Russia 2020 – Game over Putin?

Since 1990 Russia has experienced something of an escalator ride in the nation’s fortunes. From near bankruptcy the Russian economy has bounced back since the beginning of the Putin years, largely on the back of a vast overhaul of its oil and gas industry which has fuelled the increasing spending demands of Putin’s various administrations. Yet are we about to see the Russian state experiencing another rollercoaster drop in the next decade? Here are a few humble suggestions why Russia is facing a perfect storm in 2020:

“It’s the Economy Stupid” – or more accurately it’s the Oil Price.

For most of Russia’s history its economy has been primarily driven by its primary industries which have exported the vast resources at the states disposal. But in recent years the dependency of the current Russian economy on oil and gas exports has become truly staggering. Not only does Russia’s oil and gas industry now account for 49% of the state’s revenues, but Russia also requires over 2/3rds of its gas production simply to service its own economies internal requirements.

The situation when we start to examine Russia’s much discussed export of oil and gas products gets far worse (if you are Russian). Of Russia’s 600BcM of gas produced every year, around 140BcM is exported to Europe but of that 140 BcM exported to Europe, Germany and Ukraine account for 70BcM of exports combined (at 30BcM and 40BcM respectively. To re-phrase this, Russia relies on Germany and Ukraine for around 34% of its gas sales, whilst Ukraine accounts for nearly 19% of all Russia’s gas exports. Compounding even this terrifying over-reliance, the pipelines that provide Russia’s gas to the rest of its EU markets all currently use Ukraine as a transit nation. Thus for anyone who remembers the 2009 gas crisis in Europe, this is why Russian planners are so concerned about their gas position.

Even if Russia is able to construct its South Stream project to reduce its reliance on Ukraine as a transit hub it is not only competing against the EU machine, which has aggressively tried to challenge Russian gas hegemony, but also the alternative gas pipeline, Nabucco West.

Taking aside the above issues however the baseline concern for the Russian economy is to do with the price of oil. With the US explosion of Shale gas, estimated to increases the US gas production by 25% by 2020, there will be an inevitable decline in demand for oil related products on the international market, especially as other BRIC nations seek their own domestic means of energy production. In addition, the climate change agenda and the effects of air pollution in major cities is leading developing nations like China to increasingly seek gas as an alternative to oil. The problem for Russia however is that, simply put, it gets such a good price from Europe that it won’t accept the terms China and others are offering.

The implication of this fall in the oil price is an inevitable decline in the Russian state revenues. If the price of oil and gas declines then Russia will face a choice: to reduce its current output of oil and gas to maintain the price level (assuming the rest of OPEC will do likewise) or to maintain its output but at a reduced profit (and in some cases certain projects will become close to loss making). All of which is disastrous for the Russian government’s spending pledges, including its $800 billion armed forces modernisation programme….

The energy crisis however is not just linked to the state revenues from oil and gas however. The World Bank’s latest report on the ECA and FSU states has indicated that they will need to invest $1.5 trillion into maintain and modernising its energy infrastructure within the next 20 years, yet to do this will require a large increase in the price of electricity. This then leads to the next problem of the Russian economy: a large proportion of high energy intensity industries whose main advantage is price competitiveness, in no small part due to low energy prices. So the question here is: if faced with a decline in global oil and gas prices will Russia reduce its supply of oil and gas and sell its products purely on the basis of the highest bidder in Europe and at home, or will it maintain its output levels and use its oil and gas industry to subsidize its domestic manufacturing industries?

The net result of any of these variables above will mean less revenue for the Russian state and hence the problems below:

Increasing domestic instability and declining state security resources:

The re-election of Vladimir Putin was considered by many competitors to be an academic exercise. He was too strong, too popular or too well connected to lose so commentators said. And sure enough they were right, except this time Russia’s voters didn’t lie down and play dead. The scale of protests was unprecedented under Putin’s rule and provides a glimmer of the hostility ordinary people feel towards the current government.

It is true that for many Putin is still deeply popular but the same is certainly not true of his lieutenants and it is their increasingly public misdemeanours that are starting to significantly chip-away at the regimes support base. The sense of insecurity felt by Putin was perhaps best displayed by the obscene levels of attention and media coverage that was generated by the Russian punk rock band “Pussy Riot” whose 30 seconds of fame generated world-wide news coverage.

Now whilst Russia has often suppressed riots and domestic violence, it is the impact of declining state revenues that will suddenly start to lead to difficult strategic decisions on where Russia spends its resources. If the state continues to focus its funding on internal suppression then it will inevitably have to reduce its spending on its planned military modernisation programme, something which will surely reduce the global reach of the Russian military and certainly the extent it can intimidate its neighbours.

Furthermore, if Russia does retrench domestically, will this lead to more aggressive actions by those states that have territorial disputes with Russia currently? Any increased belligerence by states like Georgia and Azerbaijan would be increasingly embarrassing for Moscow, whose people would demand a response. Will the Russian state be able to in the future? Even the latest Russian fighter jet project, a symbol of its super-power aspirations, could be threatened if it fails to find suitable export partners and its numbers drop below its already low order number, (expected to be initially 100 or less).

Demographic issues:

Inherently linked in Russia with domestic security concerns is population issues and immigration. The Russian state has always incorporated a large number of ethnic minorities and different faiths, but notice the word minorities. The modern Russia today is facing a marked decline in the birth rate of European, orthodox Russians, whilst its minority populations, notably those who follow Islam, continue to grow, as does the number of immigrants from central Asian states.

This again will start to stir domestic tensions where the state has historically under invested in the East and often concentrated its investments into a few key cities like Moscow. Furthermore, regional hot-spots like Chechnya may become emboldened to push for further regional autonomy if the region’s population continues to grow whilst the typically more Slavic and European population of western Russia declines.

Linking this all back in again. Under-investment in regions with high birth rates which will require greater state resources for health care and education as well as state and/or private investment to create job opportunities for a rapidly increasing young workforce will create a policy headache for a state with limited alternatives than state spending or careers in the oil and gas sector. Both of which seem certain to decline.

Squaring the Circle – concluding remarks:

So what does all this mean? In effect Russia is facing a perfect storm by the end of this decade and the only possible solutions to its problems still look as distant as ever.

The Russian state cannot generate internal investment without an end to the rampant corruption that eats away at public confidence in the state bureaucracy and decimates the ability of financial institutions to invest sensibly into growth prospects. But more fundamentally what Russia really lacks is a functioning rule of law.

No company today can invest in Russia without the concern of expropriation or state interference and those that have tried have often been burnt badly in the process, whether BNP-TNK or Shell and its development of Sakhalin island. This hampers any serious private sector investment and again places the onus of investment squarely on the Russian state.

With declining state revenues and increasing demands on its budget, does Russia have many options left open? Can it cut spending and if so what? Can it increase its level of government debt and if so for how long and at what cost? All of these questions leave Russian policy planners feeling uneasy and with Putin’s grand ambitions so publically stated what would be the political damage if the policies failed or perhaps even worse, they were cancelled?

So while for now Russia may be having its moment in the spotlight as a super-power in Syria, it’s worth waiting to see what happens next. My suspicion? Russia may just start getting that bit quieter and quieter as this decade progresses.

So keep an eye on Russia and 2020. The Russian roller coaster may just be about to drop.

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