Too much oil in the works

Russia is booming, but for how long?

“IN A decade, we have at least to double the country's gross domestic product.” In his speech to parliament a year ago, the usually cautious Mr Putin shook the entire government out of its complacency. Never mind the exact target: can he deliver consistent growth at all?

So far things look better than ever. GDP growth breached 7% last year and seems set to do almost as well this year. And unlike the boom before the 1998 default, which was driven by a fixed exchange rate and a mountain of government debt, this one looks real. The government's finances are under firm control, and foreign-currency reserves at the end of April stood at nearly $79 billion. Moody's, a rating agency, promoted Russian debt to investment grade last October. Fixed investment grew by over 12% in 2003, which shows that companies are now modernising and expanding. Productivity is growing steadily.

As consumption figures testify, ordinary Russians are feeling the benefits. Whereas only a few years ago life outside the biggest cities was unremittingly bleak, now it is rare to find a regional capital without a profusion of smart new shops and restaurants. And most of the people spending money there are not bandits or corrupt officials, but a genuine middle class making an honest (by Russian standards, anyway) living. The number of Russians classified as “poor” has fallen by a third in the past four years. Even the demographic squeeze that alcoholism, poverty and the miserable prospects for the future have imposed since the end of the Soviet Union seems to be easing slightly. Last year, for the first time since 1998, the alarming natural decline in the population--some 900,000 per year--began to slow.

People are beginning to demand normal-country things like bank loans, credit cards and mortgages, which have only recently appeared in Russia for the first time. Companies are discovering that a population of 145m spread over 11 time-zones is a terrific market for mail order and online shopping. Though their salaries are low by comparison with the West, Russians save little, pay low taxes, tend to own not rent their homes and love gadgets and fashions, making them a goldmine for a businessman with daring and imagination. Stephan Dertnig of the Boston Consulting Group, which is bursting with new clients, estimates that a mid-sized firm which would make a 10% return on sales in the West could expect 25% in Russia.

What reforms?

Yet little of this is thanks to reforms. Although there have been some, most notably one to simplify and cut taxes (so that more people are now paying them), Mr Putin's main contribution has been to create, by comparison with his disorderly predecessor, a feeling of stability that allows people and businesses to think ahead.

Moreover, what drove growth in his first couple of years was the post-crash recovery, and much of what drives it now is an oil boom. According to a calculation by the World Bank last August, had oil prices not been rising, the 7.2% annual growth rate in the first half of 2003 would have been 4.2%; solid, but not the stuff of economic miracles.

Russia's energy dependence is pernicious in many other ways too. The World Bank estimates that the oil and gas sector, which employs less than 1% of the workforce, accounts not for 9% of GDP, as the official figures state, but for nearer 25%. The official statistics are distorted by transfer pricing, a tax dodge whereby oil firms sell cheaply to trading companies they control, which sell on at market prices. This has cost the federal government billions of dollars in potential revenues. Though awash with profits, the oil firms are lazy; they tend to invest in squeezing the most out of their current oilfields, rather than in exploring new ones. Yet many oil towns are miserable places where most businesses are controlled by the oil company. With little else to entertain them, workers often spend their pay packets on drugs and prostitutes, turning the towns into hotspots of HIV infection.

Even so, thanks to high oil prices, the federal government has run budget surpluses. Isn't this good? No: the money all too often bails out regional governments, which use it as a quick fix for local unemployment by creating public-sector jobs, when it would be better spent on building infrastructure or lowering taxes to help the private sector.

Nor is the oil cash an unmixed blessing for the economy. Combined with a weak dollar, it has driven up the rouble much faster than the central bank would like, leading some economists to argue that Russia still risks catching “Dutch disease”: a strong currency, rising imports, less competitive exports. Banks are trying to lend as much as they can, so there might be a small wave of defaults in two or three years. But the banking system is too shallow to absorb all the cash washing around. Top officials have started flagging up the risk of an asset-price bubble.

The surplus cash, along with flight capital returning from abroad, is fuelling what Roland Nash at Renaissance Capital, a Moscow investment bank, describes as “the mother of all shopping sprees” by the big conglomerates, often compared to Korea's overgrown chaebol; their rush of acquisitions is leaving “small islands of industry in a sea of chaebolised assets”. Though these firms are driving a much-needed consolidation of the leftovers of Soviet industry, they are--according to the World Bank--no more efficiently run than other businesses, and their market power and ability to wring favours from regional governments is a threat to smaller firms.

Oil prices may stay high for a while if the turmoil in the Middle East continues. But when they fall, growth will stutter, unless other parts of the economy have become stronger by then. Large swathes of Soviet-era industry have failed to restructure, and now face a growing challenge from imports as Russians' incomes rise and their tastes change. Small businesses, though growing fast, still account for a mere 12% of GDP, as against 30-70% in developed market economies. For sustainable long-term growth, these businesses need a better climate. This is where reform starts to matter.

Mr Putin evidently realises this. Having spent his first term making sure he was firmly in control, he has ambitious plans for the second. “There is a theme that the first term was one of preparation, consolidating control and removing the legacies of the Yeltsin era, while the second one is of implementation,” says Chris Weafer at Alfa-Bank. “The stockmarket is currently pricing in that this government will be able to do everything it has promised.”

Those promises include:

• Separating out the 1,000-plus banks that act as little more than pocket banks for companies from the few dozen that do retail banking and lending, and regulating the second group better.
• Making the big natural monopolies more market-oriented. UES, the state electricity firm, is already on the way to being broken up. Gazprom, the gas behemoth, probably will not be, but other gas suppliers will get access to its pipelines, there will be more private investment in its projects, and domestic gas-price subsidies may be cut.
• Investing in starved social infrastructure, notably housing, health and education, and modernising the way they are managed (for example, by expanding the use of health insurance and sorting out responsibility for the decaying communal parts of blocks of flats).
• Making the courts more efficient, more transparent and less corrupt, which is essential to allow small businesses to defend themselves, and further reducing the bureaucracy those businesses face.
• Other economic reforms, such as anti-monopoly measures, to allow Russia to join the WTO. Entry has been delayed many times, but is currently set for the autumn of next year, in time for Russia's chairmanship of the G8 in 2006.
• An overhaul of the armed forces, shrinking them and ending conscription in favour of a professional army.
• An administrative reform. A commission has identified some 5,000 functions of government, 1,000 of which it considers superfluous. These will be eliminated, and a fifth of the 2m-plus bureaucrats in central government will be fired; what the rest must and must not do will be tightly defined and put in writing.

All very fine-looking. Having reined in the natural-resources firms--a new windfall tax could bring in as much as an extra $3 billion next year--the government should have plenty of cash with which to implement these reforms. It has also hinted that it will stop running budget surpluses. Already this year, tax cuts worth $10 billion should give businesses a buzz. But there are problems.

One is that all this depends on oil prices staying high enough for long enough. True, they have a long way to fall before reaching the government's break-even level of $20 a barrel. And if this year's price predictions are right, says Mr Zhukov, the deputy prime minister, the excess will leave 500 billion roubles in the oil stabilisation fund, enough to maintain current spending for two years even if the oil price drops.

But the ocean of petrodollars is not merely drowning the economy; it seems to have put the government into a state of self-hypnosis. Ministers regularly repeat Mr Putin's mantra of doubling GDP in a decade, though that would take unbroken growth of 8% a year. When German Gref, the economy minister, said in a cabinet meeting in February that he would like to see poverty halved in three or four years, Mr Putin rebutted, “Don't be shy, say it: in three years this level will be achieved.” Shyly, Mr Gref replied, “We will do our best.” Within a few days he had increased his growth estimate for 2004.

Once again, with more feeling

The second problem is that Mr Putin has tried some of these reforms already, and his record is not good. There have been first stabs at such things as bank deposit insurance to help private banks compete against the state-owned near-monopolist, Sberbank; private ownership of agricultural land; less bureaucracy and better protection for small companies; and, as in many western countries, the difficult move from a pay-as-you-go pension system to a funded one. But all too often the implementation has been a fiasco. Workers can now invest their retirement savings with private fund-management companies instead of the state pension fund, for instance; but they were given so little information that only 2% chose to do so.

Workers at collective farms, who are entitled to a share of the farm's land, can now turn it into private property. But the law left it up to regional governments to set conditions, such as the minimum size of a private plot; some have chosen sizes as large as 200 or 300 hectares, which favours the farms' existing managers and forces the farm workers to band together in large, unwieldy groups if they want to strike out on their own. Military reform has been in the works since Mr Putin appointed a civilian silovik, Sergei Ivanov, as defence minister, but to the president's evident frustration it has more or less ground to a halt.

To many observers, any progress at all is a miracle. The land reform, says Ksenia Yudaeva, an economist at the Carnegie Centre in Moscow, “was one step forward and two steps back, but nobody believed that our state could bring the concept of private property to agricultural land.” Richard Hainsworth, a banking analyst for Renaissance Capital, says the bank reform, though it was held up and then watered down, “is going in the right direction, and it would be very difficult for someone to come in and do better.” Now that government, parliament and business all obey him, Mr Putin should, goes the thinking, be able to push reforms through faster.

But--and this is the third problem--faster may not mean better. Bad laws can now be rammed through as easily as good ones. And the reforms for the second term are more complex than for the first, so the gap between laws and implementation could grow even wider. To make them work requires an effective bureaucracy.

That is why the administrative reform matters so much. It has been years in the making. Mikhail Kasyanov, the prime minister until February, had persistently held it up, one possible reason why Mr Putin fired him. A first step towards it was a restructuring of the government in March, which notionally created separate agencies in each sphere for policymaking, implementation and regulation.

But so far it looks like little more than a reshuffle. Nobody has been fired. This may just be the cautious Mr Putin's usual strategy: he moves people sideways instead of ditching them. But the bureaucracy, immortalised in 19th-century Russian literature, is famous for its ability to frustrate its masters as much as to enrage the ordinary citizen. Nobody has yet explained precisely how this hydra, which under Mr Putin has grown even bigger, can be made to cut off so many of its own heads. And if it does not, the citizens will suffer.

Article forms part of a survey on Russia in this issue of The Economist. Article looks at the economic situation in Russia, which is booming, but for how long?

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