Why Real Prosperity Proves Elusive in Russia

Russia will get only two cheers from investors at the Russian Economic Forum, which opens in London this Monday. In theory, Russia ought to be one of the growth engines of the global economy, together with China, India and Brazil. In practice, its stuttering political and economic performance raises large doubts about its short-term prospects.

Consider, first, what is happening elsewhere. The three economic giants -- the United States, the European Union and Japan -- are becalmed. The European Commission has just cut its 2005 growth forecast for the second time in six months to 1.6 percent this year, down from 2 percent in 2004. Slower growth and rising unemployment are expected to push budget deficits in Germany, Italy, Greece and Portugal to over 3 percent of gross domestic product, and EU countries have agreed to loosen the Growth and Stability Pact in anticipation. The U.S. trade deficit widened to $58.3 billion for the month of January and may well hit $700 billion for 2005. This, together with political uncertainty concerning the fallout from Iraq, has been driving the dollar down to historic lows against other major currencies. Finally, the Japanese recovery seems to be petering out.

Against this background, Russia should be exceptionally well placed. It has benefited from an 85 percent increase in oil prices over the last 12 months. Its Economic Development and Trade Ministry has just upgraded its growth forecast for this year to 6.5 percent. President Vladimir Putin is sticking doggedly to the accepted economic recipe for emerging-market success: low and simple taxes, balanced budgets, an oil stabilization fund, reduction in bureaucracy and monetization of state benefits. Russia has agreed to ahead-of-schedule debt repayments to the Paris Club and the World Bank. Visiting Russia recently, World Bank President James Wolfensohn described Russia's economic tendencies as "positive" and "healthy."

Yet business confidence in Russia is at a low ebb, and investors have avoided the country in recent months. Capital flight tripled to almost $8 billion last year. Fixed investment as a percentage of GDP is 18 percent versus 44 percent in China, and fixed investment growth has slowed from 12.9 percent in 2003 to less than 10 percent now. Finance Minister Alexei Kudrin claims that slowing investment growth is making it difficult for supply to meet burgeoning domestic demand, leading to "catastrophic imbalances" in the country's economy.

So why do investors still shun Russia? Superficially, the answer can be summed up in one word: Yukos. Ostensibly designed to consolidate the rule of law, the destruction of Yukos sent a signal to the outside world that the Kremlin was more interested in accruing power and wealth to itself than in attracting investment to Russia. It suggested that the Russian business environment is dominated by an arbitrary and capricious state rather than by the "dictatorship of the law."

Putin has -- very belatedly -- recognized the damage he has inflicted. At his annual meeting with Russia's business leaders in March, he promised to exempt privatizations that took place more than three years ago from judicial investigations. Thus, he will draw a line under the controversial -- and sometimes illegal -- privatizations of the 1990s.

But we have heard this before. The real question is who is in control of the Kremlin. Putin has consistently put the centralization of state power, most recently seen in the abolition of direct gubernatorial elections, at the center of his political project. But recent blunders, notably the mishandling of the welfare reforms and the crass intervention in the Ukrainian presidential elections, have suggested that no one is fully in control. Russian voters seem to agree: Putin's approval rating has dropped from 65 percent to 45 percent. With weakness at the center of government, more centralization, paradoxically, has led to less, not more, predictability.

The first step in restoring investor confidence should be to restore the sense that the country is being firmly led. A bold move would be to replace Prime Minister Fradkov with someone like Anatoly Chubais, who currently heads Unified Energy Systems. A Chubais-led government would give far more assurance of competence and sense of direction than the present nonentities who surround the president.

However, Yukos is not Russia's only economic problem. In the oil and gas industry, which accounts for over 60 percent of the RTS index, numerous structural issues need to be addressed. Russia's problem is not overdependence on world oil prices but a lack of investment in exploration, refining and petrochemicals. The oil industry does not necessarily have to be a "curse." It can be a source of high value-added goods that are not as subject to wild swings in international prices as crude oil is.

The laws regulating subsoil resources need to be improved to give the right economic incentives for long-term investments. For example, one of the reasons companies do not invest enough in geological exploration is that it is not guaranteed that they will be allowed to reap the benefits of their prospecting. A market for licenses needs to be established to replace the current nontransparent and chaotic licensing rules. With the growing role of the state in the oil industry, it is especially important to establish clear rules of the game for private Russian and foreign companies.

Lack of long-term investment is an economy-wide problem that reinforces the unbalanced development of Russia's political economy. The Soviet Union rightly wanted to achieve development through manufacturing and not through natural resources, but the central planning system produced a nightmare of mis-development.

Today, Russia has a second chance. With the developed world's manufacturing capacity being increasingly offloaded to emerging markets, Russia should build on the scientific and educational achievement of the Soviet Union to create a broadly based capitalist economy. All it needs is decent government. But that is the most elusive goal of all.

Robert Skidelsky is a member of the British House of Lords and professor of political economy at Warwick University, England. He contributed this comment to The Moscow Times.