by Clifford G. Gaddy and Barry W. Ickes
SPEAKING TO a group of foreign investors on October 20, 2008, Russia's prime minister, Vladimir Putin, boasted that in contrast to policy makers around the world, including those in the leading international financial institutions, he had not been caught unawares by the present financial crisis. While "all of them" were unprepared, he said, "we did not allow ourselves to be caught by surprise. When we formulated our long-term economic and financial policy, we took into account potential risks and threats." Alluding to his insistence on building up huge financial reserves, Putin noted, "We were sometimes even criticized for being too conservative. Well, I think that conservatism proved justified."
Was Putin really so prescient? The simple answer is no, Putin anticipated neither the exact timing nor the nature of this crisis. But in a more important sense, he did prepare. For eight years Putin pursued two main economic-policy priorities. One was to set up a system that could maximally exploit the advantages of the market economy while ensuring that the interests of private business owners would always remain subordinate to the strategic interests of the state. The second priority was to make the Russian economy robust to crisis. The dual policy objectives of optimal efficiency and maximum robustness to short-term shocks are inherently in tension. They cannot be permanently reconciled. Rather, they require continual balance. Until now, the balance has been struck such that there is a firm commitment to market methods and an openness to the global economy. But whether this can continue in the face of a much deeper and prolonged crisis has implications not only for Russia's short- and long-term economic development-especially in the critical oil sector-but also for the country's geopolitical behavior.
AS RUSSIA'S leader for the past nine years-in the posts of prime minister, president and then again prime minister-Putin has presided over one of the fastest-growing economies in the world. Until very recently everything seemed to go his way. When he began his tenure, the economy was on the rebound from the 1998 financial collapse. That crisis had briefly paralyzed the economy, but because it also resulted in a fourfold devaluation of the currency, it gave a boost to domestic goods-producing sectors, like the food, auto and consumer-appliance industries, that had previously been swamped by foreign imports. By the time Putin took over, the recovery was already under way. Later, as it slowed, the oil boom took off. The rise in the world oil price from its 1998 low of under $10 a barrel to over $140 in 2008 transferred a vast amount of extra wealth to Russia. During Putin's eight years as president, Russian oil and gas companies earned over $650 billion more from their exports than in the previous eight years under Boris Yeltsin.
The oil and gas wealth was leveraged to other sectors, mainly through the channel of consumer spending. Strong growth in personal incomes boosted the retail, construction and real-estate sectors. The stock market's rise reached bubble proportions. In the spring of 2005, the market value of the companies on the country's benchmark stock exchange, the Russian Trading System (RTS), was around $300 billion. A little more than three years later, the figure was nearly $1.4 trillion. Predictably, the global crisis-and especially the oil-price collapse-hit the stock market with a vengeance. As the price of oil has fallen back to its early 2005 level of under $50 a barrel, so too the RTS capitalization is rapidly falling down to the value it had previously.
As in the rest of the world, the severity of the current global crisis and especially its effects at home were slow to be acknowledged in Russia. Most of that complacency is gone now. Across the economy, from the federal and local governments to companies and households, Russians are scaling back on expectations they held only weeks earlier. Politicians in Moscow and in regional centers do not hesitate to refer to the situation of the past three or four years as a bubble, and warn that budgets will have to be revised and personal incomes will not grow.
It is impossible to predict whether there will be serious long-term ill effects. As in any bubble, economic agents at all levels made mistakes; that is, they made consumption and investment decisions that would not have been justified in nonboom conditions. But the bubble period was relatively brief at only three years. Whatever mistakes were made in that time pale in comparison with the misallocation of resources that took place during seven decades of Soviet management of the economy. Overcoming the structural legacy of communism remains the long-term problem. Here, far too little has been accomplished under Putin. This is the other side of the "conservatism" in economic policy of which Putin boasted. While Putin and his associates regularly devote much rhetoric to the need to address the deep-seated problems of the Russian economy-the inadequate and deteriorating infrastructure, outmoded physical capital, and the demographic and health crises-it has ended up being largely lip service. There has been little action. Most of the problems remain worse now than they were at the beginning of Putin's tenure.
THE STATISTICS relating to Russians' health and mortality are well-known, but they continue to shock. Life expectancies remain among the lowest in the industrialized world. The situation is worst for males, and especially those in the younger, potentially most productive age groups. Russian men between the ages of eighteen and thirty die at rates equal to those of men twenty to thirty years older in the United States, Western Europe and Japan. And even after nearly a decade of economic growth, things are not better now than they were ten or fifteen years ago. On the contrary, death rates for males twenty-six to fifty-five years old are higher under Putin than under Yeltsin. Russia's total population shrank 13 percent faster under Putin than under Yeltsin.
Whatever policy measures the government has taken to improve the population's health have been swamped by what it has failed to do in combating such obvious problems as excessive drinking and smoking. Per capita alcohol consumption is up 29 percent since 1999. Tobacco use is up 88 percent. The Putin government claims success for its pro-natalist programs, and indeed birth rates have risen in the last couple of years. But it is likely that much of the increase is due to the general rise in living standards in the boom. If so, the current crisis will bring them down again.
Despite the rhetoric, the growth and health of the population, like rebuilding an ailing infrastructure, have simply not been the main priorities of Putin's economic policy. Unwilling to force citizens to make difficult changes in attitudes and behavior, the government promoted consumption today at the expense of investment for tomorrow, and opted for stability instead of dynamism and mobility. The priority was not to invest in long-term growth but to invest in enhancing Russia's resiliency to short-term shocks. The most urgent undertaking was to restore Russia's financial sovereignty. The steps taken were the ones that characterized Putin's conservative approach: pay off the foreign debt and build financial reserves.
WHEN PUTIN assumed the office of president in January 2000, Russia had only $8.5 billion in foreign-currency reserves. The government's external debt was $133 billion. For Putin, paying off that debt was an imperative if he was to achieve his stated goal of restoring Russia's status as a sovereign nation. This was the lesson he took from the demise of the Soviet Union. For all the underlying weaknesses of the Soviet economy, the USSR did not collapse because it had been defeated militarily. It collapsed because it lost real political sovereignty as a result of losing all financial autonomy. Once it had become dependent on loans from first Western banks and then Western governments simply in order to import enough food to prevent hunger, it no longer could claim to control its own political destiny.
In Putin's view the Russian state must never again surrender its autonomy to foreign interests. The state must have the financial reserves to withstand any future crisis. This is why financial stability was a priority. The turnaround that he presided over during the next few years was remarkable. By the end of 2007 government foreign debt was down to $37 billion. A critical turning point was in January 2005. At the end of that month Russia paid off its debt to the International Monetary Fund (IMF), three and a half years ahead of schedule. The Russia that earlier had been one of the IMF's largest debtors was now free of all financial obligations to that body. It was also at that point that Russia began accumulating funds in a newly created oil-stabilization fund and into its foreign-exchange reserves at a far faster pace than before, a rate that would grow exponentially. In 2005, $55 billion was added to the currency reserves, with another $120 billion in 2006 and $170 in 2007 bringing the total to nearly $600 billion in mid-2008. Only China and Japan had more. And with a substantial amount of those funds held in the form of U.S. government securities, Russia joined those countries as a leading financer of the U.S. current-account deficit. It was a dramatic reversal of fortune over the course of a decade.
THE RISE in the price of oil made it possible for Putin to accomplish the goal of financial sovereignty in such a short time, but his own single-mindedness in pursuit of this goal was also important. By the time the oil price began to really soar, Putin had already put in place the tax mechanism to collect the lion's share of export revenues for the central government. The fact that Russia's foreign-exchange reserves grew between 2000 and 2008 by almost the same amount as did the oil companies' gross-export revenues in that period was of course no coincidence. The oil companies faced a tax rate of over 90 percent on those export earnings.
The story of how Putin brought the Russian economy to that point has two main subplots. The first is how he succeeded in imposing such an onerous burden on the owners of Russia's most powerful companies. The second is why he refrained from crushing them altogether and, on the contrary, allowed them to become some of the wealthiest individuals in the world. For all intents and purposes, the Russian economy that Putin inherited from Boris Yeltsin was being run according to a model that had been set up by a small group of individuals, the so-called oligarchs, who owned virtually all of the value-producing sectors of the economy. Putin had seen the emergence of their system-described variously as "crony capitalism" or "oligarchic capitalism"-firsthand. The critical step was taken only weeks before Putin arrived in Moscow from St. Petersburg in the summer of 1996. A group of bankers concluded a deal with President Yeltsin. They gave their financial and media support to Yeltsin in the race for his second presidential term, and in return they received liens on Russia's most lucrative companies, centered on the resource sector. The understanding was that if Yeltsin won, they would claim full title.
Yeltsin did win the election, and the oligarchs got their property. It turned out that this was probably the high point of their power. As soon as the initial distribution of property had taken place, the infighting among them began. It continued for the next three years. They weakened one another at a time when Putin and a handful of his associates from St. Petersburg not only conceived an alternative model of management of the economy but also amassed the power-principally in the form of inside information about the oligarchs' financial and business dealings-to implement it. Putin thus began his dealings with the oligarchs from a position of strength. He did not need to compromise. Their continued existence as private owners of the most lucrative companies in Russia was a conscious choice by Putin. He allowed the oligarchs to retain ownership of the resource companies not because they were too strong for him to control, but because he wanted them to operate as private profit-maximizing entities. In choosing this approach, Putin from the beginning ruled out a return to the Soviet model of state ownership. He believed it had failed. It was inefficient and incapable of bringing the Russian economy to a competitive position in the world. Neither then nor later was nationalization of the oligarchs' property his preferred alternative. Putin's model instead was private enterprise-and private property-with strings.
Putin launched this initiative by presenting himself to the oligarchs not as a threat but as a protector. He reassured them that he would recognize the 1996 deal with Yeltsin (while at the same time reminding them that nearly no one else in the country regarded their ownership as legitimate). He was not out to dispossess them of their property, but he would completely redefine their relationship to the authorities. In February 2000 he announced that henceforth all the oligarchs would be "equidistant from power." This is to say, all the past investment each of them had made to buy influence and cultivate goodwill in the Kremlin, in the ministries and in the governors' offices across the land-their "relational capital"-was suddenly depreciated to zero. They would have to invest anew. And this time, there would be one favored place to invest-Putin's Kremlin-and their investments would serve not to secure influence over politics but only to protect them from disappropriation.
In a famous meeting in July 2000 Putin actually sat down with the oligarchs as a group and laid out further ground rules. The oligarchs could, and in fact should, continue to enrich themselves. In return, they would accept a new tax regime whose primary function was to channel more resources to the federal government. They would adhere strictly to the new regime-that is, pay their taxes, in cash, in full-and they would not try to change it. Putin also suggested a number of less precise guidelines for the oligarchs' activities. One of the most important was that they would more actively consider Russian national interests in their own foreign economic activities. The oligarchs had property rights, but those rights were never fully secure, and always contingent on the goodwill of the Kremlin. The scheme resembled a protection racket.
Putin's attitude toward the oligarchs has long puzzled observers. Many of his hard-line supporters inside Russia have complained that he treated the oligarchs too gingerly. Perhaps the only time Putin or anyone close to him ever tried to explain the logic of his approach was in a remark attributed to one of his aides, Vladislav Surkov, in the days around the July 2000 meeting. The key, Surkov said, is to understand that the stratum of truly leading entrepreneurs in Russia is "very thin and very precious . . . they are the bearers of capital, of intellect, of technologies." Russia's capitalists, in other words, were an asset every bit as valuable as its natural resources and they had to be treated accordingly. As Surkov put it, "The oil men are no less important than the oil; the state has to make the most of them both."1
The only serious and overt challenge to Putin's model would come a couple of years later, from the inside, from one of the members of the club. Mikhail Khodorkovsky, the head of Menatep Bank, who had received the Yukos oil company in the loans-for-shares deal, initially appeared to be an enthusiastic supporter of Putin's arrangement. But his subsequent personal experience caused him to rethink. A policy of greater transparency and formality at Yukos led to a sharp rise in the company's equity value and Khodorkovsky's personal wealth. As a result, Khodorkovsky began advocating an alternative model for Russia, one that differed both from Putin's and from the old crony capitalism. Business relations and other financial dealings would be transparent and formal, and property rights would be unconditional. The owners of the companies would have full rights to choose not only products but markets and suppliers, and they would make all decisions in foreign economic activity. The Khodorkovsky model was a move toward a liberal ideal. But it had deeper implications. The transparency that made the businesses more successful would expose not only the overwhelming concentration of Russia's wealth in the hands of the oligarchs but also the true state of destitution of most of the rest of the economy. It would therefore be incumbent on the government to tax the oligarchs even more heavily-unless the oligarchs could limit the tax rates. The contest for Russia's wealth would inevitably end up in an open struggle for control of the government and its tax policy. The oligarchs would have to use their financial power to shape the political system if they were to keep their wealth.
Point by point, Khodorkovsky's design ran counter to the main premises of Putin's model. Khodorkovsky was arrested and imprisoned in 2003. Since then no one else has challenged Putin's deal, which, after all, was not a bad one for the oligarchs. In 2000 the Forbes worldwide list of individuals with net worth of over $1 billion included four Russian billionaires, whose combined fortune was less than $10 billion. The updated Forbes list from the spring of 2008 contained eighty-seven billionaires from Russia (the second most in the world after the United States). Their total wealth was $470 billion.
PUTIN'S APPROACH to the oligarchs was dictated by his conviction that a market economy with private owners is superior to a state-owned and centrally administered economy of the Soviet type. He was similarly convinced that the Russian economy could not be successful by following a go-it-alone Soviet approach to the global economy. Russian companies should not just sell their products abroad. They should acquire corporate assets globally and aim to become true international players, the peers and rivals of the biggest multinational corporations. Yet how could they do this, given the extent to which Putin was taxing the profits of the major wealth producers? The weakness of Russia's financial system ruled out domestic borrowing on the scale needed. Fortunately, Putin had created an environment in which it was not just possible, but rather easy, to tap the international financial markets to acquire extra funds. By paying back Russia's debt and building its credit rating, Putin made it possible for a boom of private borrowing to take place. Thus, at the same time that Putin was using the oligarchs' export revenues to reduce the government's external debt by nearly $100 billion dollars, the oligarchs were piling up a far greater amount of new debt of their own-nearly $500 billion.
Putin and the oligarchs were participating in what might seem to be a curious scheme. The Russian companies exported oil to the West; the Russian government collected the windfall earnings from the exporters in the form of taxes; the Russian government lent those dollars to Western governments; and then, given the collateral represented by Russian holdings of Western debt, Western banks lent the funds back to Russian companies, including those that had earned them in the first place. In fact, this scheme was neither unique to Russia nor curious at all. China and other countries did the same thing with their large trade surpluses. The reasoning behind this was perfectly consistent with Putin's striving for efficiency and lower risk. Western financial institutions were better at finding the right uses for capital than their Russian counterparts (and certainly better than the Russian government). Therefore, relying on the global system to intermediate the financial flows from Russia's own oil and gas export earnings into its corporate sector represented a lower-risk way to invest the surplus and to invest in Russia. Russia was, in effect, paying the West to provide a service-financial intermediation on the basis of market principles rather than connections and corrupt practices-that it could not obtain at home.
What Putin did not anticipate was a different and much greater risk: that the entire Western financial system would implode. The crisis originating in the West froze the very mechanism that Russia was using in order to diversify its risk. The results are evident now. With no Western financial intermediation to roll over old corporate debts, Russia is itself in an acute crisis without any way out on its own.
BECAUSE SO much depends on the depth and duration of the global crisis, a precise forecast for Russia's economy is impossible. In the short term, there is little that Russia can do but try to ride things out, deploying the same kinds of bailout and stimulus measures as other countries. Russia has far greater possibilities in this respect than most countries, thanks to its financial reserves. But they are not unlimited. And no matter how well the country weathers the current crisis, its long-term challenges of deteriorating human and physical capital remain. Yet it will not be able to seriously address those until it figures out the answer to one fundamental question: how does one manage an economy that is so dependent on a single volatile and unpredictable factor-the price of oil?
There simply is no real answer for how Russia could do this on its own. The approach that is talked about most is so-called diversification, that is, development of income-generating economic activities whose success is not correlated with the oil price. Even under the best circumstances this is a very long-term option if the goal is to replace even a significant fraction of the revenue currently provided by oil. The reality is that anything close to complete diversification will not happen as long as Russia has oil and the rest of the world wants that oil. To voluntarily forego enhancing revenues from oil for the sake of investment in less profitable sectors is not economically efficient. But the main reason diversification will not happen is not economic but political. As long as financial independence is the foremost objective of the Russian leadership, it cannot politically afford to invest heavily in nonoil sectors, because, even at low prices, oil brings a cash flow that cannot be replaced by other industries.
By acting in concert with other oil producers Russia could in theory try to reduce the volatility of the oil price. This is of course one of the stated goals of OPEC, of which Russia is not a member. There has been recent discussion of associating with opec in some form and also developing technical methods of quickly adding and removing excess Russian oil from the market, something that cannot be done at present. But given OPEC's notable lack of success in stabilizing the oil price at any level, most experts are skeptical whether the modest addition of a Russian margin would make a difference.
In the absence of a viable alternative to oil dependence, it is most likely that in the future Russia will follow what might be described as the default position, that is, to continue doing what Putin has been doing: pursuing a conservative approach of exercising restraint during times of high prices and building reserves. The experience of the current crisis will undoubtedly impel him toward an even more cautious approach than before. In terms of the trade-off between policies that promote efficiency, on the one hand, and those that emphasize stability and survivability, on the other, this means tipping the balance toward the latter. That in turn implies tighter control over the economy, more constraints on the big businesses and less impetus toward integration into the global economy.
Finally, one can ask whether the current economic crisis will temper Russia's recent resurgent geopolitical posture. The likely answer is no. Russia is far from being in a state of fundamental economic health, and this crisis is likely to further impede its progress in that direction. But economic health has not been a prerequisite for Russia to act in ways typically described as "assertive" or even "aggressive." All that was needed was political sovereignty. With his macroeconomic policies, Putin reestablished Russia's sovereignty for the first time since the middle of the 1980s. He will not sacrifice it.