Russia may have been promoted to investment grade, but its political and economic turbulence show no signs of abating.
Not so fast, though. The changes in Russia since the dawn of the new century, when Putin assumed power, have been dramatic and far-reaching. The disarray that characterized Russia in the 1990s is a distant nightmare. But a range of fresh challenges facing the Kremlin and the Russian economy means that a lot of the assumptions about the new Russia are looking out of date. If anything, Russia in 2005 will be more interesting than ever.
|Politics Plays Star Role|
In Russia, politics still plays a central role in defining the direction of the economy and the investment environment. And the relative political stability and predictability that Putin has brought to Russia are among his key achievements in the eyes of most investors. So cracks in the Putin façade of political invincibility are a cause for genuine concern.
President’s Popularity Wanes
Until recently, Putin’s sky-high approval ratings virtually guaranteed that the Russian electorate would feed what Alexei Moisseev of Renaissance Capital calls the president’s “Napoleon complex.” But Putin’s standing has recently eroded dramatically: The Levada Analytical Center, a respected independent pollster, reported that the president’s trust rating fell from 58% in 2003 to 39% in late 2004. Even the Public Opinion Foundation, a pro-Kremlin polling organization, says that the percentage of respondents who said they would vote for Putin in an election fell, to 42% in January 2005 from 65% in January 2004.
One cause of the decline has been the recent mishandling of the implementation of a series of long-anticipated social reforms that would monetize social payments to the country’s 40 million pensioners. When cash payments in lieu of free transportation, subsidized health care and utilities, and other long-standing benefits turned out to be far less than necessary to compensate for the trimmed benefits, the pensioners who previously had been some of Putin’s strongest supporters took to the streets in January. The Kremlin backpedaled furiously, reinstating some benefits and browbeating regions where payments weren’t made as scheduled.
Putin may use the fiasco as one pretext to reshuffle his cabinet, likely jettisoning Prime Minister Mikhail Fradkov, who has failed in managing both the government and the economy. Economic development and trade minister German Gref and finance minister Alexei Kudrin, the remaining liberal reformers in the cabinet who have appeared increasingly under siege, may also be shown the door, although both have survived years of premature political obituaries.
|Reform Program Falters|
Putin has engineered significant land, tax, administrative, pension, judicial, corporate governance and labor reforms. And in trying to reform public tariffs, “Putin is showing courage at the expense of his personal popularity,” argues Peter Lavelle, an independent political analyst based in Moscow, and sending the message that reform is still solidly on the agenda. But implementation of reform has been uneven at best and has fallen short of what is required to lay the foundation for a genuinely liberal market order. And regardless of who is tapped to head up the government, the progress of the Putin reform program is likely to be only “sporadic and limited,” says Bim, and characterized by general stagnation.
The court system, despite improvements, is still monumentally inefficient. Corruption remains rampant, as reflected in the sharp deterioration of Russia’s relative ranking in corruption watchdog Transparency International’s Corruption Perceptions Index, from 71 in 2002 to 90 in 2004. The so-called Yukos affair, which ended with the sale of the key asset of what was Russia’s largest oil company, demonstrated how state might trumps investor rights—as well as the legal process.
Meanwhile, natural monopoly reform, which was to address the remaining vestiges of the command economy by opening the electricity, gas and banking industries to market forces, is barely limping along. The power industry is being reformed without being restructured, says Caius Rapanu of UralSib investment bank in Moscow, which is a recipe for future distortions in the economy. “New companies formed in the industry will be made to compete against each other, although Unified Energy Systems [Russia’s national monopoly power provider and distributor] will still own them all,” he observes.
Gas giant Gazprom is moving in the opposite direction of market reform and toward becoming a “hypermonopoly,” in the words of Gref. The anticipated merger of government-owned oil producer Rosneft with Gazprom and the gas company’s acquisition of Yuganskneftegas, the main production asset of Yukos, would make Gazprom a big player in the oil market—in addition to controlling by far the world’s largest reserves of natural gas. The company continues to subsidize the Russian economy, selling gas to Russian consumers at a fraction of international prices. A long-anticipated share structure liberalization, slated to take place in the first half of 2005, would position Gazprom to be one of the biggest and most liquid equities in the emerging market world.
Not everyone is excited at the prospect. “I own Gazprom shares because I have to,” says one London-based asset manager who asked not to be named, “but I have to hold my nose, because it’s one of murkiest, least transparent companies in Russia—or anywhere, for that matter.”
The dichotomy between increasing political centralization and the floundering efforts to open up the economic arena underscores what Rapanu at UralSib describes as an “underlying schizophrenia” of the Putin program. “Can Putin centralize the political environment while liberalizing the economic arena?” he asks.
Others question whether perceptions of Putin’s power are overstated. His solemn promises to not run Yukos into the ground, for example, were spectacularly broken within months. “[Putin] has to virtually put a gun to the head of each of the largely useless 1.2 million state bureaucrats to get anything done. It is a myth that the Kremlin has its eyes everywhere and is controlling everything,” says Lavelle.
But clouds are forming. The strong commodities prices that have played a central role in driving Russia’s economy may have a more insidious effect. “High oil prices may well allow the subsidization of poor policy for some time, but unless there is a change in direction, it is a matter of when, not if, growth turns to stagnation,” says Roland Nash, chief strategist at Renaissance Capital. Non-oil economic growth slowed for the sixth consecutive month in December, to 3.9%, and in November the Moscow Narodny Bank manufacturing index showed negative growth for the first time since 1998. Inflation remains stubbornly high as the government has repeatedly failed to reach its inflation targets. Continued real appreciation of the ruble is leading to the further deterioration of competitiveness.
Meanwhile FDI remains pathetically low and fell sharply in the second and third quarters of 2004. After briefly reversing, capital flight resumed in 2004, suggesting that domestic investors are finding more attractive—and safer—countries to park their cash. The market for initial and secondary public offerings has been strong, which on the one hand underscores the increasing depth of the country’s capital markets—but insiders selling out is rarely a good sign, either. Particularly concerning was the December 17 sale by Deutsche Telekom of most of its stake in Mobile TeleSystems, Russia’s largest cellular phone company. “This sale is likely the beginning of a rush of foreign investment out of Russia,” says Zeihan of Stratfor.com.
The similarities with the environment that existed before the August 1998 financial crisis are haunting for some investors. “It’s difficult to call a top, but you have to wonder when you see all the Russian money flowing out,” says one Moscow-based fund manager.
Russia’s was one of the world’s worst-performing equity markets in 2004, due in part to the Yukos affair. “Investors who have been spooked by Russia’s anti-oligarchic efforts have not seen anything yet,” says Zeihan.
|Risks Unnerve Investors|
Until perceived levels of risk decline, investors may remain skittish. “Attempting to price the risk that a bunch of bureaucrats feel empowered enough to clobber some dodgy Russian billionaire is beyond the job description of most fund managers. Better to focus scarce resources on less volatile countries,” says Nash of Renaissance Capital.