Author: Laurence Neville

Events in Ukraine have changed the outlook for Russia. Now the country faces choices about its global role that could affect the rest of the world for decades. Which path will it take?

Russia’s politics have undeniably hardened. Its adventurism in Ukraine, defiance of much of the international community and brinkmanship following the downing of a Malaysian passenger jet over eastern Ukraine in July highlight a new aggressive posture. At the least, the affair has cost Russia much of the limited international goodwill it still enjoyed. At the worst, successive rounds of sanctions could cripple the economy. Yet there is considerable disagreement about what these developments mean for Russia’s long-term future.

For some observers, Russia now appears to be embarking on a new era in which the West is to be held at arm’s length or defied outright. According to this view, Russia’s disengagement with the West, and from the agenda of globalization, reflects the triumph of politics over economics. Russia has provoked bouts of isolation since Vladimir Putin took power in 2000, but the current rhetoric is more strident. Stalled privatization plans appear to confirm that Russia’s commitment to reform has waned.

This narrative is not universally accepted. Russia’s journey in the postcommunist period has been astounding: No one under 40 (when the US Trade Act of 1974—expanding US participation in international trade and encouraging improved relations with nonmarket and emerging countries—was signed) in Russia can remember a time when the country was not part of the global economy. Disengagement from the West would be impossible and unthinkable for many Russians. Many observers concede that Russia’s efforts to open up its economy, reform corporate governance and tackle corruption have been sporadic. However, they claim, the direction of travel has been clear. In financial markets, moreover, the reform agenda remains on track.

Rather than retreating from globalization, Russia, some think, is instead redefining it. Russia is choosing to look east rather than west. This pragmatic view recognizes Asia’s role as the 21st century’s engine of growth. As for politics, diplomatic tensions, the theory goes, will lessen over time: Europe depends too much on Russian energy to follow through on its more dramatic threats. In any case, this argument goes, Putin always strategically retreats from conflict once he has maximized Russia’s advantage.


Even those who support Putin acknowledge that politics, rather than economics, is driving Russia’s current actions. However, Maria Lipman, co-author of Russia 2025: Scenarios for the Russian Future, believes the choice of politics over economics reflects a more deeply rooted trait in his administration. “Throughout Putin’s leadership, the government’s goals have been economic development, attracting foreign investment and improving living standards,” she says.

Maria Lipman

“There were considerable achievements, and growth reached as much as 8% a year. Yet, political control and sovereignty on the world stage—the idea that nobody can tell Russia what to do—have always been higher priorities.”

When Russia-leaning Ukrainian president Viktor Yanukovych fled anti-Russian protesters and Ukraine looked ready to fall into the Western camp, Putin saw a threat to Russia’s sovereignty and its Black Sea fleet in Sevastopol. Characteristically, he opted for control and sovereignty over economic stability. “To Russia, [an anti-Russian government in Ukraine] would have been an unacceptable failure,” says Lipman. “Russia went on an ‘offensive’ and annexed Crimea. The result is a serious deterioration in relations with the US and Europe and damaging economic consequences.”


Dmitry Polevoy, chief economist for Russia and CIS at ING Bank, believes “the lack of trust that now exists between Russia, the US and the EU” is worrying because it “could affect economic policy priorities.” In practice, that means reform will take a back seat.

Dimitry Polevoy

Few governments have the political capital to fight on multiple fronts. The Kremlin, preoccupied with the situation in Ukraine, is unlikely to push a reform agenda, including privatization, which is opposed by some of the strongest entities in the country.
“The program is behind schedule because of lobbying by state-owned companies uncomfortable with losing control or opening up,” says Polevoy. Recent events have given these companies greater sway in the Kremlin.

More generally, the strength of state-owned companies reflects the importance of control and unchallenged power to the Kremlin, according to Lipman. “The structure of the economy has developed specifically in response to the need to control the most economically important industries in the country, either through state ownership or by placing them in loyal hands,” she says. “That need for control has limited economic efficiency and undermined reform.”

Certainly, Russia’s reform to-do list is enormous. Structural reforms, aimed at improving the business climate and restoring private-sector confidence and investment are crucial, according to Vladimir Kolychev, chief economist for Russia at VTB Capital in Moscow. He lists consistent economic, tax and regulatory policy, reform of the state sector, a genuine fight against corruption and proper reform of the judicial system as priorities. “Russia remains an attractive market, but currently, risks outweigh rewards in many cases,” he adds.

In addition to stalled reform, the Kremlin’s need for control has thwarted economic diversification, according to Lipman. “To stimulate alternative sources of growth, people’s energy needs to be unleashed, labor made more efficient, and new technology introduced,” she says. “That requires a degree of openness that Russia is unwilling to accept, given its focus on control. Permissiveness in 2011 and 2012 [resulted in] mass protests. The Kremlin doesn’t want that experience again.”


Given the difficulties in refocusing the economy while maintaining control—and the political reluctance to continue to rely on the West—Russia is looking for an alternative model. For some observers, Gazprom’s $400 billion, 30-year gas deal with China, signed in May, typifies Russia’s new strategy.

Gazprom’s opaque pricing structure has come under increasing pressure in its core European  markets: The European Commission began an antitrust investigation into the company in September 2012. Russia is unwilling to accept such meddling in its affairs, sovereignty being paramount, and is instead turning east. The economic rationale for a new pipeline may be questionable, particularly as existing pipelines to Europe remain underutilized. However, the China pipeline offers the Kremlin two things it desperately needs: greater political maneuverability and an alternative source of finance. The recent plan by Brazil, Russia, India, China and South Africa to create a BRICS development bank will play a similar role, providing capital and political legitimacy outside the scope of Western institutions. Attendees of the BRICS meeting in Brazil in July (during which the bank was announced) pointedly declined to make a statement on Ukraine. Moreover, the BRICS bank “will probably pay less attention to governance issues than other multilaterals,” notes Marcus Svedberg, chief economist at emerging markets fund manager East Capital.

Lipman believes that Russia’s recent choices, while politically convenient, will have a long-term negative impact. “This is not diversification of export markets and sources of capital—it is reorientation, which is happening out of necessity,” she explains. “China will be the main beneficiary of these arrangements. It will draw maximum profit from the arrangement, and Russia’s dependence on China as a source of loans, collateralized by oil, will increase.”


No one doubts that the Russian economy is is faltering at the moment. “Russia is already in the middle of a mild recession, with negative sequential growth in the first and [likely in the] second quarter,” explains VTB’s Kolychev. In July, Fitch Ratings lowered its growth forecast for Russia to 0.5% in 2014 and 1.5% in 2015, mainly because of the impact of sanctions and ruble depreciation.

However, Russia’s ill health is not primarily attributable to politics, according to Kolychev. From a cyclical standpoint, credit growth, especially consumer credit, is slowing, and fiscal and monetary policy have tightened significantly, he says. “More importantly, the Russian economy is experiencing a harder-to-overcome structural slowdown as the old economic model, driven by the global commodities supercycle, has run its course.”

Russia’s continued reliance on commodity exports is owing to inertia rather than an unwillingness to relinquish control. Reform has been slow and patchy because there has not been a crisis, according to East Capital’s Svedberg. “Unemployment remains low, the budget is balanced and credit growth continues. As a result, consumption, which is the largest part of the economy at 50%, remains positive. Therefore, there is no sense of urgency [to introduce reforms]. Russia, because of its oil wealth, is a victim of its own success.”

Marcus Svedberg

While the pace of economic reform has disappointed many, it is important to understand the nuances of Russia’s position, according to ING’s Polevoy. Russia might not be “‘strongly committed’ to liberalization of its economy, but there is an understanding that sustainably-higher growth requires opening up the economy and gaining access to international equipment, capital and technologies to diversify the economy.” Similarly, in relation to privatization, Polevoy notes: “There is no strong intention not to sell.”

Moreover, there are some clear signs of reform. In 2012, Russia’s central bond market opened to international investors via Euroclear and Clearstream; corporate bonds followed in 2013, and the stock market will become more accessible this year. “Complex issues, including taxation and disclosure of beneficiaries, were overcome to enable these changes to occur,” says Evgeny Koshelev, analyst at Rosbank. “By 2015, Russian markets will be fully integrated into the global market.” Kingsmill Bond, chief strategist at Sberbank, adds that there has also “been a sustained focus on low-level corruption.”


The idea that Russia is withdrawing from the global economy is dismissed by many. Such a move is impossible, they say, given Russia’s integration into the global economy and its recently-acquired membership in the World Trade Organization. Indeed, Svedberg believes Russia’s integration within the global economy has prevented the Ukraine situation from escalating. “The conflict was contained and sanctions have been limited because Russia and the EU are dependent on each other,” he notes.

Evgeny Koshelev

Economically, Russia is subtly redirecting its focus eastward. However, this simply reflects evolving trading flows. “Russia bought a fifth of its imports from Asia ten years ago,” explains Bond. “Now a third of imports come from Asia, and Russia sends 22% of its exports to the region. The Russia/China pipeline and the commitment to broader engagement will increase exports from Russia, and over time this is likely to lead to a greater flow of capital from Asia.” Pivoting east gives Russia access to the things it needs—trade and capital—at a politically acceptable price.

Koshelev believes Russia is still pursuing globalization. After all, its trade flows and trading currencies are diversifying. “But it is different to the idea of globalization as many in the West understand it.” While Russia’s politics may be dubious, its long-term economics are on surer ground. “The fastest growth in trade is between emerging markets, and necessarily different models are emerging,” says Svedberg.  “Rather than simply repeating a Western model of globalization, we now have true globalization.”


Russia’s long-term plan might be to pivot to the East and South, but historically it has been heavily dependent on Western capital. At first glance, Russia looks vulnerable if it is locked out of US and European markets because of sanctions and negative investor sentiment. According to research by UniCredit, Russian companies and banks have up to $50 billion to repay by the end of 2014. However, the bank believes this is manageable.

“The international capital markets are an important source of funding, but in a stress scenario Russia can find internal resources to offset temporary shutdown of external funding,” says Vladimir Kolychev, chief economist for Russia at VTB Capital. Dmitry Polevoy, chief economist, Russia and CIS, at ING, adds: “There is enough short-term FX cash in the banking sector in the form of hard currency deposits to refinance Russia’s external debt.”

Already, companies are turning to local banks to refinance external loans or raise new funding. “The issue is therefore whether local banks will be able to refinance themselves and, most importantly, whether the government will step in to support banks if necessary,” says Polevoy. At the end of July, Russia’s central bank said: “If necessary, adequate measures will be taken to support” the country’s banks to protect the “interests of customers, depositors and creditors.”

Some alternative funding may be available: The recent Gazprom deal involved $30 billion of prepayments from China, for example. Moreover, Asian investors could fill the gap if US and European investors disappear from order books as a result of sanctions. “For Asian investors, Russia offers an attractive opportunity to gain emerging markets diversification and exposure to commodities,” adds Evgeny Koshelev, analyst at Rosbank.

To some extent, closure of international capital markets could be beneficial, according to Polevoy. “A decreasing reliance on international capital markets would be positive as it would reduce Russia’s external risks,” he says, adding that the best outcome may be that the need to ensure access to funding prompts authorities to speed up rather than jettison reforms.