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Wednesday, July 12, 2006

Russian Economy Being Eaten Away at its Foundations

First Kasparov fires his salvo at the Kremlin, taking advantage of the G-8 spotlight that Vladimir Putin has generously provided, and now it is Illarionov's turn. Just as a house may look good from the outside while being destroyed internally by rot and termites, the Russian economy may avoid the appearance of total disaster due to oil revenues but, as the Associated Press explains, the inner workings are on the verge of total collapse:

Russia has come a long way since its 1998 default on $40 billion of sovereign debt, burying its image of a handout-hungry giant and positioning itself as one of the world's leading energy powers.

But with oil revenue gushing in and its state-controlled oil and gas companies ascendant, the Kremlin's frequently stated goal of diversifying the economy into sectors like high technology looks like a remote one.

That is hardly surprising, given the oil sector's spectacular performance. With prices riding high, Russia rakes in more than $550 million a day in oil and gas revenue. The state gets 65 percent of that. Oil and gas exports account for about 60 percent of federal budget revenue as well as 60 percent of all exports.

Since the August 1998 collapse, Russia's hard currency reserves have soared from a feeble $12.5 billion to $247.1 billion. Meanwhile, the government is busy funneling oil companies' profits above $27 a barrel into an inflation-fighting stabilization fund, which stood at $76 billion at the end of June.

This year it will use $22 billion of that to pay all its remaining debt to the Paris Club of creditor nations. That is a far cry from the years when it could scarcely make the interest payments on its foreign borrowings.

But analysts worry that the state's oil revenue is not strengthening the broader economy at a time incentives and tax breaks are needed to help revive old Russian industries and small and medium-size enterprises. For Russia's long- term health, the economy must be freed from the vagaries of commodity markets, economists say.

"It's almost the worst of both possible worlds - the profits have been taken out of the oil and gas industry, so the companies are low on cash to grow their businesses, but at the same time no diversification structure has been put in place - they are not providing the planned growth incentives for industry," said Chris Weafer, chief strategist for Alfa Bank in Moscow.

Efforts to simplify Russia's bloated bureaucracy have stalled, allowing red tape and endemic corruption to throttle small and medium-size enterprises. According to Peter Westin, chief economist with the investment bank MDM in Moscow, such enterprises account for just 13 percent of Russia's gross domestic product, compared with 30 percent to 50 percent in more developed countries.

Meanwhile, corruption and opaque regulations hold back foreign investment - as well as what Westin calls the crucial "spillover" of technologies and know-how that comes with it. Net foreign direct investment in Russia at the end of 2004 came to $89 per capita, compared with $5,000 in the Czech Republic and $4,000 in Hungary, Westin said.

"That's the primary inhibitor for even more investment and the growth of small and medium-size business - the administrative burden and the corruption that goes with it," said Andrew Somers, president of the U.S.-Russia Chamber of Commerce.

Nowhere are the technological gains that foreign investment can bring needed more urgently than in the oil and gas sector. With global energy consumption set to soar, all eyes are on Russia to develop new and promising fields in its more inaccessible territories. Changes to the tax laws that would make such investments viable are still in the works, as are long-awaited regulations that would clarify limits on investment in certain sites in the energy sector.

Andrei Illarionov, who resigned as President Vladimir Putin's economic adviser last year to protest what he called the government's backtracking on freedoms, describes government talk of modernizing Russia's economy as only public relations.

"There are no serious steps in this regard: no privatizations, no liberalization, impediments to business are not being removed - none of this is being done," he said.

Instead, Illarionov argues, the Kremlin's efforts are going into tightening its hold on strategic industries, starting with oil and gas. Ultimately, he says, the state wants to forge "champion companies" - like the gas giant Gazprom or the oil producer Rosneft - that will serve as powerful geopolitical levers.

These days the calls to overhaul the economy are fading, said Yevgeny Gavrilenkov, chief economist at Troika Dialog, a Russian investment company.

"Five, six, eight years ago there was talk of diversification," he said. "In recent years I hear them talk about this less and less, but more about an energy superpower."

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