Russia's Changing Political Climate

The Russian government and its economic team are operating against the background of a rapidly changing international political climate. The events of 11 September have opened up new avenues of co-operation with the west, and have underscored the convergence of key strategic interests with the US and the EU. This is likely to have profound repercussions for Russia's future political evolution and the management of its economy. Closer to home, the new leadership at the Central Bank of Russia appears poised to take some major steps to deal with the structural weaknesses of the banking sector. We take a closer look at the underlying issues.<

The energy sector

The government's energy strategy over the medium term is one central component of the continuing efforts to sustain the good growth performance of the past several years. The issues here are many and interact at various levels. To begin with, there is a need to reduce the dependence of the budget and the balance of payments on oil, gas, and metals exports. Not only is this likely to remain a top policy priority for purely macroeconomic reasons, but there is also concern about undue dependence on the energy sector for structural reasons: it is leading to the continued concentration of economic activity in commodity-based conglomerates - a chaebol form of capitalism which we have alluded to in an earlier article. A second set of issues stems fr om the nature of the relationship between OPEC and the Russian government, and the desire of the latter to project itself as a reliable energy supplier to the west, especially at a time when political relations with some of the cartel's largest producers may be undergoing a shift that is likely to weigh on Russia's own interests. Few issues can move asset prices more swiftly than those linked to these questions.

On all these issues, the medium-term outlook for Russia is looking up. First, Russian oil output is rapidly on the rise. In the March/April issue of Foreign Affairs, Edward Morse and James Richard argue persuasively that "Moscow is poised to assume a far more significant position in the world petroleum sector than ever before." First, the Russian oil companies are engaged in a major process of restructuring and modernisation, reinvesting their large profits to expand capacity and enhance efficiency. Unlike their peers in many of the OPEC member countries, often dominated by state monopoly companies that bar foreign investment in the oil sector, Russia's oil companies are seeking to establish a presence among the world oil industry leaders, and are doing so against the background of a much stronger macroeconomy.

Second, the events of 11 September have precipitated a rethink within the US administration about the long-term political outlook for those countries in the Middle East that have been major suppliers of oil to the US market. In particular, Saudi Arabia, the country with the largest market share in the US (17% of total oil imports) and the world's largest oil exporter (but not producer, with Russia having recently taken first place), has been at the centre of this review. Briefly stated, the view is that, within the next decade, the Middle East is likely to undergo major political changes. The countries in the Gulf region have the highest rates of population growth in the world and, hence, the most rapidly expanding labour forces. Unemployment rates have reached historically high levels, and serious structural rigidities in their economies have resulted in anaemic growth rates and rapidly falling per capita incomes. Rising social tensions, in the context of countries with unreformed political institutions and no experience of democracy to speak of, could well result in instability. Whether these emerging tensions then lead to evolutionary and largely peaceful changes (as happened in central and eastern Europe in the late 1980s/early 1990s) or are more violent in nature is not now clear. The point is that, from a strategic point of view, the new geopolitics of energy - as noted by Morse and Richard - creates a chance for Russia "to displace OPEC as the key energy supplier to the west."

The fact that the Russian public finances, and the economy more generally, are considerably less dependent on oil revenues than, say, Saudi Arabia, which is overwhelmingly oil-based, is likely to increase Russia's leverage in discussions with OPEC with regard to its "contribution" to stable prices in the oil markets. The emerging consensus today is that Russian oil companies are likely to boost production and exports (wh ere capacity constraints are being relieved through the coming on stream of a number of pipelines) in the years ahead, even at the cost of lower oil prices. They are also likely to capture much of the share of growth in demand in countries like China, India and, increasingly, through joint ventures, the US. Furthermore, Russia remains the world's largest gas exporter, dwarfing the combined output of the US and the EU, plus Norway and Saudi Arabia.

Geopolitics

The last couple of weeks have witnessed two other major developments, with potentially important implications for investor perceptions of political stability in the country and, hence, the willingness of global players to bring capital into Russia. The establishment of the Nato-Russia Council (NRC) is expected to give Russia a stronger voice in global security issues, such as the fight against terrorism, attempts to stem the proliferation of weapons of mass destruction, the role of peacekeeping forces, and so on. It has been variously described as "an historic chance for the beginning of a real transatlantic partnership with Russia" (Joschka Fischer) or "the funeral of the Cold War" (Jack Straw). Summit rhetoric aside, it does bring Russia much closer to the kind of co-operative relationship with old adversaries that would give investors a wider margin of comfort. Together with the signing of a treaty with the US on the reduction of strategic nuclear arms, Russia under Vladimir Putin has taken two giant steps toward solidifying its political and economic roots with the US and the EU, the two focal points of the global economy.

An interesting question is whether the rapprochement with the west which Mr Putin has sought in the aftermath of 11 September is politically sustainable, given the extent of disenchantment among Russian elites with the form and the content of his foreign policy. A detailed examination of this question is beyond the scope of this article. Briefly put, the answer is "yes", and the factors that justify it are threefold. First, it enjoys broad public support. Although it may be difficult to disentangle Mr Putin's high public approval ratings (around 70%) from grassroots support for his foreign policy, the fact remains that forging closer links with the west has not hurt him, politically, with the voting public.

Second, the opposition voiced in certain segments of the media, the security/military establishment and some of the "think-tanks" reflects, to a great extent, unhappiness at Russia's much reduced global status and an unrealistic yearning for the Cold War days when the Soviet Union, in ways that Russia cannot today, could "dictate" the terms of its relationship with the west. Those days are gone, but many cannot yet face the fact. But more importantly, in its inability to offer credibly intelligent alternatives, this opposition has some of the flavour of the criticism one heard in the early 1990s concerning Russia's transition to a market economy. Lastly (and this is perhaps the weakest of the three arguments), it is sustainable because western leaders will likely not leave Mr Putin exposed to his critics by not "delivering" tangible benefits, such as support for early WTO entry.

The key point in all of this is that the longer Mr Putin pursues a policy based on a realistic assessment of Russia's strengths and weaknesses aimed at accelerating the integration of the economy to the rest of the world, the faster the fruits of this approach are likely to be visible, and the more rapidly the present opposition will be forced to retreat. This is not to say that there is no place in Russia for the kind of lively political debates that can be seen in more developed democracies. Surely there is. But the debate needs to shift from the sterile ground of "whether Mr Putin is selling the country out through accommodation with the west" to how the government (and the unhappy elites) can best push ahead with the kinds of structural and institutional reforms which are necessary for the modernization of the Russian economy.

A clear agenda in the banking sector

The improvement in economic activity seen in the last couple of years has contributed to some recovery in the banks' underlying financial position, but the banking sector as a whole remains largely ineffective in its primary role of financial intermediation. More specifically, it remains small in size, with private-sector credit (deposits) a mere 12% (16%) of GDP, compared with 24-26% (37-39%) in Poland and Hungary and 122% (125%) in China. It is dominated by state-owned banks, with the state having a controlling stake in 23 banks and the largest state bank, Sberbank, accounting for 80% of household deposits and 25% of total assets. It is poorly supervised, with more than 1,300 banks straining the administrative capacities of the central bank, but with the 800 smallest banks having total assets averaging about $1m each. Finally, it is characterized by the virtual absence of lending to small to medium-sized enterprises and to individuals, but aggressive lending to large companies linked to the commodity export business.

Although the joint Government-CBR Strategy Paper approved by the cabinet in December 2001 provides the intellectual framework for banking sector reform, valuable time was lost under the central bank's previous leadership, which took the export-led recovery of the last three years as an indication that financial intermediation would come in due course, without prodding from the government or the central bank. This did not happen. The authorities are coming gradually to the realisation that Mr Putin's wish to see an acceleration in the pace of economic growth is unlikely to be achieved without a banking system that is able to intermediate financial resources to small and medium-sized enterprises, the engine of sustainable growth in virtually every transition economy in central and eastern Europe. Among the tasks that are likely to occupy the authorities in the next year are: improving banking supervision; the introduction of a deposit insurance scheme for private banks; streamlining of the state banks; and further liberalisation of the capital account.

Conclusion

Russian economic growth prospects will continue to depend on the underlying strength of its energy sector and the ability of the authorities to deal rapidly with structural weaknesses in the banking system. The events of 11 September have provided the country with an opening to accelerate its integration to the global economy, an opening which has been seized by President Putin and is resulting in a much closer identification of the national interest with strengthened co-operation with the west. This approach has left many in Moscow unhappy, but their unhappiness does not bring with it a credible alternative, thus its effects should not be overestimated.

In the short term, we expect the authorities to be focused on banking sector issues, on the formulation of another strong budget for 2003, and on implementation issues linked to key pieces of legislation making their way through the Duma. These include an extremely important bill on land reform which was approved on first reading last week and which will finally allow private ownership of agricultural land - a first in Russia. Along the way, Russian assets, particularly equities, should continue to perform very well.