Funny games – Russia can afford them, but for how long?

September 8, 2008

Last week, the European Union decided it would put on hold the freshly started negotiations for a new partnership agreement. This agreement would have a strong economic component, as the EU wants to build a common economic space with Russia.

Today, EU Commission president Barroso, French president Sarkozy and EU chief foreign policy man Solana are in Moscow for “discussions with a view to the full application of the six-point agreement” (see here) reached by Sarkozy with Russia and Georgia in August. The agreement calls for a retreat of Russian troops to pre-August 7 positions.

The Economist this week-end  was cautiously optimistic about the fact that Europe is uniting in the face of Russia. But will the EU trio’s trip to Moscow today yield results? It is doubtful, unless it is dawning upon Russian leaders that its policies are going to cost Russia a lot of political, and especially economic, credit.

Political credit: Russia remains largely isolated regarding its actions in Georgia and its recognition of Abkhazia’s and South Ossetia’s independence (When one excepts Nicaragua – a miserable little Central American country that has a tradition of letting itself be bought off for state recognition). In particular, the new ally it likes to cooperate with to build a “multipolar world”, China, has refused to endorse Russia’ recognition, which, in its view, encourages what China fears most: (Uighur and Tibetan) separatism. Will Russia’s Chechens and Ingushetians be emboldened as well?

Economic credit (Sources for this section: FT, World Bank, BNE, DG Trade).

First, Russia’s economy has been striving in the last years along with the oil price. It hit a record 8% of GDP growth in 2007. But this growth is set to slow down, along with the stumbling oil price.

Second, Russia’s economy suffers from underinvestment. Although overall investment levels reached a respectable 21% of GDP last year, these levels are much lower than China’s (more than 40%) or India’s (more than 30%). The state has been stepping up infrastructure, utilities, and other investments. But it can only do it in collaboration with efficient private companies, mostly foreign. But Foreign Direct Investment (FDI) is low for emerging market standards. FDI flows reached a record 30bn US$ in the first half of 2008, as much as in 2007 altogehter. The problem is that since July, the country has witnessed significant capital flight. It started with Prime Minister Putin’s threats of sanctions against coal company Mechel for its pricing policies, in the midst of the BP-TNK standoff. It continued with the counter-offensive on Georgia. Estimates of the amount of capital that left the country in August are at 20-21bn US$, i.e. 2/3 of the nominal amount of FDI received in the first half of the year. The main Russian stock market, the RTS, stumbled. The Equity Risk Premium for Russian stocks rose to more than 10%, unheard of in Russia since 2005. This means Russian investment will become more expensive. This penalizes Russian businesses. The credit, i.e., the trust, investors have in Russia has been waning. While the country has so far tried to fight the usual currency appreciation that goes with a commodity-exporting economy, the recent capital flight has forced the central bank of Russia to intervene to prevent ruble depreciation! The country lost 14bn US $ of its admittedly very high 595bn US$.

Third, Russia’s trade policies are counterproductive. It put WTO accession on ice, thus telling everyone that state-sponsored adventurism and arbitrariness in trade and investment will continue. Something to deter any sensible investor ready to plough in money into Russia. It is hassling Turkish trucks bringing in goods at the border, it banned imports of pork and poultry from the US and elsewhere, and it is revisiting its trade agreement with Ukraine, officially to avoid cheap imports from other WTO members (Ukraine just joined the WTO). Russia is only hitting its consumers with such policies – food and other items will become more expensive for the average Russian, not exactly what one wants when the country is suffering from severe inflation.

Fourthly, Russia needs Europe. Europe is scared of Russia’s ability to shut down pipelines for its increasing gas demand. And Russia is now Europe’s third global export destination. The EU exports to Russia more than it does to China. And it exports what it is good at: high-value products, machinery and transport equipment. So, yes, Russia needs Europe badly, and its leaders know it. But Europe’s export and investment frenzy in Russia feeds the recent take-up of manufacturing that Russia has witnessed in the last couple of years – much needed for its economy to grow and diversify. Europe has a great deal of investments to protect in Russia as well: about 2/3 of FDI into Russia comes from Europe. Germany, the UK, Italy, France, Austria, the Netherlands and Cyprus (the latter is Russian money safely kept offshore), all have millions in Russia. If the government keeps on stepping up its policies to hassle foreign investors, then one day the money will move elsewhere, especially if indeed, the oil price continues stumbling.

So, what next for Europe? No need to linger on the fact that on the military-diplomatic side, the European Union cannot do much. But, if it accepts a little patience for the outcomes, it can devise a good economic strategy. The Peterson Institute’s Anders Aslund put it down straight in the FT last week:

“First, the EU should adopt a common energy policy, imposing the rules of the energy charter – such as transparency, equal investment rights and third-party access to pipelines – on Russia. A united EU has bargaining power as all Russian pipelines outside the former Soviet Union go to Europe.

Second, the European Commission should force Gazprom to unbundle production and transportation to break up its monopolies. Why does the EC pursue antitrust suits against Microsoft but not Gazprom? (…)

Third, the west should investigate Russian top officials and their trading companies for money-laundering.

Fourth, Russia’s big state companies habitually woo politicians in other countries. Gerhard Schröder, the former German chancellor, is just Gazprom’s most prominent catch. Western ethical rules for contacts with Russian state companies need to be tightened (…) Unethical behaviour is best fought with increased transparency.

Finally, if western intelligence agencies possess evidence of any corruption by Mr Putin or his cronies they should publish it. Nothing would undermine him more in Russian eyes than verified facts about corruption. Russia and its leaders are quite vulnerable, but to be effective the west needs to unite.”

I would also add that the EU should play it cleverly with its own trade policies. After oil and gas (65%), Russia’s main exports are metals (16%). But the EU does not let Russian metals in freely – it imposes quotas. Lifting them would help Russia’s economy diversify and entangle Russian metals business interests with the European economy. This is one method that would help leverage what Chrystia Freeland, another specialist of Russia, proposed, namely Russia’s oligarchs. Metal magnates, among others, could be good allies. Russia is also a net food exporter. Europe should open its markets to Russian agricultural exports. But I am afraid this could be asking too much, given entrenched EU protectionism in those sectors…

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One Response to “Funny games – Russia can afford them, but for how long?”

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