The Bear's Lair: The economics of Russia

By MARTIN HUTCHINSON  |  Sept. 20, 2004 at 11:33 AM
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WASHINGTON, Sept. 20 (UPI) -- President Vladimir Putin's suppression last week of Russia's upcoming regional elections finally put to rest the hopeful theory that Russia was becoming a "normal Western state." Yet the economic implications of "Putinism" remain unclear, and there is considerable confusion among international investors and Russia's potential business partners.

Putin's rule initially looked to be a thoroughly good thing for free markets, the Russian economy, and foreign investors in Russia. The economic anarchy that had led to the collapse of 1998 was lifted with remarkable speed, the worst of the 1990s bandit "oligarchs" were removed and the rest tried to make themselves respectable, the Russian income tax system was replaced with a 13 percent "flat tax" that would have delighted Steve Forbes and the Cato Institute and, best of all, the oil price started a concerted rise that appeared to remove once and for all Russia's balance of payment problems. Until the middle of 2003, it appeared as if Russia was becoming a story of mildly authoritarian rule but stunning economic success.

For careful observers, this changed last fall, when Putin imprisoned Russian oil tycoon Mikhail Khodorkovsky. Khodorkovsky had acquired his billions in the usual murky way of the post-Communist Russian oligarchs; he had bought control of the oil company Yukos for a knock-down price in the "wild privatization" spree of late 1995, when President Boris Yeltsin was seeking campaign supporters for re-election. Nevertheless, in 1999-2003, after Putin's appearance, he gave every sign of wishing to become a model industrial tycoon, importing Western managers and Western management capabilities into Yukos, and increasing the value of the company more than 100-fold from the price at which he had bought it. At the same time, he maintained a high public profile in the West, making repeated calls for liberalization of Russia's authoritarian political system.

Khodorkovsky's arrest, and the subsequent apparently successful attempt by the Russian state to bankrupt Yukos through massive tax claims, was explained off by many who wished to believe in the "normalization" of Russia. Though property rights are important, Khodorkovsky's property rights in Yukos had been acquired by extremely underhand means less than a decade ago. Had the Yukos affair been an isolated incident, or even simply a campaign against the oligarchs, many in the West would have applauded. After all, while another oligarch, Roman Abramovitch, showed his Westernized sporting spirit by buying Chelsea Football Club, the oligarchs' style of sharp Italian suits, private jets and an entourage of bodyguards was hardly such as to appeal to even the least scruffy members of the Western journalist community. Putin, too, was able to win both a Presidential and a Duma electoral victory that were decisive enough to leave little room for fraud -- and apparently, little need for it.

However, the decision to appoint all Russia's governors centrally, allegedly in response to the Beslan school terrorism, throws a new light on the matter and justifies what Khodorkovsky, in his last appearance at the Carnegie Foundation before his arrest last September had claimed: Putin is creating an authoritarian state, and may be trying to revive the corpse of the old Soviet Union.

The political implications of this I will leave to those more expert in such matters; I address only the economics of it, which are currently murky.

Clearly Putin is not trying to revive Soviet style Communism. Economically, that worked tolerably only in the large scale, heavy industry economy of the early and middle 20th century, where manufacturing economies of scale could outweigh the informational and decision-making disadvantages of central control. It would be hopeless to try to run an information-age economy on Soviet lines; the relatively small scale manufacturing (in terms of employee numbers) and rapid information transfer of a modern economy would cause any centralized decision making system to seize up from data overload. Putin is not a fool, and he is primarily pragmatic rather than ideological; he knows this, and has avoided surrounding himself with Stalin-nostalgics.

However, Putin has also seen how successful China can be with an authoritarian state and a partially free market economy, and he is trying to replicate China's economic success in Russia, possibly with the aim of using economic prosperity as fuel for his geopolitical ambitions, whatever those are. The economic question is: will this work, and what are the implications if it does?

In terms of foreign investment, which Russia needs, Putin probably doesn't have much to worry about, provided that he allows reasonable protection to assets owned by major foreign companies (he can expropriate assets held by foreign individuals without political connections as much as he likes, of course!) Citigroup and GE are said to be discussing new investments, while at $40 per barrel it will be impossible to keep the oil companies out of Russia's oilfields.

After all, even Hugo Chavez' Venezuela, about as hostile to the free market as a country can get without tuning into North Korea, is attracting hordes of oil companies buzzing eagerly at the prospect of finally exploiting the Orinoco tar sands. When your alternative business partners are Saudi Arabia, Nigeria and Saddam Hussein's Iraq, standards get lowered. Moreover, the oil business is one of the few sectors today where, provided you have simple, cheap reserves (which Russia has) old fashioned command-and-control management still works quite well.

To be cynical, there is also an accounting issue that assists large scale, high risk environments like Russia, China and Brazil to attract foreign investment from multinationals. Generally, multinational companies see maturity in their domestic markets, and thus domestic growth rates lower than they have promised the analysts on Wall Street. Therefore, to prop up their stock prices (and, no doubt, the value of top management's stock options) they are always on the lookout for opportunities to deploy large amounts of capital in countries where there is potential for new growth. It doesn't matter if their ability to earn a good return in those markets will be limited by local bureaucrats; even a modest return, on a large investment, is worthwhile when interest rates are so low. Of course, there's also a substantial risk of partial or total expropriation -- anybody who has watched the fate of foreign direct investors in Argentina can see that, in an unstable political and economic environment, the risk of loss may be so high that the expected long term return becomes negative.

Here's where the accounting issue kicks in. The loss from expropriation can be written off "below the line" as an extraordinary expense, so doesn't affect the stream of corporate earnings, and isn't taken into account by analysts in calculating the company's price-earnings ratio. In any case, it will be several years off in the future, by which time the current top management will have cashed in its options. If you have a steady stream of these large investments, each of them break-even or loss-making over its life, but producing nice operating income for several years followed by a crash, your published income statements, that Wall Street looks at, will appear quite pretty, and your share price will perform well, even though on a "true" accounting basis your emerging-market operations are making a loss.

Even outside the oil sector, therefore, if Putin maintains stability in Russia he can over the medium term expect a steady stream of multinational corporate investment.

It is in the domestic Russian economy that Putin will have more difficulty. For domestic businessmen the message is clear -- if you're not close to the Putin regime, your property is not safe from confiscation, no matter how nominally benign is the income tax regime. Capital flight, since 1991 the bane of the Russian economy, has been estimated by the World Bank at $3.5 billion in the first quarter of 2004 alone. The banking system remains extremely shaky, with the only bank where a saver can reliably put his money being the state controlled Sberbank. Thus savings will continue to flee abroad and small business, the key to future development of Russia's consumer sector, service sectors, and non-oil exports, will be stifled.

As far as the consumer sector is concerned, Putin probably doesn't care; traditionally, under both Czars and Commissars, the consumer sector was very low on the national priority list. However the service sector, and in particular software and software related services, is one where Russia could expect to play an important role owing to its highly skilled and inexpensive technology workforce. Furthermore, non-oil exports from Russia will be hampered by the lack of strong, reliable local business partners. This will in the long run stifle Russia's economic growth and prevent it from emulating the takeoff in China, a more primitive economy, but one where savings habits are ingrained and capital flight relatively more limited.

As long as oil prices remain above $40 per barrel, Putin probably doesn't have a problem, just as Hugo Chavez' catastrophic economic policies in Venezuela have been bailed out by the oil boom. However, in the long run the lack of secure property rights will hamper the economy, and any economic downturn will produce domestic discontent, no doubt to be severely repressed as is the Russian custom. Not being an oil company or a multinational, I wouldn't put my money there.

The other question, which I can't answer but which we need to think about, is what happens to the international economy if Russia becomes assertive, and seeks to re-create Soviet hegemony. With a strong economy, it will certainly have the wherewithal to do so, at least in countries like Ukraine, Belarus and the countries of Central Asia, which between them offer abundant resources and economic potential.

At present, Putin is claiming that his resistance to Chechen terrorism is part of the global War on Terrorism, and hence the West should welcome Russian power, not fear it. That is doubtfully true even now, and becomes distinctly untrue if Russia turns expansionist. However, the West has already spent the Peace Dividend from the end of the Cold War, mostly on social programs and pork barrel spending. Indeed, the United States, at least, has since 2001 had to reverse the Peace Dividend, with defense expenditures including Iraq expected to be over $500 billion this year compared with around $300 billion in 2000. Further build-up to counter a newly-aggressive Russia would be very expensive, because it would involve weapons systems quite different from those needed to fight terrorism, so the United States would be developing two largely separate military capabilities at the same time.

More and more, the 1990s look like a blissful, but alas temporary, holiday from history.

(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2004) -- details can be found on the Web site

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