Streetwise Professor

October 15, 2008

$67.88

Filed under: Economics,Energy,Russia — The Professor @ 7:30 pm

That’s the price of Urals-Med today. The $70 barrier has definitely been breeched. Now, it should be noted that Urals sells at about a $2 discount to Brent, and the Brent forward curve is pretty steeply upward sloping, so the Urals forward price should be above $70 for most of 2009. Nonetheless, the Russian budgetary cushion is getting thinner by the day.

Just a couple of comments re the still continuing debate between DR and Michel.

First, re OPEC–cartels are inherently unstable. The level of the equilibrium competitive price of oil isn’t really that germane to the ability of the cartel to peg the price above that level. The cartel must restrict output in able to do that. Every individual member has an incentive to cheat on its quota. In OPEC, as in most cartels, that cheating has been rife. In essence, Saudi Arabia has been the swing producer, and it almost unilaterally is the only force that reliably affects prices by reducing output. And Saudi wants a price of around $80. And at times (e.g., 1986), Saudi Arabia gets tired of bearing the entire burden of supporting prices. If it has to restrict output too much in order to prop up prices, it may repeat its 1986 performance and open the spigots to punish all the cheaters.

As an aside, perhaps some of Russia’s recent output stagnation/decline reflects its effort to act as a swing producer, though it may also reflect the inefficiencies associated with greater state control.

Second, re the great consumption debate. I don’t think that there is any doubt that Russian private domestic consumption has risen quite steadily over the past decade. In large part that reflects the low starting base and the resulting catch-up, the more efficient allocation of resources in the post-Soviet period, and the dramatic reallocation from heavy industrial production towards consumer goods. Moreover, per DR, it also reflects a favorable tax climate, with a low, flat tax rate. (One thing about Russia that I’d like to imitate in these parts.)

However, in some respects the consumption growth is a bug, not a feature, because of its flip side–the very low rate of domestic Russian savings. As a result, Russia is highly dependent on external capital, and current events are demonstrating the pitfalls of this reliance with a vengeance.

Relatedly, domestic investment rates in Russia are very low compared to other countries that have achieved and sustained high growth rates. Russian domestic investment is 18-20 pct. of GDP, as compared to the 30+ percent of high growth success stories.

But in the end, my long horizon skepticism about Russian economic prospects (should I say bearishness?) is not primarily rooted in traditional macroeconomic considerations. Instead, my skepticism is traceable to the weakness of property rights, the vulnerability of profitable businesses large and small to the predations of the state (of which corruption and “raiding” are two symptoms), and the brittle political/natural state institutions. As I said in an earlier post, Putin has created a sort of economic purgatory, better than the economic hell that proceeded it, but hardly ideal. And the political economy of the natural state system makes it very, very difficult to exit purgatory for something better. Moreover, although it may not be a highly probable outcome, rent-based politico-economic systems like Russia’s are vulnerable to instability and collapse. In a parallel to the girl with the curl (when she’s good she’s very very good but when she’s not she’s horrid): When they are orderly, they are very, very orderly, but when they’re not, they’re chaotic.

To me, it’s not necessarily the budgetary implications of a low oil price that creates substantial downside risks for Russia, though that’s not irrelevant. Instead, the major risk is that the system is predicated on distributing rents to keep the various clans happy. While the rents are big enough, and the clan members think the game will continue for awhile, the system can operate relatively well. When the rents erode, or economic shocks affect the distribution of rents to the substantial relative disadvantage of some, however, that stability can disappear almost overnight. Given the extreme weakness of formal institutions in Russia–and I don’ think any objective observer can dispute that formal institutions like property rights, courts, etc., are deficient there–the dissolution of the informal, relational bonds that hold things together can lead to substantial disruption.

The world is currently experiencing a major shock. (Duh.) This first major effect of this is to reduce the prices of natural resources, and the associated rents, that have been the basis for Russian politico-economic stability. Moreover, due to Russia’s dependence on foreign capital; its own self-inflicted wounds (Georgia, Mechel, BP-TNK, etc.); and its increased integration with the world economy, the world/US shock has had a disproportionate impact on Russian equity markets. Moreover, it is evident that the shock has had big distributive effects within Russia. All of these factors eat at the informal bonds that mitigate conflicts between competing factions.

Finally, the economic shock has created an environment favorable to the enhancement of the powers of the state (through acquisition of heretofore private companies at cheap prices). Even if the current structure survives the present stresses–probably the most likely outcome, even though the risk of a major blowup is higher now–this will have adverse consequences for Russian growth in the future, and public enterprises are inherently less efficient.

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14 Comments »

  1. And, the list of industries going to the state cap in hand for money or cheap loans is growing…. In reading today’s Moscow Times, I note that the power companies are asking for tens of billions of dollars in cheap loans so they can finish building planned projects (see: http://www.moscowtimes.ru/article/600/42/371700.htm) and the farming industry is asking for a $34 billion dollar bailout (see: http://www.moscowtimes.ru/article/600/42/371698.htm). Is there any sector of the Russian economy that does not need cheap loans or billions of dollars from the Russian Federation?

    Comment by Michel — October 15, 2008 @ 8:07 pm

  2. You’re right, the floodgates have opened. (Something similar may happen in the US, alas.) And the dynamic in these situations is quite simple. It’s analogous to a fishery, or a land rush. The equilibrium outcome is for everybody to rush to try to get first in line to get their share of the take, even if they don’t “need” it–if you don’t get there early, there will be nothing at all. In Russia, moreover, the dynamic is potentially more fraught with danger because these things are not determined primarily through formal political institutions, but through informal means (e.g., corruption), and, given the players, potentially violence. Like I said, $500 billion can disappear pretty quickly these days.

    The ProfessorComment by The Professor — October 15, 2008 @ 8:36 pm

  3. Kommersant is discussing this issue in their main article at the moment entitled ” Черное золото становится черным злом для крепкого рубля и твердого бюджета” (My rough translation: Black Gold Becoming Black Evil For a Strong Ruble and Firm Budget)

    One interesting passage from this article:

    “Еще в середине сентября глава Минфина Алексей Кудрин давал понять, что не видит необходимости в корректировках проекта бюджета на 2009-2011 год. По его словам, бюджет 2009 года будет “бездефицитным” при цене более $70 за баррель. Позже замглавы Минфина Сергей Шаталов заявил, что правительство не считает нужным корректировать проект бюджета, который был принят Госдумой в первом чтении 19 сентября 2008 года. При сохранении средних цен на Urals на уровне ниже $70 в течение ближайших трех-четырех месяцев уже в январе-феврале 2009 года бюджет РФ станет дефицитным по доходам.”

    Comment by Michel — October 15, 2008 @ 11:51 pm

  4. This is what Mikhail Kasyanov, a former prime minister of Russia, writes in today’s Novaya Gazeta in an article entitled “Our Market Died” (Наш рынок умер):

    “Дефицит бюджета начнется уже при 70 долларах за баррель. А при сокращении мирового спроса нельзя исключать и их падения до 30—40 долларов за баррель, а это уже означает: за год-полтора никаких многомиллиардных резервов не станет. Стране надо будет еще выплатить 500 млрд долларов внешнего долга корпораций, и объемы импортных закупок будут резко уменьшаться. Тогда в крупных городах, которые у нас живут на импортных продуктах питания, уже просто есть будет нечего.

    Единственный спасительный сценарий для властей: если внешние обстоятельства вдруг резко изменятся — и кризис сам собой как-нибудь рассосется. Именно на это, похоже, наши власти и рассчитывают. России труднее пережить кризис, потому что у нас недиверсифицированная экономика. Не работают ни рыночные механизмы, ни государственные институты, поэтому мы неадаптивны. Но если удастся удержать наше единственное на сегодняшний день «конкурентное преимущество» — высокую цену на нефть, — Россия опять сможет на некоторое время залить деньгами все свои нерешенные проблемы.” (Source: http://www.novayagazeta.ru/data/2008/77/12.html).

    Rough translation (keeping in mind the Italian saying about translation which is “translator, traitor” as you always betray the original through translation):

    “Budget deficits will start at 70 dollars per barrel, and with a reduction in in world demand one cannot exclude the possibility that prices will drop to 30-40 dollars a barrel, and this means that in a year and a half no multibillion dollar funds will stand. The country will also have to pay 500 billion dollars in foreign corporate debt and the volume of imports will drastically decrease. At that time, in the large cities where we live on imported foods, there will simply be nothing left.

    The only life-saving scenario for the authorities is if the global circumstances suddenly and dramatically change and the crisis somehow dissipates. That is what it seems our government is counting on. Russia will be hit harder by the crisis because we do not have a diversified economy. Neither market mechanisms nor state institutions function and for this reason we are unadaptive. But, if if we can maintain our only “competitive advantage” at this time – high oil prices – Russia will once again be able to pour money on all the unresolved problems.”

    Comment by Michel — October 16, 2008 @ 2:00 pm

  5. “First, re OPEC–cartels are inherently unstable. The level of the equilibrium competitive price of oil isn’t really that germane to the ability of the cartel to peg the price above that level. The cartel must restrict output in able to do that. Every individual member has an incentive to cheat on its quota.” – SWP

    I’ll reiterate a point I made in a previous point that this time around the returns from cheating by any one member are much lower than in the 1970’s.

    This graph represent the supply and demand curves for oil. (http://www.iammea.org/awissner/peakoil/supplydemand.gif)

    In 1970, equilibrium price was low because supply and demand upward curves were far apart and it took a big, coordinated production cut to raise prices. Nowadays the upward part of the curves are much closer (also the reason the equilibrium price is higher), and because of the tightness of supply, I believe collusion has become much easier and less prone to cheating (since today revenues depend much more on price than on volume, since prices have become so high).

    “In essence, Saudi Arabia has been the swing producer, and it almost unilaterally is the only force that reliably affects prices by reducing output.” – SWP

    It can also be achieved by leaning on oil companies to cut production, which probably won’t be much of a problem for Russia.

    “As an aside, perhaps some of Russia’s recent output stagnation/decline reflects its effort to act as a swing producer, though it may also reflect the inefficiencies associated with greater state control.” – SWP

    I think it 80% reflects the second peaking of Russian oil production due to geological reasons, and the other 20% what you mentioned.

    “Moreover, per DR, it also reflects a favorable tax climate, with a low, flat tax rate. (One thing about Russia that I’d like to imitate in these parts.)” – SWP

    One of the few things you like in Russian policies is one of the few things I disagree with (I don’t see the justice of the Abramoviches of the world paying the same % in taxes as the middle class, and that’s not to mention most of the wealth of his ilk goes towards acquiring positional and over-priced prestige goods, often abroad). LOL.

    About the rest:

    Suffice to say that my assumptions about things differ from yours in many ways. I think the root of growth is not high investment and institutional factors (not that they don’t help!) but human capital. I also don’t buy into the “clans” theory of Russian politics. So suffice to say I mostly disagree.

    Comment by Da Russophile — October 18, 2008 @ 10:51 pm

  6. http://www.arabianbusiness.com/534729-opec-eyeing-sharp-production-cut?r=1

    OPEC oil producers are leaning towards cutting production by 1-1.5 million barrels per day (bpd) at their Oct. 24 meeting, UAE state news agency WAM said on Friday, citing an OPEC source.

    Nothing surprising here. Russia should join them.

    Comment by Da Russophile — October 18, 2008 @ 11:23 pm

  7. My point about cartels is a very simple one. They are very good at increasing the output of promises to reduce the output of the product they produce; they are very at carrying out those promises. With the decline in demand, it is no doubt in the collective interest of oil producers–Russia included–to cut output. Individually, however, each producer wants all the others to be the suckers that cut back, while it produces to capacity.

    Cartel members are in a prisoners’ dilemma. I am certain that they will pinkie swear cross their hearts hope to die promise to cut output. I am equally certain that these solemn oaths will be honored in the breach, rather than the promise.

    Err, in a competitive equilibrium supply and demand curves cross at the competitive equilibrium price & quantity. Therefore, your statement that “equilibrium price was low because supply and demand upward curves were far apart” makes absolutely no sense. Given the slopes of the supply and demand curves, the equilibrium price level can occur at any price–just adjust the levels of the curves.

    The more elastic are supply and demand curves, the larger the output cut necessary to achieve a given price increase. The incentives to cheat are still there. They exist because of the difference between the cartel price and the marginal cost of production. If the competitive equilibrium price is $10, a cartel that raises prices to $20 faces cheating problems. If the competitive equilibrium price is $50, a cartel that raises prices to $60 also faces cheating problems. In each instance, the cartel price exceeds marginal cost, meaning that each individual member perceives an opportunity to increase profit by raising its own output.

    Your argument “supply and demand upward curves were far apart” seems to suggest an argument that supply and demand curves are more inelastic today than in the 70s. I would agree that long run supply is probably less elastic today, but that is irrelevant for discussing short run effects, and short run supply curves are probably as inelastic today as then. WRT demand curves, it is plausible that demand curves are less elastic, primarily because pricing policies in China, India, and other nations mean that consumers don’t pay the real cost.

    But even granting your premises, the conclusion doesn’t follow. The less elastic is the demand, the higher the joint profit maximizing cartel price, and the greater the deviation between this price and marginal cost. Thus, if OPEC were to attempt to set a price equal to the joint profit maximizing price, and set production quotas accordingly, under your assumptions the price-marginal cost margin would be higher today than in the 70s. Thus, the incentives to cheat would be more acute today than in the 70s.

    I have no doubt that the competitive price of oil today is higher than in the 1970s. The relevant questions for this debate, though, are (a) whether that price is above $70, especially given the prospects for a severe world economic downturn (from which China will not be immune)?, and (b) can OPEC effectively keep prices substantially above that level? Given current price levels, the answer to (a) appears to be “maybe–but barely.” The answer to (b) is, basic economics and history say “no.”

    BTW, on Friday, Urals Med was quoted at $62.72.

    The ProfessorComment by The Professor — October 19, 2008 @ 9:54 am

  8. Re human capital. No doubt important, as longstanding growth accounting research shows. But it is foolish to dismiss the centrality of institutional factors, for these greatly influence (a) the incentives to accumulate human capital, and (b) how human capital resources are deployed. In countries with weak institutional environments, human capital is disproportionately employed for rent seeking, rather than wealth generation. (Ann Jacobs wrote about this eons ago.) There is an antediluvian SWP post (don’t have time to find it now) that quotes from an article that discusses how many young, educated Russians are striving to get into the tax service, the customs service, etc., because that’s where the money is. In an environment where corruption is rife (and certainly you don’t disagree that corruption is endemic in Russia) and property rights are insecure (ditto), the returns from human capital in rent seeking activities are higher and the returns to human capital in productive activities are lower, than in environments where these problems are less acute.

    There is an article by Schleifer and Vishny that formalizes these points. At its basic level, the foregoing argument implies that the level of income in institutionally weak countries is lower ceteris paribus. Schleifer and Vishny construct a model in which there are increasing returns to rent seeking, in which case growth levels are also lower in institutionally weak countries.

    The ProfessorComment by The Professor — October 19, 2008 @ 10:13 am

  9. Wherever did I say I believe corruption is endemic in Russia? I do not. I think it is similar to those of typical middle-income country like Argentina or Turkey, as reflected in Transparency International’s Global Corruption Barometer where the question “have you paid a bribe for a state service this year?” is asked. In Russia 17% answered yes, which places them in the same quintile as Bulgaria, Turkey and the Czech Republic, i.e. slap bang in the middle of world corruption rather than at the end. This also correlated to my own observations. Although I agree that bureaucratic procedures are typically far too annoying and time-consuming, I have yet had to pay a bribe there. So I don’t take seriously the claims about “African levels of corruption” claimed by some Russia “experts” (in those countries, the % of people admitting to paying bribes yearly is typically >50%, which truly does indicate endemic corruption).

    A similar line was taken by A Normal Country (Andrei Shleifer & Daniel Treisman, Foreign Affairs, Mar/Apr 2004).

    “Yet what about sources less dependent on the perception of outsiders? In the summer of 1999, the World Bank and the EBRD conducted a survey of business managers in 22 postcommunist countries. Respondents were asked to estimate the share of annual revenues that “firms like theirs” typically devoted to unofficial payments to public officials “in order to get things done.” Such payments might be made, the questionnaire added, to facilitate connection to public utilities, to obtain licenses or permits, to improve relations with tax collectors, or in relation to customs or imports. Respondents were also asked to what extent the sale of parliamentary laws, presidential decrees, or court decisions had directly affected their businesses, in the hope of measuring the extent to which policymakers were co-opted by business.
    On both the “burden of bribery” and “state capture” dimensions, Russia ranked right in the middle of its postcommunist peers. On average, Russian firms reportedly paid 2.8 percent of revenues on bribes, less than in Ukraine and Uzbekistan, and far less than in Azerbaijan (5.7 percent) and Kyrgyzstan (5.3 percent). The percentage who said it was “sometimes,” “frequently,” “mostly,” or “always” necessary for their firms to make extra, unofficial payments to public officials in order to influence the content of new laws, decrees, or regulations was also about average: 9 percent, compared to 24 percent in Azerbaijan, 14 percent in Latvia and Lithuania, and 2 percent in Belarus and Uzbekistan. In both cases, Russian responses were very close to what one would predict given Russia’s relative level of economic development.
    How does corruption in Russia affect individuals? The UN conducts a cross-national survey of crime victims. Between 1996 and 2000, it asked urban residents in a number of countries the following question: “In some countries, there is a problem of corruption among government or public officials. During [the last year] has any government official, for instance a customs officer, a police officer or inspector in your country asked you, or expected you, to pay a bribe for his service?” The percentage of positive responses in Russia was about average for the developing and middle-income countries surveyed. Some 17 percent of Russians said they had been asked for or had been expected to pay bribes in the preceding year, fewer than in Argentina, Brazil, Lithuania, or Romania. Again, Russia’s relative position was almost exactly what one would expect given its per capita income.”

    So in conclusion I believe corruption is a minor to moderate hindrance to economic convergence with the West rather than an irreconcilable block as you would have it. If Italy, a notoriously corrupt country, managed it well back by the 1980’s I see no reason for Russia not to do it by the 2020’s.

    As for the oil price post, I’ll come back to it once I’ve mulled it over. In fact I’ll probably post specifically about that on DR.

    Comment by Da Russophile — October 20, 2008 @ 12:06 am

  10. So, Da Russophile believes that corruption is not endemic in Russia. Can’t say that I am surprised.

    What is important to note is that corruption has become much more centralized under Putin: rather than most citizens having to pay small bribes, fewer people have to pay much bigger bribes. The dedushka living off of his pension is likely to never pay a bribe, unless it is a “gift” given to a doctor to improve his access to health care. As a consequence, the number of people who are likely to say they had to pay a bribe will be quite low.

    The problem is that corruption stifles the ability of small business to establish themselves. Any attempt to establish a business will require the payment of large bribes. The ones collecting are no longer the lower level administrators, rather the higher level government officials.

    Gazeta.ru has an interesting article that asks in its title: “Кто вставляет палки в колеса бизнеса?” [Who is throwing sticks in the wheels of business?]

    The conclusion of the article:

    “Как это ни печально, но коррупция в России превратилась в способ существования огромного количества людей. Ситуация с ООО “ЭНТ”, может быть, лишь еще одно подтверждение этому. Вопрос, будет ли искоренена коррупция в чиновничьих рядах, уже стал притчей во языцех. Власть неустанно повторяет: дни коррупции сочтены, но, к сожалению, пока эти обещания лишь сотрясают воздух. Очень хочется надеяться, что в скором времени слова власти наконец приобретут реальные черты и бизнес сможет вздохнуть полной грудью.”

    The article examines how corruption stifles the growth of small and mid-sized business. In the passage above, the author notes how corruption has become central to the well-being of a large quantity of people. The state keeps repeating that it is necessary to clamp down on corruption, but so far it offers nothing but bluster and empty words. The author finished by saying that he hopes that the government will finally clamp down on corruption in a real way so that business can finally get a chance to breathe freely.

    Source: http://www.izvestia.ru/economic/article3121711/.

    Comment by Michel — October 20, 2008 @ 4:26 pm

  11. Michel makes a couple of good points. First, I pointed out in another antediluvian SWP post that the main effect of the “power vertical” has been to rationalize the corruption process, and reduce what industrial organization economists call the “multiple markup” problem; with multiple bribe-takers in a chain of transactors, the aggregate bribe is above the joint profit maximizing bribe level as each bribe taker doesn’t take into account the effect of his actions on the demand for the services of other bribe takers. Imposition of a central mechanism that controls this process leads to the imposition of a bribe that more closely approximates the profit maximizing bribe. That’s not to say this is efficient relative to a no-bribery equilibrium, just that the “power vertical” system of corruption is more efficient than a “system” of uncoordinated bribe taking. This is an aspect of my “purgatory” analogy for Putinism. I should also note that the increase of the power of the center, and a perception that it is somewhat stable results in the replacement of what Mancur Olson called “roaming bandits” with no long interest in future economic development, with a “stationary bandit” that has something of a stake in the long run prospects of wealth producers. The post-2000 Russian model is closer to a “stationary bandit”; the 1990s system was about as close to a system of roaming bandits as has been seen west of the Urals since the Dark Ages. (Modern Africa is full of roaming bandit polities.)

    Michel’s point about small business is also on the money. It is widely documented that small business is substantially underdeveloped in Russia vis a vis other transition economies.

    The ProfessorComment by The Professor — October 20, 2008 @ 5:06 pm

  12. Michel,

    Can I just point out that fewer people paying much bigger bribes actually implies that the RISKS of paying bribes have gone up (i.e. corruption has become LESS “endemic”)?

    SWP,

    OK, I’ve read up on the microeconomics of cartel behavior and based on that I agree with you, OPEC boosting prices in the long-term is not going to be any easier now than in the past.

    Unfortunately, reading that confused me more than clarified things, because it seems to go against intuition from looking at the supply/demand curve for oil.

    Now what I meant to say is that oil demand is very elastic – but only up to a point. Below a certain critical quantity it becomes inelastic since reducing consumption would result in contractions in the real economy. Same with supply. At very low prices, the supply curve is nearly flat, but there comes a point where it veers sharply upwards, because that’s when increasing its production becomes constrained by geological limits.

    Now what I was saying was that in the 1960’s, the intersection of the supply and demand curves happened at a very low price (hence the ill-thought out “supply and demand upward curves were far apart” comment – I meant that the INELASTIC parts of the supply and demand curves were far apart). Hence to substantially lower prices OPEC needed to make a big cut. That seems to be borne out by historical data – very rapidly rising production stalled sharply in 1974, and was the same in 1986 as in 1974. This implies that OPEC had to make shared big production cuts (including a) oil that they otherwise would have produced if the embargo hadn’t happened, and b) to make up for continued expansion on the part of countries not in OPEC).

    Today the INELASTIC parts of the curves are close together (and the reason why oil prices have soared in the absence of supply shocks), in contrast to the 1970’s. Basically the inelastic parts of both demand and supply are beginning to rub against each other and push the intersection/price point rapidly upwards (which doesn’t happen when the inelastic parts are far apart). This would imply that the volume cut OPEC would have to make today is perhaps only 5%, to achieve the same effect as in the 1970’s. As profits = total revenue – total costs = (price * quantity) – total costs, profits should be much less affected today since the quantity to be cut, to keep the price high, is now much lower. Yes, they’re in a prisoners’ dilemma. But based on the above the payoffs for cooperating are relatively much higher than in the 1970’s, since small reductions in volume will be matched by big increases in prices (and super-normal profits).

    Anyway, that’s what I deduce from looking at demand / supply. I realize that what you say makes perfect sense and is standard microeconomics. Is there a way to reconcile these two interpretations, or could you point out a glaring error in my logic?

    Comment by Da Russophile — October 20, 2008 @ 5:22 pm

  13. Da Russophile,

    I would say that the risks have increased. Yes, fewer people may pay, but given that those fewer pay more, corruption is stifling the economy. All suffer. If corruption stifles business (and it does) this leads to fewer jobs and less prosperity. All pay the price, even if not all pay the bribe directly.

    Michel

    Comment by Michel — October 20, 2008 @ 5:35 pm

  14. One final comment: this is what the Financial Times has to say today about oil prices and the OPEC’s ability to cut production enough to halt the slide in prices (let alone push prices up):

    “Michael Lewis, commodity strategist at Deutsche Bank, said: ‘We expect Opec to announce production cuts at this week’s meeting. However, while this may arrest the decline in the oil price in the short-term, we believe the cartel will struggle to cut production as fast as world growth is slowing next year. Consequently we expect oil prices to fall to $50 a barrel in 2009.'”

    Source: http://www.ft.com/cms/s/0/aef734d6-9e94-11dd-98bd-000077b07658.html?nclick_check=1

    Comment by Michel — October 20, 2008 @ 6:28 pm

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