Russia: How long can the "fun" last?

Business Week’s Moscow Bureau Chief explains that although Russia’s “middle class” has grown, this means absolutely nothing when the average salary is $11 a day and the government is fundmentally crazed with power and corrupt. Ask not for whom the bell tolls, Russia, it tolls for thee.

In many countries, a leader with the scandal-tarred record of Russian President Vladimir Putin would be long gone. There was his ham-fisted handling of hostage crises in Moscow and the southern town of Beslan, his meddling in elections in Ukraine, and his persecution of former Yukos oil chief Mikhail Khodorkovsky. Now add to those misadventures the deathbed allegation by former KGB spy Alexander Litvinenko that Putin ordered his poisoning.

Yet in Russia, Putin remains a hero. His approval rating stands just shy of 80%, in large part because the economy has flowered during his term in a way that would have seemed unimaginable during the crisis-ridden 1990s. Growth in gross domestic product has averaged 7% per year during that period, while real incomes have climbed at more than 8% annually. Putin “is quite tough both inside and out of Russia, which is needed,” says finance student Kim Volodzanin, busy shopping at an outlet of British department store Marks & Spencer in Moscow.

Among foreign investors, too, Russia has never been more popular, as the stock market is up tenfold under Putin. And some $17 billion in foreign direct investment has come in this year, roughly 75% of it in sectors other than oil and gas—an encouraging sign of economic diversification. The likes of Dutch brewer Heineken and Swedish retailer ikea are growing fast. More than a dozen carmakers, including Ford F, General MotorsGM, and Toyota TM, are setting up or expanding operations in Russia. And Citibank (C) this year nearly doubled its branches in the country, to 47, and says its Russian business is growing at 70% annually.

What these investments have in common is that they target Russia’s middle class. This group has grown from just 8 million in 2000 to 55 million today and now accounts for some 37% of the population, estimates Expert, a market research firm in Moscow. That’s giving a lift to the mood in the country. The share of Russians who think life is “not bad” has risen to 23% from just 7% in 1999, while those who find living conditions “unacceptable” has dropped to 29% from 53%, according to a recent poll.

These hopeful folks are flocking to places such as the new European Trade & Entertainment Center near Moscow’s Kiev Railway Station. For years, the site lay empty, a refuge for drunks and stray dogs, but today it’s a five-story mall with some 160 shops selling imported clothes, jewelry, and cosmetics. Diners fill the cafés, and a multiplex is showing Hollywood blockbusters such as Casino Royale. “Life is definitely improving,” says Alexander Kereev, a young musician out shopping for clothes. “People are earning more and spending more.”

Western retailers like the sound of that. Zara, Nike, the Body Shop, and others are opening in the new mall. “We expect that our sales [in Moscow] will almost immediately reach the level of London or New York,” says Ian Zilberkweit, who is setting up the first Moscow outlet for Le Pain Quotidien, an upmarket café and bakery chain based in Belgium.

Not everyone has shared in the prosperity. Far from it. The average Russian earns $330 a month, just 10% of the U.S. average. Only a third of households own a car, and many—particularly the elderly—have been left behind. “Of course, life used to be better,” says 68-year-old Yury Stepanov, who scrapes by on his state pension of $135 per month. And though new malls, offices, and apartment blocks are sprouting in second-tier cities such as St. Petersburg and Novosibirsk, there’s still a gulf between the capital and the rest of the country. “The farther outside of Moscow you go, [the more the] unhappy number increases,” Garry Kasparov, the chess grandmaster and a frequent critic of the Kremlin, said in an interview with Maria Bartiromo.

Some also wonder whether the expansion can be sustained. There’s little doubt that a major driver of the newfound bounty is oil and other natural resources. Without the runup in commodity prices, economic growth would have been two to three percentage points lower during the last three years, estimates the Organization for Economic Cooperation & Development. Developing countries, meanwhile, don’t have a very good track record of using windfall profits from commodity booms to lay the foundations for sustainable growth.

To his credit, Putin has used much of the cash to build up financial reserves. Russia has created a $90 billion fund—equivalent to 9% of gdp—to protect against a drop in oil prices. Fiscal policy remains tight, with the Kremlin expecting a budget surplus equal to 7% of GDP this year. And Russia is well ahead of most other resource-rich countries in its economic development, with a long tradition of education, science, and industry. Now, its tech companies are starting to give India’s outsourcing sector a run for the money. Software exports will top $1.5 billion this year, vs. just $128 million in 2001. “We really can compete on a global scale,” says Dmitry A. Loschinin, chief executive of Russia’s largest software developer, Luxoft.

Economists warn, however, that high oil prices have bred complacency. The OECD cautions that economic reforms have largely stagnated. Worse, corruption and bureaucratic interference continue to impede business: Russia ranks alongside Gambia and the Philippines near the bottom of think tank Transparency International’s annual list of corrupt countries. “It’s the general scourge of Russia,” says Anatoly Berestovoi, deputy director of a Moscow construction company. “You have to speed things up by interesting this or that official personally.”

Most troubling is government’s growing role. The Kremlin has taken control of some two dozen Russian companies since 2004, including oil assets from Sibneft and Yukos, as well as banks, newspapers, and more. Despite his sporadic support for pro-market reforms, Putin has backed national champions such as energy concerns Gazprom and Rosneft. The private sector’s share of output fell from 70% to 65% last year, while state-controlled companies now represent 38% of stock market capitalization, up from 22% a year ago. “The tendency that really worries us,” says William Tompson, the oecd’s senior Russia economist, “is the big increase in state property.”

But for now, few middle-class Russians seem to share the oecd’s concerns about the economy, or the international community’s worries about their president’s dark reputation.

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