Economy

Successes, limitations of Russia’s economic strategy

Analysis 8 June 2018
Successes, limitations of Russia’s economic strategy

The Kremlin’s basic economic strategy is to trade efficiency and growth for political control and a tight rein on Russia’s strategic sectors. Russia’s economy has faced substantial difficulties since 2013, although it is once again performing reasonably well and there is no basis for believing that sanctions will force a change in Moscow’s foreign policy.

Confronted with sanctions, low oil prices and reputational risks as a result of its foreign-policy actions, the Russian government responded to the economic crisis of 2014 without pursuing major economic reforms. The Kremlin eschewed potentially disruptive economic policies beneficial for growth but detrimental to the regime’s primary bases of support in favour of cutting budget deficits, reducing public spending and maintaining – and even expanding – political control over the economy. More widely, Russian President Vladimir Putin’s approach since coming to power has been similar, heavily prioritising macroeconomic stability in managing the economy.

Russia’s debt levels are relatively low – this year’s public debt is estimated at 14.9% of GDP, excluding that held by state-owned firms – and inflation has been held in check. Both markers are critical to the regime – which has also steadily improved the World Bank’s Doing Business rankings for Russia – to encourage international investment. These three factors aid the country’s biggest businesses, and help enrich the businessmen most closely tied to the regime and those running important state-owned enterprises. Yet real wages have fallen considerably since 2014. An estimated four out of ten families cannot always afford food. The regime, however, has made sure to maintain high employment levels to forestall social protest. Doing so reduces efficiency, but brings political benefits.

Overall, the Kremlin is comfortable letting the private sector improve efficiency, as long as it does not threaten the political interests of either the state or the country’s most powerful individuals. This approach enables the Kremlin to maintain its power, but creates limitations and dependencies that affect Russia’s foreign policy. The structure of Russia’s budget and the political role of the energy sector, in particular, are key to Russia’s economic strategy.

The hydrocarbon economy

Natural resources, namely oil and gas, form the largest source of tax revenues for Russia’s federal budget. As a rule, the extractive-energy sector accounts for roughly a quarter of Russia’s consolidated budget revenues. The functional dependence is higher when the spillover effects of energy revenues on demand across other sectors are considered – especially construction, transport and banking.

The Ministry of Energy (MinEnergo) hopes taxes on oil extraction alone will bring in 4.6 trillion roubles (about US$75 billion) annually by 2020. Russia’s total budget for 2018 is roughly 17trn roubles (about US$276bn), thanks in part to higher oil prices. Higher prices buy the regime political room to manoeuvre domestically. Since the mid-2000s, it has been state policy to deposit oil and gas revenues above a certain cost threshold – barring an economic crisis – into sovereign-wealth funds designed to provide economic bailouts and stimulus when prices collapse, the budget shrinks and the economy enters recession.

“The Kremlin can secure political support by enriching certain businessmen and networks”
These factors make Russia’s energy sector, particularly the state giants Gazprom and Rosneft, integral to both regime security and foreign policy. The Kremlin can secure political support by enriching certain businessmen and networks, while also pursuing geopolitical aims using its largest energy firms.

Cooking with gas

Gazprom has long been key to Russia’s influence in Europe. The state gas monopoly is the single largest provider of natural gas to European markets. Declining European production and the fact that natural gas cannot yet be traded freely on a global market (like oil can be) have given Russia considerable political leverage over neighbouring states dependent on Russian gas. However, the relationship is symbiotic.

Historically, Gazprom has relied on Europe for most of its revenues due to subsidies and pricing policies for domestic consumers. Maintaining dominance in Europe is vital for the company’s financial survival and the Kremlin’s ability to retain influence. On that front, Russia is lucky that Europe appears to have little leeway for stopping the steady rise of imports of Russian gas. Even so, the European Union has managed to extract concessions from Gazprom by using antitrust suits to rein in excessive pricing in markets captive to Russian gas and to allow greater market access for Gazprom’s competitors.

Because natural gas brings in considerably less budget revenue than oil, its value is more explicitly political for the Kremlin. But the domestic framework for its political use has shifted in recent years. In 2013, privately owned Novatek won the right to export liquefied natural gas (LNG), breaking Gazprom’s total monopoly on natural-gas exports. The Kremlin saw that Gazprom was grossly inefficient at expanding LNG production, crucial for market share in the Asia-Pacific, and sought to introduce a measure of controlled competition.

Gazprom acquired a controlling stake in its lone LNG plant on Sakhalin Island in 2006 by rigging an environmental-protest campaign and lawsuits to force Royal Dutch Shell and its partners to surrender a controlling stake in the project. It failed to expand production without external partners elsewhere, largely because LNG, like piped gas, is very difficult to monetise for cronies.

Gazprom’s often terrible financial performance is actually a result of its role in securing domestic support for the regime. As a recent report leaked from Russia’s state-owned Sberbank shows, pipeline routes and projects are chosen to maximise the value of contracts provided to the company’s contracting partners for construction, which are owned by businessmen very close to the Kremlin. While there is some benefit to the public – the company has been tasked with ‘gasifying’ heating and electricity generation in Russia’s remote regions since 2007 – Gazprom secures regime support with key political constituents, and pursues dominant or substantial market shares in geopolitically important states. These include major EU countries like Germany as well as former Soviet republics, countries in the former Soviet Union’s sphere of influence and now China.

These priorities necessitate a tenuous balancing act that has effectively hamstrung Gazprom’s core business competencies, forcing the Kremlin to allow other players into the sector so as to remain a competitive gas producer. But large projects with foreign-policy implications still tend to produce opportunities for the Russian government to funnel money towards supporters.

Oiling Moscow’s policy machinery

Oil accounts for around 90% of Russia’s total hydrocarbon revenues, meaning Rosneft and other Russian oil companies contribute far more to the state budget than Gazprom. Most taxes are collected from the physical extraction of oil, followed by a sizeable portion collected via duties on exports. Unlike natural gas, however, oil is traded on a globally integrated market, meaning that prices cannot be heavily differentiated across different markets to exert political influence. The combination of a globally interconnected market for oil and its greater use for state funding carves out a more complicated and important role for Rosneft and Russia’s other oil companies than that of its gas firms.

Russia’s oil companies compete domestically and abroad for projects to pursue the interests of their shareholders, owners and managers. Rosneft has emerged as the leader of the pack, a majority state-owned behemoth producing around 4.3 million barrels of oil per day (b/d). The company’s rising production – largely a result of raiding domestic assets and ensuring it wins licensing for domestic oilfields by using political resources to influence outcomes – parallels Russia’s production growth. Russia now produces slightly under 11m b/d, more than Saudi Arabia. Of that amount, around 7.4m b/d is exported (Saudi Arabia exports around 9.3m b/d). But Russia’s position is such that the Organization of the Petroleum Exporting Countries (OPEC) cannot effectively use its cartel to pressure prices up or down without cooperating with Russia.

“The oil sector plays a huge role for Russian foreign policy”

The oil sector therefore plays a huge role for Russian foreign policy overall, and for specific deals. For example, Rosneft closed deals estimated to be worth US$270bn with Chinese partners in 2013 and then offered 19.5% of the company’s shares to various external partners, including Chinese firms. In the end, a deal went through with Qatar and commodities trader Glencore. But Rosneft could use its direct ownership of shares as a carrot to entice geopolitical partners into further energy-security cooperation.

Although oil companies do enrich contractors, their primary beneficiaries are their shareholders, owners and managers. Rosneft CEO Igor Sechin has amassed political clout within Russia due to the outsize role his company plays in contributing to the budget and, most recently, attempting to circumvent sanctions and expand Russia’s influence in the Middle East. Lukoil CEO Vagit Alekperov wields his influence primarily through the financial performance of his company, of which he is the largest shareholder. While Lukoil is privately owned, it possesses and operates projects in politically important markets in Europe and Central Asia, and has played a leading role in negotiating with Tehran for Russian access to oil and gas projects in Iran. Lukoil’s biggest international assets are oilfields in Iraq. Although these are important to Russia’s energy strategy abroad, Lukoil does not carry the same political weight as state-owned firms.

The oil company Surgutneftegas is famously secretive, and precisely who owns it is unclear. The company is built on Soviet-era oil discoveries, imports no equipment and has no exposure to foreign debt or financing, making it immune to sanctions. As the country’s third-largest oil producer behind Rosneft and Lukoil, the company amasses tens of billions of dollars in capital and is frequently linked to shady subsidiaries or contractors.

The oil sector is less politicised than the gas sector, insofar as oil firms need to compete with privately owned oil majors abroad. The primary function of the oil sector is to secure public funds to be dispensed through the budget, but it also ensures immense fortunes for certain individuals. In foreign-policy terms, oil companies have generally been a leading draw for foreign direct investment (FDI), a key benchmark Moscow uses to show investors the economy is strong.

Managing the social contract

Beyond collecting and controlling taxes and contracts via the energy sector, the Kremlin has operated on a broader ‘business contract’ since Putin came to power. Policies that keep debt low and seek to rein in inflation are linked to a series of reforms that teach to the test. Russian macroeconomic policies are designed to meet orthodox benchmarks for stability so as to attract enough investment into the country to finance its strategic sectors and bring billions to Russian businessmen. But imposing budgetary restraint – partially to avoid boosting inflation by injecting more budget money into the economy – is also linked to a set of political and economic challenges posed by the resource-dominated economic model that keeps the regime in power.

Russia’s fiscal austerity has proven surprisingly durable and viable, as Putin remains popular. But the regime’s focus on the ‘commanding heights’ – energy giants, resource-exporting firms for commodities like metals and construction contractors – is accompanied by relative indifference to Russia’s microeconomic instability. The country’s energy giants, its richest businessmen and its most important businesses (in terms of the domestic economy and foreign policy) benefit from being able to exploit or shut out the private sector. Even though it largely supports Putin, the Russian population does express targeted discontent with certain policies and corruption. The Kremlin’s ability to retain legitimacy despite such dissatisfaction with policy and governance reflects its understanding of the public’s hierarchy of needs, and it correspondingly calibrates responses to dissent.

Hierarchy of needs

According to recent polling from the Russian Public Opinion Research Center (VCIOM), 76% of Russia’s entrepreneurs consider the country’s economic situation problematic. Around 45% of respondents in a Levada Center poll stated they did not believe Putin would fairly spread wealth in the interest of the average person on the street. Neither of these are great indicators for performance. Further polling from the Social Opinions Fund shows that only 27% of Russia’s citizens closely follow the government’s work and another 49% follow it from time to time.

The rest of the respondents expressed little interest. Thus, the Kremlin pitches its economic policy in areas under the control of state companies and friendly to big business to preserve order. In practice, this means sacrificing efficiency by maintaining high employment rates to prevent people – especially those living in smaller industrial towns reliant on a single industry – from protesting. According to figures from the state statistics service released in mid-May, unemployment was down 1.1% year-on-year, hovering just under 5%.

Certain sectors of Russia’s economy are not strongly controlled by the Kremlin. But these industries tend to offer limited opportunity for the state to extract large amounts of rent to redistribute to political allies, state banks or the budget. Much of the private sector is also statistically obscure, since as much as 50% of Russia’s economic activity is informal, and thus beyond the reach of government taxation or oversight. As long as people have jobs and some space exists for entrepreneurship beyond the grasp of the state, and a basic level of social benefits are provided through subsidies or pensions, dissent can be diffused.

Outlook

Russia’s economy has endured substantial difficulties since 2013. The sharp fall in oil prices and the impact of western sanctions and Russian counter-sanctions triggered a two-year recession, a credit crunch, fiscal tightening and the near-exhaustion of the country’s reserve funds. Yet oil prices are now rising and the economy is growing again. It is arguable that the relatively successful anti-crisis policies have exacerbated the long-term problems in Russia’s economy, including underinvestment in human capital, monopolisation, cronyism and labour-hoarding.

Although the impact of US sanctions imposed in 2018 has yet to become fully manifest, there is little reason to believe that Russia will change its policy course to obtain sanctions relief. The Kremlin’s basic economic strategy is to trade efficiency and higher growth for social stability, military strength and a tight rein on Russia’s strategic sectors. It is now seeking to increase tax revenues without major reforms that would weaken the control that the state and its allies have over the economy.

The main threat to Putin lies in the possibility of widespread socio-economic discontent as a result of falling living standards, cuts to healthcare and education, and an increase in the number of Russians in poverty in recent years. The authorities have promised to deliver more well-paying jobs and to increase social spending, but Putin’s fiscal conservatism and his insistence on substantial defence spending – as well as eschewing structural reforms – may make this difficult to achieve.

The article was published by our partner, the International Institute for Strategic Studies.

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