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Is Russia’s Economy Running out of Energy?

Author: Lionel Beehner
October 28, 2005

Introduction

Russia’s oil exports are up, its currency is strong, and its gross domestic product (GDP) growth has hummed along at a 7 percent clip for the seventh year in a row, surpassing all other Group of Eight (G8) members. Maybe President Vladimir Putin’s pledge to double Russia’s GDP does not sound so farfetched.

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Think again, some economists say. While Russia’s economy, buoyed by an increase in global demand for oil, has fully rebounded after the 1998 collapse and ruble devaluation, experts urge caution. Recent growth, like a Potemkin village, is not what it seems on the surface, due more to skyrocketing world oil prices than to sound macroeconomic policies.

Indeed, Moscow has expanded control over Russia’s main cash-cow: energy. “The Russian oil and gas sector’s new paradigm can be summarized in two words: ‘state domination,’” Ariel Cohen, a senior research fellow at the Heritage Foundation, wrote in a February 2005 executive memorandum. “The free-market paradigm has been abandoned.” For example, the government’s October 2003 arrest of Mikhail Khodorkovsky, formerly Russia’s richest man and head of the country’s second-largest oil company Yukos, sent shockwaves through the market (In the year after Khodorkovsky’s arrest, capital flight—only $2.9 billion in 2003—soared to $9 billion). Gazprom, the state-controlled gas behemoth, recently acquired Sibneft, Russia’s fifth-largest oil firm, and now enjoys a near monopoly on the country’s gas production and vast network of pipelines.

Hence, Moscow’s maneuvers have validated charges that Russia’s economy is unhealthily tied to oil, a commodity whose value fluctuates widely. “In 1998, when world oil prices dipped to around $10 a barrel, this drop coincided with the worst of Russia’s economic crises and the collapse of the ruble,” wrote Fiona Hill, a senior fellow with the Brookings Institution, in a December 2004 article in the Globalist. This has fueled concerns among investors that Russia’s oil-driven boom may prove short-lived, that energy companies will be unwilling to reform their outdated pipeline networks, or that the government will squander its newfound surpluses. Added to these worries is Russia’s inflation rate, currently at 11 percent, which some investors say could inch upward in the coming years. Economists—some of whom recently sent a sharply worded letter to Prime Minister Mikhail Fradkov—are also concerned about Russia’s surge in government spending, much of it allocated to Russia’s cash-strapped regional governments. Then there’s growing talk of Russia’s “Dutch Disease,” which means that high commodity prices are driving up the value of the ruble, which in turn makes Russia’s manufactured goods less competitive abroad.

A Tale of Two Russias

All of the above has contributed to the growing gap between the country’s rich and poor, experts say. Despite Russia’s 88,000-plus millionaires, 20 percent of the country’s population lives below the poverty line (that is, they earn under $38 per month). The growing economy has not broken up the country’s state-run conglomerates, which are similar to South Korea’s government-owned, inefficient chaebols. Yet their growth has crowded out small and medium-size businesses. In March, President Vladimir Putin jokingly said anyone who opened a small business in Russia should be given a medal of bravery.

The problem, experts say, is not so much starting a small business, made easier by new Russian tax rules, as it is growing a business. Under Russian regulations, any business larger than a newspaper kiosk is considered mid-sized, according to the Economist, and thus taxed accordingly. Tax breaks are only offered to small businesses, which employ roughly a quarter of Russia’s population but make up just 3 percent of tax revenue. Once a business grows to middle-income status, so does its tax burden, but disproportionately so: Profit taxes, for example, jump from 6 percent to 24 percent. Experts say the fear behind these tax rules is if mid-size companies were afforded a more simplified tax code, then large companies like Lukoil might break into thousands of tinier companies to enjoy similar tax benefits. Adding to tax problems is the difficulties small firms face securing bank loans.

Also adversely affecting Russia's wealth gap is corruption. This year’s Global Perceptions Index by Transparency International, an anti-corruption watchdog organization, ranks Russia ninetieth out of 146 countries, between Niger and Sierra Leone. A 2005 report by the INDEM Foundation, a Moscow-based pro-democracy organization, estimates businessmen pay $316 billion in bribes each year, more than half Russia ’s GDP. Moreover, the size of the bribes has risen from $10,000 on average in 2001 to $135,000 in 2005. As Dmitry Larionov, chief expert of the International Road Union, recently told Vremya Novostei, “The ingenuity of bribe-taking officials knows no boundaries.”

Some positive signs

The good news is that businesses big and small appear to be paying their taxes more. Total tax revenues climbed from $40 billion in 2000 to $153 billion in 2004. Individual Russians are also increasingly paying their taxes, thanks in part to a simplified 13 percent personal-income flat tax instituted in 2000. Adjusted for inflation, income tax revenues have risen by 14.4 percent, now supplying 31.9 percent of the revenue to Russia’s cash-strapped regions.  

More important, say economists, Russians are beginning to invest more, though Alfa Bank, a Moscow-based investment bank, estimates that Russians continue to keep nearly twice as much of their rubles under mattresses as they do in banks. Bank loans, credit cards, and mortgages are now commonplace in Russia’s big cities. More money, some $3.5 billion, is going into closed private funds, according to Alfa Capital, Alfa Bank’s asset-management arm, as regulators begin to squeeze offshore tax shelters.

Private consumption is also up in recent years. Nowhere is this more evident than in Russia’s booming retail market. Over the past five years, retail turnover in Russia, around $41 billion in 2003, has surpassed GDP growth, making it “one of the most promising sectors of the country’s economy,” wrote Peter Necarsulmer, chairman and chief executive officer of the PBN Company, a strategic-communications firm, in a January BISNIS Bulletin op-ed. This growth has been buoyed by the emergence of international retail chains, like Turkey’s Ramstore or Sweden’s IKEA, throughout Russia’s fast-growing suburbs. For those well-heeled: Bentleys, Ferraris, and Maseratis are in abundance in Moscow, a city that now boasts thirty billionaires.

What’s fueling Russia’s economy?

Russia holds the world’s largest proven natural-gas reserves, which are nearly twice the size of the next-largest reserves in Iran. Russia is also the world’s largest exporter of natural gas and the second-largest exporter of oil. Its oil and gas industries, which employ less than 1 percent of the Russian workforce, comprise roughly a quarter of the country’s GDP, although the official figure of 9 percent is distorted by questionable accounting practices like transfer pricing, economists say. Oil and gas make up roughly two-fifths of all Russian exports, leaving many investors wary of investing in such a resource-dependent market: A $1 per barrel change in the price of oil results in a $1.4 billion change in Russian revenues.

The bulk of Russia’s 60 billion barrels of oil reserves lie in Western Siberia. A good portion, roughly 14 billion barrels, is also found on Sakhalin Island, a body of land north of Japan that is frozen seven months out of the year and formerly housed Soviet prisoners. There are two joint, start-up projects underway: Sakhalin-1 and Sakhalin-2, the former led by ExxonMobil, the latter by Royal Dutch/Shell. Both projects are part of what’s known as “production-sharing agreements,” which means that foreign oil firms put up the investment capital while the Russian government gets a share of the revenues and retains rights over the oil and gas reserves. Earlier this month, the first drop of oil and natural gas flowed from Sakhalin-1. Sakhalin-2, a more ambitious project that makes up Russia’s largest influx of foreign direct investment (FDI), began in 1999.

The trouble with these projects, including those in Western Siberia, is getting the product to market, experts say. Russia, given its climate, is short on deep-sea water ports. Also, capacity has not caught up to production. Russia produces roughly seven million barrels of oil per day, but can only ship around four million via major pipelines. The rest must be transported by rail or river. Much of it goes to Europe, where energy demands are expected to double between 2000 and 2030, according to the Economist. It is shipped by tanker via the Black Sea, though Russia and Germany have signed a deal to build a pipeline under the Baltic Sea by 2010. The rest of the oil goes to the United States or East Asia. One project that would have boosted oil exports to the United States, a pipeline connecting Western Siberia’s fields with Murmansk, one of Russia’s unfrozen deep-sea water ports, was recently shelved. Another, aimed at quenching China’s growing thirst for oil, has gone through: the Taishet-Nakhodka pipeline, a $12 billion project signed earlier this year that will provide 80 million tons of crude per year to East Asia, 30 million of which will go to China.

Despite these projects, and the fact that Russia is the world’s largest natural-gas producer and exporter, production has been relatively stagnant since the breakup of the Soviet Union in 1991, says Cliff Kupchan, director of the Eurasia Group’s Europe and Eurasia division. Part of the problem is aging fields and lack of exploration. Another is Gazprom’s near monopoly over the market. Although the state-controlled $115 billion company has launched a new drive to boost exports out of its Siberian and Arctic fields and into U.S. and Asian markets, its new pipeline projects have been slowed by inefficient spending. The Economist reports that subcontractors and other intermediaries in Turkmenistan and Ukraine have been bilking the company.

Hence, Russian gas companies, worried by slow growth, have put a renewed emphasis on liquefied natural gas (LNG), which is gas frozen into liquid and shipped in refrigerated tankers and then warmed back into its gaseous state on delivery—“the wave of the future,” Kupchan predicts. Sakhalin-2’s backers have already pre-sold 80 percent of its predicted LNG over the next twenty years to Japan, South Korea, and North America. “If Russia manages to market liquefied natural gas, it has the potential to become a substantial source of energy for the United States as well,” wrote Dmitri Trenin, deputy director of the Carnegie Moscow Center, in an October 2005 policy brief. Gazprom, which acquired a 25 percent share of Sakhalin-2 in exchange for half of one of its Siberian fields, has already begun shipping 138,000 cubic meters of LNG to the United States.

Then there’s the Yukos affair, which highlighted the downside to doing business in Russia. The recent sight of Khodorkovsky, who was given an eight-year prison term for fraud and tax evasion in what most say was a politically motivated trial, being hauled off to a Siberian penal colony did not soothe investors’ nerves. “The oil market has been stalemated because of the Yukos affair,” says Anders Aslund, a senior associate with the Carnegie Endowment for International Peace and expert on the Russian economy. “When you’re fighting over property rights, you don’t do big projects.” The subsequent decision to dismantle its assets and sell Yuganskneftegaz, its main production unit, to the state-owned oil company Rosneft has also rattled investor confidence. “Vladimir Putin’s greatest accomplishment since 2000 may be that he has ensured that as much of the windfall revenues from high oil prices as possible has gone into government coffers—rather than into the hands of private oligarchs,” Hill wrote in the Globalist.

Looking toward the future

Yet reform is in the air in Russia: Oil companies are beginning to restructure and open their books. Other natural monopolies, including electricity, gas, and railroads, are undergoing reforms. UES, an electricity firm, is close to being broken up. And Russia’s government, faced with unprecedented oil-financed surpluses, has set aside a “rainy-day” stabilization fund worth $16.7 billion. Total reserves, which includes the fund and hard currency, is expected to jump to $280 billion by 2007, compared to just $12.5 billion in 1999.

All of the above, including Russia’s favorable retail climate, has helped spur investment from abroad. A handful of large joint ventures this year in Russia have resulted in a spike in FDI, half of which was related to oil and gas. Russia’s current account and fiscal surpluses have grown by over 9 percent per year since 1999, the year following the country’s financial meltdown. Foreign debt is now down to 18 percent of GDP, and Russia’s expected entry into the World Trade Organization in the coming years should give the economy an added boost.

Some experts say there are even signs of an emerging middle class, at least by Russian standards. Unlike the so-called New Russians of the 1990s—old-guard bureaucrats who exploited government contacts for profit—a new generation of businessmen is emerging, many of whom have no contact with the Kremlin and live in the country’s far-flung regions. Call them Russia’s “New New Russians.” Provincial capitals, writes Trenin, are now ringed with expensive dachas.

Of course, much of Russia’s recent success has hinged on the high price of oil. But at least part of its economic progress is due to prudent policy, experts say. “Basically the Washington Consensus works,” Aslund says, “that is, the opening up of markets, deregulation, and fiscal discipline, including tax reforms.” Yukos aside, Putin has projected a stable hand over Russia’s topsy-turvy economy, at least much more so than his less predictable predecessor, Boris Yeltsin. He has promised to reform Russia’s troubled banking sector. He has been an effective cheerleader for recruiting foreign investors, despite reservations abroad of Russia’s “democracy deficit.” Overall, as Trenin points out, “[Russia’s] business climate is still difficult, but the country is basically on track economically, even if its course is rather irregular.”

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