Streetwise Professor

CFTC Commissioner Bart Chilton never struck me as the Claude Rains type, but he recently did a good Capitaine Reynaud imitation:

“The number of people that have come in requesting to be exempt from the law, or to have the law delayed has literally shocked me,” said Bart Chilton, 50, a Democrat who has served as one the agency’s five commissioners since 2007. “A lot of folks are having problems coming to grips with the fact that they do have a new law, and will have to change their business models.”

. . . .

“The volume and intensity of the lobbying is unprecedented in my experience at the agency,” Chilton said. “They all have an ask. The types of loopholes that people are suggesting exist are either non-existent or very farfetched.”

Neither Chilton nor anybody else should be even mildly surprised, let alone shocked.  The requirements of Frank-n-Dodd are so extensive, and so intrusive, that they will impose substantial costs on derivatives market participants.  Said participants have every incentive to try to influence the rules.  And the time is now.  What’s more, they have every incentive to try any argument that might work.  What’s to lose?

The pace and intensity of the lobbying will no doubt ease after the rule making process winds up next summer.  But no matter how carefully-crafted the rules (hah!), they will not anticipate all contingencies, and will have ambiguities and contradictions.  Moreover, market participants will take unanticipated actions that will raise issues about interpretation of the rules.  Hence, for years to come market participants will continue to try to affect the agency, ask for interpretations or no comment letters, or do things that lead to an agency reaction and market participant counter-reaction.  The CFTC will also find it necessary to issue policy statements to clarify the inevitable confusions.  There will be litigation arising from the legislation and regulations that will result in decisions and findings that lead to yet more changes.

In no time, there will be a thicket of decisions and interpretations that will in turn raise new issues.  And the market will continue to adapt and innovate and evolve, both in response to the regulations and technology and market shocks.  These adaptations and evolutions will present further challenges to the regulations and the regulators.

All this will generate more lobbying and lawyering.

When this happens nobody–nob0dy–should express the slightest shock.  Unless, that is, they relish the role of laughingstock.

One of the first things I wrote on Russia was “Just Say No–to Gazprom,” published in Energy World Magazine in July, 2006.* Apparently the Poles didn’t have a subscription, as they seem bent on saying yes to Gazprom’s terms for a verrrrryyyy long term gas contract–with deliveries running out to 2037(!).  Vladimir Socor lays out some of the terms of the agreement:

1) Packaging the new agreement with the 1993 inter-governmental agreement on transit of Russian gas via Poland and deliveries to Poland, which runs to 2022; and setting the duration of deliveries by contract until 2037. All this would help Gazprom to continue monopolizing the Polish market for that duration, preventing diversification of Poland’s natural gas imports and discouraging investment in the LNG project.

2) Exclusive right for Gazprom to use the Yamal-Europe pipeline in Poland until 2045. This would consolidate Gazprom’s position in Poland and Germany for another generation.

3) Europolgas to retain ownership as well as commercial and other operating rights on this pipeline. Thus, Gazprom would be able to lock out any competitors, also precluding reverse-use of this line.

4) Poland’s national transmission operator, Gaz-System, to become technical operator of Yamal-Europe in Poland, limited to a service provider’s role. This would fall far short of the operator’s independence from the supplier.

5) Deeply discounted transit fees to remain in force on this pipeline. The discount is intended not only for Gazprom’s profit, but also to deprive Poland of plough-back funds for modernizing this pipeline independently of Gazprom.

6) A ban on Polish re-export of Russian gas to third countries, with a right for Gazprom in that case to reduce its gas supplies to Poland by a corresponding amount. This is in line with Gazprom’s traditional third-country clause, irreconcilable with the EU’s gas market legislation.

All of these terms serve to tie Poland’s hands, and perpetuate both its and Europe’s dependence on Gazprom–and its vulnerability to opportunistic behavior in the future.

This very long term arrangement would be very short-sighted, just from a narrow Polish perspective.  There is tremendous uncertainty about the gas market right now.  Shale has already revolutionized the market in the US, and the effects are so large that it is having spillover effects around the world.  There are very real prospects for shale to have similarly dramatic impacts in Asia and Europe.  LNG potential is also great, and the interaction between shale and LNG technologies could further transform gas markets.  Traditional relationships in the Caspian are changing, and quite volatile; gas that once moved only through Russia and by Russian sufferance, now could move in myriad directions to myriad markets.  Ditto the Middle East, with the Kurds in Iraq representing a real wild card, and in the longer term, the possibility for Iran to become a viable supplier.  The European gas market is liberalizing, and there is a real prospect for a spot market developing in the near- to medium-term.  All of these factors have the potential to enhance dramatically flexibility in obtaining supplies, and undermining the need for any consumer to rely on a particular producer and pipeline system.

The trends are against Gazprom, and even discounting the trends, the incredible amount of uncertainty about future supply prospects and transport technologies dramatically enhances the real option value of waiting before locking into legacy supply relationships for more than a quarter century.

This is exactly why Gazprom is so hot to do this deal now, and why it is attempting to impose all these restrictions that would sharply constrain Poland’s ability to respond to favorable supply shocks in the future.  That’s perfectly understandable: what’s more mysterious is Poland’s haste in doing a deal on terms that do not reflect Gazprom’s strategic weakness over the coming decades.

And it’s not as if Poland will benefit greatly if these developments do not pan out, and legacy production and supply systems remain dominant.  If that happens, Gazprom will act opportunistically and attempt to exploit its greater power (unconstrained by these new supply sources that proved chimerical) in the future.  In other words, this is pretty asymmetric from Poland’s perspective: they give up the opportunity to benefit from favorable supply developments, but will be at Gazprom’s mercy if those favorable developments don’t occur.

Thus, this doesn’t make sense from a purely Polish perspective.  But there’s also an externality involved: Poland dealing with Russia means that it will succumb to the typical disaggregation/divide-and-conquer strategy so beloved of Russia and Gazprom.  This will redound to the disadvantage of Europe.  Europe, therefore, is attempting to pressure the Poles not to sign this deal.  The European Commission claims that the deal contravenes EU law.

Poland, as so often in the past, is caught between Western Europe and Russia.  But the choice should be an easy one.  EU and Polish interests are aligned: Polish and Russian interests are not.  If this lot of Polish pols does the deal now, Poles and pretty much everybody to the west will be paying the price for a long time to come.

* That’s a gated link.  I’ll try to get a PDF put online.

CFTC Commissioner Jill Sommers gave a speech at a conference titled “Clearinghouses as Mitigators of Systemic Risk” that makes interesting reading.

As the title of the conference might suggest, Sommers was quite conversant in the clearing catechism:

Generally, a comprehensively regulated clearinghouse should help reduce systemic risks by facilitating the netting of transactions and by mutualizing credit risks. When a contract between a buyer and seller is submitted to a clearinghouse for clearing, the contract is “novated” to the clearinghouse. As such, the clearinghouse is substituted as the counterparty to the contract and then stands between the buyer and the seller. Clearinghouses then guarantee the performance of each trade that is submitted for clearing. Clearinghouses use a variety of risk management practices to assure the fulfillment of this guarantee function and to avoid losses at the clearinghouse. Moreover, the CFTC has closely monitored these risk management practices at the clearinghouse level and at the futures commission merchant level to ensure risk is properly being managed. The Commission has always recognized that the clearinghouse must protect itself from unnecessary risk, and if it failed to do so, large segments of the markets and market participants could be put at unnecessary risk as well.

Clearinghouses mitigate risk through the daily discipline of marking to the market price, at least once each business day, each position cleared through the use of prices that are independently determined by the clearinghouse. All gains and losses that arise as a result of the mark-to-market process are settled (i.e., paid and received) each day. Clearinghouses also require the daily posting of margin to cover the daily changes in the value of all positions as extra protection against potential market changes that are not covered by the daily mark-to-market. The methodology used by clearinghouses to calculate such margin requirements are subject to regulatory review and approval.

. . . .

With the mandated use of a regulated clearinghouse coupled with effective risk management practices, the failure of a single large trader, like AIG, would be much less likely to jeopardize all of the counterparties to its trades. I must stress, however, all risk is not eliminated, but it is substantially reduced. One of the lessons that emerged from the recent financial crisis was that institutions were not just “too big to fail,” but also too interconnected through non-transparent swaps that the institutions did not effectively manage. By mandating the use of central clearinghouses, institutions would become much less interconnected, mitigating risk and increasing transparency. Throughout this entire financial crisis, trades that were carried out through regulated exchanges and clearinghouses continued to be cleared and settled.

Needless to say, I’m a heretic.  Mandated clearing doesn’t necessarily increase netting opportunities, and even if it does, since it effectively reorders creditor priority it does not necessarily reduce systemic risk.  And if netting reduces costs so much, why didn’t firms adopt clearing voluntarily?  The “daily discipline of marking to the market price” is problematic if “the market price” is difficult to determine, due to illiquidity/lack of trading.  What’s more, regular posting of variation margin is not unique to CCPs, and is quite common in OTC deals.  Furthermore, the variation margin mechanism can be exactly what touches off or exacerbate market panics.  AIG is a terribly misleading example.  CCPs do not reduce interconnectivity; they just change the topology of the interconnections.  Furthermore, CCPs are tightly embedded in the financial marketplace, most notably in the credit system.  To pretend otherwise is foolish.

Sommers’s other remarks are more intriguing.  She recounts of the CFTC’s previous policies towards OTC derivatives and clearing in particular:

In July 1989, the Commission published its 1989 Swaps Policy Statement. This statement reflected the Commission’s view that most swap transactions, although possessing elements of futures or option contracts, were not appropriately regulated as such under the Act and Commission regulations. This was important because the Commodity Exchange Act required all futures contracts to be traded on exchange. The policy statement allowed these transactions to continue trading off-exchange by creating a “non-exclusive safe harbor” for transactions satisfying certain requirements. The safe harbor requirements included five elements: (1) individually-tailored terms; (2) absence of exchange-style offset; (3) absence of clearing organization or margin system; (4) the transaction is undertaken in conjunction with a line of business; and (5) a prohibition against marketing to the public.

In other words, prior to the CFMA of 2000, any attempt to introduce netting (item (2)) or clearing and margining (item (3)) into the OTC market would have run afoul of the Commodity Exchange Act’s requirement that all futures contracts must be traded on exchanges (designated contract markets); netted and/or cleared swaps would have been considered futures.

This should be remembered, but is typically not.  I’ve often wondered whether CFTC policy, and the CEA more generally, discouraged the evolution of OTC clearing, and channeled the industry along the path that Dodd-Frank has now declared an anathema.  We’ll never know for sure, but it must be recognized that during the formative years of the OTC market, the law and regulation effectively foreclosed–precluded–the development of institutions that Congress and the CFTC now deem essential for financial stability.  The irony.

Sommers adds some refreshing honesty about the monster that is Frank-n-Dodd.  Most notably, she discusses the swaps execution facility mandate:

An area that I am very interested in, as are many other market participants, is what the requirements of trading swaps on a SEF will be. The CFTC and SEC heard a great deal of concern about this issue from market participants at a joint roundtable on September 15th. CFTC staff has recently estimated that 30-40 entities will register as SEFs or designated contract markets. The designated contract market model is easy for the Commission and market participants to deal with. We know how they work, and market participants know how they work. SEFs are new, and the relevant statutory language is not very clear. When you read the new statutory language in conjunction with existing statutory language, it raises some questions.

Section 1(a)(34) of the CEA defines “trading facility.” It is a definition that the CFTC and market participants have been working with for years. In essence, a trading facility is a physical or electronic facility or system wherein multiple participants can execute or trade agreements by interacting and accepting bids or offers of multiple other participants. A many-to-many type model.

In defining what a SEF is in Section 721 of Dodd-Frank, Congress did not require that a SEF be a trading facility. Instead, Congress defined a SEF as a “a trading system or platform” in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that (A) facilitates the execution of swaps between persons; and (B) is not a designated contract market.” (emphasis added).

So clearly, by this definition Congress intended that a trading facility could be a SEF, but that a SEF did not have to be a trading facility because Congress used the words “trading system or platform” to define SEFs. In my view, by introducing the term “trading system or platform” when we already have “trading facility” as a defined term means that Congress must have intended a SEF to be different from a trading facility.

Her confusion is palpable.  And understandable.  If the status quo ways of executing swaps were OK, Dodd-Frank would not have added  an SEF requirement.  If Dodd-Frank intended an SEF to be the same as a trading facility, it would have said so.  Thus, Frank-n-Dodd says what SEFs aren’t–the status quo or trading facilities–but doesn’t say what they are.  It is particularly confusing because some of the requirements that SEFs must meet–interaction between bids and offers submitted by multiple participants–characterize trading facilities.  So Congress essentially handed the CFTC an enigma and walked away.  One can feel for Sommers, her fellow Commissioners, the staff–and the industry.

She also mentions the confusion over the definition of swap dealer:

One of the areas that has caused a great deal of concern among many market participants is whether they will be classified as a swap dealer or major swap participant. Such a classification brings with it the imposition of capital, margin, recordkeeping and retention and business conduct rules, and rules for segregating customer funds. Currently six rule writing teams are working on this area. One is working on a series of definitions, including swap dealer and major swap participant, one is working on registration requirements, and others are working on business conduct standards, capital, margin, and segregation issues.

The CFTC’s Chairman has stated that initial estimates are that there could be in excess of 200 entities that will be swept up into the definition of swap dealer based upon current ISDA primary member status. Registering and regulating that many swap dealers will be a huge task for the CFTC and will have very important implications for those entities and their businesses. Comparatively, we now have about 127 FCMs that are registered with the Commission. In my view it is critical that we ensure that this new regulatory regime intersects seamlessly with our existing regime to ensure that registrants and their customers suffer no disruption in their business and hedging strategies. I have asked staff to estimate the number of entities that may be swept into the definition of major swap participant. Unfortunately, they have not yet been able to do so. This uncertainty raises concerns about ensuring a disruption-free transition, an issue that the Commission and staff will be closely monitoring.

Note, and beware.  If Gensler’s 200 number is even ballpark, CFTC will have responsibility over more than twice as many entities as is currently the case.  Moreover, these new entities are often larger, more complex, and certainly more diverse than the population of FCMs currently under its ambit.  Big hedge funds, supermajor oil companies, big money managers, and universal banks are all likely to be considered swap dealers, or major swap market participants.  These are very different animals, and far more complicated ones, than the FCMs.  Moreover, they are all different from one another in crucial ways, but they have to be shoehorned into one of two standardized categories.  This is unlikely to end well.

Sommers also notes that CFTC is tasked with establishing position limits, but doesn’t have the data necessary to do the job properly:

Complicating all of that are the provisions of Dodd-Frank. The CFTC and SEC have 360 days to issue regulations establishing swap data repositories to which swap data will be reported. The Commission has 180 days for energy and 270 days for agriculture to propose aggregate position limits across futures markets and equivalent OTC markets. The problem is, Dodd-Frank requires us to propose position limits months before a mechanism is in place for obtaining the necessary data from the OTC swap markets. In order to propose appropriate limits, we must know the size of these markets. Without the necessary data for OTC markets, we will not really have all the information we need to propose appropriate limits. But, the law is the law so we will propose limits and hope they are at such a level that they do not cause damage to these markets.

Sommers also indulges in hope over experience:

CFTC and the SEC. Historically, the SEC and CFTC have not been very successful proposing joint rules, even when directed by Congress to do so. This time, however, may actually be different.

Seeing will be believing.  And even if everybody has been playing well together so far, the tough decisions have yet to be confronted, and the affected interests have yet to play one agency against another, as will occur inevitably.  Add to that normal inter-agency rivalry, compounded by a profound change in relative authority, and it is pretty plain that serious disputes are inevitable.

Sommers’s speech is a good overview of the issues and challenges facing the CFTC.  Reading her speech and Frank-n-Dodd gives me the same feeling that I had on some Christmas mornings when tasked with assembling some rather complicated toy, and having to rely on directions originally written in Chinese, then translated into Korean, before being translated into English.  The main difference being that if I threw up my hands in frustration, there would be just one disappointed little girl.

I wish Sommers and the CFTC luck.  They’re going to need it.  And so will we.

The news from Russia of late seems to be all Luzhkov, all the time.  To me, it seems to be a perfect illustration of the feudal nature of Russian politics.  A baron gets too full of himself, and gets smacked down by the king.

As to the larger implications, so much of the commentary just illustrates that the old is new again.  Kremlinology is back in vogue, which means that the signal to noise ratio is small indeed.

Some things to watch going forward.  The redistribution of the massive wealth and power inherent in such a transition bears in it the seeds for conflict.  And the potential here is high given the amounts at stake.  We’re not talking about getting rid of the governor of some obscure Siberian oblast, or even a Rossel.  This is the biggest and richest city in Russia, and its political heart.  Hence, the economic and political consequences of a shift there are potentially seismic.  This is particularly true inasmuch as Russia is entering a period of heightened uncertainty relating to the next presidential election.

But it is difficult to know what to conclude from that.  You could argue that Medvedev and Putin are sufficiently confident in the stability of the country that it could withstand the messiness inherent in a transition to a new equilibrium.  You could argue the reverse, that the political condition in the country is so fraught that Medvedev, or Medvedev and Putin, determined that extraordinary measures were required, even knowing that the immediate consequences bear their own risks for the system.  You could argue that this is a unilateral political strike by Medvedev.  Or you could argue the reverse yet again, that it is the result of an agreement between Putin and Medvedev.

In fact, I’ve seen people argue all of the above.  Given the information at hand, the best we can do is advance hypotheses, and be sure to keep in mind that they are just that.  It is very difficult to know exactly what is going on under the rug: what the dogs are fighting over, how the fight started, who is winning.

What’s more, I consider this story far more intriguing because of its potential implications:

The deputy prime minister who chairs Russian oil company Rosneft (ROSN.MM) on Thursday backed its ambitions to sell gas to China — a challenge to Gazprom’s monopoly on exports from the world’s biggest gas producer.

“This is a unified position and right now it exists in the form of an idea, a request,” a spokesman for Rosneft’s chairman, Deputy Prime Minister Igor Sechin, told Reuters.

Rosneft and Gazprom are the economic bulwarks of the two major clans in Russia.  They are intense rivals who have, in recent years, co-existed in a live-and-let-live peace, adjudicated by Putin.  Rosneft is the Sechin-siloviki entity.  Gazprom is more closely identified with Medvedev.

With mafias, drug gangs, and cartels, a simulacrum of peace is maintained primarily by explicit or tacit agreements not to invade rivals’ turf.  Slight shifts in the balance of power, or crucially, an anticipation that conditions might soon change in a way that makes maintenance of the deal impractical or unattractive, can lead to a breakdown in such arrangements.

Sechin’s threat to invade Gazprom’s turf represents a major challenge to the status quo.  Given the centrality of these two companies to the entire Russian political structure, the ramifications of this could be quite substantial.  This is the Russian equivalent of Bugs Moran’s North Side gang hijacking Capone’s South Side gang’s bootlegging trucks.  And we know how that turned out. (Chicagoans still hear about it on trips abroad:)

These two remarks by Sechin are enigmatic, and interesting: “Coordination with Gazprom will be worked out with Gazprom itself” and

“Initiatives like that are discussed with the chairman. That is an agreed position, so far in the form of an idea, a wish. Cooperation with Gazprom will be worked out,” Sechin’s spokesman said.

Worked out with Gazprom itself?  Just between Gazprom and Rosneft?  That’s not usually how these things work.  In Russia, adjustments of relations between major clans are usually intermediated at a political level, usually by Putin.  Assuming the translation is accurate, Sechin’s explicit use of the reflexive pronoun suggests something different: “this is between him and me.  Butt out.”

“An idea”?  “A wish”?  “A request”?  Sounds like an offer you can’t refuse.

Although the Luzhkov follies are garnering all the attention, this one deserves close watching, as it would represent a major transfer of turf between the two most important politico-economic interests in Russia.  And if Sechin prevails here, do you think that will sate his appetite?  If so, think again.  Success of this gambit would reflect a tectonic shift in Russia, and this would unleash yet further changes.

So watch this issue.  It could be far more important than whatever transpires with Luzhkov and the corpse of his empire.  This is the really interesting tussle beneath the rug.

Damn.

Although by some measures (such as debt-to-GDP and deficit-to-GDP ratios) Russia’s fiscal situation appears favorable relative to that of the United States, for a variety of reasons, and for now, the US can finance its massive and burgeoning spending in a way that Russia cannot match.  The fiscal strain in Russia, with a deficit of 5.4 percent of GDP, is forcing Finance Minister Alexi Kudrin to search for ways to plug the gap.

For one, he is encouraging bad habits–like cigarette and alcohol consumption  (H/T S/O):

Smoke and drink more, Russia’s finance minister Alexei Kudrin urged citizens on Wednesday, explaining that higher consumption would help lift tax revenues for spending on social services.

“If you smoke a pack of cigarettes, that means you are giving more to help solve social problems such as boosting demographics, developing other social services and upholding birth rates,” Kudrin said, quoted by the Interfax news agency.

“People should understand: Those who drink, those who smoke are doing more to help the state,” he said, offering unconventional advice as the Russian government announced plans to raise excise duty on alcohol and cigarettes.

In present value terms, this is definitely a loser, even when evaluated from the narrow perspective of government funding, and ignoring the total costs to the Russian population.  The present value of the future costs to government revenue resulting from greater consumption of these goods, in terms of early mortality (and the consequent loss in earnings–and hence taxes) and greater health care expenditures almost certainly exceed the value of the short term revenue jolt this higher consumption would provide.

It is also sad to see Kudrin sink to Orwellian arguments like: “If you smoke a pack of cigarettes, that means you are giving more to help solve social problems such as boosting demographics, developing other social services and upholding birth rates.”  Translation: kill yourself so we can pay others to have babies!

Huh?  And come on: these measures are necessary to pay for existing programs, not to pay for new initiatives.

But the financing constraints of the Russian government (which reflect, in large part, the nation’s perceived unreliability as a political risk) and the relentless presentism of the government (which I’ve written about before, and which arises from a variety of causes) mean that Kudrin has to let the future care of itself.

How nice.  It’s also interesting to note how Kudrin has learned his lesson from Gorbachev and Perestroika.  Gorbachev cratered the USSR’s already shaky financial condition (with oil revenues down due to plunging prices and plunging production, and imports up due to agricultural failures) by cracking down on vodka sales.  Less vodka sales, less taxes.  Another nail in the Soviet coffin.  Kudrin isn’t going to repeat that mistake!

Moreover, the fiscal crunch is also driving the prospects for the sales of stakes in Russian state companies, like bank VTB, and Rosneft.  This initiative is on the slow track, however, with an announcement that there will be no sales in 2010, and no decisions have been made about what firms, and how much of them will be sold in in 2011 and beyond.

Here Russia’s reputation again is hurting it.  The Russian government will retain control of the corporations, and given protections for minority shareholders, and the prospect for re-nationalization (on dictated terms) at some future date, mean that the price the country would get is likely to be discounted heavily.  Put differently, this is not a conviction privatization, driven by a recognition that reducing government ownership and control would improve efficiency; it is a desperation sell-the-family-jewels-gambit where the buyer realizes that he doesn’t get them free and clear and may have to sell them back at an unfavorable price later.  Thus Russia is unlikely to get the price that it wants, but may be forced to sell anyways even at a big discount to meet its pressing fiscal demands.

Some folks have pretty much figured this out:

Troika Dialog economist Anton Strutchenevsky said the lack of certainty in the government’s position is evidence of the fact that the government sees privatization as an ad-hoc measure, necessitated by the need to fill the black hole caused by the shortfall in budget inflows of oil money. “If, hypothetically, the price of oil jumps to $100 per barrel today, the government will trash all these privatization plans,” Strutchenevsky said. He pointed to another “weak point in the program,” which he said makes the whole scheme looks like half-measures. “The state will continue to control and manage most of the enterprises and corporations slated for privatization, since it will retain some 50 percent plus share in most of them,” he said. “You cannot privatize without transfer of some ownership and control. Few investors want to sleep in bed with a government that makes all the investment decisions.”

So, Russia is in the situation where its fiscal choices include inducing the population to kill and incapacitate itself more quickly in order to raise more taxes today, and selling shares in state companies at big discounts that reflect its inability to credibly protect the buyers.  With the price of oil drifting lower the pressure to make these unpalatable choices have only increased.

The best BRIC.  Ha!

FT Alphaville summarizes the Troika Dialog argument touting Russia as the BRIC to bet on.  According to TD:

Russia has more raw materials, a more educated and middle-class population, a strong macroeconomic framework, a better track record, more resilience to global warming, and is cheaper. Moreover, it has unique commodity assets and a clear and successful European path to follow.

Color me extremely unimpressed.  If this is the best case, Russia’s future is bleaker than I thought.

1. Raw materials are a curse to growth and long term economic prospects, not a benefit.  That has been particularly true in Russia’s case, but it is difficult to find raw material intensive economies that have been stalwart growth performers.  It’s a lot easier to find such economies that are basket cases.

2. Yes, Russia has a more educated populace than other BRICs.  But that is already reflected in the higher per capita income of Russia compared the other BRICs (another attribute that TD touts).  Moreover, as is true of much of Russian capital, the educational prowess–the human capital–of the Russian population is pretty much a Soviet legacy that is depreciating rapidly.  The current Russian educational system is pretty much a disaster, and a shadow of the Soviet system.  Corruption is rife: today, Russian educators put the cheat in ???????.  The future of Russian education is hardly encouraging.

3. TD vastly understates Russia’s crippling economic defects:

Apart from oil price dependency, which is an aspect of macroeconomic fragility, Russia’s weaknesses are poor corporate governance, which restricts the returns to minority shareholders, and regulation, which restricts ROE levels (e.g. utilities). We reject the fashionable view that other issues like weak population growth, poor infrastructure, or poor government are necessarily damaging to ROE levels.

Poor corporate governance is the understatement of the century.  FTAlphaville has a more complete list:

It ranks worst for corruption, corporate governance, and most institutions in international rankings. In financial services – such as investor protection, ethical behaviour of companies, strength of auditing, and market sophistication – again it fall short of the other Brics, according to the World Economic Forum. And it ranks second worst on the business cost of terrorism (behind India), and both violent crime and organised crime (to Brazil).

But even that list is seriously incomplete.  A more complete list would include: the absence of reliable property rights, the lack of contract enforceability, the corruption of the legal system and the absence of the rule of law, the constant threat of expropriation, the arbitrariness of government.  I could go on.

In brief, the TD analysts are being pretty thick.

Timothy Garten Ash had a more reasonable assessment a couple of months back, but it still focuses on traditional macro and structural issues and underemphasizes Russia’s fundamental problem: its institutional deficit.

These are all issues that primarily speak to Russia’s long term prospects.  Its second quarter growth numbers came out, and they show things aren’t doing all that well in the short run either.  Russian GDP grew 2.5 percent year-on-year from July, 2009 to July, 2010.  The economy actually declined month-on-month.  Although the fires certainly contributed to this decline, it is not a a favorable sign.

This is anemic even by comparison to the US.  From trough (2Q 2009) to the present (hopefully not the peak, though it might be a local one given the real prospects for a double dip), the United States grew 3.1 percent.  This was after a 4.2 percent decline from the peak in 4Q 2007 to the bottom in 2Q 2009.

In comparison, the Russian economy declined 7.9 percent in 2009, about twice the US decline.  Twice the decline and a smaller rebound is hardly stellar performance, especially since the standard of comparison–the US–has not been a stellar performer itself.

Things are even worse if evaluated on an output gap basis.  Given that Russia was growing at 5+ percent into mid-2008, the output gap is now about 15.5 percent.  Since the US was growing at about 2.5 percent, the gap her is around 5.5 percent.

The sluggish growth in Russian GDP is particularly underwhelming given that oil prices have more than doubled off their crisis lows.  This should have given Russia a favorable jolt, while serving as drag on the US.

The Finance Ministry is sticking by its forecast of 4 percent growth in 2010.  Highly unlikely, especially given the effects of the drought; the fires; and the serious prospect for a global slowdown in the last third of the year.

Short run or long run: neither looks too hot.

When I gave a talk about the national energy policies of Russia, China, and Venezuela to a group of State Department and intelligence people a few weeks back, my summary on China was: “If you want to understand Chinese policy as it relates to energy, read Mahan.”  Mahan being Alfred Thayer Mahan, late-19th/early 20th century admiral, and the author of The Influence of Sea Power on History, and other influential works.

If you’ve been following things for the last several months, you’ll have read that things are getting testy in the South China Sea*, specifically over the issue of the Spratleys, a chain of microscopic islands that are believed to hold large amounts of oil.  China has been quite bellicose in asserting its claims over the Spratleys (against competing claims from Viet Nam, the Philippines and ohter countries).  It has basically told the US and the world that the South China Sea is a Chinese lake, and that any US naval presence in that area is unwelcome.

All of this is taking place in the context of a concerted Chinese effort to bolster its naval forces and strengthen its naval presence along the sea lines of communication (SLOCs) over which raw materials flow to feed Chinese factories.  All very Mahanian.

The US response to this has been, to put it politely, supine.  The limp-wristed US response to the Cheonan sinking–and to the complete lack of any Chinese condemnation–is emblematic of this.

But apparently things are changing.  Hillary Clinton’s recent trip to the region–on which SecDef Gates went as well–represents an effort to reverse this.  This is based on a dawning recognition in Washington that American pusillanimity emboldens China and weakens our position in that area of the world.

For a typically Spenglerian interpretation of the situation, read this Mark Helprin piece in the WSJ.  I think Helprin is great for understanding the worst case, and what must be done to to avoid it.  As a prognosticator, he is too gloomy even for me.

Information Dissemination, a naval blog, is also alarmed, though.  And I must emphasize that ID is NOT a habitual, reflexive anti-administration, anti-Obama source.  Indeed, it has been broadly supportive of Obama policy initiatives.  But it also recognizes that risks have risen in Asia because of the administration’s palpable weak policies:

Beginning in 2010 a lot of folks began to legitimately question whether the Obama administration had the balls to stand up to China. The private jokes that Tim Geithner was hired to kiss ass in Asia are actually very funny – but worse, hard to argue with. In virtually every policy area, at the beginning of 2010 the United States was beginning to look weak and inept, and when the Cheonan was sunk off South Korea – it perpetuated the image of weakness by the United States once it became clear the Cheonan sinking was an attack, but the US wasn’t going to do anything in response – for several legitimate reasons.

By July the US appeared to be on the brink of a serious perception and credibility problem in the Pacific, and at the same time Russia and China was heading to Seoul to discuss the Cheonan sinking. I strongly believe that China made a strategic miscalculation, because had China and subsequently Russia backed Seoul regarding the sinking – it would have been recognized by the region that China’s influence on this major regional security event was greater than the influence of the US. Because China could not support the findings of the international Joint Investigation Group, it signaled to the rest of the region that China is still not a responsible or reliable partner in the security conditions of the Pacific. Despite what the tone of the TIME magazine article suggests, the government of every single major Pacific nation besides Russia and China believes the report that North Korea sank the Cheonan with a torpedo.

In mid-July I heard the questions being asked again – is there anyone in Washington that has the balls to stand up to China? Well, timing is everything, and after a year and a half of attempting a soft approach with China in an effort to open up the relationship – an attempt that had clearly failed – the Obama administration has changed policy in the Pacific.

The announcement by Hillary Clinton that the United States intends to play a prominent role in a new regional effort toward resolving territorial disputes in the South China Sea is the single most important foreign policy action by the United States directed at China in the 21st century. While a lot of serious people have been wondering who has the balls in Washington to stand up to China, it turns out that they have been hiding up Hillary Clintons skirt the whole time. Robert Gates was in the room in Vietnam when Hillary Clinton made this announcement – so this policy change isn’t just some State Department rogue moment by the Secretary of State.

We do not know how this will play out or what is coming next, but this is an enormous change in policy towards China. I don’t think the Obama administration wants a war with China, but they have no longer decided to be nice to China – because China sent the message that nice guys will finish last with them.

It’s about time.  Ditto with the administration’s much tougher line with Turkey.  (A lot of what has happened in Turkey is obviously domestically driven, but US policy towards Turkey has been a disaster since early in the Bush administration.  We are paying the price for this in the Middle East, the Caucasus, and the Caspian.)

In any event, as if we don’t have enough fires to deal with, keep an eye on the South China Sea, and US naval policy and foreign policy towards China.  This is a big deal.

And it relates to bigger themes.  I’ve mused whether the current historical era is more like the 1970s or the 1930s.  In my “optimistic” moments, I think the former, as dismal as that is to contemplate.  But more and more I think the 1930s is the better analogy.  And the events in east Asia are just one thing nudging me to that conclusion.

* Ironically, this morning my wife was doing some genealogy, and listening to recordings of her grandmother reminiscing about her family.  She mentioned one relative, a beauty, who said she would “walk into the China Sea when she was no longer attractive to men.”  The weird part is that her husband died in Taiwan.

Russia has ambitions of turning Moscow into a world financial center.  Proving that old habits die hard, rather than do the heavy lifting that would be required to achieve that objective–e.g., eliminating raiding, strengthening property rights, improving disclosure and transparency, bolstering minority shareholder protections, etc. (the list is very long)–the economic development ministry is recommending the Potemkin approach.  Or, to characterize it a little differently, a Soviet propaganda approach.  Literally:

According to a copy of the proposal [from the ministry] seen by Vedomosti newspaper, the economic development ministry believes Russia should create a multi-lingual internet portal to showcase Russia’s “history of success”. [What history is being referred to exactly?  Could be a pretty small website.]  The resulting campaign should draw not just upon global examples, but Russia’s previous propaganda efforts during the Soviet era, the proposal states.  [Emphasis added.]

After all, propaganda is easy; it might gull a few suckers who can be fleeced; and it does not require the implementation of reforms that would constrain the ability of the insiders to tunnel out vast sums.

To get an idea of how the game is rigged in favor of the insiders, consider the following story about the bidding process for the last large undeveloped oil property in the country:

Russia has finally set a date to auction off its last unalloted big oilfields, but analyst say the terms it set out for a potential buyer make the deposit difficult to use and develop.

. . . .

But analysts believe that the terms of the ownership, including obligations to sell 15 percent of produced crude through the oil exchange and to refine 42 percent of crude produced, can spook off the potential buyers.

“The proposed terms complicate the project significantly…. Crude exports will primarily go through the Northern Sea route, while the bulk of the refining complex is located in the European part of Russia.,” VTB Capital analysts said in a note on Wednesday.

“With additional transportation costs implied, as well as the lack of exchange trading for crude oil, the economics of the project could suffer as a result of the conditions which have been imposed.

Uralsib analysts believe that due to these conditions, Russia‘s largest oil producer, state-owned Rosneft, is a frontrunner in the tug-of-war for the fields. [Emphasis added.]

The conditions are heavily tilted to favor Rosneft.  I’m shocked! Shocked!

Russia has a choice.  It can continue to operate a system that funnels rents to the powerful.  It can create a system that protects investors and limits the pervasive corruption, rent seeking, and favoritism in order to attract investment.  It can’t do both.  All the neo-Soviet propaganda in the world can’t change that.  Any fool that falls for the propaganda deserves to lose everything–and probably will.

On Monday I gave a talk on Russian, Chinese, and Venezuelan energy policies to a group of State Department officers and some other government folks from places like ONI.  All of the people involved have energy as some part of their portfolio, and were on a trip to Houston to learn about a variety of energy issues.

At the Q&A after my talk, one person asked me: “At the Iran desk we are confused about Russia’s policy towards Iran.  It would seem that they have an interest in keeping Iranian energy, especially gas, out of the market, so would have an interest in robust sanctions.  How do you explain their lukewarm support and their dealings with Iran?”  After recovering from the “you’re asking me?” shock, I responded that it doesn’t confuse me at all.  The Russians want their cake and to eat it to.  They are playing a double game.  They benefit from turmoil in the Middle East, especially in the Gulf.  It is quite useful to them to have the US distracted by Iran, leaving Russia more space in the Near Abroad.  Russia has  strong economic interests–in nuclear power, and arms, in particular.  They don’t want to see Iranian gas to to Europe, but have no problems with it going south and east.  At the same time, they are trying to reach some kind of accommodation with the US, and aren’t thrilled about an Iran with nuclear weapons.

So Russia wants a Goldilocks approach–not too tough, but not too lax.  It wants to keep Iran on a low boil, not too hot and not too cold.

Hence the to-ing and fro-ing, the double dealings, and so on.  Alleviating pressure from their western flank by agreeing to weak sanctions–that give Russia the flexibility to engage in business dealings with Iran, including the sale of advanced S-300 antiaircraft missile systems.  When Ahmadinejad throws a hissy over Russian support for sanctions–no matter how tepid–they try to assuage him.  They criticized the EU’s more robust sanctions.  Russia and Iran signed an energy cooperation “roadmap.” And of particular interest, given that the Iranian regimes greatest vulnerability to sanctions is in motor fuels (given its inadequate refining capacity), Thursday it was announced that Russian companies including Rosneft, Gazprom Neft, and Tatneft  would start “serious deliveries” of gasoline to Iran.

In short, Russia is playing both sides against the middle, extracting concessions from the US and the EU, including special treatment, to agree to sanctions, and then turning around and dealing with the Iranians.  The resulting state of not war-not peace suits them just fine.  It seems pretty obvious, and it would be rather unsettling if the State Department really finds this befuddling.  Russia is pursuing its own interests, and those interests are not congruent with ours.  That the Russians are doing so by talking out of both sides of their mouths should be expected.   Indeed, I would be more worried if they didn’t.