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Russia: where are the petrodollars going?

Dmitri Travin
25 June 2008

For the first time in years, inflation was oneveryone's minds in the autumn of 2007. We thought it was a thing of the past.The 1990's taught us hard lessons. The unwritten consensus among the elite was that creating money was a dangerous tool of macroeconomic regulation: the ‘printing machine' had to be kept under strict control. No one would describe the head ofthe Finance Ministry Alexei Kudrin, or the head of the Central Bank Sergei Ignatiev, as populists, intent on flooding the market with rubles. But inflation rates, which had been going down ever since the end of the ‘90s, no longer are.

Last winter, all people could talk about in Russia was rising prices. Leading politicians were telling their subordinates to stop the inflation. Scholars were hunting round for objective explanations. Increasingly,they pointed to the international food market. The new word " stagflation" was doing the rounds. And the opposition noted that prices and tariffs increasingly included enormous bribes to officials. This was taking place with the full connivance of law-enforcement and antimonopoly bodies, they observed.

Spring brought no relief. You will not findcourtiers in Kremlin administration saying things like ‘Now is the winter ofour discontent Made glorious summer by this sun of York' (meaning our new PresidentMedvedev). Whatever the official statistics say, independent OECD forecasts predictthat prices will rise by 13% in Russia this year, while last year they rose by11.9%.

Who is getting richer?

However, today's inflation is not the result of mistakes in the government's economic policy. Nor can we blame the world market, although this is of course an important factor. Prices have risen in Russia because the country is getting richer. It becomes clearer all the time that we are paying with inflation for the large profits we are making from the sale of oiland gas. Since we developed a stable and promising Russian commodities market this has been exacerbated by the influx of foreign capital.

Until recently we could still cling to the illusion that oil and gas was only bringing profits to oligarchs, while the rest of the population continued to live poorly. Today, against the background of rising prices (including prices on goods of mass consumption), this is no longer a tenable argument. Petrodollars are spreading right through the country and radically changing the macroeconomic situation. We may mistrust the official statistics which keep telling us that people's real incomes have grown, but we've got to face it. For inflation is one of the factors telling us that it is true: millions of people, from oligarchs to cleaners really are benefitting from oil revenues.

Petrodollars and inflation

What happens to Russia's petrodollars? How istheir flow connected with the rise of inflation? The fact is that much of the foreign currency that comes onto the Russian market is bought up by the Central Bank to fill its international reserves. This purchase is made with rubles printed specially for this purpose. In other words, the greater the revenue from the sale of our resources on the world market, the more new money the CentralBank has to ‘make'. Thus, despite general agreement as to the dangers of creating money, Mr. Ignatiev keeps on using that ‘printing machine'.

Could he avoid doing this? He could, but ineconomics there are no categorically right and wrong answers. Every course of action has its downside. If the Central Bank does not buy up currency to replenish its international reserves, the pressure of a large mass of dollars on the Russian market, will lead to a rise in the ruble. From the view point of the ordinary Russian citizen, this prospect naturally looks quite attractive. We will become richer. We will be able to buymore imported goods, travel abroad more often, stay in the best hotels and dine at expensive restaurants.

However, from the point of view of manufacturing,this wealth is a terrible curse. An expensive ruble makes the goods we manufacture more expensive by comparison with imported goods. If the Central Bank does not stop the ruble from rising, many Russian producers will lose their competitive advantage and cease to exist. And along with them, many jobswill disappear. GDP will stop growing, and parts of the country will be plunged into crisis. In the long term, the Russian people's unexpected wealth will turn into poverty.

However, none of this means that the CentralBank's course of action is the only correct one. At the end of the day, an expensive ruble would stimulate labor productivity at Russian factories. They would not all close down. Many would be forced to adapt to the conditions of harsh competition. However, let's not discuss that problem right now. Let's just try and understand how Ignatiev's people are thinking.

Where the petrorubles go

By buying petrodollars, the Central Bank prints a large number of rubles. After the devaluation of 1998 Russia's international reserves amounted to $12 billion. Now those reserves have reached $550 billion.Where do the rubles go which are used to purchase this currency?

Some of the money comes back to the state through taxation. And the Russian fiscal system is weighted towards levying payments from those who deal in natural resources and their by-products. Firstly, there is a special tax for mining minerals. Secondly, those who export goods abroad have to pay export customs duties. Finally, the state collects an excise duty on petrol.

The money that goes into the budget spreads throughout the country. In many ways, this is the money that fuels inflation on the consumer market. A growth in prices means that the Russian economy is overheated. In other words, in the existing conditions it is unable to satisfy the growing demand for goods ranging from sausage, which is fairly cheap, to the building materials which go into expensive apartments.

Objective factors like the rise in price of goods on the international food market only partly explain this. There are reasons quite specific to the Russian economy why it cannot absorb all this money. For example, in Russia it is very difficult to open one's own business; the process involves enormous bureaucratic obstacles and large bribes. So there is a long delay between growing demand and the economy's reaction to that growth. In the interim, unsatisfied demand results in rising prices.

Ordinary citizens bear the burden of this bureaucratisation. By paying excessive prices for every day goods in the shops, they are effectively sharing their own income not only with the retailers who put up prices,but also with the official whose greed is slowing down the growth of supply.

How energy money spreads around

A major role on the consumer market is also played by the money which goes those in the mining sector of the economy, and those who serve the demand created by it. Drillers in remote parts of Western Siberia are by no means the only people receiving salaries for oil and gas.

The giants of the Russian energy business are constantly expanding their activity in major cities. Increasingly, they are investing their funds in finance, marketing, PR, and other sectors like construction, sport and mass media. They employ entire security companies, pay for consulting services, buy various types of equipment and build offices. The people working in these offices also buy cars and apartments, and deposit money in banks. The growth of bank deposits makes it possible to widen loan programs, which in its turn stimulates demand for cars, real-estate, meals in bistros and restaurants, expensive medical and education services. And naturally, the people who provide these services join in the scramble for consumer products.

One objective sign of how extensively petrodollars spread through the country (or at least through major cities) is notjust inflation, but traffic jams. Every year it becomes more difficult to drivein Moscow or Petersburg. Some invest their portion of the‘petrodollar pie' in a new Mercedes, others in a second-hand Opal, but one way and another, consumption is growing.

The corruption factor

All this is characteristic of any country which receives large revenue from the use of natural resources. Profits accrue to those who in one form or another serve the high-revenue business, and to those who receive their slice through the state. But in Russia the beneficiaries of this money also includes a special category: those connected with widespread corruption. Or, to be precise, this special category exists not only in Russia,but in many resource-rich countries of the third world - Venezuela, Nigeria,Saudi Arabia, Turkmenistan etc.

Following the trial and incarceration ofMikhail Khodorkovsky in 2003, Russian business (especially the oil sector) began to realise that it was going to have to share its revenues with state employees who could otherwise create serious problems for it. These include not just officials on whom the development of business depends directly, as was true in the 1990's.Today there are also a lot of state employees who, although they do not themselves make decisions that benefit companies, can easily destroy those companies.These include fiscal officials, customs officers, officers of the specialservices, investigators, traffic police, drug agency employees, people who protect the environment, prevent fires, fight outbreaks of epidemics etc. The very list of the people who can come and make threats, demanding their share ofthe ‘petrodollar pie', is astonishingly long.

Each of these people has a family. They too take this money and join the consumer race, and by so doing they redistribute petrodollarsto regions and industries all over the place, some of which are a long way awayfrom Western Siberia. Observers note that today the richest houses in the elite zones of the Moscow Oblast are not being built by businessmen, but by civil servants, especially those from the law-enforcement organisations.

Nor should the role of the so-called oligarchs be underestimated when calculating where the petrodollars go. In recent years their capital has increased drastically, as you can see from the list of billionaires regularly compiled by Forbes magazine. But the distribution of oil money goes far further than the people on this list.

Buying foreign assets

Especially with the price of oil rising, the more money settles in Russia, the higher inflation will be, while other costs stay the same. One way of slowing things down is to ‘force' money out of the country. Some time ago, Andrei Illarionov, former economic advisor to Vladimir Putin, suggested that we pay off our foreign debts. Russia is doing this, but such expenditure has its limits. The idea which finding favour now is that of buying foreign assets.

Already, the US senate is worried about the flowof Russian money entering America. And with good reason. In the years to come this problem is likely to get a whole lot worse.

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