When the wells run dry

Those critical of Western sanctions against Russia usually point at the fact that these measures have so far failed to do their job. They failed to bring meaningful changes in Russia’s foreign and domestic policies and failed to stop the war in the Donbas. Critics are partly right. Certainly, it took the West too long to force Vladimir Putin to the negotiating table. On the other hand, if the purpose of the West was to weaken Russia and to simultaneously split the political elite, thereby paving the way for changes in the longer term, they are on the right track. 

The crisis of the Eurozone took Europe to its knees because no one expected it ever to happen. Surely, there were doomsayers regularly blowing whistles on the lopsided nature of the Eurozone, a currency zone without coordination of the fiscal policies of its members, where the cost of borrowing converged, hiding the reality of diverging competitiveness. However, as the global economy was booming and kept the lopsided system spinning for certain interest groups and countries (including Germany) to reap the benefits, these worries were brushed aside. And then the global economy came to a sudden halt and before naysayers knew it, Europe had become a very different place.

Something similar is happening to Russia right now. Even before the crisis in Ukraine, the Russian economy had been struggling with potentially lethal structural problems. As long as these problems were only ‘potentially’ lethal, however, the political elite did not seem to care. As we saw it in Europe, being proactive at the expense of your present wealth is a difficult business even in democracies where the political elite can be held accountable much easier than in an authoritarian system like Russia’s. While oil dollars kept flowing, Igor Sechin and his lot, advocating a state-centered economy centered on commodities exports were poised to be more powerful than the market liberals of Dmitry Medvedev or the pragmatists of Alexei Kudrin. Their position did weaken during 2007-11 when the global economic crisis and falling oil prices coincided with Medvedev’s rise, but rainy-day funds accumulated before the crash helped Russia weather the crisis and in all other matters, it was business as usual. In 2011 the failure of the government’s privatisation scheme and the ‘castling’ of Putin and Medvedev signaled a return to the old normal, which, in spite of the worsening external outlook, seemed to work just fine. Up until Crimea and the West’s sanctions. And while the sanctions would have had a manageable effect on a healthy economy, they seem to have become the straw to break the camel’s back. Or, in this case, the bear’s.

Holy cows and shrinking pies

About a year after the start of Euromaidan, Russia’s economy is in tatters. Sanctions may not have had a grave impact on the oil industry just yet, but this is mostly because Arctic exploration is in recess until next spring. As soon as fields become accessible again, oil firms will face delays in drilling, for the lack of Western technology that cannot be replaced either by Chinese or by domestically developed technology in the short term. Import substitution has proven itself to be a tricky business in other fields as well, with a large  part of Russian citizens quoting rising food prices as the most worrying development in Russia recently. Meanwhile, the Central Bank has spent a hefty $54 billion this past year to protect the rouble from caving in (and may still have to spend a further 30 to 40 billion). Yet, the Russian currency has been falling and is now over 50 against the euro and 40 against the dollar.

The most evident proof of this run on resources is the recent dispute over the government’s military modernisation plans. The mighty scheme the total cost of which  is set at $700 billion had been the dowry in the marriage of Russia’s oil sector and arms lobby, the two elite groups that have managed to raise their profile most significantly since 2012. However, now the scheme is suddenly a matter of debates. The Russian state will not be able to finance the development program, claimed finance minister Anton Siluanov last week, while Vice-PM Dmitry Rogozin, in charge of arms procurements, vowed to carry on with the scheme as if nothing had happened. It seems to be clear that, with Russia on the verge of recession and budgetary resources getting scarcer, one of the holy cows of the budget is deemed ready for slaughter.

Certainly, Igor Sechin, the CEO of Rosneft has not indicated that he would be in favour of reducing the funds set aside for the modernization of the army. However, Rosneft badly needs additional funding from the very same state treasury. Global oil prices face a downwards trend, mostly due to higher supplies that may result in prices as low as $83-85 next year. Russia’s 2015 budget needs an oil price of well over $100 to break even (according to the finance ministry, under the present circumstances, the government will have to spend at least $12,5 billion from the $90 billion Reserve Fund). Rosneft is likely to generate less revenue while facing larger financing needs. Further to covering the costs incurred by sanctions, Rosneft will need money (over $40 billion according to Sechin) to refinance debt created by its expansionary policies as well as to finance its investments in Russia’s Far East. Money that it cannot expect to acquire from Western creditors any more. Clearly, it will need to take funds from where they are available.

Kirill Rogov published an informative series of articles in Vedomosti describing the different phases of development in Russia’s oil-driven economy, stressing that the present situation, after ‘the second oil boom’ is vastly different from everything we have seen before. Facing a decline in the revenues generated by Russia’s main export-oriented sector, players are trying to lay their hands on increasingly big pieces of a shrinking pie.

The much-publicised arrest of Group Sistema’s leader, Vladimir Yevtushenkov that was criticised by senior officials seems to be part of this run for resources (in Yevtushenkov’s case, Bashneft). While we cannot know for sure whether Russia’s largest privately owned oil firm, Lukoil, rumoured to be next on Sechin’s wish list, will actually be targeted by a similar procedure, it is easy to see why and how Yevtushenkov’s arrest destroyed a taboo. Resources are getting scarcer while sanctions further increase needs and make it impossible to get funding from traditional resources.

Flushing the medicine

The run on state funds will sooner or later force the oil and the arms industry into a conflict. But the story does not stop there. The Russian budget, as a consequence of the war in Ukraine and Western sanctions will face additional expenditures: the development of Crimea, about to be single neediest region in Russia, according to conservative estimates, will eat up at least 200 billion roubles per year. Further to needs related to import substitution, the Russian budget will have to cover the losses suffered by companies and people affected by Western sanctions. These come together with already existing, acute problems, like lagging infrastructure development that the development of Crimea has already been sucking funds away from, as well as the catastrophic state of some regional budgets, facing falling revenues but higher social expenditure. According to Russia’s finance ministry, the Vologda, Kostroma, Saratov, Ryazan and Belgorod oblasts, the Krasnodar region, the Chukhotsky district as well as the Republics of Mordovia, North Ossetia and Mari El are the regions facing the most serious debt problems. It would not be surprising to see another battlefront within the elite open between federal and regional elites.

The Russian elite will have to chew their way through this mess with a stagnating economy.  While this is partially a consequence of sanctions, the economy will not be miraculously repaired once the sanctions are phased out. Recovery on financial and debt markets will be more sluggish and investors, even those that cannot resist Russia’s lucrative energy market, will be more cautious in a country that is clearly not integrated into the rules-based system of the global economy and where they might be expropriated at any moment.

Also, Russia’s European export markets will shrink quicker than previously expected, and so far it hasn’t been able to credibly substitute these markets with new ones in Asia. The gas contract sealed with China may have proven a political point at a given moment, but it did nothing more. Russia will ship about one-fifth of the volume it currently sells to Europe to China, from different gas fields, and a contract on the terms of which Russia had to make delicate concessions left it reduced to a commodity trader. Rumour has it that the Chinese diplomacy has already started to refer to Russia as a ‘part of China’s sphere of interest’. China rightfully assumes that if it was able to coerce Russia into playing its game once, it will succeed again. What will this next time be about? The underpopulated, underdeveloped Siberia? Or Central Asia that Russia wishes to integrate? In any case, China’s rise will spark panic among Russia’s elite, many of whom would be terrified to see their worst fears materialise.

Kick-starting Russia’s economy will, with or without sanctions, be an uphill battle, and achieving sustainable growth through much-needed restructuring may be close to impossible in the foreseeable future. The government of Dmitry Medvedev has been reduced to a punch bag with a rubber stamp function in the past two years. It lacks not only the financial but also the political resources to carry out any reform. Those standing in line for Medvedev’s seat – Sergei Ivanov, Valentina Matvienko, Vyacheslav Volodin, Dmitry Rogozin, etc. – lack the political will and the credibility to do so. Or to answer three questions about the future of Russia’s political class: how to revive the economy? how to tame nationalists? how to keep selling Ukraine as a war/victory?

This is not 2008

It seems that at the end, it will all come down to Ukraine. The war certainly did considerable harm to Russia and it did considerable harm to Russia’s elite, forcing them to fight for an ever-shrinking pie, and, simultaneously, as Sergei Pugachev, a former Putin-ally put it in the Financial Times, reduced them to Putin’s serfs.

Whether or not Russia’s strategic goals in Ukraine have been reached is debatable. According to Professor Valery Solovei, whom I often quote, the elite seems to think that they haven’t. According to Lilia Shvetsova’s comment in the Financial Times, Ukraine has, so far, been a tactical victory but it might as well be a strategic defeat. Sean Guillory disagrees. I would prefer waiting until mid-November, the aftermath of the unrecognised Donbas elections to pass a judgement on that.

Nonetheless, one might get the impression that the only person that the crisis in Ukraine really benefitted was Vladimir Putin himself. He tightened his grip on the elite, his approval ratings have been soaring and he got himself a separate chapter in history textbooks. But is this really more than just a tactical victory?

Putin has proven himself to be the perfect puppet master when material resources were abundant. When they were not, he let Medvedev take the punches. But this is a different situation, in which Putin might not fare similarly well. What happens when resources are scarce, a significant part of the population is sobered up by harsh economic realities and the elite get desperate?

When will they consider slaughtering the holiest cow?

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