Market euphoria and political torpor

by Simon Pirani

The broader economic and political view, though, is cloudier. Although the economic reformers are fighting their corner against the siloviki (men of force) in the Kremlin power game, government indecision and lack of investor confidence has told on growth. Corruption is rampant. And the prospects of improvement between now and the 2008 presidential election seem limited.

Stock markets care more about prices today than politics tomorrow, and the Russian Trading System (RTS), Moscow’s main index, hit an all-time record 815 points in mid-August – a recovery of all the losses that resulted from last year’s government assault on, and break-up of, Russia’s most succesful oil company, Yukos.

Similar confidence was displayed at the initial public offering (IPO) on the London market of Novatek, Russia’s only substantial non-state gas producer, in late July: it was 13 times oversubscribed.

But Russia’s economic growth is disappointingly slow, given the fabulous riches generated by the oil boom, and president Putin’s target of doubling GDP in ten years looks more and more unrealisable.

“Although president Putin realises that reforms are a key, the lack of strategic decision-making is translating into slow growth and higher inflation,” says Michael Marresse, head of CEEMEA economic research and sovereign strategy at JP Morgan Chase.

“For example, investment in the energy sector has been stagnant, due to confusion over who will control oil and gas assets, painfully slow decisions on new oil and gas pipelines, and extremely high marginal tax rates that provide little incentives to oil producers to boost output.”

Nevertheless, the economic reformers in government are holding their own, Marresse notes. The recent decision to keep VAT at 18% for 2006-08, opposed by the siloviki who wanted a populist cut in the rate, was indicative, he says. Two other proposals in the pipeline – to restrain tax auditors’ power and to introduce legislation that would end examinations of the 1990s privatisations – point in the same direction.

Oleg Vyugin, head of Russia’s stock exchange regulator and a leading economic reformer, told Emerging Markets that further progress in establishing the rule of law in business is a key to further reform. “New ethical standards must be implemented in courts’ practices and in judges’ behaviour”, he said.

In terms of market regulation, Vyugin said that property rights protection will be improved by the establishment of a central depository system: “this will give more comfortable access to the stock market for companies planning IPOs”. Other legislation is planned to target the use of insider information, and to establish a framework for derivative trading, which the Russian market lacks.

Vyugin said that improving the investment climate is vital in order to make good use of the oil bonanza. “Russia has an extremely high trade surplus this year: it will amount to up to $120 billion or 20% of GDP. To use this more effectively, the government must make the investment environment more attractive and increase the domestic savings ratio.”

Russia’s problem is that Putin is surrounded on the one hand by reformers such as economic development minister German Gref (see interview this page) and Vyugin, and on the other by the “siloviki”, whose priority is to increase the state’s role in strategic economic sectors. Their most prominent representatives are said to be Igor Sechin, deputy head of the presidential administration and chairman of the state oil company Rosneft, and telecommunications minister Leonid Reiman. And the president does not want to take sides.

Some observers are concerned that these relationships may paralyse government. Ian Bremmer, chairman of the Eurasia Group, a political risk consultancy, told Emerging Markets: “The concentration of power at the Kremlin has increased dramatically, with the switch to the direct appointment of governors, and the greater influence of of the presidential adminstration over the judiciary, parliament and the media. But within the Kremlin, Putin himself has become withdrawn and indecisive.

“Putin is making himself into a lame duck president. Whether the conflicts between the groups of people around him are being fought for policy reasons or for personal gain, they are not to the benefit of the state or the economy.”

The assertion of state power against business in the Yukos affair has exacerbated another problem: corruption. A recent survey by the respected Moscow research institute Indem showed that the total volume of the “bribes market” this year stands at $319 billion, 11 times more than when a previous survey was undertaken in 2001 and more than twice the federal government’s budget.

More than 99% of the bribes are paid by businesses, and the recipients are mainly in the executive branch of the state, i.e. tax and other inspectors, police officers and other authorities.

Christopher Granville, chief strategist at the United Financial Group in Moscow, noted that the survey showed that “officials have learned to exploit their comparitive advantage in the corruption market, i.e. where their ‘services’ can not be avoided, to extort more from both citizens and businesses” – but said that signs found by Indem that people were ready to resist corruption where there was a choice “highlights the potential of deregulation, better regulation and liberalisation in squeezing out corruption”.

“The level of corruption is intolerable”

Interview with German Gref, minister of economic development and trade of the Russian Federation. By Simon Pirani

Q: Last month you reported to the government that GDP growth is slowing down. What strategies will be adopted to solve this problem and increase growth?

A: We have just completed analysis of the results of the first half of 2005, and reached the following basic conclusions. First. Previous sources of GDP growth, and in the first place the build-up of oil and gas exports, are practically exhausted. The growth of oil exports in the first half of 2004 was 22.7%; for 2004 as a whole, 15%; and for the first half of this year, only 4.2%.

Second. A positive aspect of this year’s picture is that domestic sources of development have come into play, and partly compensated for the declining impact of external factors. This resulted in an increase in the rate of growth in the second quarter over the first quarter. The expected growth rate for the year is 5.9%. First-half growth was 5.6% this year, compared to 7.7% last year.

Third. In any case, this increase in the second quarter is not stable, since outside the natural resources sector there are so far no sources of growth, except in communications.

To achieve stable growth rates near to our target of 7% plus per year, we need a substantial improvement in the quality of growth, and a shift from natural resources to innovation-oriented development.

Institutional changes are the most important part of this strategy. In the medium term these will, firstly, allow the state to play a more effective role, through administrative and judicial reform, reform of the system of management of state property, local government reform and the development of private-public partnerships. Secondly, they will raise business competitiveness by strengthening property rights, improving tax and customs administration and anti-monopoly regulation, developing financial markets, improving the quality of corporate governance, developing mechanisms to support small business, achieving effective integration in to the world economy, reforming the natural monopolies and making financial institutions more transparent.

Along with these institutional reforms, and qualitative development of our human resources, we need to shift to innovation- and investment-centred approaches to development, and to the implementation of a system of strategic national development projects that will have the state’s active organisational and financial support.

These strategies fall into three groups. First: development of infrastructure and the traditional sectors of the economy, i.e. transport, oil and gas and agribusiness. Second, development of the new economy: science and innovation, information and commuinication technology, aviation and the military-industrial complex. The third group of strategies concerns the development of human capital: education and health services, the formation of a market in housing, housing services and construction.

Q: What is the effect of high oil prices on the Russian economy and how serious is the danger of one-sided economic development? What is the best way to combat “Dutch disease”?

A: In 2005 the share in GDP growth of external price factors remained the same as in 2004. The dynamics of world oil prices suggest that the Russian economy is now moving into a phase at which further oil price rises will not boost GDP growth further. The oil price falls forecast in 2006-08 equate to a 1 percentage point reduction in GDP growth. The trend towards a reduction in the share of external factors could lead to a fall in the GDP growth rate in 2006 by up to 4-5%. If domestic factors are not activated, under conditions of falling world prices, then in 2007-08 growth rates could go down to 4.3-4.5%.

In the medium term, the sensitivity of the Russian economy to rising oil prices, especially above $30-35 per barrel, will abate substantially. Not only will the heavier tax burden result in less flexibility in production and export as prices rise, but also the strengthening of the real exchange rate will reduce the competitiveness of our processing industry.

Q: International investors have become very cautious about the investment climate in Russia. What can be done, and what is being done, about this?

A: If we discuss facts and figures, we can see steady improvement over a long period: for example, foreign direct investment grew by 130% in the first half of 2005. The tax burden has been reduced, administrative barriers cut back, SMEs given support and many aspects of the legal framework put in order.

Nevertheless, there are three reasons that Russia is insufficiently attractive for investors. The most important one, in the investors’ view, is corruption, the level of which is intolerable. The fight with corruption is one of our priorities. The two other reasons are – a lack of information, which produces in investors’ minds all kinds of myths, and finally, and we are well aware of this, the Yukos affair. On this last point I’d like to say two things. Firstly, we can’t constantly look back at the past. And secondly, today you can do business in Russia without breaking the law, and in that case there will be no reason to fear for your investments. As for the lack of information, the ministry of economic development has established an English-language version of its web site, is preparing a special investment bulletin, and taking other measures.

Q: What else would you like to say to the decision-makers at the IMF/World Bank meeting in Washington?

A: I think that the representatives of these international organisations very well know all that has been said already. We need their objective assessments, even if they are not always pleasant to hear. Moreover, I would like to address investors, who have to resolve the dilemma “to be or not to be?” Russia has great potential, natural and human. The economic upheavals are in the past and we have established the foundations of an internally stable economy and the basis for long-term growth.