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. Last Updated: 07/27/2016

The Economists Strike Back

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One year ago, President Vladimir Putin started his second term in office. He promised to use the combination of political stability and fiscal strength built up during the previous four years to push the economic and administrative reform agenda devised by the liberal economists in the Cabinet led by Economic Development and Trade Minister German Gref and Finance Minister Alexei Kudrin. But despite the promise to push the economy from natural resource dependency and vulnerability to greater depth and balance, Russia became more hooked on oil than ever. And instead of a wider wealth distribution, very little has actually changed. The recently published Forbes list of billionaires, for example, tells a story of even greater economic concentration in natural resource industries and a dangerous widening of the wealth gap between rich and poor.

Looking at the evidence of the past 12 months, many investors and business leaders thought Putin was distracted from his previously stated economic priorities as he struggled to contain the infighting in the government. Others feared he had become complacent about the economy in the face of ever increasing oil and gas revenues. Either way, the weight of evidence led many observers to conclude that the liberal economists in government were steadily losing influence and that this had led to an increase in the risk of doing business and investing in Russia.

However, over the past couple of weeks, there have been signs that the president has drawn a line in the sand on some of the issues that distracted him from the reform agenda. As part of this apparent change, influence is returning to the economic liberals. Of course, it is too early to assume this to be the start of a determined return to the original reform plan, but these recent events are encouraging for investors and business leaders who have been waiting for some reaction from Putin to the deterioration of the public's confidence in his government. It is also encouraging that on Monday, for the first time in his second term, the president scolded his government for not tackling the red tape stifling entrepreneurial initiative and stalling growth of small to medium-sized enterprises, or SMEs. The chiding came only one week after Kudrin won the upper hand over the potentially disastrous VAT reduction and after Putin's publicly reported meeting with the previously marginalized Gref. Re-emphasizing the need to push domestic growth is a very positive reaction to the public dissatisfaction with recent trends in the economy.

Reducing the VAT rate from 18 percent to 13 percent was seen as an easy way to toss as much as $11 billion to consumers and businesses and therefore as a neat step toward keeping GDP growth high. But apart from making it even harder to keep inflation under control, the $11 billion plan would have meant losses in federal budget revenue that could only have been balanced out by higher future oil revenues. This kind of thinking is called the California Disease, when governments base budget expenditure projections on optimistic revenue assumptions that are in turn based on extending current growth trends in one critical industry -- only to be left with a large deficit when that trend fails. This danger was highlighted by Kudrin and Gref ahead of last year's election, but until recently it seemed that their warning was being brushed aside. Other Cabinet members were more focused on the short-term political expediency of boosting GDP growth.

Putin's return to the subject of creating growth conditions in the domestic manufacturing industries and the SME sector -- and hopefully tackling corruption, which costs businesses over $50 billion annually -- is also very encouraging. One of the reasons he cited for the Cabinet reshuffle last February was to avoid any disruptions in the program to remove operational obstacles in these areas, and to create a series of legislative, administrative and budgetary incentives to push growth. A "competitive Russia" and "economic diversification" were very much the buzzwords at the start of Putin's second term, and the indicated pace of reform gave investors yet another buzzword to salivate over, that of "speed economics."

Instead, the administration became bogged down with Yukos and distracted by Beslan and the Ukrainian elections. Against this backdrop, it seemed that those who favored the politically easy route forward were displacing the liberal economists. Or even worse, it seemed the siloviki, who once worked with a common purpose to establish unchallenged Kremlin control, were now breaking into groups that either wanted to pursue a different economic model or just wanted to enjoy the benefits they felt entitled to as the country's new elite.

A plethora of factors have contributed to the recent decline in public confidence in the president and his government: the slowdown in economic growth in the latter part of 2004 until the surge in oil prices sent it up again; the botched monetization of social benefits; the lack of progress in Chechnya; the loss of influence in former Soviet republics; and the general air of political uncertainty. It is clearly time for Putin to fix the problem or risk political instability as the 2008 election approaches. While he has promised not to change the Constitution, the group at the top of the Kremlin power structure will certainly want their choice of succession options to prevail. To make this happen, they will need public support.

Over the past year, Russia's fiscal strength has continued to grow, yet very little of that economic strength has flowed into the underlying economy. The main reason is a lack of progress in advancing some of the reforms set out by Putin as key priorities of his second presidency. Progress was never made due to the influence shift in the Cabinet and the assumption that high oil and gas revenues would magically find their way into the economy and into the pockets of a broad segment of the population. The magic is working far too slowly. This has given rise not only to voter disillusionment, but also to a huge wealth gap: The richest Russians own 15 times more than the poorest. In other emerging economies, this level of disparity has led to political instability and regime change.

This is something Putin will want to avoid. Plan B has clearly not worked. It is time to dust off Plan A and to let the economic liberals in the Cabinet have their day.

Christopher Weafer, chief strategist at Alfa Bank, contributed this comment to The Moscow Times.