Streetwise Professor

Vlad is POd.  Seriously POd.  At the Ukrainians and the Euros, for having the audacity to modernize Ukraine’s shambolic gas pipelines without consulting HIM.  Can you imagine, the nerve.  Like Ukraine must think it is a sovereign country or something.

Here’s a glimpse at little Vlad’s foot stamping, hold-his-breath tantrum:

“It seems to me the document about which we are talking is, at a minimum, ill-considered and unprofessional because to discuss such issues without the basic supplier is simply not serious,” Putin said in the Black Sea resort of Sochi.

Just how the “basic supplier” would be harmed by measures that would improve the reliability and capacity of a major route linking its supplies to the ultimate consumer, Vlad didn’t say.

He’s so cute when he’s mad, dontcha think?  All I can say is, when he goes off like this, I know there is something right with the world.  For a change.

Loyal Putin creature Sergei Shmatko, the Energy Minister, chimed in:

Shmatko said the joint declaration touched on more sensitive issues than just gas and might damage EU energy security.

“It goes far beyond modernization of the Ukraine transit system and talks of the integration of Ukraine into the legal sphere of the European system as far as energy is concerned,” he told reporters.

Uhm, and what business is of yours, Sergei?  Ukraine and Europe have a perfect right to enter into such relations, even if it does involve some legal integration.  The concept is called “sovereignty.”  I’m sure you’ve heard about it.  After all, you and your cronies never tire of telling the rest of the world to f*ck off, and leave your “sovereign democracy” alone.  Goes both ways, dude.

Putin, gansta that he is and wants to be, sounds like one.  “Hey, Ukraine, you MY b*tch!  How dare you go out with somebody else.  Don’t make come over there and slap you around like I did that Georgia b*tch!”

This is all particularly rich in light of some of the things that Putin said during January’s gas war.  (Seems like years, not months, ago.)  At the time, Putin repeatedly denigrated the condition of Ukraine’s gas transport system, and called its reliability into question.  This was, in large part, an effort to pump up the prospects for Nordstream and South Stream, both of which would bypass Ukraine.

And that’s the real reason for Vlad’s pique.  He doesn’t want a reliable Ukrainian transportation network.  It undermines his goals, geopolitical and economic.

So, I say to Ukraine–You Go.  And to the EUnuchs–you surprise me, and in a good way.  (Though perhaps they didn’t foresee how Vlad would react.  It will be interesting to see whether they hang tough after Vlad’s outburst, and the inevitable follow on efforts to intimidate, and to play divide and conquer in an attempt to undermine this deal.  I’m sure that Schroeder will soon slouch to Moscow to get his orders to attempt to derail this deal.)

In other Russia news, Economy Minister Nabiullina has announced that the Russian economy contracted 8 percent year-on-year in February, and will likely contract 7 percent YOY for the first quarter. To put things in perspective, this collapse began in August, when GDP was probably on the order of 3-4 percent above its level as of February, 2008.  Thus, in 6 months, GDP has declined about 10-11 percent, a 20+ percent annual rate.

Economists often evaluate performance relative to growth potential.  Given a growth potential in Russia of 6-7 percent annualized, GDP should have been 7 percent higher, rather than 7 percent lower, than February 2008 as of the end of 2009.  This output gap of 14 percent compares with an approximate 8 percent gap in the US.

This is consistent with my view that the economic crisis has hit Russia harder than the US and Europe.  As is the fact that Russian economic indicators (e.g., the stock market, the ruble) have done better than their counterparts as of late.  The US market has turned around in recent weeks.  As I’ve noted, Russia is effectively a strongly procyclical economy (it’s “beta” to the world economy is greater than one) due to its dependence on highly procyclical energy and mineral industries.  With oil rallying 25 percent plus in recent weeks, in part due to the Fed’s apparent willingness to tolerate a lot of inflation to turn around the economy, and other commodity prices (e.g., copper) rallying too, Russia has benefited.

Though not so much as to justify this heady optimism by Deputy Prime Minister Igor Shuvalov (H/T R):

In comments to foreign media, First Deputy Prime Minister Igor Shuvalov said the government was increasingly upbeat about the Russian economy and hoped it would start growing again by the end of this year if the global economy doesn’t sharply deteriorate. As oil prices have risen above $50 a barrel, the ruble has steadied against the dollar and the Kremlin says there are tentative grounds for optimism, sounding an increasingly confident note about its handling of the financial downturn.

“The first phase is over,” said Mr. Shuvalov. “Most businesses have already adapted and the budget is not playing out according to the worse scenario.” Mr. Shuvalov confirmed that the Kremlin was no longer willing to offer large-scale bailouts to distressed corporations, something it did during the first stage of the crisis, but said that the government would help strategically important firms that had a genuine need. He stressed that commercial banks were now awash with cash, however, and could cover many of the lending requirements.

It is way too early to make such giddy pronouncements.  Russia is still highly dependent on the state of the world economy, which is anything but strong.  Kudrin is certainly not so ebullient.  He recently warned of a new wave of bad debts hitting Russian banks.

And Russia still faces its own home-grown curse: its legal nihilism, personified by Igor Sechin (will Marty Feldman play him in the movie?).  Sechin sent a letter to Norilsk Nickel, raising questions about some transactions, and in shades of the Mechel episode, Norilsk’s stock tanked immediately:

Norilsk slumped as much as 12 percent after the country’s biggest mining company said it received a letter from Deputy Prime Minister  Igor Sechin‘s office seeking information on transactions that were carried out last year.

. . . .

Norilsk sank 11 percent to 2,203.90 rubles on the Micex Stock Exchange, the biggest drop in a month. Sechin is seeking details on 86 billion rubles ($2.6 billion) of spending on share buybacks and asset purchases, and information on the sale of mining permits to a company owned by former Chief Executive Officer Mikhail Prokhorov, company spokeswoman  Erzhena Mintasova  said today.

Norilsk Nickel has complied with Russian law and the company’s own charter for all its transactions, Mintasova said.

Sechin, as chairman of  Rosneft, oversaw the state oil company’s acquisition of bigger rival  Yukos Oil Co.‘s largest assets at bankruptcy auctions after an investigation that led to the imprisonment of Yukos founder  Mikhail Khodorkovsky, once Russia’s richest man.

Meanwhile, the Telenor/Vimplecom farce continues:

Telenor said a Russian court rejected a motion to stay a ruling that found the Nordic region’s largest phone company liable for $1.7 billion in damages related to a dispute among OAO VimpelCom shareholders. VimpelCom sank as much as 11 percent in New York trading.

Wise words, these:

“The Norilsk and Telenor cases serve well to remind investors that Russia risk is a real phenomenon, which is the last thing Russia needs in this new, tighter-liquidity global market,” said  James Beadle, chief investment strategist at Moscow-based Pilgrim Asset Management.

The dispute is “an open demonstration of Russia’s aggressive business culture,” and is the same story as  OAO TNK- BP Holding, Beadle said.

So, in other words, la plus ca change.

The political uncertainty also continues.  A couple of interesting articles today, one by Pavel Baev in EDM, which noted:

Both Medvedev and Putin tried to perform as wise statesman meeting with Kissinger, but in reality for them global issues are just a public relations campaign of little importance compared with their real priorities of re-distributing money and property among servile but disloyal oligarchs (Grani.ru, March 20). This role of two-headed godfather is central for the regime’s survival in times of falling oil revenues when doubts in the irritated elites grow and spread under the surface of total obedience. Firing governors is apparently not enough to exterminate these mutinous doubts, so the second trial of Mikhail Khodorkovsky and Platon Lebedev is rolling towards the “guilty-as-charged” sentence (Novaya gazeta, March 18).

There is no way around the simple premise that in order to achieve a new positive start in U.S. relations, Russia has to begin a meaningful reformatting of its corrupt quasi-democratic regime. The Obama administration refrains from advocating any conditions of this sort, but Medvedev seems to be aware of the need to modernize the rigid system of “Putinism.” He remains reluctant, however, to deviate from the course set by his senior partner, who believes that the crisis hurts the U.S. more than Russia and will diminish its leadership, scorned as “uni-polarity.” Putin relies on the “fear factor” to keep the disgruntled elites under control and expects that demonstrative generosity towards pensioners and other “have-nots” would prevent an escalation of protest activity. His new anti-crisis plan unveiled last week does not envisage any new grants to struggling oligarchs, but gives first priority to social protection; it could, however, be overtaken by the unfolding disaster – as was the previous plan adopted last November (Kommersant, March 19). Such an emergency would require different kinds of measures, and forceful mobilization against an external threat is Putin’s fall-back option of choice; anti-Americanism, therefore, remains an important political resource – perhaps the very last refuge for a pair of scoundrels.

I particularly agree with Baev’s statement that the Khodorkovsky/Lebedev trial is intended to squelch “mutinous doubts.”

I found this paragraph entertaining:

Medvedev has personally explained to bankers that it would not be “fair” to demand money from the insolvent Rusal and its owner Oleg Deripaska; he also maintains that the International Monetary Fund should be governed by a board with a “fair” representation of contributors. Deputy Prime Minister Igor Sechin suggested at the recent OPEC meeting to establish a more “fair” system of regulating oil prices, which the gang of seasoned quota-fixers found only slightly amusing (Kommersant, March 16). This concern about “fairness” is not always driven by pragmatic calculations but betrays a grudge about the lost prosperity and stability that were perfectly on track until the U.S. made their economic problems everybody’s headache by provoking the global crisis.

The touching concern of Medvedev, Sechin et al for fairness brings to mind a spoiled child screaming “No FAIR!” when he doesn’t get what he wants.  Not that he earned it.

The other interesting article is from Goble’s WindowOnEurasia:

Even in other countries, he suggests, the notion that people are ready to sacrifice their rights to the state in exchange for economic well-being and will revolt if the government fails to provide it is overstated. Even in today’s severe economic crisis, the Moscow commentator says, “there are no signs in Europe of an 1848 or even of a 1968.”

In most cases, he argues, “the chief stabilizer is open political activity within a legal framework.” But in Russia, “our system is completely different, although it employs (for conspiracy!) the very same words,” an arrangement which includes the kaleidoscopic assertion that with Russians everything is exactly the same and at the same time entirely different.
This pattern has deep roots in Russian history and reflects a decision on the part of all those not intensely involved in political issues to focus on “their personal affairs and only on them” and to view politics as something alien to and apart from them and yet to see leaders as “symbiotically” involved in the survival of the state.

To this arrangement, Radzikhovsky says, a European would react with surprise: “They are DEPRIVING you (the people) of the rights to judge and decide and you (the people) nonetheless are still willing to support this arrangement!” But a Russian, he suggests, would understand the situation instantly, seeing it was being “a question of words.”

For the Russian it is not about deprivation, it is about “RELIEVING” the individual and society “of responsibility … and of the work involved in judging and deciding.” And as an example, to Radzikhovsky quotes Saltykov-Shchedrin’s observation that “the energy of the actions of fools opposes the energy of inaction.”

“The energy of societal inaction is the foundation of [the Russian] State,” he continues. “Therefore firmly or shakily, we stand by it.” Indeed, he says, “individualism (in individual affairs) plus humble fatalism (in common affairs) equals the ethnic Russian or better civic Russia (everyone in Russia, regardless of nationality acts that way) social-political SYSTEM.”
Given that set of attitudes – and Radzikhovsky insists that they can be called “sobornost,” “collectivism,” “apoliticalness,” or “alienation” – the relationship of those in power and everyone else is fundamentally different. Those in power have “a DIFFERENT function” and serve as “a shepherd” to the society.

Such a system, of course, has a dangerous tendency: the absolute power of the state in such circumstances tends to “corrupt absolutely, “both those who rule and those who are ruled.” But there is “a still more dangerous alternative: the absolute lack of rights on the part of the government and the absence of power [which can also] corrupt the people absolutely.”
The way out of this vicious circle would be a government with “LIMITED POWER,” but in Russia that has never been known and is not unknown now. “And with that is connected the completely SPECIAL role of the government in Russia,” one that is reflected in the very different attitude people have toward criticizing the government.

In most countries, Radzikhovsky continues, government is viewed as “only a superstructure’ over society” and thus as something from whose change the society does not think will change society. Consequently, any criticism of the powers that be for [such a] society is secure.”
But for Russians, “as is well known to all,” the picture is “different.” That is because criticism raises the question of leadership change, and “in the course of all Russian history up through today the main political question has not been resolved.” That is the question of the creation of mechanisms for a peaceful, regular and lawful change of the highest levels of power.”
Those in power, of course, “exploit this: destroy the powers that be and you will destroy Russia! This is a big EXAGGERATION. But it is only an EXAGGERATION” because the problematic situation it reflects is not invented but quite real. Russia has not succeeded in dividing “the powers that be” and “the country” just as it has not split power and property.

Consequently, the deference the population shows to the rulers is not so much “a slavish instinct” as an instinct for national SELF-PRESERVATION,” Radzikhovsky suggests, arguing that it rests on the notion that the powers and the population are linked together in “a biological symbiosis” whose violation by either side could lead to the death of the whole.
Thus “the real social compact [in Russia] is much more serious. It is not a trade off of independent sides,” and it is not about well-being “but about survival.” In this situation, the population will remain far more willing to defer to those in power because “the people DO NOT WANT” to do anything but “to AVOID being the opposite of humble.”

Understood in this way, Radzikhovsky concludes, the social compact in Russia has not yet been violated sufficiently to cause a revolt, especially given how great fears remain of “chaos.” And he reminds his readers that “one cannot free people externally more than they are ready for that internally.”

This is a very interesting commentary on the apathy of Russians.  It points out the fundamental lack of a civil society in Russia, the alienation between state and people (in spite of the allegedly organic relatonship between them) and reinforces a point that I made in my summer post On Russophobia, namely, that classical liberal limited government is an anathema in Russia.  (This, ironically, gave rise to charges that I was in fact a Russophobe projecting pejorative images of The Other.  But, as I noted at the time, this is considered a feature not a bug by many Russians, and many Russians like Radzikhovsky who think it is a bug acknowledge its existence nonetheless.  They have met The Other and it is Them.)

This is why, although I don’t discount the possibility of popular unrest, I believe that the main threat to the system comes from within, due to the “doubts in the irritated elites . . . spread under the surface of total obedience” (in Baev’s words).

OPEC had another meeting over the weekend, and Igor Sechin reprised his role as Lucy with the football.  Sechin repeated his fulsome praise of OPEC, and his expressions of Russia’s undying support for the cartel’s actions.  As long as, you know, like, Russia doesn’t actually have to cut output or anything:

Hounded by a pack of journalists on his arrival, Russian deputy prime minister Igor Sechin led a parade of government officials to OPEC’s latest shindig in Vienna. He proposed a slew of things for Russia and OPEC ministers to work on together, such as coordinating (i.e., raising) taxes on foreign oil firms’ crude production and refining operations.

But Sechin, at his third OPEC meeting in six months, again signally failed to promise any big commitments to keep barrels out of the global crude market even as OPEC members said they’d push on with shoring up compliance with their own output cuts.

That’s obviously good news for consumers as Russia, the world’s top oil producer, and OPEC pump almost half the crude used daily globally. Any formal and disciplined coordination between the two could easily spell higher oil prices.

Mr. Sechin claimed Russia cut production and exports in recent months but most OPEC officials weren’t buying it. Exasperated, they say independent data show Russia boosted exports by almost 700,000 barrels a day the past six months, even as OPEC members shaved their own production.

But Russia is still flirting with OPEC and may yet consummate a more formal relationship with the group. For its part, OPEC is still open to the courtship. Mr. Sechin said Sunday that Russia wants, among other things, a “permanent representative” stationed at the OPEC secretariat.

Mr. Sechin said that doesn’t mean Russian OPEC membership but a deeper and wider exchange of data, information, and ideas.

“Flirting.”  Interesting choice of words.  “Exchange of data, information, and ideas.”  In other words, you let us in on your information flow, and we’ll use that to optimize our decisions.  

Sechin claims that Russia will stimulate domestic consumption, as part of a strategy to curb exports:

Russia will cut oil exports and increase domestic oil consumption in a bid to stabilize world oil prices amid the ongoing financial crisis, Deputy Prime Minister Igor Sechin said on Sunday.

“We will be cutting oil exports through the expansion of domestic consumption. In particular, we plan to transfer 2 million tons of fuel to agricultural producers and also increase oil refining inside the country,” Sechin said.

And pray tell how will the government expand domestic consumption in an economy that is continuing to hemorrhage, especially in its energy intensive manufacturing and transport sectors?  And, the best way to divert oil from export to the domestic market would be, as I’ve said numerous times before, to raise substantially export duties.  But those have just been cut again.  And insofar as domestic oil refining is concerned, it has long been a Russian policy objective to encourage Russian refining of domestically produced oil.  Indeed, the duty structure was designed in part to encourage the export of value added refined products in place of crude.  And note that Russia also just cut its duty on refined products too.  Exporting refined products puts as much downward pressure on international prices as exports of crude.

In other words, pay no attention to Sechin as long as his lips are moving.  And never take your eyes off of his hands.    

OPEC seems to be catching on, at long last:

OPEC officials have said privately that Russia — which sees itself as a leader on the world stage — is unlikely to give up its energy independence by joining OPEC. In an apparent allusion to Russia, el Badri on Monday urged “the larger producers” outside OPEC not “to take advantage” while his organization tries to manage crude supply and demand.

Russia “take advantage” of OPEC?  Go on!  Or should that be “что Ñ‚Ñ‹!”?  

Sechin did make one revealing comment.  He suggested greater use of long term contracts in the oil market.  These contracts could be effective in facilitating a division of the market.  They also play into the traditional divide-and-rule strategy.

Sechin framed his proposal as a means of taming those eeeevvvviiiiilllll oil speculators:

The price that the producers would charge under these long-term contracts would take into account the rising costs of lifting and delivering crude, ensuring future investment, he said.  

A system of such contracts would not allow financial institutions to “unreasonably rock the boat,” Sechin said.  

It is clear, however, that as always, Russia sees benefits in reducing transparency and flexibility as means of exerting market power.  In other words, Sechin (and Russia) would like to remake the oil market into something similar to the gas market.  

This is something to be avoided if at all possible.  The nat gas market–especially the LNG sector–is evolving to support more spot trade.  The “gas OPEC” Russia has proposed can be seen as a method to throttle spot trading in gas, and to keep the market relying on opaque, long term contracting relationships that subject the buyers especially to holdup, and reduced competition at times of contract renegotiation (because supplies from other sources are locked in via long term contracts, leaving the original buyer and original seller in a small-numbers bargaining situation.)  Russia’s ability to exploit a fragmented buyers side of the market in such circumstances is well known.  The last thing we need is the oil market to adopt the same dysfunctional structure.  I hope that policy makers in consuming nations are alive to this possibility, and will fight it tooth and nail.  Experience (especially in the European gas market) suggests, however, that my hopes may be in vain.

At the onset of the financial crisis, I conjectured that this would jeopardize the South Stream and NordStream pipeline projects.  Bloomberg reports that South Stream is indeed in trouble:  

OAO Gazprom  plans to delay natural- gas deliveries to Europe through its South Stream pipeline as Russia’s largest energy producer cuts investment amid slowing global economic growth and declining energy demand.

Gazprom, which originally said it would start shipping gas through South Stream in 2013, expects a start date at the end of 2014 or 2015, according to a presentation to investors today in Moscow. Gazprom spokesman  Sergei Kupriyanov  couldn’t be reached for comment.

The cost of the project, which will bypass Ukraine by traveling under the Black Sea to Bulgaria, may reach more than 24 billion euros ($31 billion), the company told investors. Russian Energy Minister  Sergei Shmatko  said in July that the project may cost $20 billion.

Russia, which supplies a quarter of Europe’s gas, is seeking new routes to Europe after a price dispute with Ukraine led to a two-week cut in exports via the former Soviet republic. South Stream is the twin of Nord Stream, designed to link Russia directly to Germany under the Baltic Sea.

State-run Gazprom may cut investments by 14 percent this year as the credit crunch squeezes resources and revenue drops because of falling prices and demand, according to today’s presentation. The world’s largest gas producer will invest $29 billion this year, down from $33.6 billion in 2008, according to company estimates.

‘Generally Positive’

“Our takeaways were generally positive, including surprisingly large declines in expected capex outlays,” Moscow- based Alfa Bank wrote in a note to investors after the presentation. “Gazprom is adapting to the new economic reality.”

Gazprom’s  budget  is based on a $50 a barrel price for Urals crude, Russia’s export blend. Other scenarios under consideration assume barrel prices of $40, $30 and $25, according to the presentation. Chief Executive Officer  Alexei Miller  said in June, when the price per barrel hovered at more than $120, that the price may “soon” hit $250.

The 14 percent (“surprisingly large”) reduction in capital expenditure is perhaps a more important fact than the South Stream delay.  It is well known that Gazprom’s existing fields are in decline, and that it is desperate to find new sources of supply.  It has massive reserves, but getting at them is a daunting task, almost certainly beyond the company’s capabilities.  A 14 percent drop in capex will seriously impede the company’s development of new supplies.  This will further increase its dependence on Central Asian sources (esp. Turkmenistan).  This, in turn will intensify the bargaining, bribery, and conflict currently swirling around that region.  

The delay in South Stream may also give the ill-starred Nabucco project a much needed boost, but other difficulties must be overcome.  Given the gas war, however, one hopes that Europe finds the will to make the way.  Sadly, however, I have my serious, serious, doubts.  This means that Ukraine will continue to play a pivotal role in gas transshipment for the foreseeable future.  This, in turn, means that future gas wars are more likely than not.

No, this isn’t a review of a punk rock CD: It’s the latest installment in an ongoing series on the ruble’s gyrations in the foreign exchange (“FX”) market, and the title is a commentary on what is becoming a more likely outcome by the day.

Well, gyrations is not quite the right word; it connotes movement in all directions, but the ruble has been moving only one way–down.  Today (per MICEX), the ruble closed at 35.4886, about a 1.8 percent move.  Although the currency gained a bit on the Euro (which was down against the dollar), it is approaching the 41 rubles vs. the basket that central bank head Sergei Ignatiev has pledged to defend unless Urals crude plunges to $30 and remains there for an extended period.  Speculators are taking this as a challenge, it appears.  

The behavior of the ruble in the days since the band was widened to 10 percent suggests to me that the government is spending FX to defend the band, even before it is reached.  The currency has been down several days in a row, and is on an extended losing streak since the widening of the band.  Absent intervention, you’d expect the number of losing days and gaining days to be about equal.  Runs of consecutive days with adverse moves can happen, but are relatively unlikely.   In contrast, if the central bank is trying to slow the fall in the currency, and is preventing it from reaching its equilibrium level on a single day, you’d see losses day after day–which is what’s going on.  

Moreover, I’ve looked at the intraday charts on MICEX this week.  Each day the currency has gapped lower (RUB/USD–higher USD/RUB) right at the open, and then hovered there, with at most a slight movement over the remainder of the day.  Again, this suggests that the central bank is effectively setting limit orders at progressively lower levels each day, and then maintaining that level within the day.  

All of this would burn through reserves.  

The central bank–and Putin–have put their credibility on the line.  They have said that 41 vs. the basket is the limit absent a collapse in the oil price.  The market is pushing there very hard.  The conditions for a speculative attack are clearly evident.  The government’s/bank’s credibility is on the line  How much will it spend to defend it?  If it tries, NOFX is a real possibility.

Indeed, other news provides further evidence that the condition is ripe for a speculative attack.  Kudrin stated that government revenues will likely fall 40 percent in 2009.  He states further that most–but not all–of the reserve fund will be spent to cover the budget shortfall.  Of course, if oil prices fall further (and the chronic economic weakness around the world makes that a very real possibility), all of the reserve funds will go down the chute.  It should also be noted that although Kudrin anticipates that the situation will turn around in 2010, government revenues usually lag economic recovery.  Therefore, even if the Russian economy–and the world economy–begins to turn around in late-2009 or early-2010, it is likely that revenues will remain weak well into 2010.  This means that even if some of the reserve fund survives 2009, it may be dissipated in 2010.

It’s of course better for Russia that it has such a cushion than not.  But, as I noted in several posts when the crisis began in the late-summer and early-fall, the existence of the currency stockpile and the reserve funds likely provided a false sense of security, and arguably led to a delayed response to the crisis.  I specifically noted that one thing the crisis proved is how quickly it is possible to blow through $600 billion, and that’s being proven right in the Russian instance.  

The weak government revenue picture is just more blood in the water that will attract yet more sharks to the ruble market.   Given the budget picture, it’s hard to see how the central bank can credibly defend the currency at the 41 level. Trying to do so will (a) waste–waste–the country’s currency reserves, because it will merely delay the inevitable, and (b) exacerbate the weakness in the real economy, particularly the manufacturing sector.  

So, push is coming to shove.  As the FX rate approaches the band, the speculators will test the government’s commitment to maintaining that band absent a further, severe erosion of fundamentals.  Flexing to defend the ruble will be very expensive, and arguably ruinously expensive.  The next week or two should be very interesting.  Although currency and capital controls have not been widely discussed, if the attack is as severe as I expect it to be, I wouldn’t be surprised to see such measures implemented.  

It is no picnic to be a policy maker anywhere in the world right now, but Russia has to be among the worst.  This could explain Putin’s rather bizarre behavior at Davos, where he alternated between giving lectures about the virtues of a free market (!) and delivering testy–nay, ferocious–responses to genuine (if naive) offers of assistance from Michael Dell.  

Putin has essentially placed a huge long bet on the ruble.  He has staked his credibility on avoiding a precipitous drop in the currency, cost what it will.  Like many traders on a losing streak, he is effectively doubling down by stating that the band will not be widened further.  Doubling down can work, but the odds are usually quite unfavorable.

Hence, the coming days could be quite significant, not just economically, but politically.  With Medvedev showing signs of independence, and the ruble battle reaching a climax, the long-anticipated tension–and perhaps rupture–in the diumvirate could be coming.

Putin speaks the Davos urp-fest tomorrow, and has a lot to feel chastened about since his previous, boastful appearance–not that he will.  This quote hits the nail on the head, though:

“Putin will attempt to paint Russia as a willing player looking to deepen its integration into the global economy and eager to attract global investors,” said  James Beadle, chief investment strategist at Pilgrim Asset Management in Moscow. “Sadly, Russia has berated and abused many of its global partners, and now that the stakes have balanced, few will trust this new, benign rhetoric.”

Fool me once, shame on you.  Fool me twice, shame on me.  Anybody who buys what Putin is selling is a fool.  But very early on in the history of this blog, and many times since, I’ve expressed amazement at the credulity of western investors when it comes to Russia, and their belief that they’re special and will avoid becoming just another statistic.  We’ll see if Putin can succeed, yet again, playing Lucy with the football, with western investors reprising their role as Charlie Brown.  Beadle thinks not.  I’m not so sure.

The financial crisis has increased Russia’s need to tap foreign capital markets.  Not only do Russian companies need money, they often need foreign expertise.  Particularly in the aftermath of rough treatment of numerous foreign investors, this is hardly calculated to build confidence and encourage direct investment in the Russian economy:

Russia has the power to stop foreign companies developing “strategic” deposits, Natural Resources Minister  Yuri Trutnev  told Kinross Gold Corp. Chief Executive Officer  Tye Burt  in a meeting today, according to the ministry.

“This doesn’t mean the power will be exercised,” Trutnev said in a statement e-mailed by the ministry today.

The minister and Burt discussed the Canadian company’s plans to develop the Kupol gold field and a venture with OAO Polyus Gold to mine Siberia’s Nezhdaninskoye deposit, the statement said.

Russia last year passed a law that limits the holding of a foreign company in developments of Russia’s biggest deposits of oil, natural gas, gold and other minerals. Kupol, which is 75 percent owned by Kinross, is exempt from the legislation because it was acquired before the law came into effect.

Fields with more than 50 metric tons of gold are considered strategic and must be controlled by Russian companies.

“That doesn’t mean the power will be exercised.” Boy, that inspires confidence!  Where do I sign up?  Having the sword of Damocles hanging over one’s head adds a little frisson to the investment process, no?

And it’s not just foreign investors.  Arbitrary state action is also used to expropriate domestic firms:

Russian electricity producer Mosenergo (MSNG3.MM:  Quote,  Profile,  Research) is suspending plans to build four new turbines after regulators capped the price of power from recently-installed plant, a company spokesman said.

A company source said that at the tariff allowed by the regulator, it would take Mosenergo more than 20 years to see a return on an investment of some $2 billion.

Power-hungry corporations such as steel and oil firms buy capacity offered by utilies at auction. But they face intense cost pressure amid the global financial crisis and are lobbying hard for state watchdogs to rein in growing electricity costs.

At the most recent capacity auction in December, Mosenergo, which is controlled by gas export monopoly Gazprom (GAZP.MM:  Quote,  Profile,Research), offered the output from two existing state-of-the-art turbines.

The Mosenergo source said the industry watchdog capped prices at 370,000 roubles ($11,490) per megawatt for one proposed turbine and at 402,000 roubles per megawatt for the other.

The source spoke on condition of anonymity as the regulator does not make the prices public from power auctions.

“We think that our (initial) offers were capped. On average the price set for the new capacity is about a third lower than what we first offered. Aside from that, there was no clear methodology for making these adjustments,” Mosenergo spokesman Vitaly Koskovetsky told Reuters in seperate comments.

The firm’s investment committee has already approved the partial suspension of its spending plans, which must still be finalised by the board of directors at its next meeting.

The power sector’s regulator, known as the Market Council, insisted last August that Mosenergo lower its asking price at the first ever capacity auction. After days of negotiation, they agreed on a price cut of 20 percent on Mosenergo’s original offer. The watchdog at first demanded a 30 percent cut.

Near the top of the government’s economic agenda in recent months has been controlling inflation, which topped 13 percent last year.

Even though the power sector underwent sweeping free-market reforms in recent years, the Energy Ministry and the Market Council still reserve the right to cap power prices at the auctions if they deem them unjustified.  

Although the economic collapse has led to sharp drops in electricity consumption and prices,  going forward, Russia needs massive investment in its generating capacity.  Arbitrary, opaque actions such as those described above are hardly the way to encourage such investment.

And for those who would argue with my assertion that the Russian economy is collapsing, a couple of data points.  First, even the Russian government, which for months had been denying the possibility that the country could experience negative growth in 2009, now admits that the economy will contract in 2009.  (This sounds like another attempt to tell the truth slowly/boil the frog.)  Second, industrial output declined 13.2 percent in December, after a 10.3 percent fall in November, and Markit group projects that December 2008 GDP was below December 2007 GDP. Third, real wages and investment fell for the first time in 9 years in December, and unemployment rose by 500,000 (per official stats–so it’s likely worse than that).  

There’s an interesting quote in this last article:

Prime Minister Vladimir Putin has vowed there will be no repeat of 1998 and the latest polls show his ratings remain high in a financial crisis stretching back to September.  

What would de Custine say about that?  How about this:

The popularity of an autocrat appears to me as suspicious in Russia, as does the honesty of the men who in France preach absolute democracy in the name of liberty–both are murderous sophisms.  To destroy liberty while preaching liberality is assassination, for society lives by truth; to make tyranny patriarchal is assassination also.

More words to ponder.  

There are a variety of different ways to analyze the effect of the crash in energy prices on the Russian economy and political system.  One is to just focus on the basic macroeconomics and public finance; the effect of the decline on aggregate demand, income, the budget, the trade balance, the ruble, etc.  The results of such an analysis are not exactly comforting for Russia, but there is nothing in this analysis that has particularly dire implications for the country’s political stability, or that suggests that Russia’s difficulties will be all that different from those of other commodity intensive nations.

Another approach is more institutional and political-economic.  It focuses on the unique institutional features of Russia, and the salient role that energy plays in supporting this institutional structure.  It’s an analysis that I’ve favored, and advanced here at SWP.  In essence, I’ve argued that energy (and other natural resource) rents are the glue that holds the Russian “natural state” together.  I’ve analogized Russia to a cartel of violence specialists who cooperate to split rents rather than dissipate them in conflict.  But, I’ve also argued–and done so well before the recent collapse in energy prices–that a decline in these rents raises the likelihood that this (inherently unstable) equilibrium will collapse, thereby threatening Russia’s political stability.  

A recent post on the RFE Power Vertical blog argues that this may in fact be occurring in the here and now:

The political structure Putin built over the past decade was based on a vast system of patronage that, thanks to high oil and gas prices, allowed the Kremlin to purchase the loyalty of Russia’s sprawling bureaucracy and at least the tacit consent of a critical mass of the population.  

Here’s how Moscow-based political analyst Dmitry Oreshkin put it when I spoke to him about the emerging political crisis:

The vertical is not as strong as it seemed. It is based on buying the loyalty of officials with the help of oil funds. The bureaucratic class gives its loyalty to the center and the center closes its eyes to their corruption…When oil and gas prices were high and when the economy was growing, it worked well. Bureaucrats were afraid to show disloyalty to their bosses because if they were fired they would be outsiders. But when gas and oil prices are low and the economy falters, it is not possible to buy everybody’s loyalty.

Petrodollars, in short, were the lubricant that kept the system functioning. And now that these are drying up, the arrangement is breaking down with unpredictable consequences.  

A few trends, however, are already visible. Divisions in the elite — both within Moscow and between the center and the regions — are getting sharper. The most noticeable, of course, in the apparently worsening relations  between Putin and Medvedev, or at least between their respective teams. Here’s how Yevgeny Volk of the Heritagte Foundation’s Moscow office put it in an interview with RFE:

The Russian elite has never been united. There were always fierce battles for resources and there were always grievances. But when there are colossal resources from high oil and gas prices, these conflicts can be managed. But now, with the pie shrinking, the battle among the elite is becoming hotter and the conflicts are getting sharper. I don’t rule that there will be a conflict between Medvedev and Putin. Neither one of them wants to take personal responsibility for the worsening economic situation. This is especially important for Putin given his plans to return to power.

Moreover, as Oreshkin pointed out, the group of security service veterans close to Putin — people like First Deputy Prime Minister Igor Sechin and Security Council Secretary Nikolai Patrushev — have a very different notion of how to deal with the economic crisis than the economists like Finance Minister Aleksei Kudrin who are close to Medvedev:

The Putin group favors strengthening administrative pressure. The Medvedev group thinks the authorities need to do more than make threats and bang their fists on the table. They think there needs to be a better understanding of economic interests and rational economic behavior.

This is all getting very interesting very quickly. In our interview today, Volk said that a year ago the situation in Russia resembled that in the Soviet Union in the early-to-mid-1970s, when high oil prices fuelled an aggressive foreign policy abroad and facilitated a relatively stable political situation at home. Today, Volk says, the situation reminds him of the mid-to-late 1980s — and we all know what followed that.

Volk’s “Cocaine Blues” point is right on.  

Viewed from this perspective, the decline in energy prices is uniquely ominous for Russia because of the pivotal role that commodity rents play in maintaining the country’s political equilibrium.  

Post author Brian Whitmore promises that he is preparing a more detailed look at this issue.  That’s good to hear, because it’s an interesting one.  Indeed, I think the role of rents will be critical in determining Russia’s political path in the near to medium term.

This piece by Andrei Tsygankov presents a persuasive appraisal of Russia’s long term “strategy,” such as it is:

The global economic crisis has prompted some observers to speculate that  Russia  has little choice but to abandon its international assertiveness in favor of re-engaging the West and diversifying its energy-dependent economy.  

The Russian leadership, however, has shown little inclination to principally revise its international strategy and its petro component. The Kremlin assumes that the alternative to its energy-based strategy is a decline relative to existing and rising powers, which will lead to the degeneration of Russia into a geographically truncated, under-populated and resource-depleted  nation that accepts political demands from others.  

. . . .

The government understands that the only way out of its progressive power differential situation is to fully exploit the comparative advantage of Russia’s energy reserves. Already in 1997, while working for the governor of St Petersburg, Vladimir Putin wrote in his doctoral thesis about the critical importance ofoil  and  gas  to preserve Russia’s great power status within the next 50 years. The Kremlin believes that building up the capacity to shape global energy markets is not a luxury, but a necessity.  

. . . .

The idea is to develop a capacity to shape world markets first and only then to become serious about diversifying its economy. Russia needs to attract sufficient investments for its energy projects. Then it wants to develop energy fields and build the northern and southern pipelines that are scheduled to become operational in 2011 and 2014, respectively. Only after generating sufficient resources for a great power recovery will the government diversify the economy. The intention has been to diversify by 2020 – perhaps too optimistic, even by pre-crisis standards.  

This strategy is about as realistic as planning to win at poker by filling inside straights–repeatedly.  It relies on things breaking just right.  It puts Russia’s fate in the hands of the most volatile, fickle, and tempestuous markets–the markets for energy.  It (as the article notes) depends upon assistance from nations and companies that Russia has stiffed or expropriated.  It is hostage to technological change–innovations that reduce the demand for energy undercut the strategy.  It is vulnerable to policy and regulatory changes, most notably climate change legislation designed to reduce dramatically energy consumption.  

In other words: Good luck with that.

Several thoughts come to mind.

First, such a strategy represents a damning–no, an extremely damning–assessment of Russia’s prospects by its own political leadership.  Anytime anybody out there wants to accuse me of Russophobia–hey, I’ve got nothing on Putin et al.  They are evidently so despairing of Russia’s ability to compete demographically, technologically, militarily, or economically in any area other than energy that they are essentially giving up in these areas without a fight, and wagering everything on everything breaking their way in energy.  

Second, this strategy has one, and only one, objective in mind–derzhavnost.  It is aimed solely at restoring the Glory Days, at making Russia a “great power” yet again.  It reminds me of nothing so much as Terry Malloy (Marlon Brado) in On the Waterfront: “You don’t understand! I coulda had class. I coulda been a contender. I coulda been somebody instead of a bum, which is what I am.”  There is evidently no thought of using Russia’s energy bounty to fund a modern economy or a civil society; of addressing its pressing demographic and health problems; of restoring its once formidable but now decrepit education system; or even of building some decent roads.  In other words: Russians don’t matter, but Russia does–as a state.  This attitude has a long legacy in Russia; sadly, it is a legacy of pain and poverty, and an attitude that is a failure even on its own terms, because Russia has never been an enduring great power.  The episodes of Russian importance on the world stage have been short lived, and ended  each and every time in chaos and destruction.  

Third, the centrality of energy to Russian geopolitical strategy means that attempts to make distinctions between “commercial” and “political” motivations behind the actions of state firms such as Gazprom are futile.  Commercial and geostrategic motivations are so intertwined that dichotomies between them are fallacious and misleading.  So, when anybody tries to argue that the dispute between Ukraine and Gazprom is purely commercial in nature, just a hard nosed confrontation over price, don’t believe them.  Sure, money matters, but in large part because money can be used to fund dreams of empire.  Moreover, when the geopolitical prize is large enough, Russia/Gazprom are willing to leave money on the table to advance its political objectives.  

In brief, this is a strategy of desperation of a clique of megalomaniacs.  They have 18th century ambitions, and intend to achieve them using mid-20th century (at best) economic tools.  It’s like watching a train wreck.  Worse–the latest in a long line of train wrecks.

I’ve said it before, and I’ll say it again.  Putin and the siloviki are the 21st century equivalents of the Bourbons.  They have learned nothing, and they have forgotten nothing.  If (pace Marx) history repeats itself first as tragedy, and then as farce–how does it repeat itself the fifth time?

The Russo-Ukrainian Winter War continues apace.   Professional and personal time demands preclude an extended original response at this time, so I’ll resort to the gambit employed by baseball broadcasters during rain delays–reruns of past games;-)

Here’s a warning about Gazprom I penned (or would that be “pixeled”) in June, 2006.   This was originally published in World Energy Magazine:

Just Say No–To Gazprom

Churchill famously said that Russia “is a riddle, wrapped in a mystery, inside an enigma.” There is nothing mysterious, however, about recent Russian policy to leverage its primary strategic asset—energy—to regain its status as a world power even as it faces an existential demographic crisis.

The Russian state’s vehicle in this endeavor is the monopoly gas provider Gazprom. Like ripples from a stone thrown in a pond, Gazprom’s influence is spreading from Russia, first to the “near abroad”—Ukraine, Armenia, Georgia, Belarus—next to the old Warsaw Pact countries, now to western Europe, and eventually, perhaps, to the US. Through murky deals and the specter of economic blackmail, the company has obtained control of pipelines in Belarus and Armenia. Georgia is under intense pressure to sell its gas trunkline. With German assistance, Gazprom is in the process of increasing Polish energy vulnerability by building a Baltic pipeline that will allow Russia to sell gas to Western Europe while cutting off Poland, thereby resurrecting unpleasant memories of past Russo-German collaboration at Polish expense.

Gazprom is now obtaining positions in gas distribution networks in Western Europe. It mooted the possibility of buying the British gas distributor Centrica, which set off a controversy in the UK over the wisdom of such a transaction. Recently other Europeans have echoed these concerns. Gazprom and the Russian government have responded acidly to European criticism, calling the Europeans hypocritical in insisting that Russia open its upstream energy market to foreign investment while considering limitations on Gazprom investment in the European midstream.

Europe would be well advised to evaluate Gazprom moves with intense skepticism, and to dismiss charges of hypocrisy. Appreciable control over the midstream would enhance Gazprom’s market power in the European market which it could use to impede or foreclose development of alternative supply sources, thereby allowing Gazprom to charge supracompetitive prices, especially as North Sea gas reserves decline. Insofar as hypocrisy is concerned, not all investment is created equal. Upstream investment in Russia does not raise the same serious competitive concerns as Gazprom ownership of significant slices of the European distribution network and control of most major pipeline routes from producing regions in Russia and Central Asia to consuming markets in Europe.

This advice goes double given the geopolitical ramifications of Gazprom. No less an authority than Russian President Vladimir Putin laid out in his (perhaps partially plagiarized) PhD thesis a strategy to utilize vertically integrated state owned energy companies to restore Russia to its former power and influence. In this regard, it is useful to remember the oft-omitted second part of Churchill’s aphorism, namely that the key to understanding Russia is “Russian national [read state] interest.”

Europe should therefore resist encroachment of Gazprom into the intra-European gas transportation network, encourage and finance development of pipelines from gas producing regions that are outside of Gazprom control, and proceed full speed with development of LNG infrastructure.

Lest this be considered a jeremiad against Russians, nothing could be further from the truth. The interests of the Russian state and the Russian people have been antithetical for centuries, virtually without pause. Although Gazprom’s meteoric rise has enriched a few in Russia, and empowered and emboldened the state, this does not bode well for Russians at large. Petrostates are largely immune from pressures to liberalize their economies and facilitate the development of private property rights and civil society. Pace GM, what is good for Gazprom is not good for Russia.

And the Russian strategy of putting all their strategic eggs in the energy basket is very risky too. Energy prices are high now, and the Russian economy is riding high with them. But energy prices go down too, and a poorly diversified Russia just recovering from a virtual economic collapse in the 1990s (exacerbated by low oil prices) is in no position to thrive given even a moderate correction in energy prices.

So as the G8 Summit in St. Petersburg approaches, Europe, Japan, and the US would be well advised to push their host hard on liberalizing the Russian energy market and to resist pressures to extend Gazprom’s reach to the Atlantic.

I think this stands up pretty well, even if I do say so myself;-)

Of course, the Europeans have done nothing that I (and many others) recommended.   They fiddled while Rome froze, as it were.   As in most things that are important, they demonstrated that EU solidarity is a farce, as each nation cut its own self-serving deal with Gazprom, and eminentos* such as Schroeder and Berlusconi played monkey to Putin’s organ grinder.   (Whenever I see photos of the ludicrously grinning Schroeder next to Putin I can’t get the organ grinder image out of my mind.) If “Europe” (as an entity) wants to be taken seriously, perhaps Europeans should take vital things seriously, rather than merely being supercilious posers.

My warnings of the dangers of Russia’s dependence on energy, its vulnerability to energy price declines, and the corrosive effect of energy dependence on its civil society have also been borne out.

Just call me Cassandra;-)

In today’s WSJ, Gary Kasparov opines that Russia as an incentive to sow chaos in the Middle East in order to pump up oil prices.   He emphasizes that relying on Russia to take a constructive role in constraining Iran’s nuclear program is particularly foolish.  I advanced the same hypotheses about a year ago here:

Moreover, it should be noted that uncertainty and the potential for supply disruption can drive energy prices higher. This undermines Russia’s interest in promoting stability in major energy producing regions, such as the Gulf, Nigeria, or South America. Indeed, it may provide an incentive to sow instability in these regions. As a result, there is a reasonable basis for suspicion over the motives behind its policies regarding Iran, as well as other energy producing nations.

To say the least, Russia’s acute dependence on energy, and its desperate need for higher energy prices makes it very tempting for Putin to stir the pot in the Middle East, rather than try to help resolve problems there.