Making BRICS Development Bank Work - Vivan Sharan, Samir Saran, Courtsey Ria Novosti

Putin 3.0: Creating hedges for the next decade?

http://indrus.in/articles/2012/05/17/putin_30_creating_hedges_for_the_next_decade_15789.html

May 17, 2012, Indrus.in Samir Saran, Vivan Sharan

Is Putin going to lessen the Russian dependence on stagnant European demand for oil and gas despite the favourable terms of trade and rely on the hard-bargaining China?

The Kremlin has recently announced that Vladimir Putin will be skipping the upcoming G8 meeting in the US sighting domestic concerns and will be visiting China on June 5-7 as his first foreign trip since being inaugurated as President. It is clear that Putin views Chinese demand for Russian oil and gas as a hedge against stagnant Western demand, particularly European demand for Russian exports which showed a huge 47% negative year on year variation in 2009 and is unlikely to grow at rates that will sustain the Russian economy for too long. However, China drives a hard bargain and its quest for energy security through import diversification and oil equity means that it will not accommodate for more than a minimum amount of dependence on Russian raw material linkages.

While his predecessor and protégé Dmitry Medvedev repeatedly emphasised the need for Russia to diversify away from its “primitive” focus on the oil and gas sector, Putin seems to be doggedly set on continuing his outlined profit maximisation doctrine by largely relying on the sector to fulfil social spending promises made during his election campaign. Russia recently surpassed Saudi Arabia as the largest producer of crude oil, and holds the world’s largest natural gas reserves.  Approximately 40 percent of the Russian Government’s tax comes from oil and gas related businesses. While Putin has been able to successfully leverage Russia’s natural resource endowments in the past, he is now faced with burgeoning structural problems including huge manufacturing sector inefficiencies, negative demographic trends, deepened socio-economic inequities and populist rebuttals to alleged systemic corruption under his oversight. 

The European Union (EU) is Russia’s biggest market and the EU also accounts for around 75 percent of FDI into Russia. According to the European Commission, Russia accounted for 47 percent of overall trade turnover in 2010; a trend which has normalised after the brief disruptions caused by the global financial crisis. However Russia’s competitive advantage with the EU is largely restricted to the trade of fuels and minerals. Even with its massive oil reserves, Russia has lagged behind in the production of petrochemicals and refined oil. While the margins earned on refined oil based products in a globally integrated oil market may not justify expansion of production facilities and there is a distinct competitive advantage in favour of the “Global South” in terms of labour costs and environmental tariffs there are few explanations for the lack of emphasis on developing a profitable export oriented petrochemicals sector in the country. It doesn’t help that the recent socio-political turmoil adds to the disincentives created for any FDI investment flowing into the country.

Indeed Russia exhibits many of the symptoms of the “Dutch Disease”, a term that broadly refers to the deleterious effects of large asymmetric increases in a country’s income, most commonly associated with discovery of natural resources such as crude oil. While there is no consensus about whether the country suffers this affliction and indeed there have been significant per capita income gains as a result of exploitation of raw material wealth, there are real and palpable threats to sustained growth that need to be proactively mitigated by the establishment. A 2007 IMF Working Paper found that some of the exhibited symptoms included a slowdown in the manufacturing sector, an expansion of the services sector and high real wage growth in all sectors. Simultaneously, oil exports have increased by close to 70 percent over the last decade and the value of exports has gone up by around 620 percent during the same time span. Russian crude oil production recently hit an all time high, and Putin is determined to maintain production levels above 10 million barrels per day (about a third of OPEC’s total production) for a “fairly long time”.

In many ways, resource based linkages have guided and defined Russian foreign policy since the disintegration of the Soviet Union. Resources have also dictated Russia’s economic fortunes, which have traditionally fluctuated with the price of crude oil. Crude oil has quadrupled in value since the early 2000s, and at the same time, Russia has transitioned into becoming a Middle Income Economy with an incredible number of super-rich. It is interesting to note however, that despite the asymmetric dependence on raw material exports, Russia’s currency has been depreciating. Due to the underinvestment in the manufacturing sector and the overall lack of competitiveness of the domestic goods, import growth has tended to outpace export growth. The current account balance as a percentage of GDP has declined substantially since the mid 2000s and with structural production ceilings being hit in the oil and gas industry, there is uncertainty about where the additional export growth is going to be generated. Putin seems certain that recently announced tax breaks for upstream oil and gas exploration projects and fiscal incentives for M&A activities will help fuel this production growth. Tax breaks have been provided for offshore energy projects with Western companies including Exxon Mobil Corp., Eni SpA and Statoil ASA.  Simultaneously he also plans to raise extra revenues from the resources sector to pacify some of the populist anger that is brewing through increased government spending, in particular by significantly increase extraction tax on gas suppliers.

Putin has an uphill task, to reassure foreign institutional investors of the legitimacy and stability of his political apparatus. In order to achieve competitive advantage in the export of petroleum related products, the Russian Government has ambitious goals to create six regional clusters of world class ethylene (the world’s most widely produced organic compound) production facilities and expects production capacity to reach 11.5 million tonnes per annum by 2030. This projection assumes a fundamental amount of investments and supporting infrastructure capacity building in the form of product pipelines, road and rail links. Distribution and feedstock concerns already plague the industry.

The seemingly irreversible economic meltdown in Europe must act as a trigger to stimulate new ideas and a break out of the traditional resource centric growth mindset in the Kremlin. Developing and emerging countries account for around 50 percent of global GDP in purchasing power parity terms and Russia must look to deepen integration through trade with these markets. China is but one of these and its sino-centric economic startegy may soon be an albatross around its neck. Moreover trade must be on the basis of a diversified basket of products on offer with emphasis on value addition.

The East Siberia-Pacific Ocean (ESPO) oil pipeline which is now operational has enabled Russia to bring oil to its remote eastern coast, from where it supplies to China, Japan and South Korea. The Chinese have been actively lobbying to get all of the oil transported through the ESPO, but Russian oil companies are naturally hesitant as they are unwilling to forgo the higher margins they receive by selling to Western countries. The Russian experience with the hard bargaining Chinese must not colour their prospective engagements with other emerging and developing countries. In the next few decades, global growth will be a function of how such economies in Asia and Africa perform, and in turn, so will Russia’s economic fortunes. Putin would do well to hedge away from dependence on European demand even though terms of trade may be favourable and fall in the comforting squeeze of the Chinese option.

Summing Up Human Rights

In what is essentially an unequal world, preponderance on development, especially amongst the lower per capita income economies, is natural. The Eurocentric discourse on human rights is simply not applicable to large proportions of the world’s population. The notion of a basic minimum entitlement to goods and services is utopian given the technology and productivity levels that exist today. This entitlement by its very definition, involves a necessary redistribution of consumption patterns across the world. Given that the Earth has a finite amount of resources, only a finite amount of real wealth can be created. This in turn implies that unless the democratic frameworks in existence throughout the world are overturned, and the fundamental right to accumulate wealth through legal enterprise is denied, any meaningful discourse on redistribution of wealth and in turn basic human rights stands on shaky foundations.

The BRICS View on Iran: India's Motivations, Vivan Sharan * As Published in Dalal Street Investment Journal, April Issue

The recently concluded BRICS Leaders Summit in Delhi yielded comprehensive and progressive outcomes on a number of important issues. Besides being able to achieve consensus on significantly deepening the intra-BRICS cooperation agenda with emphasis on market based integration, BRICS Leaders for the first time, were also able to coherently express views on sensitive foreign policy issues including on the Arab-Israeli conflict, the Syrian imbroglio and the contentious Iranian nuclear programme. Through the Declaration, BRICS members have recognized Iran's right to "peaceful uses on nuclear energy consistent with its international obligations". The Declaration has also unambiguously stated that BRICS members do not support "plurilateral initiatives that go against the fundamental principles of transparency, inclusiveness and multilateralism". The BRICS position on Iran's sovereign rights and the respect of international law is an unequivocal rejection of interventionist policies outside of the UN framework. It is interesting to briefly examine India's motivations for adopting such a firm policy stance given its simultaneous proximity to powers such as the U.S and the EU.

For decades, Iran has faced multiple sanction regimes, for allegedly sponsoring terrorism and for developing a nuclear programme with the intent to make nuclear weapons. The U.S has led such efforts, following a fairly predictable model of incrementally imposing unilateral sanctions each time Iran's governance apparatus has been less than deft in handling its foreign policy priorities and messaging. This default model of response has been used by the U.S administration since the Islamic Revolution, which led to the overthrowing of the Shah of Iran, a close ally of the West. Sanctions have been used by the U.S to achieve highly ambitious foreign policy goals, which history proves, are hard to achieve without simultaneously establishing economic and political synergies (South Korea) or the blatant use of force (Iraq). Repeatedly, studies have shown that sanction regimes cannot work in isolation of comprehensive strategies for engagement. Yet, there has been little or no will to explore alternatives and with the Jewish lobby at Capitol Hill, the policy hostility towards Iran will be hard to reverse.

The problem with imposing sanctions on a country which has the world's third largest proven reserves of oil and second largest conventional natural gas reserves is that the implications are felt globally. An important characteristic of the global oil market is that it is an integrated market. The price of oil is highly correlated throughout the world due to market arbitrage. This means that plurilateral initiatives by the U.S or the EU to curb Iran's economic viability by imposing barriers on the free flow of trade and finance are in effect paid for by all net consumers of oil, including developing countries such as India. Iran's production capacity has also been more or less stagnant for many years at around four million barrels per day. Sanctions have prevented Iran from accessing technology to upgrade oil infrastructure and increase supply, which would theoretically ease oil prices. This is a perverse and fundamentally flawed dynamic. Why should the developing world pay for the foreign policy interventions of the West? Why should India, a country with over 800 million poor and stark levels of energy poverty, subsidise American and European foreign policy and in turn face insurmountable fiscal deficits year after year?

India and Iran share historical ties, and there is definite cultural affinity between the two nations. However, these are not the reasons why Indian policymakers have supported the seemingly ideological stance taken by BRICS members. India imports around 12 percent of its oil from Iran, its second largest supplier after Saudi Arabia. While in a globally integrated oil market, import substitution should theoretically be fairly simple, Iran sells oil to India based on long term supply contracts that offer a competitive rate. Moreover, many of the PSU refineries in India are geared towards the processing of sweet crude oil which is imported from Iran. Mangalore Refineries and Petrochemical Limited (MRPL) and Hindustan Petroleum Corporation Limited (HPCL) in particular are two large PSUs whose profit margins depend to a significant extent on the sweet crude mix imported from Iran. While the private sector, including Reliance, has been fairly quick to respond to the political risk and diversify imports, the public sector understandably cannot adapt as fast (Essar Oil is the private sector exception which was the largest importer of Iranian Crude in the first quarter of 2012). India is certain to continue importing oil from Iran and only the relative quantities in the composite import basket are likely to fall over the long run as gradual refining technology improvements are carried out by the aforementioned PSUs. 

In the first quarter of 2012, India overtook another BRICS member, China as the largest importer of Iranian Crude, with direct imports of over 430,000 barrels per day. This is in spite of the difficulties of carrying out financial transactions with Iran due to the existing sanctions regime which specifically also targets financial institutions such as the Central Bank of Iran. In 2010, the Reserve Bank of India mandated that oil import payments to Iran would have to be settled outside the Asian Clearing Union (ACU) mechanism, which involves the central banks of India, Bangladesh, Maldives, Myanmar, Iran, Pakistan, Bhutan, Nepal and Sri Lanka. There is an old adage that "markets always find a way' and this has largely been true in the case of imports from Iran. A recent development has been the institution of a settlement mechanism through which India can pay up to 45 percent of its import costs in local currency. India in its Union Budget for FY 2013 paved the way for the efficient working of this mechanism by including a tax exemption for such transactions which would otherwise be classified as "income earned abroad' (by Iran) and therefore be liable up to a 40 percent tax.

A common argument by Iranian Government officials is that if the current sanction regime followed by the U.S and EU has led to the appreciation of oil price by 8 or 10 percent, it has only benefited Iran, which continues to supply oil to its major consumers China and India at more expensive rates. Indeed the cost-benefit works in Iran's favour as Iran is more than able to offset losses due to higher transaction costs with the appreciation of the underlying price of the asset. The BRICS members consist of both net oil exporters and importers and represent 43 percent of the world's population and therefore represent a more than credible global zeitgeist. They have suggested better international policy coordination to maintain macroeconomic growth momentum and curb commodity price volatility as immediate imperatives for the global economy. Since commodity prices are highly correlated with the oil economy, it is in all nations' interests to ensure a viable and stable price for oil to ensure sustainable development in the current sluggish and uncertain global economic growth environment. BRICS provides a platform for India to voice concerns and direct strong criticism against Western countries that directly influence oil prices through the conduct of irresponsible foreign policy outside the international framework. In a way the BRICS platform allows India to express views that the constraints of realpolitik do not allow it to. It allows India's 21st century foreign policy to evolve and emerge to better reflect domestic concerns.