Russia’s economic battle lines

MOSCOW. (RIA Novosti political commentator Peter Lavelle). On Monday President Vladimir Putin asked lawmakers to refrain from the temptation to use windfall oil tax revenue to fund populist policies that would fuel inflation.

 Putin's statement comes as the 2006 budget is being drafted with an expected surplus of $17.5 billion. The president’s plea might or might not be heeded, but the real danger that threatens Russia’s longer-term macroeconomic growth prospects is unnecessary compromises and competition among Kremlin elites.   

Russia's economy continues to expand, though at a pace that disappoints most economists. The Kremlin's economic liberals such as Finance Minister Alexei Kudrin and Economic Development and Trade Minister German Gref have, under severe political pressure to do otherwise, maintained their growth predictions at 5.5-6% for the next couple of years, less than the average of 6.5-7% experienced during 2000-2004, to achieve Putin's all-important goal of doubling Russia's economy within a decade.

Realizing that Russia's once galloping economic progress is losing its some of is steam, Putin has gone to great lengths to reassure domestic and foreign investors. Investment-friendly laws have become legislation, including decreasing the statute of limitations on privatization from 10 years to three. Putin has even met with international business leaders to make it clear, if only indirectly, the Yukos affair was a one-off event and that Russia was open for foreign investment.

However, it is not all that simple. The president knows this, the competing groups in the Kremlin fighting for influence (and quite possibly wealth) know this, and, most importantly, foreign and domestic investors know this. With foreigners now effectively banned from investing into energy and raw materials and a list of other industries deemed too "strategic," many investors remain unconvinced.

Many of the problems facing Russia's economy are, for the most part, self-inflicted or in spite of government economic policy. For the present, high consumer spending has supported Russia's recent growth, but with foreign direct investment at about $70 a head (compared to thousands of dollars per head for Kazakhstan and eastern European countries), additional outside investment is believed to be necessary to energize Russia's current economic growth and potential.

Not everyone in the Kremlin agrees though. With the Stabilization Fund standing at about $30 billion and accumulating about $3 billion per month from oil-related taxes this year, pressure has been mounting to spend windfall revenue. Indeed, the fund has already been tapped to finance spending increases for 2005 in the wake of street protests against the replacement of Soviet-era social benefits in-kind with cash payments.

Some Kremlin officials claim that Russia can afford to dispense with foreign investment to fund the state’s "strategic industries." These same officials do not appear to be particularly concerned about or understand how such a policy would fuel inflation and accelerate ruble appreciate -- two issues that threaten the current pace of economic growth.

Another factor complicating matters is Prime Minister Mikhail Fradkov’s political demand that Gref simply draw up a plan to double Russia's gross domestic product within in a decade, or a plan that would produce the needed 7.2% growth for a number of years to come. In so many words, Gref replied that he did not want to become involved in economic central planning and told the Fradkov what he was demanding was simply "impossible."

As courageous as Gref and other Kremlin economic liberals have been in countering the rigid demands of the government to increase growth, they too have compromised -- a compromise that may see inflation eat away at much of their hard work.

Gref and others have argued the Stabilization Fund should be used to pay off Russia’s foreign debt of over $100 billion and be held in reserve in the event of an unexpected economic shock to support the value of the ruble. Fradkov sees the fund as means to please his boss by literally "buying" economic growth and a source of revenue to purchase popular support by supporting a number of social programs ahead of Russia's 2007-28 election season.

The two sides compromised. The government will be allowed access to the excess oil revenues originally destined for the Stabilization Fund at the cut off level of $27 a barrel instead of the present $20 a barrel.

Fradkov got the better of the arrangement. Fiddling with the Stabilization Fund could pump an additional $10 billion into social spending. To date, non-monetary factors such as state-control tariffs for national gas and electricity have fueled inflation, now government spending is set to add to this.

As a result, the government's own inflation target of 10% is probably unrealistic. Additionally, increased spending will also mean more petrodollars will pour into the economy which will inevitably drive the value of the ruble up even faster. It will take little time before high inflation and an appreciating ruble have an impact on the economy: Russia's unreformed industrial sector, which accounts for almost half the country’s jobs but pays little in terms of tax revenues, will be hit hardest.

Even with the policy differences and compromises cited above, Russia's economy could go on as it is for years without major adjustments. With $144 billion in reserves and the robust Stabilization Fund, a strong trade surplus and external sovereign debt of a mere 17% of GDP, Russia is in no immediate danger. However, what is missing is the political will to reach Russia's economic potential. Infighting behind the Kremlin’s walls may be able to compromise to assure the present level of economic growth is sustained or even accelerated for a short time, but risk longer-term growth.