In this background note I will cover, first, the broad character of recent developments in the Russian economy and Russian economic policy; then the recent development of Russian state finances; the role of oil and gas; the changing levels and composition of Russian external debt; and prospects. I also include a brief end-note on economic dependence.

BACKGROUND:  RECENT DEVELOPMENTS IN THE RUSSIAN ECONOMY

  Two quite different tendencies can be seen in recent Russian economic development. On the one hand, the state has become more interventionist since 2003, acting in ways that seem damaging for the business environment. On the other hand, private Russian and foreign investment in the economy has continued to grow strongly. GDP growth has averaged 6.7% a year from 1999 through 2006, with no obvious slowdown in the second half of that period. The coexistence of these two tendencies is not easy to understand. Whether buoyant growth can continue alongside such heavy-handed intervention in the long run, is not clear. So far, the two have coexisted for almost four years—a long enough run for many purposes.

  The state has intervened in ways that are incompatible with the rule of law. It has made selective use of the tax, environmental and natural-resource licensing systems to destroy the Yukos oil company and re-nationalise most of its Russian assets, and to enable Gazprom to acquire a controlling stake in Sakhalin Energy (by purchase from Shell, Mitsui and Mitsubishi, but a purchase conducted under administrative pressure); and it is in the process of securing a controlling stake in the Kovykta gas field for Gazprom at the expense of TNK-BP. Less attention has been paid in the Western media to the use of similar tactics in the acquisition by the state arms-trading company, Rosoboroneksport, of control of the giant titanium producer, VSMPO-Avisma, from private Russian owners. State holding companies are being established in a number of sectors—so far, in defence-related industries, but there has been some talk of going further.

  When the Yukos affair began, some observers pointed out that nobody believed the rule of law prevailed in Russia in the first place; therefore, the argument went, events like the state attack on Yukos did not alter expectations: a high political risk was already priced into Russian assets. Indeed, leading economic indicators do not show much obvious damage. Nonetheless, the Yukos affair marked a change of trajectory in Russian economic policy, and the amount of attention it received in the Russian and foreign media suggested that it was not seen as normal, even for Russia. The flattening of the Russian stock exchange (RTS) index in 2004 and the surge in capital flight in 2004-05 probably reflected some loss of business confidence; still, this was a blip, and did not last long.

  One interpretation, favoured by Yevgenii Yasin, the doyen of Russian liberal economists, is that there have been real costs to the Russian economy, but they take the form of economic growth forgone; the pace of Russian GDP expansion, while high by international standards, has been considerably lower than it would have been in a liberal environment. It is true that total gross fixed capital formation, at about 19% of GDP, and inward foreign direct investment (IFDI), at about 3% of GDP in 2006, are both rather modest for a middle-income country engaged in catching up the more advanced economies. Another interpretation is that any longer-lasting damage to business confidence is confined to certain sectors, notably oil: that Russian and even foreign investors soon grasped the new informal rules of the game: business as usual outside a few industries.

  Certainly the state is re-occupying the oil industry.

  Sources:   Derived from Rosstat; OECD; Gazprom.

  At the same time, the growth of output and export volume of oil has slowed strikingly. This cannot be blamed entirely on re-nationalisation, but it probably cannot be fully explained without reference to state take-overs. Until summer 2006 the slowdown was masked by rising oil prices. (See Chart 2 below.)

  The earlier dynamism in oil production, in 1999-2004, was provided by private firms. Unless it is recovered soon, oil earnings will depend largely on world prices, whereas earlier they were driven by both price and output-volume growth. The implications for Russian GDP growth will be discussed later.

  Source:   Derived from Russian Customs Service data.

  Note:   Volume includes oil products as well as crude oil.

RUSSIAN STATE FINANCES

  For most of the past eight years, rising oil and gas prices have helped strengthen Russian public finances. Those finances have been well managed. This has been the achievement primarily of the Finance Minister, Aleksei Kudrin. But it is notable that Kudrin's fiscal conservatism has been supported by President Putin against all the lobbies that would love to raid the foreign reserves and the stabilisation fund.

  Recovery after the 1998 financial crisis was kick-started by the big devaluation of the rouble that was forced on the Russian authorities at the time. This revived domestic manufacturing. Previously, industry had been close to collapsing in the face of import competition. Then oil-price rises boosted state, company and household incomes, financing consumption and investment spending that lifted economic activity in both goods and services production. (The rapid growth of spending power also boosted imports, and there is some evidence that Russian production of tradeable goods outside the natural-resource sector is again losing ground to imports. The real exchange rate of the rouble has appreciated to about where it was before the 1998 devaluation. Rapid restructuring, modernisation, cost control and new investment might have offset this loss of competitiveness, but there has probably not been enough restructuring.)

  Public finances, meanwhile, are strikingly robust. End-2006 foreign-exchange reserves were almost twice the level of 2006 merchandise imports ($295 billion against $163 billion). The federal budget last year showed a surplus of 7.3% of GDP. (Regional and local budgets are in aggregate roughly in balance, and are more or less constrained to remain so, with severe restrictions on borrowing, and the assistance of transfers from the centre.) The stabilisation fund, based hitherto on tax revenues on oil—not gas—above a threshold export price, was in March 2006 $108 billion, or about 10% of GDP. (The arrangements governing the stabilisation fund will change from February 2008; the changes will be described below.) At this level relative to GDP, the fund could be drawn down to maintain budget spending at planned levels for three years in the face of a halving of world oil prices.

  The stabilisation fund has been used to sterilise foreign currency inflows, reducing inflationary pressure from booming export revenues. This has been done not only by building up the fund but also by deploying substantial tranches of it to pay down state foreign debt, often ahead of schedule. Debt developments will be described in a separate section below. The bottom line is that public debt to non-residents, including debt owed by the Central Bank of Russia, was at end-2006 about 5% of 2006 GDP—a minuscule amount.

THE ROLE OF OIL AND GAS

  Overall, the Russian public finances are in enviably good shape. But it should be noted that the dependence of exports, the budget and GDP on oil and gas is high.

  Sources:   Central Bank of Russia; Kudrin lecture at Higher School of Economics, 21 February 2007 (for value added in oil and gas as % GDP in 2006, presumably at current prices).

  So far as mutual dependence between Russia and the West is concerned, the relationships are closest with Europe. In 2006 Russia conducted 53% of its merchandise trade (imports plus exports) with the EU of 25 nations, as it then was. That compares with only 15% with other CIS countries and a mere 4% with the US. This is roughly what one would expect from gravity models of trade, which predict the partner-composition of countries' merchandise trade from their economic size (eg, total GDP) and the distances between them. [1]Movements of capital are less influenced by distance; Russian outward and inward FDI (for example) are more geographically diversified than trade. Business and leisure travel by Russians, and acquisitions of personal property (yachts, country houses, football clubs) are again more focussed on Europe. So are banking and stock-market links, with Russian companies' initial public share offerings (IPOs) lately concentrated on the London Stock Exchange.

  Most Russian gas and oil that are exported outside the CIS go to Europe. In 2006 44% of Russian oil output and 24% of gas production went to non-CIS exports. Since domestic sales are at significantly lower prices than exports, the major contribution that oil and gas make to the Russian federal budget (almost a half of revenue—see Chart 3) is dominated by revenues from the European market.

  Does that provide Europe with leverage over Russia? The answer is: almost certainly not. That is because Moscow is a single actor controlling one side of the transactions, and there is no single actor on the European side. Russia can and does strike bilateral energy deals, specifically over gas supplies, with individual EU countries.

  At the same time there is Russian talk of diversifying their markets, and switching their energy supplies to Asia. That is not a serious concern for the short or medium term. The extent to which, and the prospective period of time over which, Russian oil and gas earnings are tied by the pipeline system to Europe are complicated subjects. Here it may be enough to say that Russia has few market alternatives over the next few years. Sakhalin oil and gas are starting to go to Asia-Pacific markets. That includes liquefied natural gas (LNG) deliveries to Japan and Mexico (the latter partly for the US West Coast market). Development of oil and gas pipelines to China and the Pacific coast are at an early stage. Broadly speaking, eastwards deliveries of hydrocarbons depend on the development of reserves in Eastern Siberia and the Russian Far East (the latter including Sakhalin). Only if some West Siberian oil or gas is diverted in future to eastbound pipelines would a geographical diversification of Russian markets be at the expense of traditional sources of supply to Europe, and that would be very costly.

  Russia may therefore be said to be stuck with Europe, at least for the next few years, and probably for longer. The problems for Europe, including for the UK, are twofold.

  The first one was mentioned three paragraphs above: Russia can bargain more effectively over energy supplies than Europe, or any one European country, can. It is true that the relationship is one of mutual dependence: we need the oil and gas; they need the money. But it is not symmetrical. This is because the Russian state, acting through Gazprom, its statutory gas export monopolist, and Transneft, the oil pipeline monopolist, is a single actor, and the European Union, in this particular context, is not. The energy dependence of EU states on Russian supplies varies greatly, and national monopolies or near-monopolies like E.On, Gaz de France and ENI make ready partners for Gazprom, with both sides having incentives to sign long-term gas supply contracts (the oil market is more open). Lobbying by their own national champions reinforces the desire of many European governments to seek bilateral energy deals with Russia.

  The Competition Directorate of the European Commission has been seeking to break up European gas and electricity monopolies and move Europe towards more open and flexible markets. That would weaken the influence of Gazprom in particular national markets, but it is not likely to happen soon.

  The second problem is this: Russia's ability to maintain and increase the volumes of oil and gas deliveries to Europe is in doubt. The major existing gas fields are in decline. Russian domestic gas consumption is growing. It rose at 1.4% per annum in 2000-05 (BP Statistical review of Energy, 2006). EU gas consumption has been rising somewhat faster, at 2.3% pa over the same period (ibid.). Gazprom's own production (it accounts for around 90% of the Russian total) is approximately flat. Its plans for raising supplies rest on a growth of gas production from Russian independent producers (including oil companies) and the acquisition at favourable prices of growing amounts of Central Asian gas—which for the time being lacks other means of reaching rich markets. Meanwhile Gazprom is also buying its way into Russian projects that others have brought close to fruition (Sakhalin Energy, Kovykta), using state muscle to encourage the original owners to sell. What it is not doing very much of is upstream development of its own. Its $20.1 billion investment programme for 2007 includes $6.4 billion for acquisitions, against $3.9 billion for development of major fields. Its recent acquisitions have included a good deal that was outside the industry: media businesses and power stations, in particular.

  Russian oil is extracted by a mixture of private and state enterprises. The disappearance of two leading private companies, Yukos and Sibneft, into the state sector, together with constraints on (state-controlled) export pipeline capacity, seems to have taken the dynamism out of oil-industry development.

  The Russian authorities have been reliable energy suppliers to Europe in the past, except for hiccups in January 2006 (gas) and January 2007 (oil). They are hardly likely to want to lose their reputation as reliable suppliers. The two hiccups in supply are best understood as unintended side-effects of badly-managed attempts to alter the terms of their energy relationships with other CIS countries—in these two cases, Ukraine and Belarus.

  Russian policy-makers could release more oil and gas for export to Europe by raising domestic electricity and gas prices and thus curbing demand. Russian industrial and household energy usage is wastefully high, and the present low prices are a disincentive to invest in more energy-efficient equipment. For obvious political reasons, however, there are limits on the rate at which those domestic prices are raised.

  To sum up: Russia needs Europe, so far as its energy sales are concerned. Moscow, however, has a strong bargaining position over energy because it is a single actor while Europe is not. Russian policymakers have no interest in appearing unreliable as energy suppliers, but bungled policy-making sometimes jeopardises their supplies to Europe; and their ability to raise energy supplies to Europe substantially in the next few years is doubtful.

RUSSIAN EXTERNAL DEBT

  In the 1990s, when Russia was economically very weak and politically turbulent, the Russian state was in poor financial shape and had substantial debts outstanding to the Western world—partly inherited Soviet-era debt to Western banks and Western and other governments, and partly post-Soviet debt, including to the IMF and World Bank. This gave Western governments some leverage over Moscow. That leverage has now gone. Russian public external debt has been paid down.

MEMORANDUM ITEMS

2006

Public external debt defined to include debt of commercial banks that are at least 50% state-owned

  148.7

  GDP  978.7

  Notes:   General: total and Paris Club debt are denominated in a variety of currencies, so the dollar total can change over time because of changes in exchange rates; London Club debt to Western banks, also from the Soviet era, was completely paid off during the period covered by the table.

  Sources:   Central Bank of Russia

(www.cbr.ru/statistics/credit_statistics/print.asp?file=debt_06.htm [and 05.htm, etc for earlier years]; the first memorandum item is from:

www.cbr.ru/statistics/credit_statistics/print.asp?file=debt_an.htm); the GDP figure is from Troika Dialog.

  Meanwhile, as the Russian state's credit rating has risen—latterly to investment grade—and the Russian economic boom has continued, Russian firms have increasingly borrowed in the West. As public external debt has fallen, Russian private debt to non-residents has risen. Chart 4 illustrates this. "Business debt" here is outstanding indebtedness of Russian non-bank corporations to non-residents.

  Source:   as for Table 1 debt figures.

  The bottom line—to repeat—is that the Russian authorities now owe the West very little. They are financially strong. Russian company debt to Western lenders has been growing, but this does not compromise the financial independence of the Russian state. Indeed, the Russian state plans to inject funds into Western capital markets. The Russian government plans from February 2008 to split the stabilisation fund into a reserve fund of about 10% of GDP, conservatively invested (as it is at present) in other governments' securities, and a future generations fund, invested in (mainly foreign) stocks and shares. It is estimated that the future generations fund will start at about $24 billion.

PROSPECTS

  Some slowdown is widely expected in the Russian economy over the next few years. It is of course possible to construct all sorts of scenarios, including some gloomy ones combining large and sustained falls in the oil prices with open conflict within the political elite over (or just after) the Putin succession in 2008. But it makes sense to focus here on two baseline scenarios.

  The Russian government recently adopted an economic projection to 2010 in which GDP growth slows from the 2006 year-on-year rate of 6.7% to 6.0% in 2009, turning up slightly to 6.2% in 2010. This is a scenario that assumes some success in switching Russia towards becoming more innovative, and therefore more competitive outside the natural-resource sector. The slowdown stems in part from a projected movement downwards of the average annual Urals oil price to $50 a barrel in 2010. Given the projected modest deterioration of export prices alongside continuing domestic economic growth, the current account balance-of-payments surplus declines and disappears over the period. That in turn assists a modest further disinflation to around 5% (consumer price index) in 2010 (www.economy.gov.ru).

  The Bank of Finland, which has an outstanding team of Russia analysts, has put out a forecast through 2009 that is slightly more downbeat: GDP growth in the BoF projection is 6.4% in 2007, 5.8% in 2008 and 5.6% in 2009 (www.bof.fi/bofit_en/seuranta/ennuste/index.htm). Their assumptions about the oil price are similar to those of the Russian government. They, too, foresee the disappearance of the current-account surplus.

  These projections look reasonable, as starting points. The Russian economy now has considerable momentum. A substantial middle class has emerged, and is spending freely, propelling among other things a rapid growth in the service sector. A population that suffered grievously from inflation in the 1990s shows no sign of pressing its political class to go in for a splurge of public spending, despite the sorry state of Russian infrastructure and public services. Putin has spoken in populist terms about his `national projects' in health care, education, affordable housing and agriculture, but spending on them last year was only 0.7% of GDP, and they have not been pursued to the detriment of the stabilisation fund. Investment growth is strong despite uncertain property rights. There is no obvious reason for that to change.

  There are several signs of normalisation in the Russian economy, notwithstanding the authorities' turn towards statism. The gross private-sector capital outflow from Russia dipped from $50 billion in 2005 to $40 billion in 2006 and the portion of that outflow that was capital flight—as distinct from officially recorded outward foreign investment—declined. After 2004 the net private capital outflow turned into an inflow. [2]The removal of capital controls in mid-2006 has helped; meanwhile a number of big Russian companies are turning themselves into transnationals: the most active recently have been in metals: Norilsk Nickel, Rusal (now, as Rossiiskii alyuminii, the world's biggest aluminium producer, ahead of Alcoa), Polyus Gold, Severstal and Evraz. These are private companies. They no doubt consult the Kremlin ahead of any major move, but their progress onto the world stage has a commercial logic and probably gives them a little more independence from the political elite. Russia is no longer an anomalous middle-income country that exports more capital than it imports. It is now importing capital, on balance, but also—like other emerging-market economies—growing its own transnational companies.

  Factors tending to slow Russian economic growth, regardless of changes in the oil price, are the following.

—  The working-age population has started to decline.

—  Manufacturing is contending with a rapidly-rising real effective exchange rate (the inflation-adjusted exchange rate of the rouble against a trade-weighted basket of currencies).

—  Transport and other physical infrastructure are in poor shape.

—  The investment share of national income remains low for a country that has good opportunities for catching up the rich world.

—  Studies by Professor Cooper (Birmingham University) and Professor Tabata (Hokkaido University) show a striking lack of export competitiveness outside the natural-resource-based industries, and a decayed research, development and innovation system.

—  The state's increasing control of the oil industry seems to be taking the dynamism out of what has been a key source of growth (see above). If such control is extended further, the consequences will be correspondingly worse.

  The balance of evidence and arguments suggests a modest slowdown in the medium term. A return to market reform and a reduction of ad hoc state intervention would help, but are not on the present political horizon.

END-NOTE: SOME OBSERVATIONS ON ECONOMIC DEPENDENCE AND INDEPENDENCE

  National economic separateness, or near-autarky, has since World War Two been an unusual state of affairs. Myanmar now and Albania after it broke with both Moscow and Beijing are two examples that come to mind. Even the USSR after Stalin was far from economically independent: it came to depend quite strongly on Western technology and grain. Economic independence on the pattern of Albania or Myanmar brings only limited advantages to a nation's political leaders, and those are perhaps chiefly to do with keeping their own population under control.

  What has happened in Russia since the 1990s is a shift from economic weaknesses, indebtedness and aid receipts to economic strength, financial robustness and a considerable degree of interdependence, chiefly with Europe. The present Russian leaders have made the most of a national sense of recent past humiliations and present economic recovery. It is helpful for them domestically to play up Russia's new-found strength by repeating that they will not be lectured to about "values" or how to conduct themselves in Chechnya, and by withholding their agreement on Iran or Sudan or anti-missile shields.

  It is a big step from this sort of muscle-flexing to a deliberate manipulation of (say) gas supplies to Western Europe to compel agreement in some other area of policy. That is not to say that such use of the energy lever is impossible, but it would have high costs to Moscow in the long run, and would at the very least not be lightly used.

  Another source of Russian influence over West or Central European countries' policies may be quite unrelated to Russia's economic strength: namely, the buying or blackmailing of leading politicians. Some recent events suggest this is not as far-fetched as it may sound.

Professor Philip Hanson

Chatham House and CREES, University of Birmingham

30 April 2007

2   Calculated from Central Bank of Russia balance of payment data. Details available if requested. Back