Aslund on Economic Cold Warfare

Writing in the Moscow Times Anders Aslund, a senior fellow of the Peterson Institute for International Economics and the author of Russia’s Capitalist Revolution: Why Market Reform Succeeded and Democracy Failed, gives Russians the bad news about their economic future under the dictator Vladimir Putin, a proud KGB spy with no economic training who has never run a business.  Following, a second piece from Aslund in which he explains how Russian economic weakness can be exploited in the new cold war to the West’s advantage.

Aug. 8 stands out as a fateful day for Russia. It marks Prime Minister Vladimir Putin’s greatest strategic blunder. In one blow, he wiped out half a trillion dollars of stock market value, stalled all domestic reforms and isolated Russia from the outside world. Russia’s attack on its small democratic neighbor was bad enough, but its recognition of two conquered protectorates as independent states has been supported only by Hamas, Belarus, Venezuela and Cuba. Putin is turning Russia into a rogue state.

Russia has gone through a grand economic recovery, but its strength must not be exaggerated. In current dollars, its gross domestic product has increased almost ninefold in nine years, but even so, it accounts for only 2.8 percent of global GDP. At present, its per capita GDP of $12,000 is a quarter of the U.S. level. While this is impressive, much of its catch-up potential has been exhausted.

The official government target is to reach half the U.S per capita GDP by 2020. It is possible to achieve that goal, but it would require carrying out extensive economic reforms during the next 12 years. The problem, however, is that Russia’s foreign aggression has strengthened the authoritarian regime, and this has ended all hopes for substantial reforms at a time when they are needed the most.

To understand Russia’s economic dilemma, we need to consider the causes of the country’s growth over the last decade and the current challenges. The dominant cause of growth has been European or capitalist convergence, which Russia has enjoyed thanks to Boris Yeltsin’s hard-fought introduction of a market economy, privatization and international integration. The country’s short economic history can be summed up as: All good comes from private enterprise. The government’s contribution has been to keep the budget in surplus and reduce taxation.

A second cause of the high growth has been the huge free capacity in production, infrastructure and human capital after the collapse of communism. The recovery was also coupled with remonetization, as Russia has enjoyed one of the greatest credit booms of all time. With the rise of the new capitalist service sector, a huge structural change has spurred growth. Together, the systemic and structural changes amount to a gigantic catch-up effect that all post-Communist reform countries have experienced. The average annual real growth in former Soviet states from 2000 to 2007 was 9 percent, but it reached only 7 percent in Russia.

The third factor behind Russia’s growth is the most spurious — namely the oil price windfall since 2004. While it has boosted the country’s budget surplus, current account balance and currency reserves, it is likely to have damaged its policy badly, as the elite focused on the distribution of oil rents rather than on the improvement of policy. As a consequence, Russia has seen no economic or social reforms worth mentioning for the past six years.

Moscow’s current economic dilemma is that the old sources of growth will soon be exhausted. Undoubtedly, some capitalist convergence will continue, but it is bound to slow down.

Unfortunately, it is easy to compile 10 reasons why Russia is likely to have lower growth in the near future than it has had for the last nine years.

1. Internationally, one of the greatest booms of all times is finally coming to an end. Demand is falling throughout the world, and soon Russia will also be hit. This factor alone has brought the Western world to stagnation.

2. Russia’s main problem is its enormous corruption. According to Transparency International, only Equatorial Guinea is richer than Russia and more corrupt. Since the main culprit behind Russia’s aggravated corruption is Putin, no improvement is likely as long as he persists.

3. Infrastructure, especially roads, has become an extraordinary bottleneck, and the sad fact is that Russia is unable to carry out major infrastructure projects. When Putin came to power in 2000, Russia had 754,000 kilometers of paved road. Incredibly, by 2006 this figure has increased by only 0.1 percent, and the little that is built costs at least three times as much as in the West. Public administration is simply too incompetent and corrupt to develop major projects.

4. Renationalization is continuing and leading to a decline in economic efficiency. When Putin publicly attacked Mechel, investors presumed that he had decided to nationalize the company. Thus, they rushed to dump their stock in Mechel, having seen what happened to Yukos, Russneft, United Heavy Machineries and VSMP-Avisma, to name a few. In a note to investors, UBS explains diplomatically that an old paradigm of higher political risk has returned to Russia, so it has reduced its price targets by an average of 20 percent, or a market value of $300 billion. Unpredictable economic crime is bad for growth.

5. The most successful transition countries have investment ratios exceeding 30 percent of GDP, as is also the case in East Asia. But in Russia, it is only 20 percent of GDP, and it is likely to fall in the current business environment. That means that bottlenecks will grow worse.

6. An immediate consequence of Russia’s transformation into a rogue state is that membership in the World Trade Organization is out of reach. World Bank and Economic Development Ministry assessments have put the value of WTO membership at an additional growth of 0.5 to 1 percentage points a year for the next five years. Now, a similar deterioration is likely because of increased protectionism, especially in agriculture and finance.

7. Minimal reforms in law enforcement, education and health care have been undertaken, and no new attempt is likely. The malfunctioning public services will become an even greater drag on economic growth.

8. Oil and commodity prices can only go down, and energy production is stagnant, which means that Russia’s external accounts are bound to deteriorate quickly.

9. Because Russia’s banking system is dominated by five state banks, it is inefficient and unreliable, and the national cost of a poor banking system rises over time.

10. Inflation is now 15 percent because of a poor exchange rate and monetary policies, though the current capital outflow may ease that problem.

In short, Russia is set for a sudden and sharp fall in its economic growth. It is difficult to assess the impact of each of these 10 factors, but they are all potent and negative. A sudden, zero growth would not be surprising, and leaders like Putin are not prepared to face reality. Russia’s economic situation looks ugly. For how long can Russia afford such an expensive prime minister?

Writing in the Financial Times, Aslund expands on Russia’s economic weaknesses as a means of attack for the West:

Russia’s invasion of Georgia has shocked the west and spurred talk about how to  respond. The conventional wisdom is that the west can do little to punish Russia. True, western governments have limited leverage, but in economic terms the Russian invasion has already hit it hard, even before western governments lifted a finger. This economic blow shows the west how it can punish Russia’s leaders.

On the fateful day of August 8, Russia’s stock market plummeted 6.5 per cent. It has now fallen 36 per cent in the past two months, wiping out $500bn (€346bn, £281bn) of shareholders’ capital, almost equal to Russia’s international currency reserves of $580bn. During the week of the invasion, capital outflow reached $16bn, causing a sudden domestic credit squeeze. Two wealthy Russians have been identified as among the biggest sellers of Gazprom stock . They cannot have been happy with Vladimir Putin, the Russian prime minister. Indeed, Mr Putin’s boasts about Moscow as a new global financial centre and the rouble as a coming international reserve currency have become a sad joke.

These substantial losses are likely to last. In a note to investors, UBS, the investment bank, explains that the old paradigm – that investment in Russia carries high political risk – has returned. UBS cut its price targets on Russian companies by an average of 20 per cent or a market value of $300bn.

Russia’s economic strength should not be exaggerated. Its gross domestic product has jumped from $200bn in 1999 to an estimated $1,700bn this year, yet it accounts for only 2.8 per cent of the world’s GDP. Despite the Georgian success, Russia’s military is under-resourced. Official military spending is $48bn, or 7 per cent of US defence spending. With oil and natural gas accounting for 60 per cent of its exports, Russia is dependent on world energy prices, which are falling. Its energy production is stagnant because of renationalisation and the hostile climate for investors. Corruption is Russia’s worst scourge and the state cannot carry out infrastructure investment because of huge kickbacks. With authoritarianism, economic reforms have stalled but without them high growth rates will not be maintained.

The west faces a choice between sanctions and economic engagement. Trade sanctions would only strengthen the security elite’s hold on the economy and reinforce its dictatorship. It would be wrong to oust Russia from the International Monetary Fund or stop its membership of the World Trade Organisation, because open markets and international standards will only expose Mr Putin and his cronies. Instead, the European Union and US should impose ethical and legal standards that make it costly for Russia to misbehave, targeting big state companies and top officials not private citizens or businessmen.

First, the EU should adopt a common energy policy, imposing the rules of the energy charter – such as transparency, equal investment rights and third-party access to pipelines – on Russia. A united EU has bargaining power as all Russian pipelines outside the former Soviet Union go to Europe.

Second, the European Commission should force Gazprom to unbundle production and transportation to break up its monopolies. Why does the EC pursue antitrust suits against Microsoft but not Gazprom? It would have to divest its pipeline network outside Russia’s borders, abandon blatant price discrimination and end its planned construction of the Nord Stream and South Stream gas pipelines.

Third, the west should investigate Russian top officials and their trading companies for money-laundering.

Fourth, Russia’s big state companies habitually woo politicians in other countries. Gerhard Schröder, the former German chancellor, is just Gazprom’s most prominent catch. Western ethical rules for contacts with Russian state companies need to be tightened and the EU should establish American rules for the disclosure of income anybody earns from lobbying. Unethical behaviour is best fought with increased transparency.

Finally, if western intelligence agencies possess evidence of any corruption by Mr Putin or his cronies they should publish it. Nothing would undermine him more in Russian eyes than verified facts about corruption. Russia and its leaders are quite vulnerable, but to be effective the west needs to unite.

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