Russia in the World

Speech at EBRD Business Forum, May 21st 2007

Russia’s integration into the world economy has been based on energy. Energy is predominant both in its domestic economy and foreign trade. In 2006, oil and gas made up 40% of GDP, and 60% of Russia’s exports. Since 2000 rising oil export revenues have been the main driver of GDP growth, as the price of Urals oil rose from below $10 a barrel to over $60.

Who would have predicted such an outcome a hundred years ago? Russia started to industrialise at the end of the 19th century. Industrialisation was the core of the Soviet developmental strategy. Its aim was to catch up with the United States and then overtake it, showing the superiority of central planning to the market.

Central planning did succeed in making the Soviet Union a developed economy. But it was a misdeveloped one. It never caught up the United States: its economy today is only one-seventh as large as America’s. This was because development Soviet-style took place not by exploiting Russia’s comparative advantages and moving up the value chain as Japan did and now China is doing, but in order to build a formidable military machine. As a result, Russian products, with the important exception of military weapons, could not be sold in hard currency markets.

Soviet development strategy left Russia with a high level of scientific and technical manpower.But its lack of marketeability forced the Russian economy back to its natural resource base. Today the Russian economy is more dependent on the export of oil and gas and minerals (and the manufacture of the rail tankers and pipelines which facilitate it) than it was in Soviet times, a unique type of de-industrialisation.

Experts agree that Russia needs to diversify away from excessive reliance on extracting energy. It has started to do so, with help from the EBRD. Investment is increasing by 10 per cent a year, most of it in the non-energy sector. Extraction is yielding to investment in downstream projects such as liquefied natural gas, refineries and petrochemicals. This should improve the export balance between price-volatile raw materials and less volatile value-added products. But there are definite structural obstacles to diversification, which unless overcome will destroy any prospects of Russia achieving its goal of becoming a normally developed great power.

The chief of these arises from the so-called ‘oil curse’, more accurately the ‘natural resource’ curse – the belief that one can live forever off nature’s bounty. The way the ‘curse’ works as follows:

1.The Dutch Disease. Cash inflows from energy exports weaken the competitiveness of the non-energy economy by forcing up the exchange rate.

2.Volatility. Commodity prices are more volatile than industrial prices, so that a country which depends on commodity exports is much more vulnerable to terms of trade shocks.

3.State monopoly. Natural resources are viewed as part of the nation’s ‘patrimony’ which need to be kept under national control for use as a foreign policy instrument. Policy focuses on consolidation of hydrocarbon production into giant para-statal companies. Foreign investment is deterred.

4.Struggle for control of monopoly rents. Natural resource abundance can divert political and economic energy from the struggle to create wealth (including the replacement of existing resources) towards the struggle to redistribute rents (super-profits) flowing from it. The wealth is already there, it does not need to be created.

5.Authoritarianism. The government has a revenue base outside the income tax system, and has thus less need for popular consent to its policies.

6.Struggle for control of territory. The uneven distribution of resources within a resource rich country either encourages resource-rich regions to break away, or encourages resource-poor regions to establish control over the whole country by dictatorial means.

Russia has experienced all six of these effects.

1.The Dutch disease. The gains from the ruble devaluation are exhausted, and since 2003 the ruble has appreciated 15% in real terms against the dollar.This is reflected in the deceleration of Russian economic growth since 2002. Growth is set to slow further as the economy becomes steadily less competitive.The overvalued exchange rate is an important factor, though only one, stopping the growth of small and medium-sized manufacturing enterprise. The SME sector –the seedbed of future growth –is only 25% of GDP, the lowest in emerging markets and well below the EU average of 60-65%.

2. Volatility. The volatility of oil prices is a huge potential weakness. According to the Brookings Institution (‘The Russian Federation’,October 2006) ‘Russia has balanced its future on the twin pillars of oil and gas, which are vulnerable to the vagaries of the global market’. As long as oil and gas prices remain buoyant there will be favourable spill-over effects on the economy; but the spill-overs may turn into burst bubbles if there are sharp energy price corrections.

History gives ample warning. Twice in the last century Russia’s economic and political life was ruptured by terms of trade shocks.The first, which no one now recalls, was in the late 1920s. The then Soviet development strategy, devised by Nicolai Bukharin, was to use grain exports to provide a ‘primitive accumulation’ fund for industrialization. The collapse of the wheat price in 1929 led directly to the ruin of Buckharin, the forced collectivization of agriculture, and the triumph of Stalin and the doctrine of ‘socialism in one country’. This was a momentous event in world history. Grain –the oil equivalent of the day – provides the otherwise mysterious link between the simultaneous crisis in the communist and capitalist systems in the late 1920s.

The second, more immediately relevant rupture, came in the 1980s, with the fall of real oil prices (2004 dollars) from $78 dollars a barrel in 1982 to $40 in 1990. This ruined Gorbachev’s programme of perestroika and led to his fall from power and the collapse of the Soviet Union –an event no less momentous.

3. President Putin’s policy to preserve a ‘strategic sector’ of the economy under government control has led directly to the drive to consolidate and re-nationalize companies privatized under Yeltsin. The doctrine of the undefined ‘strategic sector’ keeps property rights and business governance opaque. This helps to deter both domestic and foreign investment.

4. Russian economic and political life is dominated by the struggle for rents. Rents –or windfall profits- are estimated at almost 40% of GDP. These rents are shared between the government (in revenues and bribes), the owners of oil and gas companies, and the consumers (in the form of subsidized prices) ‘The real issue at the heart of the Yukos affair was the redistribution of Russia’s oil assets and windfall profits’. (Brookings Institution, ibid.2006).Little thought is given to increasing productivity even in the energy sector, much less to ensuring its reproduction in the future as existing fields are depleted.

5. Oil and gas represent 40 per cent of state budget revenues. This helps to explain the growing authoritarianism of the Putin system.

6.The oil boom has increased gaps between regions, which are most marked in per capita gross regional products and life expectancy. The rise in the Gini coefficient –measure of inequality – is an important consequence of the lack of an adequate distributional formula to redress regional inequality.

So we return to the task of building a broadly-based economy. Expert opinion believes that the government’s top priority should be to improve the private investment climate. In its macro-policy the government has basically followed this prescription by cutting taxes, amassing a huge budget surplus, liberalizing capital flows, and accumulating foreign exchange reserves. It has used the surpluses from the Stabilization Fund to buy foreign securities. All this is according to the dictates of ‘sound finance’.And it has led to a boom in the retail sector and in residential construction and property values, not only in Moscow. The micro-picture is more unsettling since, as I have argued, it is in the interests of the political elite to keep property rights and business practices as opaque as possible.

The alternative policy would be to use the bounty from oil and gas exports to repair badly damaged state institutions and restore public goods like law and order, education, health care, and obsolete infrastructure. Belatedly, the government has committed some revenues from the Stabilization Fund to kick-start the ‘knowledge’ economy. But implementation of the President’s ‘National Projects’ has lagged well behind the rhetoric.

In any case, the Russian state is clearly ambivalent about diversifying. The energy economy gives elites too many incentives for short-term enrichment and national posturing. Political elites see energy as the way back to superpower status. Russia is Europe’s main supplier of gas. Bartering gas for trade deals, foreign acquisitions, and control of its ‘near abroad’ seems to be at the core of Russia’s European economic policy, while oil is its main source of leverage with China. In the view of one commentator(Christopher Weafer in the Moscow Times 18 April 07) developing the oil and gas economy still further has superseded the goal of diversification.

This would be a disastrous choice . I believe that the clock is ticking on Russia’s oil bonanza. I don’t know when it will end –or whether the agony will be sudden or long drawn out. The hydrocarbon windfall can help build a better future, but it is not that future. Russia desperately needs a new generation of public spirited leaders who do not regard the patrimony as a source of plunder and nationalist posturing. I doubt it will find them, so the curse will probably have the last word.