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Analysis & Opinion
25.04.08 Russia Profile Weekly Experts Panel: Russia’s Modernization Challenge
Introduced by Vladimir Frolov

Contributors: Vlad Ivanenko, Eugene Kolesnikov, Andrei Liakhov, Alexander Rahr

Last week, two new developments highlighted the challenges Russia's President-Elect Dmitry Medvedev will face as he seeks to modernize the country.

On April 15, LUKOIL's Vice President Leonid Fedun told Britain's Financial Times that "Russian oil production has peaked and may never return to current levels." He believes that Russia's figure of about 10 million barrels per day in 2007 is the highest production he will see "in his lifetime." He compared Russia, the world's second-largest oil producer, with the North Sea and Mexico, where oil production is plummeting, "saying that in the oil-rich region of Western Siberia, the mainstay of Russian output, 'the period of intense oil production [growth] is over'."

On April 16, Russia's Federation Council, the upper chamber of the Russian parliament, passed a bill that restricts foreign ownership of "strategic enterprises" to a minority stake. The bill also requires that in certain strategic sectors Russian state companies should have more than 50 percent of shares, while "strategic" oil and gas deposits can also be developed only by state companies with majority control.

The bill also requires the FSB to pass a formal judgment on whether a potential acquisition by a foreign company of a stake in a Russian enterprise on the strategic list presents a threat to Russia's national security, opening the way for corruption and arbitrary government meddling.

Russia's oil production and exports are hindered by the failure to develop new technology and exploit new fields in more challenging geological and environmental conditions. To develop such fields, particularly on the Russian seabed, in the Far East and in the Arctic, Russia needs expertise and technologies employed by international oil majors, the likes of Shell or ExxonMobil. But many foreign firms are reluctant to make new investments and bring new technology to Russia, as a result of what is widely seen as Russia's strong-arm tactics against foreign energy investors in recent years.

Due to underinvestment in exploration and production technologies, Russia may see its main source of revenue--oil exports--go down.

Medvedev inherits a Russia that has largely exhausted the restoration path of development, and is now facing a much tougher challenge – modernization. It will require different approaches than those used under Vladimir Putin, and it will require new engines of growth other than the energy sector. Russia needs massive investments – over a trillion dollars, according to some estimates – into its industrial and transport infrastructure that has been largely inherited from the Soviet Union. It needs to diversify its economy from dependence on natural resources into high technologies, if it wants to remain a major power. It needs to rebuild its public health and education systems to produce a competitive workforce, in a population which will decline over the next decade because of previous poor health conditions.

But Medvedev also inherits some of Putin's policies that might hamper his modernization agenda, as they restrict the flow of Western expertise, technologies, and money necessary to make a breakthrough.

As Tom Graham of "Kissinger & Associates" emphasized in his speech at Johns Hopkins University in Washington, "Success will also require Russia to repair its relations with the West. For Russia cannot modernize itself on its own, even if it must play the largest role. The money, know-how and technology it needs can only be found in the West. And Russia cannot guarantee its security at a time of great global upheaval without friends and allies."

Does Medvedev understand the modernization challenges facing him and the country? Does he realize that the situation calls for a new set of policies that, although building on the past, cannot be a mere continuation of Putin's course? Will he seek engines of Russia's modernization in openness to the outside world and in a cooperative relationship with the West, or will he succumb to the temptation of self-reliance? Does he appear to have an understanding with Putin that to move the country forward new policies are in order? Where does Putin stand on this?

How will Medvedev deal with Russia's stagnating energy sector that has been the principal source of revenue for the Russian budget? How will he treat foreign investors, particularly in strategic sectors? How will he build the relationship with the West, particularly the energy relationship with Europe? What can the West do to help Medvedev modernize Russia?

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Alexander Rahr, Director of the Russia Program, German Council on Foreign Relations, and Professor of History, MGIMO State University, Moscow:

The crisis in the Russian oil sector will not be felt over the next five years. Besides oil, there is also gas. The Russian oil sector is not the strongest in the world, anyway. In its goal to become the world's new energy superpower, the Kremlin concentrates more on gas production than on oil delivery. Russian gas will remain the Kremlin's main export asset.
Russia fully understands that it has to change its economic policy and place more emphasis on investment in its rotten infrastructure. Typically for Russia, the country's leadership may have developed a master plan on how to proceed further, but it will not implement it, like it did not implement other strategies in the past two decades. It is more important for the Russian elite to use the existing momentum and get richer and richer, than to think about the future.

Is Medvedev going to change the situation? A lot depends on whether he will succeed in getting his liberal economic ideas through the conservative state bureaucracy. As it looks now, Putin will create a government structure mainly for himself, with several deputy prime minister posts, which will mostly go to representatives of the siloviki. It remains to be seen how much of a "policeman" the government will be over the economy in future.

When you ask representatives of the Russian energy sector these days about foreign investments and the need to integrate more Western technological know-how into the Russian economy, you will get the following answer: "We have enough money now to buy all of the needed technologies from the West ourselves. We don't need physical investors from abroad."

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Eugene Kolesnikov, Private Consultant, The Netherlands:

The role of the West in the development of the Russian oil and gas industry, as well as the creation of an innovative economy along with the issue of Russian independence, are all critical and interdependent factors that determine the path to Russia's modernization.

In my view, alarm about declining oil production that threatens Russia's modernization is misplaced. The era of hydrocarbon energy is in its terminal phase. It is probable that the next century will see hydrocarbon energy become obsolete. If Russia wants to become and remain an independent modern economy, it should not treat oil and gas as an overriding priority. Investment, political and administrative efforts, and human resources that flow into the oil and gas sector, come partly at the expense of the other sectors of the economy. Russia should not place itself on the altar of the world's energy demands and become the northern Saudi Arabia as many in the West would prefer to see it.

This certainly does not mean that Russia should abandon its oil and gas sector. Oil and gas can serve Russia well while it is changing its course toward an innovative economy. Since Europe and Asia will remain hungry for Russian oil and gas for decades to come, there is no threat whatsoever that investment or technology will become an issue—just consider the Shtokman project as a case in point. Besides, Russia has sufficient oil and gas reserves in Eastern Siberia, the North-East and the continental shelf to sustain and increase overall hydrocarbon production. That is all Russia needs to get the cash for reforms, and to maintain its geopolitical resource leverage in Eurasia for the next 50 years.

What Russia needs much more than an obsessive fixation on the relatively straightforward oil and gas industry is accelerated development of an innovative economy and of modern society. The 2020 strategy is a blueprint for such an undertaking, designed by Putin's team. The focus has now shifted to the implementation of this strategy—the biggest challenge for Medvedev, Putin, and United Russia. There are substantial grounds for optimism there, if we take into account the revolutionary results of Putin's eight years in power, and the much strengthened Russian socio-political foundation.

Can Russia modernize without the West? The answer is rightfully "no." If you look at the so-called success stories of modernization—Japan, South Korea, Malaysia, Taiwan and China—none would have been possible without the determined geopolitical and geo-economic support of the West. Does this mean that Russia should give up its independence, and beg for support provided on Western terms, as it did in the 1990s? The answer already given by Putin is "no." Russia has become too important a player geopolitically and economically for the West, and particularly for Europe, to artificially contain its economic development. Direct foreign investment is on the rise. Joint projects in the high tech sectors are taking off. Russia's attraction as a place for business and investment is high, and will only improve as Medvedev goes about implementing his plan to establish the rule of law.

There is no basis for doom and gloom when thinking about Russia's modernization. It is, of course, a daunting task. But it can be done in a manner that enhances Russia's unique role in the Russia-Europe-United States partnership, and does not reduce Russia to an oil and gas producing province of the West.

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Andrei Liakhov, Doctor of Law and Professor, London:

It is impossible to ascertain what any person, let alone a politician, thinks. Medvedev's business background at Ilim Pulp and at Gazprom allows any observer to believe that the former has a good grasp of the real situation in the Russian economy. He is also aware of the hunt for Russia's natural resources (in the widest sense), which began in 1991, and of the relative inexperience and weaknesses of the Russian business elite which quite often has a negative impact on Russian businesses' international expansion plans. He is also acutely aware of the differences in business culture that exist between Russia and the West, sometimes complicating the matters further.

In all likelihood, he knows about the "grab'n'run" approach adopted by some Western investors to the exploitation of Russia's natural resources. Well-known stories surrounding the development of the Vankor oil deposit by Anglo Siberian, the sorry sagas of Chernogorneft, SIDANKO, and several gold deposits in Yakutia and Kamchatka, make it unlikely that openness to foreign investors will be the answer to Russia's economic problems.

"Russia PLC" has (or at least its management tends to think so) enough resources of its own to ensure its ability to tackle some, if not all, of its development problems, and certainly there is a temptation to "close the company to new investors" and build its interaction with the outside world on the strict basis of sales and purchases.

The impact that all this will have on Medvedev's thinking will only become evident with time. However, the reality is that business is rarely concerned with national borders. With Russian business becoming increasingly interested in expanding internationally (LUKOIL and RusAl are two best known examples), the pressure to be open to international business will increase. The big game, in my view, will be centered on defining the boundary beyond which openness to international business will start threatening Russia's national interests and its national security.

As to where Putin stands on this - both men stated on numerous occasions that they will both work in accordance with the Constitution. The role of the prime minister is to propose and implement economic policies, and thus Putin will continue to play a crucial role in determining the way Russia will interact with the outside world on economic matters. If anything, I would expect his involvement in running the economy on a daily basis to increase.

There are several general problems with the Russian energy sector, each of which has several possible solutions. For example, problems associated with the growth of oil extraction levels originate from more than 17 years of severe underinvestment into geological exploration, the exorbitant level of taxation, and the huge inertia resulting in the unwillingness to introduce modern, efficient extraction methods, which should increase extraction levels at the existing wells. The ever-changing tax regime is seen as the single most serious obstacle to the growth of the Russian oil industry.

None of these problems require selling Russian oil reserves to international majors. The Sakhalin experience shows that participation of international oil majors may not necessarily result in more cost efficient or ecologically friendly development of oil reserves.

However, it would be unwise to refuse international cooperation simply because we can do it ourselves. It is always useful to draw on the boundless experience and expertise of the international oil business, but not necessarily by allowing them to directly participate in the most profitable and promising projects. Russia has enough money to buy this expertise through hiring experienced managers, commissioning research and development and engineering works from international firms, supporting domestic R&D organizations, and educating local managers at renowned world industry institutions.

Russia has a lot of choices, and it would seem that all the board of "Russia PLC" needs to do is to make several key strategic decisions on how fast it wants to achieve the result it needs, because organic growth takes much longer, and growth through farm-ins and acquisitions is more expensive. What choices the board will make, we should see quite soon.

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Vlad Ivanenko, PhD, trade and energy analyst, Ottawa:

There are many strange things that go hand in hand in Russia today.

Its energy sector revenue is continuously increasing, but leading oilmen cry for help because the sector’s output is stagnating. Statistical indicators point to solid economic growth, but the boom coincides with apparent contraction of economic freedoms for local entrepreneurs. The incumbent president, Vladimir Putin, follows the letter of the law, and transfers presidential powers to the President-Elect Dmitry Medvedev, but subsequently limits the latter’s power with numerous legal and political constraints. Where is Russia heading under president Medvedev?

While several hypotheses are plausible at the moment, the dynamics of the Russian past are likely to shape its future, unless the country experiences an unexpected shock. With this caveat in mind, let’s briefly outline what future Russian leaders did in the past and under what circumstances.

As a vice prime minister, Medvedev experimented and modestly succeeded with the so-called National Projects. Chosen sparingly, these programs - in health, education, and affordable housing - were aimed at developing human capital. This is exactly what the economists at the Washington Consensus School would recommend the government of a developing country to do.

Attaining political stability was Putin’s main achievement. He should also be credited with choosing ministers who maintained budgetary discipline and abstained from excessive regulation on the federal level. In its turn, a favorable macroeconomic environment allowed the Russian economy to thrive. On the negative side, Putin was increasingly reluctant to trust people outside of his inner circle, creating, essentially, a clique.

The political weight of energy magnates has dwindled after the downfall of the richest Russian, Mikhail Khodorkovsky, in 2003. Energy revenue flooded state coffers, allowing the government to build one of the largest “war chests” in the world. At the same time, the list of Russian billionaires continued to swell, and amounted to 110 in 2007. Metals and construction have become new sources of private wealth.

In external affairs, the Kremlin proclaimed supremacy of national economic interests, which it defined in terms of economic might under its control. Energy has remained at the top of Russian exports, and dominated the export structure even if the latter is considered in constant prices. On the mergers and acquisitions front, national companies expanded in metals and construction abroad. The Kremlin pushed foreigners out of the domestic energy sector, but in other sectors – notably in electric utilities, car manufacturing and food processing – foreign capital expanded.

These observations suggest the following scenario for Medvedev. The new president will have economic development as his overriding objective. Under him, the state will continue to maintain macroeconomic stability, to invest in human capital and in public infrastructure, and to support a few “national champions.” Putin will take charge in controlling the high-ranking state bureaucracy, otherwise uncontrollable because of weak democratic institutions. The economic role of the energy sector may gradually recede as public investments start paying off, and the rest of the economy, particularly food processing, trade, and construction, will become more important. Russia will be able to attract foreign technologies either through direct investments or through mergers and acquisitions, provided that no war-bordering crisis happens in its relationship with the West.

Overall, Medvedev has enough resources to meet the challenge of Russian modernization … albeit as an economist, I hate to see him succeeding without our professional advice!
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