17.11.2007
Russian Global Position After 2008
№4 2007 October/December
Vlad Ivanenko

PhD in Economics, Ottawa, Canada.

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.