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From Battered to 'Island of Stability'

Putin, flanked by Gref, test-driving a Lada Kalina last year. State-owned AvtoVAZ is selling a blocking stake to Renault. Vladimir Rodionov
Editor's note: This article, the seventh in a series about President Vladimir Putin's legacy, examines the economy.These are extraordinary times. Less than 10 years ago, Russians were looking bleakly into the future, their savings wiped out and their confidence shattered in their country's government and banking system.

Now, amid jittery global stock markets and a dramatic reversal in fortune for most of Wall Street's powerhouses, the shoe is on the other foot. Russia's economy is more insulated from the rout than most of its emerging-market rivals, and the country is molding a new role for itself.

Speaking at this year's World Economic Forum in Davos, Finance Minister Alexei Kudrin rammed the point home, noting that Russia would emerge as "an island of stability" amid the gathering storm.

Each time he speaks in public these days, Kudrin ?€” the Kremlin's messenger on all things economic ?€” reels off an impressive array of statistics, ranging from foreign direct investment figures to GDP growth, that underscore the immense economic achievements of President Vladimir Putin's government during his eight years in office.

Indisputably, Putin was a lucky man. He came to power at the end of 1999, when the country was emerging from a decade of painful reforms and a catastrophic financial crisis in 1998 to boot. The only way was up.

Cast forward eight years, and annual GDP growth is averaging more than 7 percent. Russia has paid down its foreign debt, boasts the world's third-largest foreign currency reserves, has built up a huge reserve fund to guard against another crisis, and Russians ?€” from the richest to the poorest ?€” are now materially better off.

"It's wrong to compare the Russian economy today with the Russian economy in the 1990s," said Grigory Yavlinsky, leader of the liberal opposition party Yabloko. "It is necessary to compare it with the possibilities."

The extent to which Putin can be directly credited with the economic boom is arguable.

Few are more aware of just how far Russia has come than Yegor Gaidar, the acting prime minister in the early 1990s who saw through some of the country's most painful economic reforms following the Soviet collapse.

"It's important to remember that the foundations were created in the 1990s," Gaidar said, "when Russia started to become a market ?€” mostly private ?€” economy ?€¦ and the basic institutions necessary for the functioning of a private economy were created.

"Russia in the 1990s was like being in hell, Russia in the 2000s was like being in heaven. ?€¦ But to think the 2000s are not strongly connected with the 1990s is a big mistake."

Anders ?slund, a fellow at the Washington-based Peterson Institute who advised Yeltsin's government on economic reform in the early 1990s, agreed. "My view is that Putin was lucky," he said in e-mailed answers to questions. "The main economic problems had been resolved in the 1990s with growth and macroeconomic stability firmly established in 1999."

A Liberal Agenda

Putin, of course, inherited a quite unenviable list of problems ?€” political instability, crippling foreign debt, a one-engine economy centered on its oil wealth and a banking system that had lost the confidence of a burned population.

Surrounding himself with a group of liberal economists led by Kudrin, then-Economic Development and Trade Minister German Gref and former Kremlin economic adviser Andrei Illarionov, Putin pursued a prudent fiscal policy in the early years of his presidency, and the budget has boasted a surplus since 2000.

"In many cases, [Putin] was an instigator and initiator of reforms ?€” he was very active in asking and requesting from his economic team what else [could] be done on stimulating economic growth," recalled Illarionov, now a fellow at the Cato Institute in Washington.

"He had a very strong feeling that reforms were necessary. He was not only ready, but able, to listen ?€¦ to long and sometimes boring discussions on the technicalities of implementing reforms," Illarionov said, adding that Putin's skills in this regard were quite "extraordinary."

The early reforms set the standard, arguably the most radical being the introduction of a new Tax Code in 2000, which saw taxes slashed to a flat rate of 13 percent, based on the idea that a lower rate would make evasion less worthwhile.

Many economists point to the tax reform as the single biggest achievement of Putin's presidency, applauding the fact that to this day it has not been revisited. While there are still issues to be ironed out ?€” most notably the level at which to set value-added tax ?€” this is fine-tuning, economists said.

Changes followed to the Civil Code, the Customs Code, the judiciary, and attempts were made to ease the bureaucratic burden for small companies. In these, Putin was less successful, and small businesses still account for just a fraction of the country's economy.

The judiciary, meanwhile, can hardly be described as independent, bureaucracy and corruption remain major obstacles for the smooth operation of business, particularly for smaller companies, and pension reform has stalled.

Similarly, education and health care reform have a very long way to go.

"In the areas of corruption, small business development, health and education, particularly, there was some progress, but not as much as [the government] initially claimed in 2000," said Ksenia Yudayeva, an economist at the government-affiliated Center for Strategic Research.

In 2002, Russia was reclassified as a market economy by the European Union, and a year later Putin made his now-famous claim that Russia would double GDP by 2010, a target that is still within reach. It set the tone for the government's economic agenda, and officials soon took up the cry, leaning on Cabinet ministers and industry to achieve this.

Such an ambitious target took its toll. At a Cabinet meeting in June 2005, an agitated Gref played the antagonist to Putin's lead, telling then-Prime Minister Mikhail Fradkov that doubling GDP was "unrealistic."

Fradkov responded by urging Gref to "search, search for sources of economic growth."

While Putin's target was ambitious, the economy's growth has been truly impressive, reaching 8.1 percent last year, outstripping official expectations. Others argue it could have been even higher.

"In 2000, Russia's GDP growth was third among the 15 post-Soviet states, [but] in the last three years, it [has ranked] 13th," said Illarionov, who has emerged as one of Putin's strongest critics since quitting as his adviser in December 2005.

Yavlinsky, a trained economist who is another hardened critic of Putin, said the statistics put across a one-sided picture.

"Economic growth is very high, but so what?" he said.

"It's absolutely not enough. ?€¦ I'm talking about the other side of the coin, I'm talking about the machinery of the Russian economy. There are no private property rights, there are no incentives, there is no feeling that you can find justice, and there is no economic freedom," he said.

But for those who lived through the pain of the 1990s, Putin has restored the most important thing of all: stability.

Stability has come at a price, as evidenced by the clampdown on independent media, the eradication of a tangible political opposition, and people's growing alienation from the state. Yet it is almost a cast-iron certainty that a clear majority of Russians who turn out for Sunday's elections will vote for Putin's handpicked successor, Dmitry Medvedev.

"Probably the greatest legacy of the Putin era for the economy has been a degree of political stability," said Alan Russo, chief political adviser at the European Bank for Reconstruction and Development. "That gave investors a degree of confidence [to bring] money back into the country and [decide] to invest in Russia for the first time."

By the middle of Putin's first term, foreign investment was starting to pick up, led by energy majors eager to get a slice of the country's huge reserves.

The future of private-sector investment in the energy sector seemed all but secured in fall 2003 when oil major Yukos stood poised to sell a stake to ExxonMobil. But within weeks, the deal was scuttled, Yukos chief executive Mikhail Khodorkovsky was arrested on fraud and tax evasion charges and the firm was staring at the first of many multibillion-dollar back tax claims.

Western criticism rained down on the Kremlin for what was widely seen as a politically motivated attack on Khodorkovsky, and investors hung back. In the first half of 2004, $5.5 billion was pulled out of the country.

Yet after foreign investors were assured that the Yukos affair was largely a one-off, they returned in spades, albeit a little warier and wiser about the "rules of the game."

For many, the attack on Yukos marked the turning point in Putin's economic approach.

"After 2003, we see almost no economic reform," Illarionov said, adding that the "next to total" destruction of institutions over the last five years meant that Putin's legacy would be a mixed one.

Other economists also described Putin's rule as a presidency of two parts, with the later years marked by a remarkable consolidation of power during a period of high oil prices. With the windfall afforded by these high prices, some argued, the government lost the political will to push through unpopular structural reform.

"[The period of] 2003 through 2007 has been lost time. Putin's second term is the greatest opportunity missed since Brezhnev," ?slund said.

Return of the State

From early on in Putin's second term, the state started to play a greater role in the economy, effectively renationalizing Yukos under Rosneft, and encouraging loyal businessmen to prop up Rosneft's subsequent initial public offering.

The state's involvement started to stray into a number of areas, particularly those it deemed strategic, such as aerospace and metals. In the defense industry, the owners of titanium maker VSMPO-Avisma were pushed into selling out to state arms trader Rosoboronexport, while midsized Russneft looks as if it will end up in the hands of Kremlin-friendly oligarch Oleg Deripaska after facing a slew of tax evasion charges.

The country's largest commercial lenders, meanwhile, remain state-controlled, despite some tentative noises regarding full privatization. In some areas, both foreign and private investors have simply been crowded out.

While sovereign debt has been paid down, corporate debt has soared, prompting fears that these companies might look to the state to bail them out. By October 2007, Russian banks and companies had borrowings of more than $300 billion, much of it lent to state-controlled companies, such as Rosneft.

On the flip side, the state initiated an ambitious program to sell off electricity giant Unified Energy System. But, even here, Gazprom has built up controlling stakes in many of these assets, undermining the basic principle of the reform.

Growth is being driven by the state, said Yevgeny Nadorshin, chief economist at Trust Bank. Government approval is required for major projects, certainly strategic ones, while state projects and the increased government spending drive demand.

"Business has complete dependence on [its] relations with the authorities," Nadorshin said. "If government expenditure reaches its limit, or if oil prices fall, this growth base will drop. We lack private initiative.

"We could suddenly find that 10 years of growth has been in the wrong direction. ?€¦ Then there will be a crisis," he said.

While most economists say excessive state intervention is a hindrance to growth, they are reluctant to say Russia's growth could have been higher without the state.

"If market forces had been allowed to operate freely, that could have attracted even more foreign direct investment and capital inflows into the economy," said Ivailo Vesselinov, a senior economist at Dresdner Bank in London. "But it's very difficult to know if that would have been the case in Russia, given Russia's history in the 1990s, and the generally accepted failure of more liberal economics."

In the last couple of years, the government has unveiled a new model to power growth: public-private investment channeled via state corporations. The corporations now include Russian Technologies, the successor to Rosoboronexport, and those covering aircraft manufacture, nanotechnology and the 2014 Sochi Olympics.

"The question is whether government intervention would be helpful, or whether it would be neutral or even damaging," said Yudayeva, of the Center for Strategic Research.

Oil Wealth Dependence















KEY ECONOMIC EVENTS
August 2000 ?€” Putin signs into law the much-praised Tax Code, which introduces a flat rate of 13 percent.
July 2002 ?€” Russia is invited to take up full membership in the Group of Eight, giving it the right to take part in financial discussions.
November 2002 ?€” The European Union grants Russia market economy status.
May 2003 ?€” Putin makes the much-quoted claim that GDP will double by 2010.
October 2003 ?€” Yukos chief executive Mikhail Khodorkovsky is arrested on tax and fraud charges in what is seen as a key turning point toward more state control over strategic economic sectors.
January 2004 ?€” The stabilization fund is established. The same year, oil prices start to climb, exceeding $50 per barrel.
October 2004 ?€” Moody's awards Russia an investment-grade rating, a prerequisite for boosting foreign portfolio investment in the country.
December 2005 ?€” State arms trader Rosoboronexport, headed by close Putin ally Sergei Chemezov, takes control of ailing carmaker AvtoVAZ, the first in an ambitious series of takeovers.
July 2006 ?€” Currency controls are lifted on the ruble, making it fully convertible.
January-December 2006 ?€” Russia holds the Group of Eight presidency. Despite being criticized over its New Year's cutoff of gas to Ukraine, the government is generally credited with a good performance at the St. Petersburg G8 summit in July.
August 2006 ?€” Russia pays off the last $23.7 billion of its sovereign Paris Club debt ahead of schedule.
November 2006 ?€” Russia and the United States sign a key bilateral agreement on Russia's accession to the WTO, paving the way for the final, multilateral stage of talks with the organization.
December 2006 ?€” Inflation is brought down to single-digit figures to stand officially at 9 percent.
April-June 2007 ?€” Gazprom takes control of two major foreign-led energy projects, Shell's Sakhalin-2 and TNK-BP's Kovykta, after sustained periods of pressure from state environmental officials.
August 2007 ?€” The U.S. subprime mortgage crisis hits global financial markets, leading to a tightening in credit terms for Russian companies.
January 2008 ?€” Global markets tumble further, closely tracked by the Russian stock indexes. Finance Minister Alexei Kudrin declares that Russia is an "island of stability" amid the worldwide turmoil.
February 2008 ?€” The stabilization fund, which has grown to $160 billion, is split into the Reserve Fund and the National Welfare Fund.


MT



While rapid economic growth has been centered on natural resources, it is to Putin's credit that his government was able to manage the oil revenues and avoid the so-called "oil curse," whereby countries in similar positions have frittered away the vast revenues accrued.

Central to this success was the establishment of the stabilization fund, a brainchild of Illarionov's, which sterilized windfall oil profits to head off inflationary pressures while covering any substantial fiscal gap. By the end of 2007, it had accumulated a total of $160 billion.

On Feb. 1, the fund was split into the Reserve Fund, which will be invested in low-risk bonds and other instruments, and the more proactive National Welfare Fund, which could eventually be invested in equities.

Oil and other raw materials currently account for about 75 percent of the country's exports, and diversification is one of the biggest bones of contention in assessing Putin's legacy.

In light of the expected global slowdown or recession, Russia is walking a tightrope, capitalizing on its natural-resource wealth while times are good but exposing its economy to the risk of external shocks, such as an oil-price crash.

While fewer than 1 million of Russia's 142 million people work in oil-related industries, they produce about half the country's GDP, said Vladimir Popov, a professor at the New Economic School in Moscow.

"It's definitely one of the failures ?€¦ that the Russian economy became completely dependent on oil and gas," Popov said. "This is a continuation of the trend that existed in the 1990s, but [Putin] should be held responsible for not being able to stop it."

Since 2004, oil prices have soared from a level of about $40 per barrel to break through the $100 barrier this year.

The problem, experts argue, is that it is very difficult to tackle difficult reform when times are good.

"That is not a situation which makes you very inclined to implement very difficult structural reforms," Gaidar said. "You do not start serious and not always easy economic reforms when everything is OK."

In the most telling indication yet of how Putin views his own legacy, he told the State Council last month that overdependence on the energy sector would have profound consequences for the economy.

"We have only modernized the economy in a piecemeal way. This will lead to increased dependency on the import of goods and technologies and to a strengthening of our role as an energy annex to the global economy," Putin said. "Following this scenario, we will not be able to guarantee the security of the country or its normal development, and we will threaten its very existence."

Perhaps Putin was being a little hard on his government, but his message of diversification has seldom been more urgent.

Private enterprise has burgeoned under his watch, even if some reforms have not gone far enough. Foreign investors are generally turning toward the fast-growing consumer sector, while real estate has gone from strength to strength. Lifting controls on the ruble in 2006 provided a further boon to investors.

"The most rapidly increasing sectors of the economy are not extractive industries," Gaidar said. "We are a long way from the situation where we can say Russia is a stable, diversified economy ?€¦ [but] we are going in this direction."

In 2006, Russia proudly held the presidency of the Group of Eight, and while some critics have argued that Russia should not be a member of the group of industrial democracies, Putin has insisted on equal treatment.

Illustrative of the Kremlin's assertiveness has been its reluctance to sign off on certain key concessions demanded by the West for Russia to join the World Trade Organization. After 15 years of talks, the country is only now nearing the point where it looks likely to achieve accession.

Inflation is one of the few areas where Putin has admitted achieving only limited success. While the government was hugely successful in reducing inflation from 20 percent in 2000 to single figures by 2006, it started climbing again in 2007. The country's poor were the hardest hit by soaring food costs, a result of Russia's place as an increasingly integrated part of the world economy.

The true extent of Putin's achievements will perhaps not be known until long after he has stepped down from power, as his economic model of increasing state intervention has yet to be fully tested.

"[His] legacy ?€¦ will probably only be known when the country faces some future tests," said Russo, of the EBRD. "That is, when the environment turns less friendly, when oil prices drop ?€¦ [or] when Russia is forced to compete in the global economy when they join the WTO."

Previous reports about Putin's legacy can be found online at www.themoscowtimes.com

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