Give the Donkey a Sporting Chance

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The State Duma elections did more than just give President Vladimir Putin a mandate to choose his future role as a moral authority and national leader after he leaves office. The result is also a mandate for the government to continue on the course of planned economic and administrative reforms that Putin has outlined. He sees these as necessary as the country pursues the goal of creating a more diversified economy with greater wealth distribution and, eventually, less dependency on oil and gas revenues. For investors, that is the most important result they want to see from the political transition that is now taking place.

While incremental growth in the economy is now coming from sectors outside of the extractive industries, the money that is driving that growth, as well as the confidence that allows lenders and borrowers to invest in Russia, is still very firmly dependent on oil and gas taxes. More than 60 percent of federal budget revenues still come from oil and gas taxes. Over two-thirds of the value of exports is earned from the products of extractive industries, and the share of extractive industries in the nation's gross domestic product is closer to 25 percent if calculated using a methodology used in the European Union. Last week, the government approved a revised revenue forecast of 7.65 trillion rubles ($314 billion) and a GDP growth rate of 7.3 percent based on higher oil revenues. That extra money was used to increase state spending in the economy, including increasing salaries for government employees, and that helped drive the higher growth rate in such sectors as retail and real estate.

The economy can be likened to a race between a racehorse and a donkey. The racehorse is a long way down the track since it has been fueled with almost $1 trillion of oil and gas wealth over the past eight years. It represents the almost 1,500 percent growth in the stock market over the past eight years, the seven-fold increase in the value of the economy to almost $1.4 trillion, and the growth in the country's fiscal reserves to a level that is now the third-highest in the world.

But the donkey is carrying the basic support structures necessary to sustain the racehorse. It represents the legislature, the civil service, demographics, industrial capacity and so on. It is struggling, and the gap between the two is widening. At some point, the racehorse has to slow down to allow the donkey to catch up or its advancement will increasingly become riskier, speculative and unsustainable. This is why the government simply has to put greater efforts into improving the lot of the donkey.

For investors looking to participate in the country's future growth, the fact that Putin's Plan is now more likely to remain on course is also very important. Over the past four years, the government has been mainly focused on creating national-champion companies within so-called strategic industries. Reestablishing a strong role for the state in these key industries is a priority that the president has consistently said was a necessary precondition before the government would increase investment spending and support more widespread industrial reforms. Foreign investors looking to gain access to the largest segments of the economy have been increasingly frustrated over the past eight years. Hence, while the volume of foreign direct investment has been rising, it still remains modest compared with that seen in other major developing economies.

Now that the state has largely repositioned itself within the strategic-industry segment, the priority is shifting toward investment. The state itself plans to sharply raise its spending in basic infrastructure and in such industries as electricity, railways, petrochemicals and in the regions. Finance Minister Alexei Kudrin recently stated that investment spending will rise from about $160 billion in 2006 to almost $440 billion in 2010. How that money is spent and the efficiency of its deployment will go a long way to determine whether the Russian economy will finally start to break away from its oil-price vulnerability by 2010.

Chris Weafer is chief strategist at UralSib Capital.