Russia's Jerry-Rigged Oil Pump

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We read with interest the Oct. 22 comment, "Russia's Top Economist Needs to Face Reality," by Anders Aslund in this newspaper. While it is gratifying to see that Aslund emphasized the price of oil as the predominant factor in the Russian economy -- an argument we have made for a long time -- we would offer a different interpretation of recent events and their impact on Russia's economy right now.

The price of oil has been the main driver of economic events in Russia since the 1970s. While oil prices have recently declined precipitously, it is too soon to tell whether this is a temporary response to the global financial crisis or a more persistent change. Until only recently, investors were expecting $200 per barrel oil prices. This means that we do have to see what happens with the world oil price before jumping to conclusions about impending economic collapse in Russia. It also means that prices have been low for too short a period to have a serious impact on the real economy -- something that Aslund argued has already taken place.

Aslund asserts, for example, that Russia's gross domestic product is no longer growing. He cites a report that GDP growth "slowed to 0.4 percent" in September and claims that this means that his own prediction of zero growth of GDP for next year "has already been achieved." But this figure of 0.4 percent growth is on the month -- that is, September as compared to August of this year. September's performance means that the economy is still growing at a 5 percent annual rate. Surely, the growth rate has been falling, but it still has a way to go before reaching zero.

Some of the other signs of economic slowdown he offers also appear exaggerated. The rate of growth of capital investment, he writes, "has declined to 8 percent from 24 percent over the same month a year ago in September." In fact, the State Statistics Service reports that capital investment grew by 11.8 percent in September as compared to September 2007. While this is somewhat down from the year-on-year growth in September 2007, which was 13.7 percent, it is still higher than in the three preceding months of this year -- 7.9 percent in August, 9.9 percent in July and 10.8 percent in June. And retail sales, which Aslund writes "have been hit," were as strong in September as in the preceding six months -- growing at an annual rate of over 14 percent. Perhaps Russia's economy is in for a major slowdown, but there is as yet little evidence of this in the data.

We do, however, agree completely with the premise that if the flow of oil wealth into Russia contracts, there will be a slowdown. So what has happened with Russia's oil? Aslund correctly notes that the physical volume of crude oil exports fell by 5.9 percent in the first eight months of 2008. But it is important to note that roughly half of that decline is explained by the country's recent effort to process more of its own oil and export the refined products instead of crude. Moreover, if we look at revenues, which is what matters from the point of view of aggregate economic activity, we find that combined earnings from both categories of oil exports -- crude and products -- are up 64 percent for the first three quarters of this year compared to the same period last year. Again, a persistently low oil price will reduce that growth, but there is one important fact to keep in mind: Even if, beginning tomorrow, oil prices were to drop to $50 a barrel for the rest of 2008, the average price for the year would still be close to $100. That means that 2008 oil export revenues would be more than 30 percent higher than 2007. It will take a persistently lower oil price -- or a further fall in volumes -- for oil export revenues to fall in 2009. It could happen, but given recent data it is hard to make that forecast just yet.

This is not to say that the economy is set for smooth sailing. Presently, the country is facing a much more immediate threat, one resulting from the global financial meltdown. Russia has relied almost entirely on the global system to intermediate the financial flows from its oil and gas export earnings into its corporate sector. It worked like this. The corporate sector was at the end of a chain generated by the oil bubble. Russia exported oil to the West. Western consumers paid Russian exporters for the oil at prices that produced a windfall for the Russian government, which collected the windfall from the exporters. The government lent those dollars to Western governments and with those Russian holdings of Western debt as collateral, Western banks lent the funds to Russian banks and corporations, including oil exporters.

The reason why Russia chose to do things in this seemingly curious way is important. Realizing that its own system was not reliable in allocating capital, Moscow understood that the U.S. channel was a lower-risk way to invest the surplus and to invest in Russia. Russia was in effect paying the West to provide a service -- financial intermediation using market principles rather than connections and corrupt practices -- that it could not obtain at home. China has made the same choice. While it might seem regrettable, in view of the monumental mistakes committed by the Western financial institutions, the Kremlin had little choice but to follow this strategy.

With a frozen global system and no Western financial intermediation to roll over old corporate debts, Russia is itself in an acute crisis without any way out on its own. Think of the extra cash that was being transferred from Western consumers to Russia as a steady flow of air feeding into a pump -- the Western financial system. The pump sent the air back into the Russian corporate sector. What now has happened is a double whammy for those end recipients of the flow. First, the steady flow of fresh air into the pump has stopped as a result of the collapse of oil prices. Second, the pump has broken down as a result of the paralysis in the global financial system.

It is the second problem -- the broken pump -- that is Russia's real problem today. After all, although the flow of air has stopped, there still is a big reserve tank -- foreign exchange reserves and the stabilization fund -- that could continue to feed the pump. But there is no backup pump at home. The only thing Russia has is an old jerry-rigged, incredibly leaky Soviet model that doesn't work either. The Kremlin has no choice but to use its own pump, but the more it does, the more of its reserve air just leaks away.

The necessity to recycle its huge oil windfall has made Russia heavily dependent on a functioning global financial system. Its dilemma is that it can do very little to help restore the health of the international system. Nor is there much it can do at home in the near term to fix the real problem -- its dysfunctional financial system. Бslund's advice to push ahead with "liberal market reform" may be fine for the country's long-term development, but it is no answer to the immediate crisis. In this critical period, Russia will be, as so often before, largely at the mercy of forces outside its own borders.

Clifford G. Gaddy is a senior fellow at the Brookings Institution. Barry W. Ickes is a professor of economics at Pennsylvania State University.