Channelling Energy in the Wrong Direction

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 percent of gross domestic product and 60 percent of exports. Since 2000, rising oil export revenues have been the main driver of growth, as the price of Urals oil rose from below $10 per barrel to more than $60.

Who would have predicted such an outcome 100 years ago? Russia started to industrialize at the end of the 19th century, and industrialization was the core of Soviet development strategy. The aim was to catch up with and overtake the United States, showing the superiority of central planning over the free market.

In fact, the Soviet Union never caught up with the United States. Its economy today is only one-seventh the size of the United States’. This was because Soviet-style development was dictated not by comparative advantage, but by military imperatives. Most Russian products could not be sold on world markets.

Despite high levels of scientific and technical expertise, this lack of marketability forced the economy back to its natural-resources base. It is more dependent on resources now than it was in Soviet times — a unique type of de-industrialization.

It is clear that Russia needs to diversify away from excessive reliance on extracting energy. It has started to do so. Investment is increasing by 10 percent per year, most of it in the nonenergy sector. Extraction is yielding to investment in downstream projects like liquefied natural gas, refineries and petrochemicals. This should improve the export balance between raw materials and value-added products. But there are definite structural obstacles to diversification, and unless these are overcome, they will destroy any prospects of Russia becoming a normally developed economic power.

The chief obstacle arises from the “curse” of natural resources — the belief that you can live forever off nature’s bounty. The curse, and the way it has manifested itself in Russia, involves the following:

• Dutch Disease. Cash inflows from energy exports weaken the competitiveness of nonenergy sectors by strengthening the domestic currency. The gains from the 1998 ruble devaluation have been exhausted and the ruble has appreciated against the dollar by 15 percent in real terms since 2003. This has been reflected in the deceleration of 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 — preventing the growth of the small and medium-sized manufacturing industry. This sector — the seedbed of future growth — contributes only 25 percent of GDP, the lowest share among emerging markets and well below the European Union average of 60 percent to 65 percent.

• Volatility. Commodity prices are more volatile than industrial prices, so a country that depends on these exports is much more vulnerable to terms-of-trade shocks. The volatility of oil prices is a huge potential weakness. As long as oil and gas prices remain buoyant there will be favorable spillover effects on the economy. But these could turn into burst bubbles if there are sharp energy price corrections. Remember what happened in the 1980s? Oil prices, in 2004 dollars, fell from $78 per barrel in 1982 to $40 in 1990. This ruined Soviet leader Mikhail Gorbachev’s perestroika program and contributed to his fall from power and the collapse of the Soviet Union.

• State monopoly. Natural resources are viewed as part of the nation’s “patrimony” and have to be kept under state control for use as a foreign policy instrument. Policy focuses on consolidation of production into giant pseudo-state companies. Foreign investment is deterred. President Vladimir Putin’s policy of preserving this “strategic sector” of the economy under government control has led directly to the drive to consolidate and renationalize companies privatized under Boris Yeltsin. This doctrine of a vaguely defined strategic sector keeps property rights and business governance opaque, but gives Russia clout as an “energy superpower.”

• The struggle for control of monopoly rents. An abundance of natural resources can divert political and economic energies from the struggle to create wealth, including the replacement of existing resources, toward the struggle to redistribute rents flowing from them. Russian political life is dominated by the struggle for rents. These windfalls are shared among 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. 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.

• Authoritarianism. The government has a revenue base outside the income tax system, and thus has less need for popular support for its policies. Oil and gas account for 40 percent of state budget revenues. This helps to explain the growing authoritarianism of Putin’s system.

• 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 authoritarian means. The oil boom has increased gaps, most markedly in per capita gross regional products and life expectancies, between regions. The rise in the Gini coefficient, which measures economic inequality, is an important consequence of the lack of an adequate distributional formula to redress regional inequality.

So the task of building a broadly based economy cannot be shirked. There is widespread agreement that the government’s top priority should be to improve the private investment climate. In macroeconomic 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 of this follows sound financial dictates. It has led to a boom in the retail sector and in residential construction and property values, not only in Moscow. The microeconomic 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 national projects has lagged well behind the rhetoric.

The state is clearly ambivalent about diversifying. The energy economy provides elites with too many incentives for short-term enrichment and national posturing. They see energy as the way back to superpower status. Russia is Europe’s main supplier of gas and gas-for-trade deals, and foreign acquisitions and control of its “near abroad” seem to be at the core of the country’s European economic policy. Oil is also its main source of leverage with China. As Christopher Weafer wrote, developing the oil and gas economy further has superseded the goal of diversification.

This choice would be disastrous. I believe that the clock is ticking on Russia’s oil bonanza. No one can tell when it will end — or whether the agony will be sudden or long and drawn out. The hydrocarbon windfall can help build a better future, but it is not that future. Russia desperately needs a new generation of leaders who do not regard the patrimony as a source of plunder and nationalist posturing. Unless it develops a public-spirited ruling class, the curse will have the last word.