Russia After the Financial Crisis 04Nov09

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Russia after the Global Financial Crisis

Clifford G. Gaddy1

Barry W. Ickes2

November 4, 2009

1. Well over one year into the global economic crisis, it is still not clearhow events will ultimately play out in the coming months and years. The crisis has certainly been dramatic, no less for Russia. Although wecannot be sure when or how the crisis will end, we can start to thinkabout how it will impact Russia’s economic future — both the structureof the economy and the policies that the leadership will pursue in lightof the lessons they draw from recent events.

2. Three facts are essential to understand how Russia was drawn into thecrisis, how it has been affected by the crisis, and how its futureeconomic policy, including its relationship with the outside world, willevolve.

3. First, Russia has been and will remain dependent on oil and gas. Nosingle factor is more important for Russia’s future than the volume of rents that will accrue to the country from these resources. The size of the rents depends in turn on the world price of oil and gas and on thequantities that Russia will produce. Russia’s influence on the price isweak in the short term but possibly important for the long term. Russia

will itself choose how much oil and gas to produce. But that choice willdepend crucially on its perceptions of the long-term price and theextent to which arrangements can be made to share the risk of lowprices with the rest of the world.

4. Second, the structure of the Russian economy is still predominantlyshaped by its Soviet legacy. That makes it susceptible to what wedescribe as “rent addiction.”3 By that we mean the political and socialimperative to use the oil windfall to support noncompetitiveenterprises in other industrial sectors. Rent addiction intensified overthe period of the boom preceding the global crisis. It did not disappearwhen rents collapsed in late 2008 and early 2009. It remains a majorproblem for the future of the Russian economy.

1 The Brookings Institution and CRIFES at PSU ([email protected]).2 CRIFES at The Pennsylvania State University and the Brookings Institution([email protected]).3 [Gaddy & Ickes, EGE article on Rent Addiction]

mailto:[email protected]

mailto:[email protected]



Russia after the Global Financial Crisis Page 2

5. Third, economic policy under Vladimir Putin continues to be guided bytwo central priorities, priorities he has had since the very beginning of his tenure as leader of Russia: to maximize the efficiency of theRussian economy, on the one hand, and to ensure strategic stateinterests — beginning with state survival — on the other. The first of

these imperatives, efficiency, dictates Putin’s preference for a freemarket, private ownership, and the country’s participation in the globaleconomy. The latter imperative, national security and “survivability,”dictates a model of not absolute but contingent private property rights. There has always been a tenuous balance between the twoimperatives. The current crisis has exacerbated the tension.

OIL AND GAS

6. The crisis has made abundantly clear that the key element of theRussian economy is the oil and gas sector. Resource rents drive the

economy. During the boom this was hidden from view, to some extent,by the rapid growth in virtually every sector in the economy, not justthose connected to oil and gas, including industries that suppliedinputs to or performed services for the resource sector. Also apparentlyunconnected sectors such as retail trade, telecommunications, realestate, and others saw their sales, profits, and share prices risesharply. Some observers argued that this was evidence of theemergence of a non-oil economy. But the abrupt collapse of oil pricesin the summer of 2008 made it evident how dependent these othersectors were on the continued high oil prices.

7. Russia’s stock market indices show the correlation. The benchmarkRTS index has tracked the oil price for the past ten years, but nevermore closely than in the most recent 18 months. The oil price soaredto record heights in the summer of 2008, collapsed by about 70percent by the end of the year, and then has risen back to a priceroughly half of what it was at the peak. The RTS index behaved in thesame way and continues to do so.




8. One might object that since such a large share of the index’s value isfrom oil and gas companies, it is not strange that it is stronglycorrelated with the oil price. In fact, at present (the fourth quarter of 2009), oil and gas companies account for only slightly more than half of the index. Sectoral indices for the non-oil and gas industries havebehaved largely the same as oil and gas. Perhaps even morepersuasive graphic evidence for the “everything is oil” argument weare making is in Figure xx, which shows the annual sales revenues of Russia’s largest (by sales) companies outside the oil and gas sector ,matched with the annual average oil price.

9. Retail sales (figure 2) show a similar picture. While oil prices wererising, the growth in retail sales was taken to be an independent




source of economic growth — a sign of success if not of economicdiversification. When oil prices collapsed in the summer of 2008,however, retail sales collapsed as well. The dependence of the latteron the former became evident as the oil price regime switched.

10.Not only financial indicators but also indicators of the physicaleconomy followed the oil price. This is clearly seen in Figure X whichdisplays the world oil price and the production of rail freight cars inRussia. The collapse in oil prices led to an almost immediate andsimilar collapse in railway freight cars.




Policies in the Boom

11. The historic growth in oil prices up to July 2008 led first to a boom,then a bubble in the Russian economy. In the first phase, recoveryfrom the very low oil prices of the 1990s fueled real economic growth

and genuine improvements in economic performance. Many of Putin’spolicies were sensible in the face of the rent expansion. His firstpriority was to get rid of the sovereign debt. [Kudrin quote back whenhe was appointed to Finance Ministry.] Putin inherited a public foreigndebt of USD XXX bns. He began reducing it as soon as he enteredoffice. [Table] But it was the boom in oil prices that began in early2004 that allowed him to in effect fully retire the government’s foreigndebt. In January 2005 Russia paid off the entire balance of its debt tothe IMF — three and a half years ahead of schedule. He then began tobuild reserves, in the form of foreign currency assets accumulated inan oil stabilization fund on the Norwegian model, and in international

exchange reserves more broadly. The currency reserves grew by $55billion in 2005, $120 billion in 2006 and $170 in 2007, bringing thetotal to nearly $600 billion by mid-2008. Only China and Japan hadmore.

12.If one plots the paydown of the government’s foreign debt and thesimultaneous buildup of its foreign exchange reserves, an informativepicture results. (See figure 3). It was in the second half of 2004 thatthe state debt was exceeded by the forex reserves for the first time inthe history of the Russian Federation.

13.[The boom allowed Putin to eliminate Russian sovereign debt andenhance financial independence. The collapse of the oil priceexperienced in the summer of 2008 does not wipe out all those gains.]




14.As clear as his priorities for use of the resource rent were in this initialperiod, problems began to arise as the world asset bubble led to abubble in oil prices. Rent began flowing into Russia at a rate that wasno longer as simple to manage as before. The problem was to preventa new wave of addiction arising from the explosion in rents, a problemthat had plagued the Soviet Union in the 1980s after the first andsecond oil shocks. To restrain rent growth in an environment of soaringprices — a factor beyond Russia’s control — Putin sought to restrainRussia’s own output through tax and other policies for the oil sector.[See Gaddy & Ickes EGE]

15.Nevertheless, Putin’s policies to manage the windfall were not entirelysuccessful. Three problems arose. The first was that even while thestate foreign debt was being paid down, private sector debt began togrow sharply in 2003 and by 2005 was reaching bubble proportions.Second, despite efforts to curb rent growth and to sequester thewindfall in the reserves, Russia suffered from overconsumption. Third,because of the specific, “addictive” nature of the Russian economy,much of the rent that was invested rather then being consumed endedup being used counterproductively. It helped preserve the so-calleddinosaur industries. We discuss each of these problems in turn.

Private Sector Debt Bubble

16.Putin began with a sensible policy of recycling surpluses and foreigncapital inflows. Rory MacFarquar has advanced the thesis that privatesector borrowing offset balance of payment surpluses.4 Putin’s ideawas to rely on foreign capital since it would be invested better thandomestic capital. This was a recycling phenomenon, not unlike the

4 [Need source footnote on Rory]




case of China (Bretton Woods II).5 But the bubble led to an explosion incapital inflows as private borrowing expanded. The belief that high oilprices would persist, combined with low interest rates abroad, madeforeign borrowing attractive. Over time the process led to an over-extension of lending, and to a deterioration of the collateral that was

held. Borrowers became more extended, and the system became morevulnerable to sudden stops of capital inflows. This is what happened toRussian in the summer of 2008. What began as a sensible processended up creating more systemic risk.

a. Figures on private sector borrowing vs sovereign debt, EMratings improved [Table]

b. The story is the following: oil prices improved Russia’s creditstanding. This fueled capital inflow, further causing RTS to rise.But it is not an independent cause, since without oil no creditinflow. This was shown completely in the crisis, beginning in July

when oil prices plunge.c. Consider the counterfactual of global credit crunch but oil prices

remaining high. A temporary shock due to de-leveraging mighthave hit RTS, but it is hard to believe this could be sustainedsince Russia would have been a great buying opportunity. This isevident in the subsequent movement in RTS and oil. RTS and oil jointly recover before credit crunch is over.

Consumption Bubble

5 A key difference, however, is that the household savings rate in China was muchhigher than in Russia, and the financial system in China is more controlled,especially with regard to capital flows. These differences made Russia moresensitive to a sudden stop than China. This difference did not seem important whencapital was flowing in.




17. The rise in oil prices led to an expansion in retail sales (figure x) andimports (figure x). Especially high-end consumer imports soared.Personal automobiles are the starkest example. Imports grew from fivebillion dollars in 2004 to over 30 billion dollars in 2008 — a rate nearlytwice as fast as all other imports.6 [Table with types of imports?] In

some sense increased consumer spending was a natural response torising incomes. Import growth reflected the inability of Russianproducers to respond to the rise in demand.7 The problem was thatthese tendencies were dependent on the level of oil prices — anexceedingly volatile price. If prices came down so would consumptionand imports. That is precisely what happened.

ADDICTION

6 Before the oil price collapse in July 2008, Russia was on a pace to import

USD 34 billion worth of cars for for the year. The average reported importvalue of the imports also rose: from under USD 10,000 per car in 2004 toover USD 16,000 in 2008.7 The import share of the Russia car market (measured by number of vehicles), which had risen from 6 percent in 1999 to 35 percent in 2004,climbed further to around 65 percent by mid-2008. By value, importsaccounted for 8 percent of the Russian market in 2000, 54 percent in 2004,and around 80 percent by mid-2008.




18. The third problem stemmed from the addictive nature of the Russianeconomy.8 In a rent-addicted economy, the resource boom filters intothe economy through production. Part of the rent was used to preservethe so-called dinosaur industries. In the recent boom, the rents allowedenterprises to expand production capacity without restructuring. But

their production is dependent on those rents. As the rents are thenwithdrawn from the system these enterprises find themselves insimilar conditions to those they faced in the early 1990s.

19. The following thought experiment suggests why addiction made thebubble and its subsequent collapse more problematic for Russia than amere consumption bubble would have been. Imagine an oil produceridentical to Russia without addiction. Instead, assume that all of theexcess income had been spent on imported consumption goods. Whenoil prices collapse, the consumption boom ends. But there are noknock-on effects from declines in railway car production, housing

construction, and other sectors fueled by the boom. In Russia’s rent-addicted economy, a large part of the windfall had been invested in theproduction sector — and much of that was for purchase of newequipment abroad. But the key thing is that rather than investing toreplace old obsolescent plants, investment merely added to totalcapacity.

20. As a result, the number of claimants on the rent increased. This madeit more difficult to implement policies to cope with the bubble bursting.

a. Adjustment in consumption is natural – just falls as income falls.

But in addicted production sectors the adjustment is notrestructuring, just shrinking of output but not structuraladjustment.

b. Another reason for less structural adjustment is the Roland Nashhypothesis. Inadequate institutions (in terms of marketefficiency) lead to banks rolling-over rather than claimingcollateral. This could be beneficial if the crisis is external and itprevents over-reaction. Good for short-run macro, bad for long-run productivity.

21.Depending on how skillfully the addicts were in claiming the rentduring the windfall, they will then be better positioned to “recover”after the collapse. That is because the adjustments they made duringthe boom give them an advantage to claim rents in the future. Thebest example of this in Russia is the railroad industry. We look again atthe relationship between railway car production and the oil price, now

8 [Gaddy & Ickes on addiction]




using monthly data to see the most recent resurgence in oil prices.Notice how the recovery in oil prices has generated a recovery inrailway car production as well. 9

i. Industrial production is still below y/y, but it is recoveringin time series. Year to year comparisons are misleading aswe approach the anniversary of the start of the crisis.

22.Notice that if the economy were not addicted and had just engaged inthe consumption boom, it could have avoided the creation of afinancial system dependent on foreign capital inflows. The systemwould have been less sensitive to a sudden stop of capital flows and

would now be in a better situation to cope with the crisis.

The Illusion of “Diversification”

23.While some argue that Russia's crisis is “home grown,” this argumentis rather absurd. If one considers how large a crisis Russia would havewith $120 barrel oil, the answer speaks for itself. Some then argue thatif indeed Russia’s crisis is due to collapsing oil prices, then Russiashould have been less dependent on oil and gas. Then it would haveexperienced less of a shock from the international financial crisis. Thisis not clear. Eastern European economies that are not oil exporters arealso suffering dramatically from the crisis. Ukraine (which one canthink of as Russia without oil and gas) and Hungary have alreadyreceived bailouts from the IMF. Russia avoided this fate thanks to the

9 [Yakunin interview. He admits that there is overcapacity in freight carsnow, but still the orders continue to flow to the plants. It is rent-sharing. TheRussian Railways are key.]




large dollar reserves it was able to build up precisely because it was alarge petroleum exporter.

24.Disregarding for a moment the experience of other economies, let ussuppose that Russia had undertaken a diversification program in 2000.

What is the likelihood that this would have resulted in success by thesummer of 2008? How could such a program of “diversification” havebeen financed if Russia had not focused on exporting oil? Moreover,one must think hard about the meaning of diversification. To havehelped, the performance of the “new” sectors developed in adiversification effort would have to had fluctuations uncorrelated withoil and gas. Sectors that are positively correlated would not lead to anydiversification. It is not clear what Russia could have diversified intothat would have dampened fluctuations. What we do know is that tothe extent that the Russian economy grew in the last eight years, it didso in sectors dependent on oil and gas revenues. The sectors that

supposedly signaled an economy that relied less on oil and gas —retail, construction, real estate, finance, consumer goods, andespecially, heavy manufacturing — turned out to be totally dependenton oil and gas income. Had Russia devoted more investment funds tomanufacturing or to greater expansion in capacity in the retail sector,it is likely that the shock to GDP from the world crisis would be evenlarger.

a. Energy and growth. China and India. Why would you diversifyaway from the big prize? Makes no sense whatsoever. Only if prices fell to $10 per barrel.

b. Volatility is not a problem, only level is. Volatility can be dealt

with by diversification, not of production, but financially and viainvestment in the oil sector.

i.Show chart on oil and gas producers [what is this?]

25. Therefore, the relevant question to ask as regards pre-crisis policy is:Given an unavoidable dependence on oil, how do you best manageyour oil and your revenue from oil? The accepted wisdom is: create apetroleum fund. Russia did just that. Some forty percent of grossexport revenues were channeled into its various petroleum funds.Moreover, the government acted properly with these funds. It did notinvest inside Russia. It put the funds it in foreign securities, because

the point of such a fund is to diversify risk. Had it instead used thefunds for domestic investment, Russia would be in an even moreserious position today: consider that every single non-oil sectoral indexin the benchmark Russian stock market , the RTS, fell more than the oiland gas sector index since the market’s mid-2008 peak. (The oil andgas index fell 68 percent, while the overall RTS index fell by 76 percentfrom peak to trough. The telecom and consumer goods indexes fell by




around 80 percent, and the manufacturing and financial sectors byover 90 percent.)

a. Add chart of RTS without oil and gas, though marketcapitalization would be tiny

b. Then look at Ukraine and Hungarian stock market. Couldsufficient diversification have happened to insulate Russia fromthe global crisis? Look at global stock markets. The US stockmarket fell 50% — far less than the Russian stock market — butit had not grown as fast as Russian market did prior to the crisis.Moreover, the Russian market has rebounded much faster.

[add EURO350 and GLOBAL1200 to this]

c. The depth of the Russian market crash was indeed dramatic. Butit is easy to focus only on the downside. One needs also toremember how much Russia gained during the boom: retail salesdid grow, consumption rose, and reserves rose.

26. To sum up, the crisis in Russia is all about the oil. Russia hasexperienced a large fall in asset prices because it had the largestappreciation prior to the bubble. As oil prices fell this caused Russianasset prices to fall dramatically. At the same time, the international

financial crisis led to a net outflow of capital and increased thedifficulty of servicing dollar-denominated debt. This problem iscommon in many emerging markets. The difference in Russia is thatthis is accompanied by the direct impact of lower oil prices and thusexport revenues.

RESPONSE TO THE CRISIS




27.By all indications, Putin has chosen not to prioritize using the reservesfor a social safety net for Russian households. Rather, he appears to becounting on Russians to turn to traditional self-defense mechanisms fordealing with internal crises. Experience with the so-called virtualeconomy of the 1990s suggests that Russians have coping

mechanisms. These include not just barter and other arrangements butgrowing food on private plots.

28.Exchange rate policy has been the most notable means of support forhouseholds and companies. Again, the apparent intent was to letpeople fend for themselves, but giving them time to adjust to theshock through gradual devaluation. In the period from early Octoberthrough mid-December Russia spent around $100 billion of its foreignexchange reserves to keep the ruble’s value up as the oil priceplummeted.10

29.More important, is the fact that using Russia’s vast foreign exchangereserves to support the ruble allowed Putin to provide protection forkey oligarchs — a key element of his system. As Putin considersprivate ownership to be critical for efficient management, he does notwant them to fail. Nationalization is not a preferred option for Putin.

Protection in this environment ties them even closer to him.

a. Putin needs oligarchs now to step up and shoulder burden.Pikalyovo.

10 Between October 3 and December 19 the oil price fell by 64 percent, while the ruble lostonly 6 percent against the dollar.




b. Put Putin quote here.11 Less than in US stimulus package. Putin ismore resolved than ever to stick to his fundamentals. And tocoping with addiction.

c. No evidence yet that he wants to abandon system. Rather hewants to put more pressure on oligarchs to perform as intended.

Keep to the deal, they have to pull their weight.d. Putin is asking himself now is whether they acted correctly in the

crisis – not hard to look good in the boom, but were there actionsin the boom robust to crisis which is what concerns him.

THINKING ABOUT THE FUTURE

30.[The future is about (1) priorities; (2) the Model; (3) the means.]

The Priorities

31.Putin’s priorities are stability and sovereignty. Stability has come fromcurrency intervention. Oligarchs sharing rents. Incomes bettersupported now than in 1998, thanks to strong state – no governmentwage arrears. In private sector. Jobs are main concern.

32. Sovereignty is about foreign economic policy. The debt-reserves issuewas key.

33. The idea that this crisis will cause Russia to turn back towards thesituation of the 1990s — dependence on western finance and advice,and submissive in its international behavior – is wrong.12 There is a

11 Speaking to members of Russia’s Chamber of Commerce and Industry on May 27, 2009,

Putin said:

“We often hear variations on the theme of import substitution. I would like to reiteratemy opinion on this matter. I do not believe import substitution is an end in itself. And ingeneral, when we speak of import substitution, we tend to say that in this or that plantwe produce goods of no worse quality than one or the other of our competitors. That’s afaulty approach to addressing the issue of innovative development. What does "of noworse quality" mean? We must manufacture our better and cheaper goods, or not manufacture them at all. Maybe it’s easier to buy them from abroad?

“I understand full well that when we are speaking of the country's defense capabilitiesand about areas of state activity that must be developed for the sake of nationalsurvival, then we do have to produce those goods domestically, even if it is moreexpensive. ... But if we are speaking in general about the economy then there is noreason to engage in import substitution if we can buy things more cheaply abroad.Because if we always just try to play catch up, we will always be behind.”

12 The experience of this crisis makes this less likely than ever. The rapidlyintensifying crisis in Eastern European economies only reinforces his conviction thathis way was correct. Where he might have trusted western economic expertisebefore the crisis (though never western intentions) he is less likely to trust it now.




misconception in the international community about Russia’sresurgence. Missing quadrant argument.

a. Oil prices have not fallen back that farb. Putin tries to change the nature of the game, though reserves

etc., to avoid going back. The missing quadrant argument is

mechanical; it ignores behavioral responses such as Putin’sactions to avert the threatened outcome.

34. The issue for Russia’s international behavior is not overall economichealth but primarily the issue of financial independence (sovereignty).Putin will defend this at all costs. Having built up international reservesof over $600 billion Putin was better able to cope with the financialcrisis than would otherwise have been the case. He thus views thecrisis as validation of his model.

The Model

35.[Two elements: (1) Rent-sharing; (2) Protection Racket]

36.[Will he try to control addiction?]

37.Putin will continue his model of private ownership of key strategicresources but under his firm control.13 This will continue his policy of balancing the two imperatives of strengthening the State andenhancing economic efficiency. The essential point of his model is thatPutin will make this choice.

a. The crisis has called into question, for Putin, the notion thatthese guys are really efficient. Banking crisis and Deripaska messcould suggest otherwise.

The Means

38.Any forecast for Russia’s economic future depends on the flow of rentsfrom oil and gas. For analysis, it is crucial not to get distracted by otherissues. Key is oil and gas, investment in oil and gas, and rentdistribution from oil and gas. Other issues are ephemeral.

39.[Rent is product of (1) Price; and (2) Quantity]

40.The Oil Price. In the short term the volume of rents available toRussia is almost entirely a question of the oil price.14 Only a view of thelong historical perspective shows how anomalous the recent price

13 The mechanism is Putin’s protection racket. Putin provides insurance againstexpropriation in exchange for submission to his directions.14 See, for example, http://www.wtrg.com/prices.htm




spike was. [See Figure] From 1947 thru May 2008 the median worldprice of oil was $19.04 in 2007 dollars, and the mean world price wasapproximately $27. The growth in oil prices by 2006-7 already reachedlevels only seen in oil spikes previously caused by wars. The maximumprice of $147 per barrel was almost double the price reached during

the Iran-Iraq war, the previous maximum price observed.

[I’ll add 2009 to this – around $62.]

41.Let us suppose that we are in a new price regime. This seems to bethe consensus forecast from agencies like the EIA or IEA. What doesthis imply about the political economy of Russian resource

dependence? Russia owns the world. Huge SWF’s from resourceproducing countries. Huge transfers of wealth from industrializedcountries.




a. Under this scenario, the folly of Russian diversification away fromoil and gas is self-evident. It is also clear that in this scenarioPutin’s Protection Racket System would remain very robust.

i. It will be more vital for him to maintain it, and it will beeasier to sustain because of the wealth transfer.

b. Is this really a robust forecast for the global economy? Can theglobal economy adjust to such a rapid reversal of fortune? Whilethese seem to be consensus forecasts for oil prices, theconsequences they imply for the distribution of world wealthmakes us skeptical about the robustness of this scenario.

i. The necessary adjustments in exchange rates, trade flows,and patterns of capital flows make us skeptical.

42.Investment in Future Oil. In the medium term, the key issue for

maintenance of the rent flow is the quantity of oil and gas produced. This requires investment in new reserves, primarily located in EasternSiberia. Development of these new reserves raises a whole new costdimension. The eastern oil is in regions that are colder, more remote,and geologically more complex. It also introduces a significantadditional risk dimension. Obtaining the new reserves requires large,non-discrete investments, something that exposes Russia to a hugerisk if prices return to low levels. Russia needs to share this risk toavoid being hostage to persistent low oil prices. This point is central tothinking about Russia’s future relationship with the global economy.

a. This is a problem because of the uncertainty about future oil

prices. Investments are irreversible so price shocks can becostly. Primarily because of fear of a return to a low oil price.

b. The supposed fear of volatility (e.g., Sechin) is really fear of areturn to a low price regime, which is the historic pattern. Thelast six years of oil prices have been historically anomalous. Thekey question for Russia, and others, is whether we have in factentered a new price regime, or will prices return to the historicalnorm?

i.Price pictures here

43. The big problem is that Russia cannot control oil prices and mustanticipate various scenarios for how long prices will be low. Because itcannot control prices it has to worry about the level. Volatility is anadditional issue. Volatility can be addressed through diversification of income risk.

44.What happens, on the other hand, if oil prices return to the historicpattern? This makes it much more costly to expand to Eastern Siberia.




If they cannot diversify this risk they will not be able to sustain currentlevels of production.

a. There are two possible futures with low Russian investment andfuture production

i.Russian output falls, but demand and supply are such that

prices remain in the historical price regime. This means lowfuture Russian resource rents. This is the worst future forRussia.

ii.Russian output falls, the world energy balance suffersbecause of no other demand or supply shifts, and the EIAscenario becomes true. This is obviously less problematic.

b. Consider the following payoff matrix. There are two pricescenarios (low = LP, high = HP) and two possible futureproduction levels for Russia (LO, HO).

LP HP

LO Bad for RussiaGood or bad for World

Good for RussiaBad for World

HO Bad for RussiaGreat for World

Russia Rules the WorldBad for the World

Figure 11: Payoffs with no Diversification

c. The important point of the payoffs in figure 11 is that with nodiversification the interests of Russia and the “World” differ. Thestates where Russia is better off are those where the “World” isworse off and vice versa. When there is no diversificationinterests diverge.

d. Now compare this to the payoffs in figure 12 when the risk of investing in high output is shared between Russia and the rest of the world. Obviously this case is only relevant in the high output

cases. In the diversification case the risk of price volatility isshared between Russia and the “World.” Therefore, there is aconvergence of interests.

e. One might argue that one can achieve the same outcome withinvestment in claims against incomes, rather than in oil output. Thus, the “World” could buy securities that pay off in the state(HO,HP) and sell securities that pay off in the state (HO, LP).




Russia would be on the other side of the transaction, and riskscould thus be hedged financially. Financial diversification may bean alternative means of achieving a convergence of interests.

LP HP

HO Shared Low Gains forRussia and West

Shared High Gains forRussia and West

Figure 12: Payoffs with Diversification

1. Russia will remain part of the global economy because of itsdependence on oil and gas and its role as an exporter. Attempts todiversify into other sectors is not a practical solution in this situation. Itis how Russia chooses to share the risks involved in future oildevelopment, and the opportunities that the outside world provides forsuch risk sharing, that will determine the nature of Russia’s relationwith the global economy.

2. If the relationship between Russia and the West remains only that of seller to buyer, then integration will be minimal, Russia will bear all therisk of reserve expansion, and it will consequently be less likely toexpand reserves. Global energy security will be weakened. Russia willhave little incentive for cooperative behavior in general.

3. A positive development would involve sharing the risk with western oilcompanies. At the same time, Russia would be able to diversify itsincome risk by investing in global assets (e.g., Sovereign Wealth Fund).Such an outcome would tie Russia’s interests more closely with theglobal economy. This would lead to more reserve expansion and futurerents, enhance global energy security, and provide an incentive forRussia to cooperate more fully with the global economy.

4. Missing Quadrant.

5. The idea that Russia will become compliant now that oil prices havefallen significantly misinterprets Putin’s system. Russia was compliantin the 1990’s when oil prices were low and Russia was weak. Putin builtup reserves and paid off the foreign debt when oil prices increased. This was a strategy to gain independence of action. For Putin theoptimal level of reserves is higher than it would be for a normalcountry with access to international capital markets. The latter woulduse this access as insurance, borrowing in bad times and saving in




good states. For Putin, however, the optimal level of reserves is higherbecause he will not forego the independence that high reserves bringhim.

6. But this does not mean that low oil prices reverse behavior. First, oil

prices are not all that low. They have only returned to the 2004 level,and in that period Putin was already paying off all external debt.Second, during the boom years Putin built up reserves. He ismaintaining them at a still high level even after bailing out manyoligarchs.

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Russia After the Financial Crisis 04Nov09