Putin’s Impossible Dream

 

nigel gould-davies, a political scientist and former British diplomat, teaches at Mahidol University International College in Thailand. He is an associate fellow of Chatham House.

Published October 29, 2018

Illustrations by Jonathan Carlson

 

On May 7, Vladimir Putin was sworn in as president of Russia for the fourth time. A few hours later, he signed a decree setting out “national development goals” for his new term in office. By 2024 Russia would be one of the five largest economies in the world and growing faster than the global average. Life expectancy would rise five years to 78. Poverty would be halved.

These are extraordinary ambitions. But at first glance, Putin’s success or failure matters little outside Russia. The country’s GDP, calculated at current exchange rates, is just 3.5 percent of global GDP — less than that of Brazil, Italy or Canada. Russia’s major role is as a supplier of oil, gas and other raw materials.

But Russia’s economic fortunes matter to us all. They will shape the country’s global ambitions and internal stability. They will determine both how many guns Russia’s foreign policy can deploy, and how much domestic butter will feed popular support for the regime. With Russia once again at the top of Western security concerns, the implications are profound.

It is very unlikely that Russia will become the “modern and vibrant” economy that Putin imagined at his inauguration — the problems holding it back are deeply rooted in its system, and long-debated reforms that might tackle them will not be adopted. Rather, Russia faces relative decline and growing isolation in a global economy. Putin’s most difficult presidential term has just begun.

How Russia Got from There to Here

To see why, and what lies ahead, we must understand how Russia got here. Like geological ages, three political eras have deposited layers of experience that built up the structures, practices and policies of Russia’s current political economy. History is prologue, not destiny, of course: leaders can make bold, creative choices that defy legacy and reshape the future. Indeed, Russia itself has seen more of this than most countries in the past three decades. But there is little reason to think it will happen under current leadership — and many reasons why it won’t.

The first of our three eras is the Soviet one. Russia’s six decades of state socialism is the longest period of centrally planned, anti-market rule ever endured by a country (though North Korea is on track to gain this distinction in the early 2020s). Russia’s industrial base was laid by administrative fiat, not market decisions, much of it at brutal speed and cost in the 1930s and 1940s under Stalin. After his death in 1953, mass terror ended and enthusiasm for building socialism gradually waned. Without the incentives of fear and ideology, and absent a profit motive, stagnation gradually set in. Uniquely in the developed world, Soviet life expectancy began to fall in the 1970s.

In an effort to stop the slide, the Brezhnev leadership ramped up foreign sales of oil and gas in return for grain and hard-currency loans. But the decision to opt for capitalist trade and credit amounted to a Band-Aid rather than a cure. Hobbled by low productivity and a rising defense burden, inefficiencies and shortages grew. Russia fell further behind as the scientific-technological revolution of microchip and laser began to transform Western economies and militaries.

Things got worse still in the 1980s as energy prices fell sharply, triggering a solvency crisis. Meanwhile, Gorbachev barely tinkered with economic reform, even as he moved boldly to open up the political system: glasnost far outpaced perestroika.

The collapse of the Soviet system in 1991 bequeathed Russia an economy riddled with distortions and inefficiencies. A second era began, a turbulent decade of wrenching transition. Boris Yeltsin’s reformers began a bold “shock therapy” that freed prices, carried out mass privatization, demilitarized the economy, and dismantled much of the state mechanism of control.

All this took place against a background of severe upheaval: from 1991 to 1993, the country came close to civil war. In these conditions, the conversion from command economy to a decentralized market-based system was, as one reformer put it, like “making an aquarium from fish soup.

These were hard times for much of the population. National income fell by up to 30 percent, even as inequality rose. A “Moscow average,” the joke went, meant “worse than last year, better than next year.” Special interests captured and diverted reform policies. Powerful oligarchs gained lucrative oil and mining assets for a pittance. Many people lost their savings in the 1998 financial crisis and sovereign default. But by the end of the 1990s the foundations of a market economy, imperfect and incomplete, had been laid.

Enter Putin, and the start of a third era, in 2000. Though he was Yeltsin’s chosen successor, the former KBG officer brought very different views about the methods and purposes of power to the presidency. At the heart of his project has lain a tension between two goals: to make Russia prosperous, and to restore it as a great power on the international stage.

At first, the twin goals of power and prosperity seemed manageable, even complementary. Putin set about rebuilding the “super-centralized state,” that he insisted was “in Russia’s genetic code,” more rapidly and successfully than anyone imagined. He coerced and cowed oligarchs and regional governors who had gained significant power. He also appointed an able economic team that pushed through further reforms, including a flat income tax and a land code. Putin also created a Stabilization Fund to sequester a portion of oil revenues for a rainy day. Indeed, for a time, it seemed that Putin’s vertikal [i.e. governance from the top] strategy of state power would foster a more liberal economy.

But this marriage of market reforms and “dictatorship of law” was brief. A turning point was the 2003 Yukos affair that led to the nationalization of Russia’s largest private company and jailing of its CEO, Mikhail Khodorkovsky. Soon after, Putin signaled the end of reforms. The Russian state, cut down in the 1990s, began to grow again — and with it, corruption and inefficiency.

Yet while Putin lost enthusiasm for further reform, he remained keen on global markets. He believed that Russia’s prosperity required deeper integration. From 2000 to 2008, energy export earnings totaled almost a trillion dollars. Accumulated foreign direct investment rose from $2.7 billion to $75 billion.

Putin, moreover, sought an active role in global governance. In 2006 Russia held the presidency of the Group of Eight for the first and only time, and in 2012 joined the World Trade Organization.

Putin’s first two terms (2000-08) were fat years for Russia. The economy grew at nearly 7 percent a year, raising living standards faster than in almost any period in Russian history.

Putin was fortunate in his timing. The oil price rose five-fold, accounting for half of Russia’s growth. The rest was concentrated in construction, trade, telecoms and transport, and was made possible by the market foundations painfully laid over the previous decade.

Internal Contradictions

By 2008 Russia was far more authoritarian, centralized and prosperous than at the turn of the millennium. Putin’s synthesis of a strong state and international integration seemed a winning formula. But it began to fall apart for two reasons.

First, the global financial crisis hit Russia harder than any other major economy, highlighting dependence on the oil price and lack of diversification. But what followed was more telling. Initially, oil bounced back and the economy seemed to recover. However, the dysfunctions of a growing state, papered over for a time by booming energy exports, soon emerged.

In 2013, with the price of oil still over $100, the economy grew by only 1.8 percent. The hydrocarbon growth model that had served Russia well in the previous decade was reaching exhaustion. Even though petrodollars continued to flow in ($1.2 trillion worth from 2009 to 2012), they were no longer sufficient to propel brisk growth.

The second reason for the unwelcome slowdown was geopolitical overreach. Putin sought to harness Russia’s deepening role in the global economy not only to domestic growth but to the projection of power beyond Russia’s borders. Russia used economic ties to coerce and corrupt small neighbors, and, more ambitiously, to leverage Europe’s dependence on natural gas from Russia into political influence. It also cultivated Western elites by offering lucrative positions and investment opportunities (a k a, “caviar diplomacy” and “lords on boards”).

 
Russia used economic ties to coerce and corrupt small neighbors, and, more ambitiously, to leverage Europe’s dependence on natural gas from Russia into political influence.
 

But Putin’s ambitions proved too great. On the first day of its presidency of the G8, Russia cut the gas supply to Ukraine. This cast Russia’s main G8 theme, “energy security,” in a darkly ironic light. The downstream supply disruption that followed was a wake-up call to Europe on the risks of dependence on Russia. This and other alarming Russian words and deeds led the EU to step up efforts to diversify energy supply and to launch legal action against the monopolistic practices of Gazprom, Russia’s giant state monopoly for gas exports.

Waning growth eroded support for Putin’s government, fueling the biggest demonstrations of his presidency. No longer able to deliver on the promise of prosperity, the regime sought fresh popularity in nationalism. Putin vilified the European Union, Russia’s biggest trading partner, for abandoning traditional social values and pressured Ukraine into abandoning a trade agreement with it. When this provoked demonstrations that forced out president Viktor Yanukovych, Russia retaliated by annexing Crimea and intervening militarily in eastern Ukraine.

This was a watershed moment.

Despite cooling relations, the West had until then supported Russia’s integration into the global economy. Now it imposed sanctions, restricting Russia’s economic access for the first time since the end of the Cold War. Russia in turn banned food imports and promoted import substitution. An enthusiast of deeper economic ties for a decade, Putin now declared that “our development depends primarily on us.”

 
Key decisions on investment and asset use are made by former operatives from the military or security services. Their instincts are to control, and to use that control to enrich themselves and their networks.
 

Things got worse for Russia when oil prices fell 70 percent over 2014-16 — the fourth time since the late 1980s that a collapse in energy revenues hit Russia hard. Yet while this initially hurt Russia more than the sanctions, it is sanctions that will ultimately matter more.

Oil prices have doubled again since their last big dip, easing some pressures. Sanctions, though, seem here to stay.

They are not designed to hurt the economy as a whole, but to deprive the key energy and finance sectors of technology and capital. Individual sanctions on oligarchs and their companies also bite deep. The United States’ singular ability to isolate a chosen target from access to much of the global financial system has created deep uncertainty in Russia’s economic elite.

Three tumultuous eras, then — Soviet, Yeltsin and Putin — have together molded the Russian economy. Russia still bears the imprint of Soviet industrialization, with its legacies of outdated technology, a fetish for gigantic industrial facilities, one-industry towns and monopolistic linkages.

One further legacy: Russia has the lowest “temperature per capita” in the world. This is a fact determined by government dictate as much as geography: Soviet planners sent millions to live in Russia’s least hospitable climes.

Russia’s transition had begun to erase these legacies. But even in the best of circumstances, they would impose deadweight costs for a generation. And, needless to say, these are not the best of circumstances. The controlling state, cut down in the 1990s, has roared back under Putin.

Unlike Soviet times, the state does not plan — but it does own. Since 2000, the state’s share of production has risen from 30 percent to over 50 percent. Most of the oil and gas industry, and 70 percent of the banking sector, are now in state hands.

Accordingly, key decisions on investment and asset use are made by government officials, not by markets. Increasingly, these officials are, like Putin, siloviki — former operatives from the military or security services. Their instincts are to control, and to use that control to enrich themselves and their networks. The bloated state is inefficient and corrupt.

Not surprisingly, government employment has become a popular career option. Conversely, according to polls, only 2 percent of the workforce aspires to become entrepreneurs.

The wider business environment is poor. Russia is ruled by relationships, not laws. A sistema of ties, networks, favors and dependence that ultimately lead back to the Kremlin, dominates the economy. Property rights are weak and poorly protected. Reiderstvo, seizure of assets by rival companies with the help of police or security services, is a serious threat that discourages private businesses from growing out of the protective cover of small size.

Corruption is everywhere. Russia ranks 135th on Transparency International’s Corruption Perceptions Index, behind the likes of Myanmar, Malawi and Pakistan. As one businessman said after being forced to sell his company and move abroad: “only in London did I realize that back in Russia I had spent 20 percent of my time on business and 80 percent on confrontation.” That was 10 years ago; times are tougher now.

Russia’s own “economic security strategy,” adopted last year, candidly acknowledges endemic problems: high levels of crime (both organized and individual), a large underground economy (born of the need to evade the organs of the state), a declining education system and poor market infrastructure. Many consequences follow. Under Putin, capital outflows have averaged tens of billions of dollars annually — $31 billion in 2017. Those who know best how money is made (and kept) in Russia are sending it to safer places when they are permitted. Labor productivity is 40 percent of the U.S. level.

Demographic trends will only make things harder. The working-age population is due to fall by 4.8 million over the next six years. Compounding this, emigration has risen since 2014 — especially among the highly educated.

This is not an economy poised for growth and innovation. And an adverse international environment is making things worse. The longer Western sanctions are in place, the more they will hurt. Meanwhile, government measures to protect companies and oligarchs from the effects of sanctions are bringing more assets under state control, compounding the problems of inefficiency and corruption.

 
The Russian economy will not collapse, but its long-term prognosis is poor. Russia now has a less dynamic economy and faces a more hostile global environment than at any previous point in Putin’s leadership.
 

Global energy markets are also changing in ways unhelpful to Russia. With America’s production of shale oil making it the world’s swing producer, prices are unlikely to rise and stay high for long. Conversely, any price fall will hurt Russia, which still relies on oil and gas for half of its federal budget revenues and 20 percent of GDP. Meanwhile, the rise of the liquefied natural gas market, as well as the EU’s progress toward a coordinated energy policy, is blunting Russia’s ambitions to use its gas as an instrument of geopolitical extortion.

There is one bright spot. Despite deep structural problems, Russia’s economy is relatively well prepared to weather a financial crisis. Putin is a fiscal conservative driven by a horror of financial dependence. He remembers the humiliation of the 1998 default and is plainly determined to ensure that it is not repeated, even repaying IMF loans early. Russia’s sovereign debt as a portion of GDP is now only 32 percent, far less than that of any OECD country.

Hefty foreign exchange reserves fortified by the rainy-day Stabilization Fund prevented the 2008 crisis from having a more severe impact. This experience, and the collapse of relations with the West, reinforced Putin’s caution.

Hard-currency reserves are now approaching $500 billion, enough to cover two years’ worth of imports without selling a barrel of oil. And despite a budget surplus forecast for 2019, Russia’s broad-based (and unpopular) value-added tax is set to rise from 18 percent to 20 percent. Russian government debt is once again rated as investment grade despite the looming specter of sanctions against international lenders.

The Russian economy will not collapse, but its long-term prognosis is poor. Russia now has a less dynamic economy and faces a more hostile global environment than at any previous point in Putin’s leadership. Growth has not exceeded 2 percent since 2012 and is on course for only 1.8 percent this year. This is far lower than the global average of 3.1 percent — not higher, as Putin demanded after his latest inauguration. Evsey Gurvich, head of Russia’s Economic Expert Group and a member of Putin’s Economic Council, gloomily forecasts that “developing market countries will start to catch up and overtake us, and developed countries will move further ahead in technological development.”

Gurvich is not alone in using the term zastoi (stagnation), with its unmistakable allusion to Brezhnev’s “era of stagnation.” Putin has already exceeded Brezhnev’s 18 years in power. And like Brezhnev, he cannot reform.

There is no mystery to the reforms Russia needs. Putin sets up rival groups to study them and checks them off in many of his speeches. But no major economic reform has been passed since 2004. Faced with a failing model in 2012, Putin chose a revanchist, not reformist, path that deepened Russia’s isolation from the West and brought new problems.

Why this refusal to change course when the status quo is failing? Because reforms would challenge the entire system Putin has built. Weak rule of law, ill-defined property rights and great discretion to reward and punish give Putin and his circle the levers to maintain power. All this is incompatible with independent institutions, transparency and accountability.

Furthermore, if commercial rather than political considerations were allowed to drive energy policy, Putin would not be able to use energy to project power abroad. Though these ambitions have been sobered by setbacks, they remain significant. The clearest example is the controversial Nord Stream 2 pipeline, which is being built to deepen Germany’s dependence on Russia’s natural gas — and, in bypassing Ukraine, to increase its vulnerability to Russian pressure.

The China Option and Other Fantasies

What could Russia do, short of serious reform, to prevent stagnation? Under Brezhnev, the Soviet Union expanded trade and capital flows with the West to prop itself up. Russia is now turning to Asia with parallel ambitions.

Russia’s relations with China are warmer than at any time in the past 60 years. The Sino-Russian “strategic partnership” is symbolized by the Power of Siberia pipeline that will begin supplying gas to China in 2019 under a 30-year contract.

But Russia’s bargaining power with China is weak. It has few options for expanding trade and investment, while China has many. In public, China is respectful to a fault, ensuring that Russia doesn’t lose face. But it has already shown itself to be a tough, pragmatic partner on key issues such as energy pricing. And as China continues to grow three or four times faster than Russia, their relationship will be increasingly shaped on Chinese terms. China’s economic expansion via the Belt and Road Initiative into Central Asia (where it has already displaced Russia as the dominant trading partner) could even become a source of friction.

Finally, how will Russia cope with the digital revolution now disrupting the world? Some argue this is an opportunity. Russia has astonished the West with its skill in harnessing the internet as an instrument of information warfare. Could it build a digital economy that brings efficiency gains without reform? Russia’s thriving home-grown social media channels show it has the talent to accomplish this.

 
A failing economy will leach away popular support — unless, perhaps, the Kremlin manages to sustain fealty with further nationalistic adventures.
 

But technical innovation will take Russia only so far if it does not address structural issues. The digital sector is as vulnerable as others to the dysfunctions of the wider system. Russia’s best-known internet entrepreneur, Pavel Durov, left the country after facing state pressure and losing assets. Businessmen who built up mobile phone companies have suffered similar fates.

Clumsy efforts to block Russia’s popular (and internationally regarded) Telegram Messenger app earlier this year illustrated how the reflexive intervention of state security can hinder digital progress. At worst, Russia’s failure to foster conditions for digital transformation could cause it to fall further behind the West, just as Soviet failure to diffuse computers through the non-military economy did.

Putin appears to recognize the stakes. Speaking recently about artificial intelligence, he predicted that “whoever becomes the leader in this sphere will become the ruler of the world.” But wishing won’t make it happen.

No Exit?

Some argue that Russia is now a “normal” country with problems typical of an upper-middle-income economy. But much about the scope and methods of Russia’s domestic control and external ambition are anything but normal. A resurgent, increasingly silovik [security-oriented] state owns key assets and manipulates rules to maintain control. Russia’s most important industries, oil and gas, are instruments of foreign policy — and the policy of a frustrated superpower at that. All this is undermining growth and innovation.

Declining economic performance will strain the ties that bind Russia together. Elites will struggle more fiercely over a smaller pie, especially if Russia suffers further sanctions. A failing economy will leach away popular support — unless, perhaps, the Kremlin manages to sustain fealty with further nationalistic adventures. But this could lead to a new arms race. Given the economic imbalance between Russia and the West, it is a race Russia cannot win.

So watch how Putin plays a weak hand. Until now he has used Russia’s limited assets to consolidate control at home and wield influence abroad. But his ambitions contain seeds of decline that will likely erode domestic cohesion and stoke international tensions — with possibly fateful consequences for Russia and the world.

main topic: Russia