Russia's economy

Smoke and mirrors
 

As Vladimir Putin stands aside (sort of), how much has he to do with Russia's booming economy—and how long can it last?

 

Eyevine

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FIRST appeared the wooden kiosks, selling everything from vodka to stockings. Vladimir Bulanov, a burly entrepreneur from Nizhny Novgorod, built them in his workshop in 1991. Then came his first shop, trips abroad, fridges from Belarus, mandarin oranges from Cyprus. By 1995 he was rich, sporting a red tie and a white linen suit: an archetype of Novy Russkiy, drawing jokes and contempt. Mr Bulanov no longer wears that suit, and fails to drive a Bentley (his dream car) only because “neither society nor the roads are ready for it.” Five years ago he bought an old and bankrupt factory making heating elements for samovars and submarines, and installed new German machinery which he shows off with delight.

The emergence of genuine businessmen like Mr Bulanov, and their acceptance in society generally, may be Russia's biggest achievement—and one reason why the economy is growing at 7% a year. But this has nothing to do with Vladimir Putin, who is standing aside as president this week. Mr Bulanov is no fan of Mr Putin; he prefers freedom to fear and corruption. “The only things that will stop me”, he says, “are a bullet or a prison cell.” The future of Russia will be determined by the contest between men like him and the machinery of the state.

Even Mr Putin's critics are impressed by Russia's transformation in the past few years. A country that almost went bust ten years ago now boasts a $1.3 trillion economy, foreign-currency reserves of nearly $480 billion and a $144 billion stabilisation fund for surplus oil and gas revenue. Annual growth of real incomes has been in double digits. GDP per head has risen from less than $2,000 in 1998 to $9,000 today at current rates of exchange.

Never before have Russians shopped or travelled so much. Restaurants, mega-malls and airports are heaving; streets are choked with foreign cars. Nor is the wealth confined to Moscow; every other city now seems to have a decent hotel, an Italian restaurant and a Hugo Boss store. Mr Putin boasts that this is the result of his presidency, and implies that most Russians would back Dmitry Medvedev, his chosen successor, even if the election were free and fair. Asked by a foreign journalist why there is no political competition and why Mr Medvedev has not taken part in televised debates, Mr Putin says: “The salaries here are going up by 16%. There's the answer to your question.”

Yet the truth is that Russia's economy began its rebound 18 months before he became president. Behind it lie three factors: a revival of private initiative, oil prices that have risen fourfold during his presidency and macroeconomic stability. Only the third can be credited to Mr Putin. The economy is now more dependent on oil than ever. And the outlook is bleaker: a slowing world economy means that oil prices may not rise further, and could even fall.

According to Mr Putin, the state was barely functioning when he took over from Boris Yeltsin in 2000. One of his most bellicose speeches lambasted his predecessors in the 1990s who “acted against state and society, who served the interest of oligarchic groups and squandered the national wealth, those who led Russia to the mass poverty and corruption with which we are struggling to this day.”

In fact, Mr Putin came to power at an unusually benign moment. The debt crisis and devaluation of 1998 had flushed out the financial system, removed constraints on the rouble and enforced fiscal discipline. With much of the economy in private hands and most prices liberalised, recovery inevitably took off. By the end of 1999 Russia was already growing by more than 6% a year. In 2000 growth accelerated to 10%, a rate still not matched eight years later. Symbolically, four days before Mr Putin was officially elected as president, the first IKEA store opened in Moscow.

To be fair, at first Mr Putin worked hard to consolidate growth. His government simplified and cut taxes. Budget reform brought clarity and stopped the government making unrealistic pledges on spending. Mr Putin not only chose a liberal economist, Andrei Illarionov, as his economic adviser, but also listened to him. For the most part Russia used its oil windfall prudently, repaying debt, building up reserves and filling its stabilisation fund. Many of the reforms conceived in the 1990s were passed at last, including legislation to improve the judicial system and allow a free market in land. The benefits of Mr Putin's early efforts are still felt today.

Where did it go wrong? Mr Illarionov, who quit his post in 2005, argues that the breaking point was the attack on Yukos that began in mid-2003. The significance of the Yukos affair went beyond the destruction of Russia's largest oil company and the imprisonment of its boss, Mikhail Khodorkovsky. It dictated the country's entire economic and political course.

The attack on Mr Khodorkovsky was presented as a crackdown on the oligarchs. Yet it created a new, more powerful and less visible caste that began to play a dominant role in the economy. The share of crude-oil production controlled by state and semi-state companies doubled. Growth in oil output, which before the Yukos affair had been running at about 9% a year, slowed to just 1% by the end of 2007.

Worse, the destruction of Yukos negated any efforts to strengthen the rule of law. “The problem is not that the Russian legal system is weak,” says Vitaly Naishul, who watches Russian institutions. “The problem is that it does not exist. The Russian justice system has as much to do with justice as the Soviet system of trade with trade.” That problem is as old as Russia, but under Mr Yeltsin the courts, however corrupt, were at least independent of the Kremlin. Under Mr Putin, judges have again turned into bureaucrats who rubber-stamp dubious administrative decisions.

The destruction of Yukos and the redistribution of its assets to Rosneft, a quasi-state oil company chaired by Mr Putin's deputy chief of staff, showed that property rights count for little. “After Yukos nobody can feel safe,” says the owner of a factory making kitchen shelves in Kaluga. Instead of cultivating the rule of law, as Mr Putin promised, Russia was subjected to the rule of thugs, says Mr Illarionov. What followed was not nationalisation, but a series of police-assisted raids and takeovers of private firms by new oligarchs. The targets included not only oil and gas companies but also a titanium producer, an airport operator and lucrative bits of property. As Vedomosti, a business daily, complained, “The practice is so widespread, it is impossible to list all the cases.”

Andrei Sharonov, a liberal reformer who left the economics ministry last year, says he underestimated the impact of arbitrary bureaucratic decisions. “We have turned our back on healthy competition. The system rewards those who are closer to the centre of power, not those who work better. It is easier to get a competitor into a jail than to compete with him.” Businessmen complain that corruption, already rampant in the 1990s, is now more entrenched, and the sums involved are getting larger.

Corruption is of two kinds. One sort is driven by private firms and individuals who bribe officials to turn a blind eye to the rules. This allows businesses to get around a net of conflicting and outdated laws. “If everyone followed every rule and instruction in Russia, the country would grind to a halt,” says Mr Naishul. The other kind of corruption emanates directly from the Kremlin and benefits state officials and their friends who double up as businessmen. Both damage the country, but the second is more insidious.

The deterioration of Russian institutions has been tracked by the World Bank, Transparency International, the World Economic Forum and Freedom House. Russia's corruption is on a level with Togo's. Yet foreign and domestic investment keep rising, along with Russia's credit rating. A survey of 106 foreign firms in Russia last year showed that 82% were broadly satisfied with the investment climate. Russian businessmen may grumble, but they still put up their money. Last year fixed capital investment rose by a record 21%, leading some economists to talk of an investment boom.

A recent raid by tax police on a small company that sells liquid oxygen explains the paradox. The taxmen came just before the new year to demand 5m roubles ($204,550) for “irregularities” in the accounts. The owners pulled local strings and, after a short negotiation, cut the demand to 500,000 roubles. They paid and the taxmen left. As one owner says, “It was unpleasant but didn't hurt much. Our monthly profit is 800,000 roubles so the bribe was just over half that. If we hadn't paid, the taxmen would still be here and we would lose more.”

The construction market in Russia is growing by nearly 20% a year. With a profit margin of 25%, the liquid-oxygen company can afford to pay bribes to a growing number of bureaucrats. “The inadequacy of political competition, the lack of media freedom will be felt over time. But for now there is enough low-hanging fruit for people not to take notice of it,” says Christopher Granville, an analyst at Trusted Sources, a research firm.

The real cost is one of lost opportunities. Growth of 7% sounds good, but it is far below Russia's potential. Over the past few years, Russia has been outstripped (though from a lower base) by the former Soviet republics of Ukraine and Georgia, which have no oil. If Russia enjoyed the rule of law, was not stifled by inefficient monopolies such as the gas giant Gazprom and had roads rather than vague directions, its growth—given the oil boom—could surely have been in double digits.

The structure of the Russian economy remains skewed towards a few giant companies, mostly forged from Soviet-era assets. Small and medium-sized businesses contribute less than 15% of GDP. The cost of opening a business is higher than in most other countries. Only 5% of firms have been created in the past ten years, according to the World Bank. And start-ups do not seem to push up the productivity of incumbents, a sure sign of weak competition. In even more worrying contrast to the 1990s, polls show that half of young Russians want to work in the government rather than go into business.

Russia's business climate and red tape also deter potential new investors. Although foreign direct investment (FDI) doubled last year to $27.8 billion, that is still only 2.2% of GDP—half the level achieved in Ukraine. Half of FDI went into mineral resources, and only some of it was genuinely foreign. (Tax havens are still the top investors in Russia.)

The share of oil and gas in Russia's GDP has increased, according to the Institute of Economic Analysis, from 12.7% in 1999 to 31.6% in 2007. Natural resources account for 80% of exports. Like a powerful drug, oil money has masked the pain caused to the Russian economy by the Kremlin. But the disease remains.

To appreciate the impact oil prices have on the economy, compare real GDP growth of about 7% with growth measured in international prices. In dollar terms, says Rory MacFarquhar of Goldman Sachs, Russia's economy has grown on average by 27% a year, the fastest of any big economy since 2000. The flow of petrodollars is fanning a massive consumption boom, making Russia the sixth-biggest market in Europe. Disposable incomes (and retail trade) have been growing twice as fast as GDP.

The problem, says Peter Aven, the head of Alfa Bank, is that Russia has failed to convert the oil stimulus into domestic production. Imports are growing much faster than manufacturing. The rapid real appreciation of the rouble is hurting Russia's producers, and many goods are of poor quality. This is why Algeria says it wants to return 15 military jets it purchased from Russia.

Productivity remains far below that of most developed countries. In the first years after the 1998 crisis, labour and capital efficiency went up by 5.8% a year. But that growth was driven by using spare capacity left from Soviet times. Sustaining it will require more investment.

Meanwhile the economy, unable to digest the money generated by the oil-and-gas boom, is clearly overheating. Inflation moved into double digits in late 2007, pushed up by, among other things, a huge inflow of capital attracted by swelling reserves and the strong rouble. Unlike oil revenues, which can be partially channelled into the stabilisation fund, this money cannot easily be absorbed.

As Kirill Rogov of the Institute for the Economy in Transition explains, in most emerging markets the bulk of capital inflows come in as direct investment. In Russia, they take the form of loans. Investors clearly prefer to lend money to Russian companies, especially if they are state-controlled, rather than to invest directly. (In fact, FDI in sectors other than energy has fallen from 1.6% of GDP in 1999 to just 0.65% in 2007, according to Mr Illarionov.)

AP

Taking the credit on every channel

Russian corporate debt stands at $400 billion, only slightly below the official foreign reserves. By some estimates, about half this debt was accumulated by state-controlled banks and companies, such as Gazprom and Rosneft, in the course of taking over private assets and (in the case of Gazprom) buying up electricity-generating capacity. They were not spending money on their core business, or to boost productivity. Some state companies are now lobbying the Kremlin to pay off their debts. Cheap credit from foreign banks has oiled the emergence of Russia's state capitalism and its foreign expansion; but this economic model relies on rising oil prices and cheap money.

Officials have been trying to persuade themselves and others that Russia is an island of stability in a sea of economic troubles. But Yegor Gaidar, a liberal economist and former prime minister, says the Russian economy is highly sensitive to swings in the world economy. When global growth slows, oil and metal prices tend to fall and money flows out of emerging markets. (In January Russia saw a renewal of capital outflows.)

When the oil price is unpredictable and inflation is in double digits, spending more money seems unwise. Yet this is what Russia has been doing. After years of fiscal discipline, last year's budget saw spending rise by 20% in real terms. Over the past eight years spending on state bureaucracy and law-enforcement agencies has doubled as a percentage of GDP, and the number of bureaucrats has risen from 522,000 to 828,000.

The main beneficiaries of the spending increase last year were newly created state corporations, including those involved in nanotechnology and the 2014 winter Olympics—and those bureaucrats, who are skilled at enriching themselves. Russia ranks fourth in the world in creating new millionaires. A shiny new Bentley, spotted recently outside an expensive Moscow restaurant, carried a special pass on the windscreen linking it to the Supreme Court.

It is little wonder that the gap between the top 10% and the bottom 10% of the population is growing, along with a sense of injustice. Russians have turned a blind eye to all this because average incomes are rising. If the trend reverses, they may start to ask harder questions.

What happens next will depend on the government's flexibility. It could tap into reserves and the stabilisation fund. If the oil bonanza stops and the government continues to spend at its current pace, thinks Mr Gaidar, Russia's reserves will last for about three years at most. The alternative is to liberalise the economy, strengthen property rights and break up Gazprom. With Mr Putin's track record (and he has promised to be Mr Medvedev's prime minister), this second course is unlikely.

But Yevgeny Gavrilenkov, chief economist at Troika Dialog, says that swings in the balance of payments concentrate the minds of all Russian leaders. At the moment they can afford to be arrogant and aggressive. But if the oil price stabilises and money stops flowing in, the Kremlin may become a friendlier place. After a decade of growth, Russia is still only back to the level it reached just before the fall of the Soviet Union. And one thing is certain: it will not reach first-world prosperity, as promised by Mr Putin and Mr Medvedev, with third-world institutions. To grow further, it will need to dismantle the lawless system Mr Putin has created.