Russian Global Position After 2008

17 november 2007

Vlad Ivanenko

Resume: As Russia regained its power, inherent problems of conflicting interests and cultural incompatibility, which were temporarily hidden under the cover of Russia’s powerlessness, have come to the fore. The initial EU reaction to these new circumstances is to find ways to keep Russia at arm’s length, that is, to erect legal protective mechanisms along its eastern border.

The year 2008 promises to mark a new era in Russian history. After popular President Vladimir Putin resigns in accordance with the Constitution, the next leader will face a number of challenges that have been identified but not dealt with properly by his or her predecessor. The gravity of the tasks and absence of solutions left unexplored by the Putin administration will push the new leadership to search for original ideas.

So far, the current Kremlin administration has not shown a particular passion for brave new strategies. Yet, its apparent passivity is not a sign that after the transitional period of the electoral cycle is completed in 2008 there would not be a push for novel approaches. On the contrary, whatever happens with the presidential position requires that either the old leader staying at the helm or his successor will activate his or her search for strategies that work.

Among the key issues that Russia now faces, finding its rightful place in the global economic system is the most pressing. Russia’s elite want a place in the club of international decision-makers; and they want international respect. Average Russians have developed a taste for comfortable living and now long for personal success. In order to achieve their dreams, the country must overcome a few hurdles.

Russian companies, for example, will not be recognized as equals on the global stage unless they attain world leadership in several key industries. Russia cannot be assured of a steady flow of wealth if it does not change the composition of products that it sells; it must gear itself toward high value-added goods and services. If the country manages to fulfill these plans, it will receive a greater return on its commodities, coupled with a strong position in certain strategic areas. This will guarantee that Russia will continue to accumulate wealth and that its voice be heeded at international forums.

It is not going to be easy. Russia needs to capitalize on its presently favorable situation and move up the career ladder of the global hierarchy. Still, it is possible. Given the high prices it receives from its primary products (hydrocarbons and metals), at least for the time being it will enjoy a steady flow of cash and global respect. However, its leaders know history well enough to realize that in the long run the export of staples does not guarantee the stability of income and political influence. The flow of money can reverse following the whims of commodity markets. Even if the terms of trade remain positive, great piles of cash are not enough to claim the status of a world power. The latter means that other countries rely on the leader’s wellbeing. Here, Russia is just a beginner who is learning the ropes.

Many other states are watching with growing suspicion as Russia attempts to raise its international profile. Their concern is twofold. The nations that were previously subjected to Soviet dominance are rekindling the old fear of Russian suppression. They see a newly confident Russia as a historical threat to be contained even at the expense of their own prosperity. The more developed countries have a different worry. As members of a privileged club, they understand that Russia’s resurgence – along with the growing influence of other non-members such as China, India or Brazil – threatens their global dominance. The option to invite Russia, and, hence, bind it by the existing rules, is on the table but the members are reluctant to make a proposition because of Russia’s inconsistent record of playing by the club’s rules.

Can Russia reach its desired objectives and, at the same time, address the concerns of its other world players?

RUSSIAN CONDITIONING AND WESTERN RESPONSES

As the successor to the Soviet Union, Russia has inherited the industrial structure and trade pattern that reflected the realities of that time. Being surrounded by presumed “enemies,” the Soviet leadership chose to live in a relative autarky. As a result, the country did not participate in global technological chains outside the Soviet sphere of influence. Low-key cooperation with satellites that the Soviet Union controlled placed more emphasis on political than economic logic. Soviet international trade was a little more than a primitive barter scheme conducted on the national level. The only area where the Soviet Union allowed meaningful long-term cooperation was trade in energy products sold to “trusted” European partners – and only because the country needed a steady inflow of funds to pay for missing consumables and advanced technologies. Elsewhere in the world, the Soviet Union was renowned for selling its weaponry and crude oil at subsidized prices to enemies of the Western world.

Following the collapse of the Soviet Union, the issue of Russian participation in the global division of labor came to the fore; however, the new leadership in Moscow had only a vague idea of how to proceed under the new circumstances. Subsidized trade was gone, but so was the cash flow. Lacking its own expertise, the Kremlin sought Western advice, particularly in economic affairs. The latter came from international financial institutions, such as the IMF and World Bank, which were informally authorized by leading Western powers to guide the Russian transition. At that time, Russia resembled any other international defaulter and fragile state – the main clients of these institutions. Having accumulated expertise in crisis management, international experts extended the same recipes, known collectively as the ‘Washington Consensus,’ to the Russian client. In essence, these ideas implied that government should reduce its regulatory role to the minimum and give private players a chance to build up their fortunes. In the end, the invisible hand of the market would prevail, experts explained, and the state would prosper due to the higher efficiency of the private entrepreneurs.

The IMF and other Western organizations concluded that Russia’s principal advantage was in natural resources, particularly in the energy sector. For Russia to profit from this natural abundance of wealth, they suggested maintaining extensive growth of extractive industries and their orientation toward higher export prices. Given that domestic energy companies lacked advanced know-how, the format of production-sharing agreements (PSA) – by which Western companies became operators of Russian oil and gas fields and local companies, in other words, their minor partners – was deemed to be optimal.

In the early 1990s, this logic seemed to be impeccable, but over time its negative hidden implications became evident. The huge divergence between domestic and global prices created lucrative opportunities to capitalize on arbitrage instead of investing in production. Trade liberalization, coupled with an ineffective tax system, sapped money flows away from state coffers. Domestic inflation, driven by an overall re-orientation toward exports, pushed whole sectors of manufacturing into the red. Unemployment jumped. These side effects raised widespread suspicion about the sincerity of Western advice, which turned into open hostility after the Russian sovereign default of 1998. Ordinary Russians could not see the benefits of economic liberalization that they were told was just around the corner. Instead, they witnessed a steady decline of domestic industries and infrastructure, while a small group of well-connected former apparatchiks and shadowy dealers captured and divided Soviet patrimony for their own benefit. “Is this what the transition to capitalism and democracy is all about?” they asked the Kremlin leadership in a single voice. But the leaders could not provide a reasonable explanation.

As disgraced advisers packed and heeded westward after the default, an interest in alternative, home grown strategies grew stronger. After a brief experimentation with the unfinished reforms of the Gorbachev era, the new team headed by Vladimir Putin proposed two options. The first was to stick to the old recipes of the Washington Consensus, which supposedly failed because they were not introduced in earnest. The second was to learn from China, the former Soviet student that became greater than its teacher. Both approaches seemed to be sensible and compatible in certain areas. On the one hand, the policy of liberalization demanded keen attention to macroeconomic stabilization that was achieved by severe reduction in government spending. On the other hand, a few state-owned monopolies that were not privatized due to historical reasons, such as Gazprom, proved to be highly competitive in the global arena. Furthermore, the Kremlin learned a simple fact: private owners occasionally have their interests at heart and sometimes – like in the case of oil company YUKOS – go against perceived national priorities. In the latter case, the Kremlin resorted to force to uphold its supremacy in economic affairs.

The combination of economic freedom with heavy regulation and control is a distinctive feature of Russia’s system. For better or worse, the country finds itself in between the two worlds. Moscow is envious of the discreet charm of Western economic prosperity and wants to replicate its success. Europe is the top destination for wealthier Russians who enjoy its style of life. At the same time, many consider the West to be a strong competitor that needs to be contained if Russian domestic interests are at risk. This “love-hate” duality explains the inconsistencies in Russia’s foreign policy as observed from the outside.

The West had its own conditioning regarding its relationship with the new Russian state. The EU was elated when the iron curtain fell and reintegration with its forcibly separated parts, like Eastern Germany, became possible. Other former Soviet satellites were happy to regain independence. But since they were unsure exactly how long the unexpected loosening of Russia’s grip would last, they pushed for the rapid accommodation of EU standards, the so-called acquis communautaire, to qualify for membership. Their aspirations were actively promoted by the U.S., which wanted to consolidate its victory in the Cold War over its long-standing adversary. However, while sharing the same triumphal political attitude toward defeated Russia, the EU and the United States were divided on how economic affairs with this country should be formed.

After securing, against U.S. advice, the delivery of Russian natural gas in the 1980s, the EU became addicted to growing energy supplies from the former Soviet Union. The end of war fragmented the Soviet bloc. New national players threatened to obstruct deliveries if a “fair” share in energy revenues was not forthcoming. To secure the continuation of trade, the EU proposed a treaty that later became embodied in the Energy Charter. Consistent with the quasi-consensual approach dominant in Western negotiations, the EU did not author the new policy but instructed an international organization – the International Energy Agency (IEA) – to draft the document. It should be noted that as an organization the IEA was formed by oil importers within the framework of the OECD – a group of leading Western countries – in the 1970s. Its main objective was to find ways to protect energy importers in time of future energy crises. From its perspective, the turmoil in the post-Soviet space represented another threat to oil and gas importers, particularly due to the threat of interruptions along transportation routes and an anticipated fall in production. To contain the damage, the Energy Charter proposed to give equal rights for all producers on existing pipelines and unrestricted competitive access to energy riches and new transportation infrastructure. Thus, the Charter provided a potential legal foundation to develop EU-Russian cooperation in the energy sphere, but on conditions beneficial predominantly to importers.

The position of the U.S. was different. This country continued to be only marginally involved in trade with Russia, yet it sponsored the penetration of Western oil companies in the post-Soviet space and was active in influencing Russia’s foreign policy worldwide. With Washington’s support, Western companies took control of offshore oil fields in Azerbaijan, and got the status of PSA operators in large projects in Kazakhstan, as well as on the Russian island of Sakhalin. The U.S. administration supported plans to develop alternative transportation routes such as the construction of trans-Caucasian oil and gas pipelines that bypass Russia. This robust policy of containment was somewhat softened by Washington’s plans to engage Russia in international affairs, albeit on American terms; for example, it has brought Moscow to the G7, an informal forum of major Western powers, to discuss and develop new global initiatives. However, here the progress was checked due to objective reasons. By and large, Russia acquired institutional norms and cultural traits that set it aside within the Western club. This led to opposing responses to threats thought by the Americans to be common for all, hindered understanding in areas objectively open to cooperation, and eventually bred mistrust and open conflicts.

By and large, the common Western policy toward Russia, if there is one, fluctuates between the overly optimistic hope that Russia can become a true partner because it is a country “like us,”  to the similarly unwarranted gloomy perception that it can never be trusted because of its perceived inner hostility to the Western style of life. The frequent recurrence of this “hope-frustration” cycle has split Russia’s Western pundits into two warring camps, which could best be described as the Russophobes and the Russophiles. These two groups trade among themselves in no other commodity than insults, while lobbying for incompatible policy options.

RUSSIAN-EU AREAS OF COMPETITION

Russia survived the turbulent transitional years of the 1990s, overcame the administrative chaos in the 2000s, and is now prepared to compete in at least two areas that the EU continues to consider its own turf.

First, Russia is not satisfied with its status as a raw materials exporter, which the EU, incidentally, is quite comfortable with. Russia has good reason not to be satisfied. Despite the impressive growth that its economy has been experiencing since 1999, its national standard of living rates are significantly lower than the European average and their further growth is not a given. The low level that the current boom started from, together with the favorable terms that Russia received for its exportable energy resources, accounts for a large portion of growth in the period 2004-2007. However, a potential downturn in the global commodity markets may stop the inflow of foreign earnings any time. Thus, finding a strategy that ensures that Russia is on the path of sustainable economic development is the key problem that the Kremlin now faces. Currently, it has two tools at its disposal.

To maintain a trade surplus, Russia needs to preserve the beneficial terms of trade – using its monopoly power when possible. To that end, it should not relax its control over oil and gas routes going to Europe from the east. So far, Moscow has proven to be a capable market player. It has postponed the construction of trans-Caspian pipelines that are intended for carrying Central Asian energy resources via the Caucasian republics to Turkey. It also prevented the transit of its own energy resources, like the Murmansk route envisioned by YUKOS before its demise, to destinations disapproved of by the Kremlin.

However, Moscow understands that only long-term diversification of its income sources can ensure that Russia’s welfare will not be utterly dependent on the vagaries of global markets. Being awash with cash, Russia is looking for the optimal combination of investments that give it the global competitive edge in technologically advanced and, consequently, higher value-adding industries. Yet, to its displeasure, Moscow finds that it entered international markets too late. Now, in order to secure its rightful place, Russia must compete and defeat established companies, many of whom are European. Such a perspective is not attractive to Brussels.

Second, while Russia has retreated politically, it has not abandoned economic and cultural links with former territories of the Soviet Union. Russia’s recovery in the past eight years has had favorable effects on adjacent republics. To the surprise of outside observers, they discovered that many Soviet technological chains that were broken along the borders of the newly independent states have tenaciously maintained their connections. Particularly strong are the links between Russia, Belarus, Ukraine and Kazakhstan; their inter-regional trade levels continue to grow by leaps and bounds. In spite of constant political bickering, these four countries have all the necessary preconditions to form a common economic market similar to the EU, but on what basis and when remain open questions.

The Kremlin’s use of both options does not bode well for the EU, which, being a net importer of energy, naturally benefits from greater competition among energy importers. The advance of Russia’s energy power raises its ability to collect a monopoly rent. This is especially true for Eastern European countries, where Russian oil and gas concerns have historically dominated the energy balance. When Russia was disorganized and dependent on trade with the EU, these countries could solicit price favors by playing on differences among private suppliers and threatening to interrupt transit if necessary. Now the Kremlin has consolidated its control over the sector, which reduces domestic rivalry and allows Russian energy giants like Gazprom to raise prices almost at will. Western European countries are less dependent on Russian deliveries as they have a diversified network of suppliers. But as their demand increases and supply stagnates, the importance of deliveries from the post-Soviet space grows. To reduce Russia’s monopoly power in energy, Brussels supports alternative routes of supply that bypass this country. Predictably, Moscow does all it can to obstruct such attempts.

Similarly, the EU fears that the appearance of strong Russian competitors in other areas where its companies have traditionally strong positions (such as in the aerospace sector) will weaken its competitiveness worldwide. Here, Brussels has ample room for maneuver. Russian companies do not have advanced technological expertise in many sectors. To raise their competitiveness, they need to accumulate know-how in Europe, among other places. Potentially, Russian firms can buy controlling stakes in EU companies and, consequently, get access to their technological secrets. However, once they cross a certain limit, they will face the red light from EU regulators or private investors. On a number of occasions (recall the failed merger between steel companies Arcelor and Severstal, or the unsuccessful attempt by Vneshtorgbank to put its director on the board of aerospace giant EADS) the ambitions of Russia’s suitors were contained.

The future status of those countries in between Russia and the EU is another source of constant tension. The European appetite for enlargement appears to be momentarily satiated and Brussels shows no desire to invite new problematic countries, which may add to its already heavy burden of problems brought about by the last two rounds of expansion. Neither does the EU approve of Russia’s potential expansion westwards. Preserving the current level of ambiguity seems to be an optimal situation for the EU at the present time. This approach makes sense economically. Inviting countries like Ukraine and Belarus cannot be justified because these countries cannot offer products that are in high demand in Europe, but they will need subsidies that the already overstretched EU budget cannot satisfy. On the other hand, Ukrainian and Belarusian producers compete over important items of Russian export, for example, fertilizers and steel. In addition, their conflicts with Russia over transit payments reduce Russia’s bargaining power. To address the concerns of European customers, exporters have to provide further guarantees of delivery and postpone their expansion in the EU markets due to bad publicity that such conflicts create.

OPTIONS TO DEFUSE CURRENT RUSSIAN-EU CONFLICTS

There are two conflicts now poisoning the EU-Russian relationship. The first one involves the future status of Ukraine and Belarus. As has been said above, the fall of the iron curtain did not remove the implicit boundary line between the EU and Russia, although some hoped it would shift eastward. The EU absorbed ten new members from the former Soviet bloc before taking a pause. Meanwhile, Russia sorted out most of its disagreements and proposed to its neighbors to form an economic union. Ukraine and Belarus are unsure how to react. On the one hand, their economies are dependent on trade with Russia, and the latter can be impaired if they refuse to cooperate. On the other hand, if the EU opens its markets for Ukrainian and Belarusian products, and allows labor migration westward, both countries would prefer to side with the EU and forego the benefits offered by the Russians.

Brussels appears to be benefiting from the current uncertainty as it sends contradictory signals to both countries. This approach is rational. The EU does not want to see Russia stepping into the void, but, at the same time, it is reluctant to initiate a new round of expansion. At the moment, this policy is proving successful as Minsk and especially Kiev have not exhausted their hopes. However, this position cannot be maintained for long. Given that trade with Russia brings increasingly sizable benefits in the terms of cash flows, and that the Kremlin can now offer tempting rewards for further cooperation, the time when Moscow can attract both countries to its side seems not far off. With this forecast in mind, the EU can either postpone the inevitable, or build protective mechanisms in at least one nation, Ukraine, before both countries close ranks with Russia. Here, a historical digression may be informative.

Several years ago, when Ukraine was believed to be entering the EU fold, Russian commentators discussed the hidden benefits that such a development could bring to Russia. They noticed that the Ukrainian economy had strong links with Russia and that Russian entrepreneurs were active in that country. Therefore, their argument was as follows: if Ukraine joins the EU, Russian businesses will get a bridgehead to expand in Europe from behind its trade barriers erected, for example, to limit the export of Russian steel. Similarly, because they will be able to participate in internal European mergers and acquisitions, Russians can get access to sensitive know-how that can be eventually transferred to their factories. The economic benefits of Ukrainian accession may be augmented by political gains. Being connected to Russian interests, Kiev will provide a voice, defending Moscow’s position in internal EU affairs.

Now, if Ukraine reverses its direction and forms a union with its eastern neighbor, the same argument can be applied from the European perspective. Suppose Ukraine joins a Russia-sponsored common economic space in a few years. In such a scenario, Brussels may provide incentives for EU companies to invest in Ukraine now in order to be able to use their Ukrainian subsidiaries to penetrate Russian protectionist barriers later on. To capitalize on political expediencies (like leapfrogging trade quotas, or moving head offices offshore to avoid taxes) is an established practice in business even if it may be ethically dubious. Incidentally, a recent example shows how EU companies may benefit from standing under the Russian flag. When British Petroleum faced problems in Venezuela, it employed the regime of special treatment that Russian companies receive in this country and transferred its Venezuelan interests to its Russian subsidiary TNK-BP.

EU investment in Ukraine, in anticipation of its eventual economic union with Russia, would be particularly rewarding in industries that Russia considers to be strategically important. European companies have specific expertise in technological products with high value-added, but these products are exactly the type Russia wants to develop on its own in order to eliminate its raw material-based economy. Here, Moscow wants to have as much national control as possible. However, it understands that to bring Kiev over to its side, it needs to offer sizeable benefits to Ukrainian firms. Given that Ukraine has traditionally supplied industrial goods to Russia, Moscow is likely to give guarantees that such products are not treated differently on the Russian market, even if they are produced at Ukrainian plants that are controlled by EU nationals. Moreover, under the cover of an economic union, Ukrainian sister companies will be accepted in common technological chains, including sensitive technologies, which their EU parents will be unable to enter from the outside.

In general, greater cooperation between European and Russian firms through third countries, like Ukraine, may help to solve another grave problem that poisons the Russian-EU relationship. It is an open secret that Russian standards of public governance are below the level acceptable to the EU. Arbitrariness and low accountability of Russian public servants make it difficult to do business in this country, while the case in Ukraine may be different. EU companies demand higher standards from state agencies and Ukrainian bureaucrats will need to accommodate their interests and, hence, limit their intrusiveness by a formal set of rules. A more favorable business environment will not be lost on Russian companies that, as has been mentioned above, have strong positions in this country. As more Russian companies get a sense of what it means to operate in a friendly environment, they will either accelerate the transfer of their operations in Ukraine, or demand similar changes at home. Thus, Ukraine’s inclusion in the Russian zone of economic interests, if accompanied with the strong presence of EU companies on its territory, can create an additional channel of conveying European democratic values to Russia. The improvement of Russia’s public governance can be only lauded as it removes one of the key irritants in EU-Russian contacts.

Still, EU officials should realize that building democratic institutions is a process that proceeds at a pace and in an order that is conditioned by local norms. It has become common wisdom among development economists that local involvement and interest in projects sponsored by the West was the key to their success in Africa, Asia and elsewhere. Before expressing rightful indignation of authoritarian excesses, some European politicians may need to consult their own history. They will be surprised to learn that universal suffrage, for example, was hardly a European norm before the reforms of the 1900s, or that political parties were often clubs formed to lobby for “pork-for-barrel” interests of its members. Here, the inclusion of Romania and Bulgaria – countries that share cultural traits with Russia – in the EU legal space, gives Brussels a rough idea of how fast and in what order Moscow can build its democratic institutions of governance. If it cannot speed up the process of Romanian and Bulgarian adjustment to its acquis communautaire rules, it should not expect Russia to democratize any faster either.

* * *

The last several years have not been an easy time for the Russian-EU relationship. As Russia regained its power, inherent problems of conflicting interests and cultural incompatibility, which were temporarily hidden under the cover of Russia’s powerlessness, have come to the fore. Suddenly, the EU faces a tough competitor in areas that it once considered to be its internal domain. The initial EU reaction to these new circumstances is to find ways to keep Russia at arm’s length, that is, to erect legal protective mechanisms along its eastern border.

Today, the gradual hardening of German, British and French positions vis-à-vis Moscow indicates that this approach will persist in the short term. This may be an optimal policy for tactical reasons, but the policy of containment is not going to work in the long run because it is contrary to Russian national interests, and Russia has enough resources to overcome EU resistance in the end. Fortunately, there are alternative policies of political repositioning that can be employed together with the current policy.

Three problems taint the EU-Russian relationship today. First, the role that Moscow envisions for its energy sector is contrary to EU interests, and it is unlikely that Russia will accommodate European fears without sizeable concessions from the EU. The best Brussels can do in this area is to make a quid pro quo deal by accepting Russia’s status as a dominant energy supplier, in exchange for Moscow’s acquiescence to the growing role of European companies in Russian manufacturing sectors.

Second, the uncertainty that surrounds the future of those states that lie between Russia and the EU benefits the EU but irritates Moscow. Because these countries historically gravitate toward Russia, the appearance of a common economic space in the post-Soviet region seems to be inevitable. Here, Brussels can do better by combining its attempts to perpetuate uncertainty with assisting its companies to build a powerbase in Ukraine before this country acquiesces to Russia’s tempting proposals of economic benefits.

Finally, the problem of undemocratic governance that prevents Russia from integrating with the EU horizontally should not be understated as a subconscious factor that keeps these two regions apart. Here, current Russian attempts to preserve an authoritarian style of governance appear to be unsustainable in the long run. Meanwhile, European frontal attacks are unlikely to succeed because they will meet widespread hostility and resistance among would-be benefactors – Russian citizens. To succeed, the democratization drive should be based upon internal demand for efficient public services, and here a greater exposure of Russian companies to the Western business environment, sponsored potentially by Brussels, can empower them to demand a publicly accountable government at home.

Last updated 17 november 2007, 12:19

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