be significantly weakened. While we have some sympathy for this line of thought, it is possible to overdo it. It is not clear that his present opponents have any other person to give their support to; he maintains high levels of popular support (boosted by a growing economy) and we are cautiously optimistic that the US administration will continue to engage with Russia in meaningful ways, that are mutually beneficial – with Nato cooperation being a prime candidate.

Structural reforms: maintaining momentum

While the agenda is broad we would consider the following four areas to be the most important; delays would be bearish for growth and for asset prices.

Banking sector: Low levels of financial intermediation due to inefficiencies in the banking sector are likely to become a heavier drag on growth. It already may be contributing to the segmentation/polarization of the industrial sector, with a top tier of large enterprises, many of them generating large cash surpluses, unable to invest these funds profitably because of the absence of financial instruments and thus being forced to invest abroad. At the same time, small to medium-sized companies are unable to obtain credit because of weaknesses in the legal framework; the evident success of the EBRD’s micro-lending programme highlights the presence of repressed demand for credit. This is of concern because the evidence from other transition economies in central and eastern Europe suggests that it is new enterprises that most contribute to and sustain growth. While there is better understanding of these issues within the government, it is not clear that this has yet translated into reforms in the financial sector; progress this year will be thus key.

WTO: The government seems keen (and Mr Putin is pushing hard) to accelerate the WTO accession process. The reform agenda in this area is broad – a starting point is likely to be the forthcoming consideration by the Duma of changes to the Customs Code to bring import procedures in line with WTO requirements. While the political will is clearly present, we have concerns about the power of vested interests, particularly in industries whose owners may have misunderstood the ramifications of accession. It is encouraging that the Russian Union of Industrialists and Entrepreneurs has come out in favour of WTO entry and consider the main risk here the limited administrative capacities of the government to manage the accession process in a way that meets WTO requirements within the agreed target date: June 2003.

Pensions: Reforms to the pension system approved last year have brought into being individual retirement accounts the contributions to which are to be managed by private managers. The system is in its early infancy: it applies to young workers (less than 35 years old); the share of the payroll tax which may be invested is small (2 percentage points of the gross wage); the investment guidelines for the fund managers remain to be formulated; the relative roles to be played by the pension fund and the government in managing the pension reform process need to be made clearer. But, over the longer-term, the potential for these reforms and future amendments to them is vast, not only for putting the finances of the pension system on a firmer basis, but also for promoting the development of Russia’s capital markets.

Stabilisation fund: We have argued elsewhere the merits of creating such a fund. [1] With lower oil prices in 2002 than assumed in the budget, the political environment for making progress in this area may have improved as the arguments would shift away from how to spend the money accumulated in the fund to how to put a legal framework in place to ensure that the funds eventually collected are invested under transparent guidelines.

[1] See “Russia Needs a Stabilisation Fund”, Global Weekly Economic Monitor, 9 November 2001, and “Bringing Stability to Russia”, Personal View, London Financial Times, 18 December 2001.