RUSSIA - Hey Big Spender

Russia’s overwhelming presidential favorite, Dmitry Medvedev, promises to ramp up spending to meet the country’s social and physical needs. But his plans pose a threat to economic stability.

When Vladimir Putin ascended to the Russian presidency at the end of 1999, the country was struggling to get off its knees after a decade of post-communist chaos. The government had defaulted on its debt just a year before, triggering a deep recession, and was still drawing standby loans from the International Monetary Fund. Russian troops were mired in a brutal and seemingly endless conflict in Chechnya. Putin, an austere martial arts master and former KGB spy, exhorted Russians to sacrifice in the name of restoring national dignity.

Today, as Putin prepares to hand the presidency to his protégé, Dmitry Medvedev, the overwhelming favorite in the March 2 presidential election, Russia stands transformed. An oil-fueled boom has raised economic output by more than two thirds over the past eight years, boosting per capita income to more than $8,000 on a purchasing power parity basis — ahead of Turkey and Brazil and poised to overtake Poland. The once-bankrupt Treasury now controls some $450 billion worth of foreign exchange reserves, the third-largest pool in the world behind those of China and Japan. And far from preaching austerity, Medvedev, a 42-year-old English-speaking lawyer and first deputy prime minister, is promising to spend freely to modernize the country’s roads, schools and housing.

“Our position is that a free, educated, healthy person is the most important factor determining a country’s development and future,” Medvedev said at a December cabinet meeting on the four so-called national projects — in education, health care, housing and agriculture — that he has overseen since they were established in 2005.

Russia has been starved of investment since the 1980s, and increased spending — managed correctly — could upgrade the country’s dilapidated infrastructure and generate new sources of sustainable demand. Modernizing the aging electricity-generating network should give a boost to the engineering and equipment industry, for example, and a burst of housing construction should spur employment and the building materials sector. “An appropriate model for us may be Australia in the 1950s and ’60s,” says Evgeny Gavrilenkov, chief economist at Moscow investment bank Troika Dialog. “Raw materials exports got the country moving, then it developed its own long-term momentum.”

But in spending today’s riches, Medvedev risks destabilizing the economy with an inflationary surge and ignoring a host of reforms that are vital to long-term prosperity. Inflation rose to 11.9 percent in 2007, from 9 percent in 2006, reversing an eight-year downward trend; producer prices jumped 17 percent last year, according to the World Bank. The Kremlin was sufficiently worried about food costs to lean on wholesalers and retailers to adopt a voluntary price freeze on essential items in October, a measure that was extended last month until May.

“Inflation is problem No. 1,” Finance Minister Alexei Kudrin told Russian and foreign investors at a Moscow conference in December. “In the fight against inflation, we lost 2007.”

International investors are counting on Kudrin to keep the economy from overheating and defend the cause of economic liberalism in the Kremlin. But the Finance chief, who has tried to hold the line on spending by preserving some of Russia’s windfall oil gains in a stabilization fund, increasingly finds himself on the defensive. His deputy, Sergei Storchak, was arrested in November for allegedly conspiring to embezzle $43 million, a charge most Kremlin watchers considered to be largely political. And in December, acting Prime Minister Viktor Zubkov publicly upbraided Kudrin at a cabinet meeting, claiming that 1 billion rubles ($41 million) in aid bound for earthquake relief on Sakhalin Island had been “lost.” The Finance Ministry insisted that the funds had been requested by local government but not appropriated.

“If Kudrin goes, all these new government expenditures may just wind up buying villas in Monte Carlo,” one development bank official in Moscow says privately. Medvedev hasn’t commented on these controversies.

Russia is also losing ground in efforts to build a competitive business environment. Oil wealth has enabled Putin to reassert the state’s authority over wide swaths of the economy and created powerful national champions like oil and gas giant Gazprom and Rusal, the world’s largest aluminum producer, which is run by Putin ally Oleg Deripaska. But the climate for fostering new businesses has deteriorated. In Transparency International’s corruption perceptions index, Russia ranks a lowly 143rd out of 179 nations — tied with Indonesia and just behind Syria and Pakistan. When Putin came to power in 2000, the country was 82nd. Russia comes in 106 out of 178 countries in the World Bank’s ease of doing business index. China, by contrast, ranks 72nd and 83rd, respectively, in the two indexes.

Red tape and rent-seeking attitudes stifle innovation and competition across the economy, entrepreneurs complain. “I am trying to start a low-cost airline, but all the existing airlines have local monopolies defended by local authorities,” Alexander Lebedev, billionaire chairman of Moscow-based conglomerate National Reserve Corp. and until last December a Duma deputy from the populist A Just Russia party, which supports Medvedev, tells Institutional Investor.

The Kremlin’s tough stance toward foreign investors poses an added risk to Medvedev’s planned spending spree. The government wants to spend $1 trillion on everything from new roads and airports to a modern Alpine resort complex at Sochi for the 2014 Olympic Winter Games. It will need the private sector to finance half of that massive program, says Evgeny Trusov, a partner in Ernst & Young’s Moscow office. But multinationals have recently seen Putin’s government tear up multibillion-dollar energy agreements reached in the 1990s with giants like Royal Dutch/Shell Group and BP, leaving them wary of committing to expensive new projects that take decades to pay off. “I would describe companies’ attitudes as very cautious,” says Andrew Somers, president of the American Chamber of Commerce in Moscow.

Medvedev arrives at this crossroads as a thoroughly untested leader, but a leader nonetheless. He spent 17 years as a Putin aide and has pledged fealty to “Putin’s plan,” the purposefully vague rallying cry of the dominant United Russia party, which is backing him. “What we need is simply decades of stable development,” Medvedev said in a speech last month. “Decades of normal life and constructive work.”

Medvedev’s first act as successor-designate was to invite Putin to stay on as his prime minister, an offer that was accepted. But Russian analysts caution against viewing Medvedev as a puppet. The country’s constitution and tradition lodge all real power with the head of state, including the right to fire the premier and government at will. Sooner or later, observers say, Medvedev will grasp this power and Putin will fade. Ideally, the former president will stay in place long enough to leash the siloviki — ex-KGB cronies Putin elevated to senior positions, like deputy chief of presidential staff Igor Sechin — while Medvedev consolidates control. “The Russian way is that the president has all the levers of power and all the glory, while the prime minister is a scapegoat,” says Yuri Korgonyuk, an analyst at Indem Foundation, a Moscow think tank. “Putin will go well or go badly, but he will go.”

As a consequence, Kremlin watchers are poring all the more intently over Medvedev’s sparse public record. After earning a Ph.D. in law from Leningrad State University (now Saint-Petersburg State University) in 1990, he spent the next decade as a lecturer there and as a part-time legal adviser to the St. Petersburg city government’s committee for external relations, which was chaired by Putin. After Boris Yeltsin resigned the presidency in favor of Putin on New Year’s Eve, 1999, Putin called Medvedev to Moscow to serve as his deputy chief of staff, then promoted him to chief in 2003. In November 2005, Putin made Medvedev his first deputy prime minister in charge of the four national projects, but they have received too little funding to judge Medvedev’s management skills. “Except for banalities like the fact he was only 24 when Communism ended, there is not much to say about Medvedev,” says Roland Nash, chief of research at Renaissance Capital in Moscow.

The candidate is closely associated with one of Putin’s biggest legacies: Russia’s new brand of state capitalism. Putin decried the excesses of the oligarch years and brought so-called strategic sectors of the economy under the Kremlin’s thumb, most notably by dismantling the former Yukos Oil Co. and prosecuting its boss, Mikhail Khodorkovsky, for fraud and tax evasion in 2004. The government has bullied two of the world’s leading oil companies over the past 18 months, forcing Shell to yield control of a $20 billion project on Sakhalin Island and BP to sell for a cut-rate price of less than $1 billion the majority stake that its Russian joint venture, TNK-BP Holding, owned in a giant East Siberian gas field. The beneficiary in both cases was Gazprom, whose chairman, installed in 2000 by Putin, is none other than Medvedev.

State capitalism has proved successful so far, thanks in large part to abundant oil revenues. Inflation-adjusted economic output has risen by 70 percent since 1999, and household disposable income has doubled, according to the World Bank. Little wonder, then, that Putin is preparing to leave the presidency with an 87 percent approval rating, according to Moscow-based independent pollster Levada Center. That makes Medvedev a virtual shoo-in for election in March.

Putin got a big helping hand from oil prices, which have risen from about $25 a barrel when he took office to more than $90 today. But oil is not the only reason for Russia’s economic improvement. During Putin’s reign, the government slashed personal income taxes by adopting a flat 13 percent rate in 2001, a bold step that persuaded millions of Russians to legalize their earnings. A new deposit insurance system introduced in 2005, coupled with economic stability, encouraged consumers to take savings out from under their mattresses. Bank deposits climbed by 150 percent over the past three years, to more than 11 trillion rubles, according to the Bank of Russia. Banks in turn have ramped up lending, driving a consumer and property boom. Output from Russia’s mineral extraction sector inched up 2.2 percent last year, according to the World Bank, while retail trade jumped by 14.8 percent and construction by 23.5 percent.

The gains of the past eight years are readily apparent. Putin inherited a society that seemed to be dividing between bandits and beggars, and leaves Medvedev with a growing middle class attached to the values of education and asset accumulation. “What’s changing about this country is that people are getting mortgages to buy apartments, and then they have to work hard to pay the mortgage,” says Ruben Vardanian, the chief executive of Troika Dialog.

What Putin failed to do, however, was nurture new internationally competitive industries. Fully 85 percent of Russia’s exports are raw or primary materials: oil and gas, metals, chemicals and fertilizers. The petroruble windfall is pouring into foreign producers’ pockets. The country’s current account surplus plunged last year to 5 percent of GDP, from 10 percent in 2006, and Kudrin projects it will disappear entirely by 2010.

The macroeconomic bright spot for Russia is investment, which expanded by 21 percent in 2007, compared with 12 percent in 2006, and now represents about 20 percent of GDP. Although the investment rate is less than half that of China, the acceleration has fueled hopes that Russia will use its resource bounty to generate sources of sustainable growth.

Foreign capital has also been pouring back into Russia, mostly as loans to local banks and big state companies. The capital account, perennially in deficit until 2006, ran an $82.3 billion surplus last year, according to the central bank.

The Kremlin aims to keep the investment boom alive by spending more of its own resources, notwithstanding Kudrin’s efforts to keep the fiscal brakes applied. The most visible battleground has been the Stabilization Fund, established in 2004 to bank excess oil revenues under the Finance Ministry’s management. It has since accumulated more than $150 billion, invested by Kudrin in sovereign dollar- and euro-denominated bonds. But a law passed by the Duma last year and taking effect February 1 caps the fund at 10 percent of GDP, or about $125 billion, based on 2007 figures. The rest will be diverted to the new National Welfare Fund.

Kudrin and his lieutenants insist that the welfare fund will also serve as a conservative, rainy-day vehicle. “The fund will be invested in sovereign bonds with a rating not lower than double-A in 2008,” Dmitry Pankin, head of the Finance Ministry’s debt department, told reporters in December. But Putin himself, in his state of the nation speech last year, recommended tapping the fund for capital investments from housing to scientific research. “It is inadmissible for a country with such reserves accumulated from its oil and gas revenues to be at peace with the fact that millions of its citizens live in slums,” the president said.

The result was a $22 billion supplementary budget package that combined regular revenue with a one-time $11.7 billion raid on the Stabilization Fund. About $8 billion of the additional spending went to capitalize the state-owned Bank for Development and Foreign Economic Affairs, a revival of the Soviet-era Vnesheconombank, which is designed to finance infrastructure projects. Another $5 billion was earmarked for a new state-owned company, Russian Nanotechnology Corp.

Government spending jumped by 38 percent last year, raising it from 14.8 percent of GDP to 17.5 percent. This year’s target is 18.8 percent of GDP. Candidate Medvedev has already pledged big increases in social spending, starting with a 50 percent hike in the allocations for his four national projects, to a total of 300 billion rubles next year. And in December at the United Russia convention, where he formally nominated Medvedev, Putin announced that the government would double a planned pension increase, to 14 percent, and bring it into effect in February, seven months ahead of schedule.

Still, Kremlin planners talk of budgetary spending as a catalyst, not a substitute, for private investment. Faced with turmoil in Western markets, “investors will turn to Russia from the U.S. and Europe,” Arkady Dvorkovich, an economist who heads Putin’s Presidential Experts Directorate, told the Moscow investment conference in December.

Many foreign companies are eager for a piece of the action, seeing Russia’s investment needs as a big opportunity. “It’s hard to run a modern economy when you don’t have a consistently good road between Moscow and St. Petersburg, and the safe speed limit for trains is 50 kilometers an hour,” says Michael Rodzianko, head of business development in the new Moscow office of URS Corp., a San Francisco–based construction services company.

The term du jour in Moscow business circles is public-private partnerships, or PPPs. Russia is using St. Petersburg as a venue for several closely watched projects currently out for international tender, including a 28 billion ruble ring road and a 9 billion ruble tunnel under the Neva River. “If I had one wish for this country, it would be having PPP go forward,” says Maarten van den Belt, chairman of the Russian subsidiary of Germany’s WestLB. “If they get it right, government funds could be leveraged in a remarkable way.”

But the obstacles to getting it right are formidable. First there is inflation. Investment champions like China and Vietnam stave off rising prices with an all but limitless pool of low-wage workers, explains Klaus Rohland, the World Bank’s country director for Russia. In Russia average earnings have doubled since 2002, to almost $500 a month, and employees are pushing for more. Unions at Ford Motor Co.’s St. Petersburg plant staged the first serious strike of the post-Soviet era in November, keeping 2,000 workers off the job for four weeks. (It ended inconclusively, with a mutual promise to negotiate further.) “Russians ask me why they can’t spend 10 percent of GDP on infrastructure, like China, instead of 5 percent, like they do now,” Rohland says. “They can’t because they have no abundance of labor.”

Business executives also face mounting supply bottlenecks that are driving up prices. The cost of drilling an oil well, for instance, has climbed from $500,000 to $4 million over the past two years, says Michael Calvey, co-managing partner of Moscow-based private equity firm Baring Vostok Capital Partners, whose investments include petroleum prospector Volga Gas Co. The price of building materials in Russia rose an average of 28 percent last year, according to Krakow, Poland–based research firm PMR. “What keeps me awake at night is inflation driven by capacity constraints of our suppliers,” says Lee Timmins, Moscow-based partner of international real estate developer Hines Interests, which has invested more than $2 billion in Russian construction.

More fundamentally, the government’s extending of its tentacles throughout the economy threatens to stifle initiative. The state has expanded its influence far beyond energy, taking control of Russia’s top titanium producer, Vsmpo-Avisma Corp., and electric-generator builder Power Machines Co. Multibillion-dollar share issues last year by state-owned Sberbank and VTB Bank bolstered their position as the country’s top two lenders.

The Kremlin is also increasingly seen as puppet master to private business oligarchs. In the past six months, Rusal’s Deripaska has taken control of oil producer RussNeft, whose former owner, Mikhail Gutseriev, fled Russia after being charged with illegal entrepreneurship and tax evasion; Deripaska has also acquired 25 percent of metals giant Norilsk Nickel.

Russia did create one successful model for reform and investment during the post-Yukos years: the overhaul of Unified Energy System of Russia. Chief executive Anatoly Chubais, the 1990s privatization czar who took over UES after falling from political grace in 1998, broke up the power monopoly’s non-nuclear business into 21 regional utilities, all marked for privatization. The state retained the national power grid and all nuclear generating facilities.

Last year the new entities attracted multibillion-dollar investments from oligarchs including Vladimir Potanin, a partner in Norilsk who also controls Rosbank; TNK-BP partner Viktor Vekselberg; and Lukoil president Vagit Alekperov; as well as multinationals such as Germany’s E.ON and Italy’s Enel; plus $1.5 billion more from two IPOs.

Medvedev and Putin have plenty of opportunity to follow UES’s example in other industries. Legal groundwork was laid long ago for privatizing fixed-line telephone company Svyazinvest, and Communications Minister Leonid Reiman has organized the sector into nine regional “baby Svyazes.” Russian Railways, Europe’s only profitable state railroad, under the leadership of longtime Putin friend Vladimir Yakunin, plans to spin off bits of its freight operation and take them public. No. 2 bank VTB already sold 22.5 percent of itself in an $8 billion share offering last May and will be fully privatized eventually, Gennady Melikyan, first deputy chairman at the Bank of Russia, tells II.

Novorossiysk Commercial Sea Port, which runs the Black Sea Port — the country’s busiest — raised $980 million in November by floating 20 percent of its shares in London.

Medvedev could nurture these promising economic shoots over the next four years without relaxing the Kremlin’s cherished monopoly on political power or betraying “Putin’s plan.”

But momentum is going in the opposite direction now, toward overweening state structures and an all-too-visible hand that is alternately in the pocket and on the neck of private business. “If Russia doesn’t improve infrastructure dramatically, growth will slow,” RenCap’s Nash says. “But improvements will take good government management, something Russia is not exactly famous for.”

President Medvedev could exert leadership to beat back the smothering late-Putin state, even though he has thrived within it. With his humanistic tone and legal background, Medvedev stirs hope compared with rivals, like fellow vice premier Sergei Ivanov, whose world view was forged in the Soviet military or KGB. “Medvedev was the best choice available,” says Troika’s Gavrilenkov. “Putin honored his debt to the country by choosing someone from outside the security services.”

But the best of Putin’s inner circle will not be good enough unless he can embark on a fresh wave of economic reforms. Today’s high oil prices will buy Medvedev time. Russians can only hope he has the vision and strength to use it to build long-term prosperity.