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.
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