Russia Fails to Diversify Economy Away from Energy

Vladimir Putin talks of economic reform but his government continues to lean heavily on oil.

Gazprom managing chairman Alexei Miller speaks with Russian prime minister Dmitri Medvedev in Moscow, June 2012
Gazprom managing chairman Alexei Miller speaks with Russian prime minister Dmitri Medvedev in Moscow, June 2012 (Gazprom)

President Vladimir Putin and his deputy Dmitri Medvedev have talked for years about the need to reduce the Russia’s dependence on oil and natural gas exports but progress in this area is lacking. Indeed, they have recently taken steps that run contrary to their stated goal.

Despite the economic reforms that were enacted during Putin’s first eight years in the Kremlin, including dramatic income tax cuts, sound fiscal consolidation and education and infrastructure investments which helped fuel economic expansion, corruption and entrenched interests block further growth. The state maintains a heavy hand in key industries, most recently evidenced by Putin’s intervention in a dispute between the European Commission and Russian energy giant Gazprom when he shielded the latter from an antitrust probe.

The Kremlin is a majority shareholder in Gazprom which alone accounts for 12 percent of Russian exports. The company still reported a $44 billion profit last year but exports are falling and domestic gas production in Europe is on the rise. Economy minister Andrei Klepach has warned that Gazprom could find itself under pressure from shale gas competition as early as 2014.

Nevertheless, at the government’s behest, the company continues to pursue hugely overpriced projects for political ends that are unlikely ever to pay for themselves. According to The Washington Post, “Gazprom executives have been very slow to recognize the competition. Their company is large and sprawling and, with a seemingly eternal income stream, had no need to be innovative or especially adept at what it did.”

The recent sale by oil company BP of its 50 percent stake in TNK-BP to Russia’s state-owned Rosneft seems to follow a similar trend. Putin was even publicly squeamish about the deal which will make Rosneft responsible for nearly half of Russia’s oil production. “Both the government and I had mixed feelings when the idea of this project appeared,” he said. “This is not in line with our trend to reduce the growth of the state sector.”

Prime Minister Medvedev echoed the president’s concerns in an interview with French media this week, saying, “We don’t need a state-owned economy. We don’t need the majority of companies to be state owned.” He described the TNK-BP deal as “exceptional” and said that while “Rosneft is a state-owned company, this doesn’t mean that this will last forever.”

“However,” he added, “the state has the right to maintain its presence in key and important sectors, including the nuclear power industry and the defense sector.”

In the same interview, Medvedev, who switched places with Putin to become prime minister again in May, admitted that his government had “failed to achieve any real progress” in diversifying the Russian economy. “We rely too much on hydrocarbons, on crude oil and natural gas,” he said before arguing that advances were being made in aerospace technology, bioengineering, pharmaceuticals and nuclear power. “We consider these directions to be quite promising and we have positive experience in these areas from the past.”

For now, taxes and income from fossil fuels still provide up to 60 percent of state revenue and, writes Robert A. Manning in The National Interest, the TNK-BP deal will only “reinforce Russia as a petrostate” while discouraging reformers.

The problem is that moving in the direction of more economic modernization and less tight political control would likely put Putin’s power network at risk. Instead, as financial pressures from slow oil demand growth limit Moscow’s ability to deliver the goods to the Russian middle class, Putin appears to be keeping his focus on tight political control of the middle class and keeping oil at the center of Russia’s economy.

That may preserve political stability, Putin’s paramount concern, but, writes Manning, “it is difficult to see how Russia can become a globally competitive modern economy without a concerted effort to move toward a modern diversified knowledge economy, a more credible judiciary confronting corruption and political reform.”

It is also difficult to see how it will keep the Russian middle class satisfied in the long term. Even if there is no credible political opposition at present, a liberal candidate could well pose a challenge to Putin if he runs for reelection in 2018 unless significant improvement is made in the meantime.