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Russia: how to spend the petrodollars?

Dmitri Travin
15 July 2008

While many people in Russia have profited from the high price of oil and gas and the influx of petrodollars from abroad, others have been losing out.

The losers include people who look as if they have done well. The property market is a good example. In a rapidly growing economy there will always be plenty of room for speculation. For as people's income goes up, assets purchased today may be quickly resaleable at a considerable profit. Currency speculation was extremely popular in Russia for some time. But since the Central Bank brought the exchange rate under control, speculation of this kind has ceased to be profitable. So large sums of money have been invested in property instead.

In the early 2000's, the price of apartments rose rapidly. Russians were trying to improve their living conditions and earn decent wages at a time when GDP was growing fast and petrodollars were pouring in. However, as it became clear that the price of housing was rising much faster than the average level of inflation, speculative capital moved into the property market. People began buying flats not just to live in, but for resale. Even when the property was not used, it was earning its owner good money, and it could always be rented out too. Property owners were making much more on their investment than those who left their money on deposit. And these investments were far less risky than investing in company shares, for example.

The rapid rise in the housing market stimulated speculation, and this in turn fuelled inflation. A further inflationary factor in recent years was the growth in mortgage lending. As demand for housing vastly outstripped supply, prices leapt up, increasing the temptation to speculate. In these circumstances, even middle class people were finding, paradoxically, that they could not improve their living conditions. The country was getting richer. Many Russians were living much better. But however much more people had to spend on food, clothes, cars, appliances and travel, they could not buy what they wanted most - a roof over their heads.

The economic boom also hit people whose incomes were growing more slowly than prices were rising. This was particularly serious for those living on state hand-outs. Inflation is part and parcel of a market economy: prices increase, depending on supply and demand. But in order to raise pensions and other social welfare payments you have to take decisions. These decisions may be delayed. They may not include everyone whose incomes have fallen, and if the inflation statistics are not quite right, now will the decisions be. As long as price increases remained relatively low, as was the case in Russia until quite recently, this was not so serious. But today, with rising inflation, if the state ‘forgets' about a particular category of citizens, the consequences may be grave indeed.

What to do with the petrodollars

According to a survey conducted in June 2008 by the Levada Centre, one of Russia's most authoritative independent polling organisations, 82% of Russian citizens are worried by inflation. By comparison, a year ago only 64% of those surveyed were worried by price rises. People are talking about how to minimise the negative consequences of the petrodollar boom.In my first article I wrote about the difficulties of combating inflation and the fact that the Central Bank's tough monetary policy may lead to the Russian economy becoming less competitive. But apart from anti-inflation measures, there are other approaches to solving these problems.

The one most talked about by ordinary citizens is this: Russia's income from the sale of oil and gas should be spent on buying investment goods abroad. Some would prioritise repairing the roads (there is an old joke that says that there are two main problems in Russia - fools and roads). Others would favour buying building materials, or equipment and technology for industrial enterprises, etc.

The problem is who would make these purchases. The decisions would be made by officials if the government were to concentrate the maximum amount of petrodollars in its hands, by increasing customs export duties, for example, or nationalising the energy sector of the economy. This would inevitably lead to an increase in the already outrageous level of corruption in Russia. For officials would be responsible for choosing the foreign companies from which goods should be bought. Experience shows that the choice of supplier is based on so-called ‘kickbacks', which go not to the state but into the pocket of the official who arranged the purchase.

If the decisions were being taken by Russian companies which earn petrodollars, they would only do so if it were profitable. It should be noted that imports are growing fast enough as it is. But the problem is that if it is more profitable to invest in the housing market, you cannot force a company to invest in road building, where returns on investment are very problematic.

There have been suggestions that mass purchases of foreign goods should be made. This only goes to show that many Russian citizens still think they are living in a state economy of the old Soviet kind. They believe that it is possible to control the corruption of state employees. Such propositions may be somewhat naïve, but influential lobbyists could well throw their weight behind them if they could get in on the ‘kickbacks'.

Tax cuts?

A different approach to resolving the petrodollar problem has been attracting a lot of attention. Some influential economists have been proposing that the taxes on business should be cut. At first glance, the logic looks impeccable. Instead of increasing social expenditure, which causes inflation, we will make life easier for Russian business. With low taxes, new companies will appear, competition will increase, as will the supply of goods, and this growth in supply will be the best response to the increased demand caused by petrodollars. The pressure of competition will stop inflation, as sellers will be unable to raise prices.

However, this apparently rational solution could also create problems for the Russian economy. Firstly, we should not forget that oil prices are unpredictable. Today they are rising, but tomorrow they may fall. Of course tax cuts would make everyone happy, but if they have to go up again tomorrow because prices are falling on the energy resources market, the decision will not be so easy to make. The Russian authorities, who are used to making concessions to populism, may prefer in this difficult situation not to increase taxes, but to borrow more. This could put financial stability at risk.

Secondly, many experts believe that the Russian economy is currently overheated. In other words, it is growing so quickly that it no longer has the capacity for short-term growth. If this is the case, then reducing the tax burden would lead not to increased production but to yet more money being invested speculatively. Housing will become even less affordable for the middle class, and the stock market ‘bubble' will go on growing until sooner or later it bursts, damaging the economy as a whole.

Slash bureaucracy?

Neither purchasing goods abroad nor reducing taxes are the optimal means for ‘digesting' the petrodollars in the Russian economy. But another interesting approach is being mooted by democratically minded politicians and economists. They point out that catastrophic bureaucratisation is one of the main reasons for the economy being overheated. Every attempt to expand production involves protracted negotiations with officials. And naturally, these negotiations include bribes and ‘kickbacks'. If you want to build a major housing project, for example, you need land. Without this, your money is useless. And allotting land is the prerogative of officials.

The numerous obstacles that stand in the way of starting businesses are also connected with licensing, taxes and supervision by various state organisations (customs, fire service, anti-drug service etc.). Some of these organisations are used by criminals to conduct raids on successful companies. And the threat of raids, in turn, deters Russian companies from expanding their business.

Thus, liberalisation and de-bureaucratisation of the economy could be a truly effective means of developing production in Russia. If the obstacles to the expansion of businesses were removed, the petrodollars could serve as a real stimulus for the creation of new firms, increased competition and an increase in GDP. If this were to happen, reducing the tax burden could also be helpful.

The Russian government undoubtedly understands this. But almost all attempts at liberalising the economic system in recent years have proved unsuccessful. And this is no accident. There is too much vested interest in maintaining the high bureaucratic barriers, as these barriers ‘feed' off businesses. True freedom of enterprise is incompatible with the revenue received by officials who control the economy.

This state of affairs could probably be changed if the Russian political system were democratised and the media were freer. But there is no popular pressure on government to move in this direction, as the benefits from this abundance of petrodollars have evidently outweighed the problems discussed in this article. People believe that life has improved thanks to Vladimir Putin, and they do not support opposition politicians who are of a different opinion.

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