Dmitry Medvedev has taken over as Russian president this month with bold plans to modernize Russia’s economy. Their fulfilment will depend, above all, on how quickly Medvedev – supported by Vladimir Putin as prime minister – can push through a new round of economic and administrative reform.
Another key challenge will be to attract private capital, including foreign capital, to partner the state in reinvesting Russia’s accumulated oil wealth. Steve Thunem, head of global markets at VTB-Europe – whose team of bankers will be selling that partnership to international markets [see separate story] – tells Emerging Markets: “Medvedev’s Russia is very much an economic stability story. It has been discounted in the market for quite a while: people are very comfortable with it.”
The highlights of Putin’s two-term presidency were Russia’s transformation from debtor to master of vast offshore sovereign funds; centralization of political power and assertion of state control over oil, gas and other strategic sectors; and the flowering of capital markets, topped by the Gazprom shares liberalization and a string of IPOs (initial public offerings) in London.
The priorities for his successor are to reorganize the ponderous state bureaucracy, reform pensions and benefits, take Russia into the WTO, and launch the industrial modernization drive.
Putin used his last big speech as president, on February 8, to lay stress on economic efficiency and innovation. Labour efficiency should be quadrupled in 12 years, state intervention in the economy reduced and the tax burden lowered, he said. He talked about cutting value added tax: the market expects it to fall as low as 12%.
Medvedev, addressing businessmen in Krasnoyarsk a week later, promised financial reforms: a new bank refinancing system, the use of pension savings and the National Wellbeing Fund, one of the state’s two new offshore funds [see below] to boost the financial system; and tax breaks on securities transactions and other measures to boost domestic stock markets.
The big get
Yaroslav Lissovolik, chief economist at Deutsche Bank in Moscow, says the state bureaucracy may prove the toughest nut to crack. “Since 2000, when Putin came in and promised to reduce the number of bureaucrats, their ranks have swelled from 1.1 million to 1.6 million. Medvedev needs to use wisely the political will provided by the election.”
Reform of social benefits will be no pushover, either. The last attempt, in 2004, was almost completely reversed after street protests by pensioners, the most serious public opposition Putin faced in eight years. A second go – along with price increases for electricity (that will follow from power sector reform) and gas (scheduled to reach European netback prices for industry by 2015) – will certainly test ordinary Russians’ support for the Medvedev-Putin team.
Using oil WELL
Administrative, financial, judicial and other reforms are critical to ensure that Russia’s oil windfall is spent the right way, politicians from Putin downward believe.
The state plans to invest tens of billions of dollars in the sectors it has prioritized – including raw materials processing, power, aerospace, shipbuilding, agriculture and IT – and to make over Russia’s physical and transport infrastructure.
Chris Weafer, strategist at Uralsib bank, expects a doubling of state spending over the next three years. This “should act as the main growth driver”, and bring with it unprecedented investment opportunities. Lissovolik at Deutsche agrees, but cautions: “Inefficient spending from the budget is a big worry.”
Russia’s state-controlled corporations, the big three state-owned banks (VTB, Vneshekonombank and Sberbank), and business groups loyal to the Kremlin such as Oleg Deripaska’s Basic Element, will figure prominently in this state capitalist boom.
Foreign investors, both strategic and portfolio, will also be more than welcome. It was emblematic that on the day Medvedev was elected, Renault bought a 25%+1 share of the car producer Avtovaz for $1.1 billion. The controlling share is held by the newly-founded state corporation Russian Technologies, which was fashioned by Sergei Chemezov, an old KGB colleague of Putin’s, from assets grouped around Russia’s arms exporting company.
“About $40 billion of IPO issuance seems likely in 2008, including an offering from Rusal and several issues from the power generation sector”, Uralsib’s Weafer says. He estimates that there was $32.8 billion of equity issuance from Russia in 2007, including $18.6 billion in London. That was nearly double the 2006 total of $17.6 billion, most of which was accounted for by Rosneft’s IPO.
While the corporations owned by the state and its favoured businessmen continue to grow, a final settlement is expected this year with the remaining out-of-favour oligarchs.
So key holdings in the gargantuan nickel and palladium producer Norilsk Nickel will, barring upsets, be sold by Vladimir Potanin and Mikhail Prokhorov – probably to Deripaska’s world-beating aluminium company, Rusal. At the time of writing, Rusal was putting together a $4.5 billion acquisition financing with 10 international banks, but had still to beat off an alternative bid from iron ore and steel magnate Alisher Usmanov.
The backdrop to Russia’s state-led investment boom is a fundamentally bright economic outlook, with growth forecast at 6.5–7.5% this year. There are clouds on the horizon, though: inflation, worries about competitiveness, and the impact of world market conditions on the financial system.
Good as ever
Russia’s own fundamentals are as good as they have ever been. The trade balance in 2007 was close to its highest for 15 years ($129 billion). The current account surplus was also high (6% of GDP). Russia remains vulnerable to the oil price, but it would have to drop to $27/barrel to negate the trade surplus.
The state finances are impregnable. Central bank reserves are $476 billion, the world’s third largest after China’s and Japan’s. And in February, the offshore stabilization fund was split into a Reserve Fund for stable investment, which started at $125.4 billion, and a National Wellbeing Fund for more aggressive investment at $32 billion.
The big spoiler is inflation, which in January reached an annual rate of 12.6%. A price freeze on bread and other key foodstuffs has been extended to May. There have been moves to curtail liquidity, such as raising banks’ mandatory reserves requirements, and more are expected.
Steven Fisher, corporate bank head (Russia and CIS) at Citi, fears that the manufacturing sector could get caught between inflation and pressures to compete. “Inflation could be a serious destabilizer. Companies face rising costs, and employees who want higher wages, on the one hand, and the need to increase productivity and competitiveness issues on the other.”
Entry to the WTO will put the manufacturing sector under still fiercer competitive pressure from the world market, he points out.
Medvedev and Putin certainly have much to do.