Russia’s economic policy in Putin’s fourth term

Photo: Press Service of the President of the Russian Federation (CC) commons.wikimedia.org

This was a period where demographic trends were still relatively favourable and the labour force was growing. This demographic dividend is set to disappear in the near future, and barring a sharp increase in migration, the labour force will start to gradually decline. Russia’s per capita income remains just 30 per cent of the European average, and the potential for rapid catch-up growth appears to have faded.

For the more liberally inclined members of Russia’s establishment, the slowdown in growth since 2008 is evidence of the exhaustion of Russia’s resource-based economic model. The standard-bearer of this group is Alexei Kudrin, a former finance minister and trusted ally of Vladimir Putin. He sees the fundamental problem as the dominant role of the state, which uses oil and gas rents to prop up an inefficient manufacturing sector. Soft budget constraints resulting from state subsidies and cheap credit to inefficient state-sponsored firms depress competition and prevent the reallocation of resources to more productive firms and sectors.

Quick evolution

Kudrin is in no doubt that the economy is seriously underperforming. He describes the last ten years as a “lost decade”, in which Russia failed to make the necessary structural reforms to allow it to move away from its over-dependence on oil and gas exports. In 2015 he proposed a new growth model based on conventional liberal measures. Improving the business environment by promoting investment and reducing the state’s involvement in the economy was the principal motors of growth. Since then his think tank, the Centre for Strategic Research, has produced a comprehensive reform agenda covering almost every aspect of the Russian economy.

The diagnosis seems dire. But if we look at Russia from a geo-economic perspective, the Kremlin’s economic policy could actually be considered a success. While low GDP growth might suggest stagnation, Russia’s economy has, in fact, been rapidly evolving over the past six years. At the heart of the new policy has been a comprehensive range of measures to insulate the economy from external shocks. Elements of this strategy have been part of Putin’s economic policy from the beginning. In the early 2000s, his government used the windfall from high oil prices to pay down foreign debt and build up sovereign reserves. At the same time, the economic policy was broadly focused on integration with western and global markets while conditions were favourable.

Then the uprisings across the Middle East and the 2011 mass protests in Russia prompted a decisive shift in focus towards insulating the regime from external influence. In the economic sphere, this led to an increased securitisation of economic policy (turning loans into tradable bonds), attempts to de-offshore Russian capital, and a policy of import substitution in certain manufacturing sectors. Economic integration increasingly came to be seen as a means of power projection rather than mutually beneficial exchange. This culminated in the Ukraine crisis in 2014, which was in part a product of competition between rival models of economic integration.

Since 2014 the United States and European Union sectoral sanctions have put economic sovereignty at the heart of the Russian government’s decision-making. There were three main components to this strategy. First, it mobilised public funds and state-owned banks to provide liquidity and financing to sanctioned firms. Second, the programme of state subsidies to support manufacturing and import substitution was substantially expanded. The most radical and disruptive moves were taken in the agricultural sector, where almost all western food imports were banned. Third the government has sought to replace western financing and technology, where possible, with alternative sources.

Strength or vulnerability?

Despite some initial disruption, the Kremlin’s efforts to counteract and mitigate the impact of sanctions have in fact been quite successful. As the British academic Richard Connolly recounts in his new book, Russia’s Response to Sanctions, it is precisely those aspects of Russia’s economy that Kudrin identified as a drag on productivity that have been pivotal in its response to the sanctions. The Kremlin was able to support the economy effectively because the state already played a large role in it, and it had established mechanisms for redistributing hydrocarbon rents to other sectors. The state-led redistributive model ensured that the authorities were well placed to respond to the disruption caused by sanctions and that support was offered to affected sectors and organisations. The effect of the sanctions has therefore reinforced a highly interventionist economic policy and a dominant role of the state in driving economic development.

The impact of the sanctions on energy and defence sectors has also been limited. Russian oil firms were forced to abandon joint ventures with western firms to develop off-shore fields, but considering the sharp drop in oil prices from mid-2014 this retrenchment makes some commercial sense. At the same time, despite limited access to external financing, Russia’s oil companies have been able to maintain – and even expand – production in existing fields. The Russian defence sector has had some success in replacing western and Ukrainian components with other suppliers (including domestically produced equivalents), albeit in some cases of lower quality. Following an extensive programme of import substitution, it is unlikely that the Russian defence sector, in the event that sanctions were withdrawn, would now seek to re-establish supply links with western or Ukrainian businesses.

What conclusions should we draw from this? First, from the Kremlin’s point of view, the current economic model is a source of strength. It is therefore highly unlikely that the government will undertake the kind of liberal reforms that most critics of Russia’s economic policy advocate. If anything, the government is likely to further expand the use of state-led initiatives and administrative diktat in an attempt to push up the growth rate. Following his re-election in March this year, Vladimir Putin called for the government to raise Russia’s growth rate above the global average (implying a rate of expansion of 3.5 to 4 per cent per year) and to increase investment to 25 per cent of GDP (from its current level of around 20 per cent). In August, Andrei Belousov, a presidential advisor, called for a windfall tax on the excess profits of 14 major businesses in order to fund the state investment programme. In September, Sergei Shvetsov, a central bank deputy governor, called for Russian businesses to show more patriotism and to invest domestically.

Second, regardless of its effectiveness, the experience of the past six years shows that external analysts need to take developments in Russia’s economic strategy seriously. There has been a tendency among pundits and policymakers to dismiss Russia’s economy as either a petro-state or a kleptocracy. As former US President Barack Obama dismissively put it in 2014, “Russia doesn’t make anything. Immigrants aren’t rushing to Moscow in search of opportunity … history is on our side.” The late John McCain declared Russia a “gas station masquerading as a country.” These characterisations are, at best, one-sided. Russia has a sizeable manufacturing sector, though admittedly for the most part uncompetitive on global markets. In 2013, before the international sanctions were imposed, Russia was the eighth largest manufacturer in the world. In 2017, Russia was the fourth largest recipient of immigrants in the world. Undoubtedly, corruption and capital flight are serious problems. However, examining Russia’s political economy through the prism of a rent-seeking model leads to a narrow understanding of the government’s policy. In fact, a survey of the past six years suggests that the government is able to think strategically about its political economy and act decisively in response to external pressures.

Vindication?

This suggests that analysts should give serious attention to the major economic initiatives that Russia is likely to pursue in the coming years. Three in particular come to mind: the expansion of economic ties with Asia; the development of alternatives to the US financial system; and the Eurasian Economic Union. To date, progress on all three has been limited. Beyond a few flagship deals – such as the Power of Siberia pipeline that will deliver pipeline gas from Russia to China for the first time – Russia’s pivot to Asia has failed to deliver a significant increase in Chinese direct investment. Portfolio investment from Asia has also failed to offset the sharp decline in western financing as a result of the sanctions. However, this could change, as is likely, if western sanctions on Russia remain and US-China relations continue to deteriorate.

Likewise, official Russian strategic documents depict the international system as increasingly characterised by competing economic and political blocs and intensifying competition for resources. This suggests that the Eurasian Union, which tends to be dismissed by many observers as a virtual integration project, will remain a significant element of Russian strategic thinking. Arguably the EU’s failure to take the Eurasian Union seriously as an economic and political project contributed to the geopolitical crisis in Ukraine.

The last six years have seen major changes in Russia’s political economy, with important implications for its foreign policy. There remains a risk that, as Obama predicted, low growth will relegate Russia to the periphery of the economic system. The international order, seen        from Moscow, appears to be evolving in a direction that vindicates the Kremlin’s turn to “economic sovereignty”. For the moment, however, its economic policy appears increasingly in tune with the times.

Alex Nice is a freelance analyst and former Europe Manager at The Economist Intelligence Unit in London.

economy, Russia, sanctions