13.05.2007
Russia’s Search for a Place in Global Trading System
№2 2007 April/June
Vlad Ivanenko

PhD in Economics, Ottava, Canada.

As Russia
searches for its place in the global system of trade, what options
does it have? An analysis of Russia’s trade composition and
bilateral relationships with its partners reveals several
alternatives that it can use for integrating into global world
markets.

RUSSIA’S NATURAL
STRENGTHS AND WEAKNESSES

Russia is a
country richly endowed with mineral deposits (hydrocarbons, metal
ores), renewable resources (forests, water) and fertile land. These
natural strengths are somewhat offset by its harsh climate, lack of
transportation routes, and an underdeveloped public infrastructure,
which has not been historically tailored to the needs of a trading
country.

The composition
of Russian exports (see Table 1) reveals that this country is
globally competitive mostly in products whose value can be
attributed to its natural advantages: energy resources (crude oil,
gas, coal), timber, diamonds, and non-ferrous metals (platinoids,
copper, nickel, and aluminum). These resources account for 45-55
percent of total Russian exports. Semi-processed goods, which stand
at 19-23 percent, make up the second most important group. Its
composition (motor and heating fuels, iron and steel products,
fertilizers and processed wood) shows heavy dependence on the
availability of domestic raw materials and cheap energy with low
value added. While there is some residual influence of Soviet
investment preferences (for example, the Soviet Union developed
Siberian gas and oil fields with pipelines leading to external
markets), the products of pre-1991 industrial projects do not enter
the shortlist of top export groups. The latter observation
indicates that modern Russia is able to compete globally only in
extraction and rough processing of natural resources.

Historically,
European trade routes dominated the geographical structure of
Soviet exports and, as Table 2 indicates, Russia has not done much
to diversify its exports since then.

A closer look at
the composition of exports to individual states shows that Western
routes are conditioned on trade in hydrocarbons delivered through
sea terminals and pipelines. In general, crude oil, oil products
and natural gas weigh heavily in total exports. Applying, somewhat
loosely, the Herfindahl-Hirschman Index (HHI) of monopolization to
Russian trade with individual countries reveals that the HS group
2709 (crude oil) accounts for 40-50 percent of total export, or
1,600-2,500 points on HHI scale, to most states, especially the EU
countries. The dominance of crude oil in trade structure
illustrates the degree of Russia’s reliance on this product. The
lack of alternative exportables is particularly evident in Russia’s
trade with former socialist countries such as Poland. Russia sells
a greater variety of products to post-Soviet states (Ukraine,
Belarus and Kazakhstan) but even here crude oil is its main
staple.

An analysis of
trade statistics reveals several facts. First, the composition of
Russia’s exports indicates that this country is heavily dependent
on its natural resources and little on its labor and capital
endowments. Second, former Soviet investment in the transportation
infrastructure determines Russia’s dependence on two groups of
trading partners.

The first group
comprises European countries, with Turkey – thanks to a gas
pipeline that was built in 2005 – as the latest addition. These
importers treasure trade with Russia primarily because of their
dependence on Russian hydrocarbons. Currently, the growth in energy
prices has increased Russia’s attraction for the region. However,
given that energy prices are volatile, the existing situation seems
to be fragile and hardly suggestive of durable Russian-European or
Russian-Turkish trade integration. It is a marriage of convenience,
at best.

The second group
comprises post-Soviet countries. Here the situation is different.
Due to historical circumstances, these states continue to purchase
a wide variety of Russian products, which results in relatively low
values of HH indices. This is especially characteristic of
Kazakhstan. The pattern of trade with Belarus is somewhat
distorted, however, leading to high HHI value. The bias is
explained by Russian oil companies’ delivering crude oil to their
refineries in Belarus with the consequent sale of resulting
products in the EU.

Finally, Russia
is a significant exporter of certain non-energy products to some
countries outside Europe and the post-Soviet space, such as Japan,
the U.S. and China. The slow growth in the export of non-staple
products beyond traditional markets suggests that Russia searches
for ways to diversify its trade, yet at this point it would be
premature to say that it is succeeding.

RUSSIA’S “ORBIT
OF GRAVITATION”

Oftentimes, in
order to define the strength of countries’ bilateral relationships,
economists use the so-called ‘gravity model’ of trade. The model
represents an economic analog of the Newtonian theory of
gravitation and assumes trade to be positively related to
countries’ economic “weight,” which is measured by the gross
domestic product (GDP), and is negatively related to some measure
of “distance” between countries’ ceteris paribus. Since the concept
of distance is undetermined (it includes all potential trade costs,
including transportation expenses), it is expedient to use the
inverted form of the model, with distance represented as an unknown
parameter. The distance (Dist) is computed as the product of the
countries’ GDPs divided by the product of their export and
import,  or

Then, a “short”
distance reveals partner countries with which a state trades
relatively more intensely than with other partner countries of
similar economic “weight.”

Table 3 shows
that the intensity of Russian trade is the highest with several
post-Soviet countries and some European states. This confirms the
above observation that Russia belongs to two trade groups – the
post-Soviet core and the EU. The gravity test also provides
additional information, in particular, that the post-Soviet core
comprises Russia, Ukraine, Belarus and Kazakhstan. Among EU
countries, Finland shows the strongest link, with Germany, the
Netherlands and Italy rapidly approaching the level of
Russia-Finland trade integration. On the other hand, the Baltic
States and Moldova are slowly drifting away from Russia. Table 3
covers a rather long period, but it does not include data on the
recent growth in trade between Russia and such non-European
countries as Turkey and China.

Since the unit of
account for “distance” is not insightful, it would be appropriate
to compare the data shown in Table 3 with information available for
other countries. Globally, the shortest “distance” in 2005 was
registered between the pairs Singapore-Malaysia,
Belgium-Netherlands and the U.S.-Canada, which have values ranging
between 50 and 250. Thus, the shortest “distance” between Russia
and Belarus is far behind the values shown by global leaders in
trade integration. To achieve a similar level, Russia and Belarus
should expand their trade turnover – which currently stands at $20
billion – to total $45-105 billion. Still, Russia-Belarus
cooperation is comparable with that of Spain and Portugal (1,285
and 1,272 respectively in 2005), or Australia and New Zealand
(2,261 and 2,549).

The gravity model
can be used to chart the borders of actual or potential unions of
trading countries, which are often construed similarly to “hub and
spikes” structures commonly used in the optimization of transport
routes. Large countries and popular city-states play the leading
role in forming a hub through which member countries of such a
union – potentially informal – pass trade flows in multilateral
trade. For example, it comes as no surprise that the U.S., having
the highest “gravitational mass,” dominates in NAFTA, while the
other members, Canada and Mexico, trade between themselves
predominantly via the “hub.” Germany is the center of gravity for
several Central European countries (Austria, Italy, Switzerland,
Poland and Hungary), but the structure of this union is more
complex. The German hub overlaps with a smaller center, Belgium,
which shows a “shorter” distance to France, Luxembourg and the
Netherlands. Sweden dominates in Northern Europe where it draws
such countries as Norway, Finland and Denmark into the Scandinavian
group. Singapore stands as the main destination for trade routes
within ASEAN. Similarly, the United Arab Emirates finds itself the
center of the Middle East group of countries.

Russia generates
a weaker gravitational power than the top trade leaders but,
nevertheless, it has sufficient “mass” to attract Eurasian states.
Apart from Belarus, Ukraine and Kazakhstan, which definitely belong
to its orbit, Uzbekistan and Turkmenistan weakly gravitate toward
Russia. In their turn, Kazakhstan and Uzbekistan are local centers
of attraction for Kyrgyzstan and Tajikistan respectively, while
Ukraine is the local center for Moldova. Thus, all of these
post-Soviet states form a chain that connects them to a potential
Eurasian union.

The Caucasian
republics conspicuously fall out of the above picture. Georgia,
Armenia and Azerbaijan form a separate group that is only weakly
attached to the outside world. Azerbaijan shows the greatest
“gravitational mass” among the three and some outward pull toward
Turkmenistan. Russia’s presence in Transcaucasia is “somewhat
visible” due to the transit of Central Asian gas and export of
electricity.

Similarly, the
Baltic countries form a compact group on Russia’s western border,
but their cohesion is one degree stronger than that existing
between the Caucasian countries. Here, the chain connection among
Lithuania, Latvia and Estonia leads to Finland, which, in its turn,
belongs to the orbit of Sweden. The pulling attraction of Lithuania
– the most distant country in the group – to the southern centers
(Poland and Belarus) is about equal, but these countries do not
generate trade flows sufficient to compete with the Nordic
direction of Lithuanian orientation.

RUSSIAN OPTIONS
IN GLOBAL INTEGRATION

If one ignores
specific sectors where domestic producers achieve global clout due
to the uniqueness of their position (for example, in titanium
alloys used in aviation or palladium for car manufacturing),
Russian trade integration involves two groups of partners: Europe
and post-Soviet states. However, the two groups differ in export
and import structures and, consequently, provide dissimilar forms
for such integration.

Option 1: EU-Russian integration.
The lack of products other than energy weakens European interest in
Russia as a partner. For most EU countries, Russia is simply an
energy supplier. Consequently, many EU members limit their vision
of Russian-European integration to the sector of energy and,
desirably, without cross-sectoral linkages. Virtual disengagement
is particularly popular among East-European states that are still
resentful of former Soviet dominance. At the same time, while
minimizing imports from Russia, these countries find themselves to
be heavily dependent on hydrocarbon deliveries from this country.
For example, Poland and Lithuania have extremely high HHI scores
for import of crude oil (9,446 and 9,903), implying that Russia is
practically their only supplier. Unsurprisingly, these countries
demand that Russia sign the Energy Charter to ensure unrestricted
access of Central Asian producers to its pipelines and, preferably,
admit European producers to its oil and gas fields. However, such a
proposition is not acceptable for Russia as it reduces its export
and transit revenues. Other European importers are less concerned
with Russian energy clout as they have diversified networks of
suppliers. For example, German HHI in crude oil equals 1,672, with
its largest supplier, Russia, accounting for 30 percent of the
import. Thus, while Poland is bent on hard bargaining with Russia,
Germany can afford a more accommodative stance if Russia
reciprocates in other areas. Meanwhile, Russia resolutely shows no
inclination to sign the Charter, which is understandable given its
heavy dependence on hydrocarbon trade.

Currently, the
EU-Russian dialog on deepening trade relationship seems to be
stalled on two counts: first, Russia is unwilling to compromise on
the energy front as it is its only trump card in trade negotiations
and, second, the EU lacks consensus on negotiating anything else
but energy. Under current circumstances, talks between Russia and
separate EU members may prove to be more fruitful and, at least
initially, to sustain momentum in integration. Two countries,
Germany and Finland, now serve as major points that connect Russia
economically to the EU: Germany provides a potential link to the
Central European cluster of business activity and Finland links
Russia to the Nordic group.

Let us consider
what would happen if the EU lets its members define the speed of
eastward integration individually. Germany and Finland are already
disproportionably involved in bilateral trade and they will choose
fast integration. However, given that trade between them and Russia
is disproportionate, a concessionary quid pro quo approach cannot
work if economic sectors are treated separately. Thus, to agree on
concessions, several sectors should be involved simultaneously.
This constraint rules out the possibility of natural integration
that takes place on the level of individual enterprises and
requires government interference to coordinate the process. Let us
consider what mutual concessions might look like.

Both German and
Finnish companies export a large amount of machinery and
electronics to Russia. The latter reciprocates predominantly with
energy products. These three sectors can form the core of
integration activity, particularly through mergers and
acquisitions, but also with direct investment in new assets. The
economic benefits of such integration – the economy of scale gains
– are obvious; yet to become politically feasible the parties
should agree on the national division of such gains. Since Russian
machinery and electronics makers do not wield political clout
compared with the national energy lobby (Gazprom or Rosneft), and
German and Finnish energy companies do not have serious interests
in oil and gas extraction, it is expedient to condition Russian
energy expansion westward on German and Finnish access to Russian
machinery or mobile telephony markets. The resulting expansion of
mutual trade can be large: for example, if Germany and Finland
raise their level of integration with Russia to the current level
of Germany’s integration with Poland, total Russo-German and
Finnish turnover will rise to $82 and $20 billion respectively from
current $41 and $15 billion.

Facts indicate
that some German, Finnish and Russian companies have identified the
potential of this strategy. German carmaker Volkswagen has
announced plans to develop a ?400 million technopark in Kaluga. AMD
has sold its Dresden microchip facility for estimated $250-300
million to Russian company Angstrem in Zelenograd. A mulled merger
of telecommunication assets of Russia’s Altimo and the
Swedish-Finnish concern TeliaSonera would be a step in a direction
that the Russian government is likely to approve. However, the
process of integration is proceeding in a haphazard way as other
moves lack an inter-sectoral quid pro quo approach. Moreover, they
may provoke discord because they resemble foreign attempts at
hostile takeovers. Russia has been right not to demand a place on
the EADS corporate board as it has little to add to the EADS value
at the moment. European companies seem to be less sensitive to such
considerations. Siemens, for example, attempted to get a
controlling stake at the main Russian power plant maker Silovye
Mashiny. This raised Russian suspicions that this firm was
attempting to define its domestic energy renovation program.
Similarly, it transpired recently that Finnish utility Fortum might
not be allowed to take a controlling stake in the St.
Petersburg-based generating company OGT-1 for strategic
reasons.

The observation
above shows that attempts at unsolicited cross-border mergers are
self-defeating in the long run because they provoke economic
nationalism, which seems to be incompatible with true partnership.
Responding to popular pressure, the political authorities deign to
protect the jewels of the domestic economies; their destiny is to
be guarded jealously. In order to progress, the sides should be
willing to compromise on their dominance in those sectors where
their comparative advantages are indisputable. After all, the total
of bilateral gains is what matters most, while the national
distribution of gains can be adjusted through further
negotiations.

Interstate
negotiations can enhance the process on two counts. First,
inter-state agreements reduce the risk of opportunistic behavior of
national companies. Second, government intervention solves the
potential problem of market failure due to the unequal distribution
of integration gains. To achieve Pareto-style efficiency,
governments redistribute gains from winners to losers. For example,
the Russian government may find it expedient to compensate losses
or invest in the public infrastructure, supporting local machinery
producers using additional energy revenue. Finally, governments –
notably that of Russia – can be tasked with the objective of
reducing red tape and other obstacles to order to fill formal
agreements on real partnerships. It is an open secret, documented
in many surveys, that the business environment in Russia contrasts
negatively in comparison with conditions that German or Finnish
enterprises face at home. The feeling of alienation that this
difference creates makes formal pledges of cooperation ring
hollow.

Option 2: Eurasian economic
union
. In another geographic area, the Eurasian
space, Russia remains the local center of gravity for a number of
countries. Moreover, because Russian and other Eurasian markets
have been historically intertwined, there is strong demand for a
wide range of goods produced locally. Thus, regional integration
has sufficient momentum to develop into a full-fledged joint
market.

Five countries –
Russia, Belarus, Ukraine, Kazakhstan, and, to a lesser degree,
Uzbekistan – form the core of the group. The core attracts smaller
European countries (Moldova) and Central Asian states (Kyrgyzstan,
Turkmenistan and Tajikistan) that have attraction to the union. The
longevity and strength of such a union depends on the net benefits
that its members derive, such as gains from utilizing economy of
scale, which are particularly large for capital-intensive
industries, and greater bargaining power that the would-be group
would have vis-?-vis the rest of the world. To realize the latter
(redistributive) benefit, the countries need to coordinate their
moves in dealing with outside consumers and producers. A greater
coordination, while not necessarily increasing global efficiency,
empowers the prospective bloc to charge higher prices on their
wares and to purchase imports cheaper than when they are competing
against one another.

Given the
existing structure of Russian trade with other post-Soviet
countries, the energy sector takes the central stage in integration
efforts. However, to become an engine of inter-state cooperation,
several hurdles should be overcome. The first problem involves the
unequal energy pricing at home and abroad that provides implicit
subsidies to domestic energy consumers but distorts the nature of
integration. The sorry state of the Russia-Belarus “single economic
space” is a case in point. Being separate countries in everything
but energy pricing, Belarusian enterprises received Russian oil and
gas subsidies of about $4 billion in 2006. Naturally, Minsk
realized that it received all perks and no obligations from the
“union” and refused to go further. When Russia expressed its
displeasure and suggested to re-introduce a customs border between
the two countries at the end of 2006, a full-fledged trade war
broke out, destroying the minimal goodwill that still existed
between the two countries. Similar discontent is now brewing in
Kazakhstan, which argues it cannot get the “fair” price for its
gas, which is sold at the Russian border at almost Russian
(subsidized) domestic prices. Another complication concerns Western
energy majors, which signed production-sharing agreements (PSAs)
with the former Soviet republics at the dawn of their independence.
Russia was the first to stop this practice (currently Russia has
only three PSAs projects, retained under pressure, which are to be
brought in line with Russian general legislation), but Kazakhstan
still relies, albeit with increasing reluctance, on foreign
partners in what many see as PSAs deals. Since PSAs are not
renegotiable in principle, regional integration in the energy
sector cannot proceed without gaining the consent of foreign energy
companies.

Both problems are
technically solvable if there is goodwill. To prevent conflicts
associated with the distribution of energy gains within the union,
the future members can swap stakes in national oil and gas
companies. This may be calculated by the amount that matches their
relative contribution in the joint development and transit of
energy resources, minus subsidies they receive due to lower
domestic prices. Furthermore, to facilitate the process of
bargaining and monitoring, prospective members can establish a
‘coordination and conflict resolution energy committee’ similar to
the International Energy Agency (IEA) that comprises 26 OECD
countries. Coincidentally, such an organization, in charge of
streamlining national practices that inhibit regional energy
cooperation, can provide a “Eurasian” solution to the problem of
stalled negotiations regarding the Energy Charter of 1994. If
Eurasian oil and gas producers and transit countries agree on a
common stance, their voice is more likely to be heard by the
IEA.

Apart from
multilateral agreement on energy, Russia may initiate a series of
bilateral integration projects. This particularly concerns the iron
and steel sector where Russian and Ukrainian interests intersect;
both countries are large steel exporters and competitors on the
international market. A common agreement to combine efforts in
domestic projects, such as the construction of trunk pipelines, and
matching export plans, will provide for greater specialization
within the countries. These steps will increase aggregate profits
for both countries, however, at the present time, the two countries
are moving in opposite directions. The accumulated force of mutual
distrust pushes Russia to substitute Ukrainian steel products: for
example, it initiates the construction of several mills that
produce large-diameter pipes. If implemented, these plans will
drive the large Ukrainian producer, Khartsyzsk Pipe Mill, out of
the Russian market with great losses for the latter. To prevent
such mutually destructive trade wars, both countries need to reach
a common agreement on cooperation in the area, which is vital for
the development of a common Eurasian steel market.

Cooperation in
agriculture and agriculture-related industries offers another field
where the interests of the five countries overlap enough to warrant
a negotiation. Russia, Ukraine and Kazakhstan are significant
exporters of grain, while Belarus and Ukraine have strong positions
in dairy products. In addition, Belarus has retained its
agricultural machinery plants whose output – tractors and trucks –
found a ready market within the former Soviet Union. All these
states want to revitalize their agro-industrial sectors, but their
plans remain uncoordinated at the moment. These internal plans can
be enhanced if complemented with interstate agreements on
cooperation in agricultural production and trade. Unfortunately,
the national authorities continue to rely on confrontational
measures aimed at solving short-term problems. This confrontational
atmosphere leads to the inefficient use of available resources. For
example, it has been reported that after Ukraine introduced export
quotas on grain to keep the domestic price of bread low, a
significant amount of its crop was destroyed and disposed of to the
detriment of national producers.

Food processing
is a sector where cross-border mergers allow for the rapid
realization of advantages offered by economies of scope. The
process is already underway, for example, in the beverage sector
where breweries like Baltika (Russia) and Obolon (Ukraine) are
large exporters to each country. Other joint projects can involve,
for example, large-scale production of pork, poultry, sugar and
vegetable oils.

Option 3: Trade with other
countries.
Russian potential for integration with
other countries is limited to individual projects. Currently,
Russia offers few products that have international appeal apart
from energy. Because such projects have no economy-wide linkages
neither for Russia nor its partners, there is little rationale for
state activism. Some Russian companies, such as Norilsk Nickel or
Rusal, expand aggressively in other countries as they have become
“too large” to be content with regional leadership. Given their
global clout and expertise, they are able to take initiative on
their own. In this situation, the role of the state is reduced to
logistic support and mediation among national players.

There are
indications that the Russian government understands its role. For
example, in October 2006, the Kremlin weighed in favor of a merger
among domestic aluminum majors Rusal, Sual and trading firm
Glencore from Switzerland after being asked to mediate.  The
very next month, the Kremlin resolved a commercial conflict among
Severstal, Bazel and Renova, which competed for the right to
develop the Tavan-Tolgoi coal field in Mongolia. In the latter
case, public support was indispensable as the project proceeded
within the tentative framework of Russo-Mongolian agreement on
state cooperation.

*  * 
*

Ongoing
globalization and the logic of economic prosperity prompts Russia
to search for ways to realize its comparative advantages in the
international division of labor. After the country has completed
its economic restructuring and accumulated international reserves
and expertise, Russia will continue to grope along, navigating
through hidden reefs while exploring tempting
possibilities.

Russia today is a
staple economy, with mineral and natural resources comprising the
largest share of its exports. Energy products dominate trade with
many countries, creating a one-sided view of Russia as the pure
supplier of oil and gas. Russian imports are more diversified,
however, suggesting that there are many possibilities for strategic
interaction that other countries can exploit.
Several EU countries have developed relatively strong bilateral
links with Russia. Judging by the force of attraction, Germany and
Finland are key countries that link Russia to Europe. These links,
if enhanced, can introduce Russia to larger integration areas
developed in the Nordic and Central Europe. If that happens, EU
countries can gain from stronger linkage to Russian energy
resources, thereby enhancing their energy security. On the other
end, Russia may expect a gradual improvement in the machinery and
electronic sectors, benefiting from greater exposure to European
technologies.

Russia may also
form the backbone of a regional union for several post-Soviet
countries. The union can be built by employing multiple channels of
cooperation in the energy, steel, and agro-industrial
complex.