Russia has never had it so good. The record price for hydrocarbons has given a tremendous boost to the country that holds 25% of the world's gas supplies and competes with Saudi Arabia as the world's largest exporter of oil. The Kremlin has put about $108 billion of its petro-dollars into a Stabilization Fund, which it has used to pay off almost all of its Paris Club debt, IMF debt and London Club debt, in the process gaining an investment grade credit rating (in late 2004) and becoming a net creditor. In addition to the Stabilization Fund, the central bank has a further $250 billion in foreign currency reserves, giving Russia the third biggest pile of foreign exchange reserves of any country in the world.
This petro-wealth has trickled down and led to a consumer boom in Russia. James Cook, manager of the Aurora Fund, a $64 million equity fund that specialises in the Russian consumer sector, says: "Spending was up 66% last year. The middle class is growing quickly. If you look back to 2002, the poverty rate was 25%; now it's down to 12%."
Russians, historically rather a melancholy people, have the feel-good factor in abundance - President Putin's policies enjoy an approval rating of about 80%, according to the latest poll. The government's self-confidence has been given an enormous petro-shot in the arm. Just eight years after the humiliation of the 1998 debt default and 16 years after the traumatic collapse of the Soviet Union, the Russian state has returned as a global power.
This renewed assertiveness defines all aspects of economic policy. Russia tends to measure its progress against the West. During the 1990s, the country was treated by Western governments, bankers and development consultants as a problem child, slowly learning how to behave like a Western liberal country. Now, the government feels itself gloriously economically empowered, and no longer thinks the West has any right to lecture it. Putin's speech in Munich earlier this year, in which he declared that "the US has overstepped its borders in all spheres - economic, political and humanitarian - and has imposed itself on other states", was seen as a reassertion of Russian foreign policy and an indication of the confidence the Kremlin now has in its ability to follow its own path.
During the 1990s, when the oil price was generally low and the rouble weak, Russia was in desperate need of Western capital - from the US Treasury, the IMF and private investors. Boris Yeltsin was happy to talk about democratisation, a free press, liberalisation of the economy and anything else, in order to win money from Western backers - even if the government rarely followed through on its rhetoric. But with the oil price much higher, GDP growing at almost 7% a year and a strong currency, the Russian state no longer has to rely on bail-outs from the IMF to balance its books.
Analysts have dubbed Putin's style of highly restrictive and authoritarian government 'managed democracy', which Nikolai Petrov, senior scholar at the Carnegie Endowment for International Peace in Moscow, defines as the state controlling society and elections "under the appearance of democracy". Western governments and NGOs have lambasted the Russian government for the increasing state control of the media and harassment of opposition politicians and NGOs.
The Kremlin, for its part, is showing increasing signs of paranoia, in particular that the democratic revolutions in Serbia, Ukraine, Georgia and Kyrgyzstan were not really democratic at all, but funded by the CIA. It feels that under the guise of promoting democracy in the region, the US is really following its own national interests, with the aim of gaining access to Russia's natural resources. Relations between the Kremlin and its near neighbours are at their worst for years, with Russia engaged in bitter disputes with Estonia, Poland, Lithuania, the Czech Republic and Georgia - all former parts of the Soviet Union or ex-members of the Warsaw Pact.
This suspicion about Western intentions has pushed Russia into reactions that have further exacerbated the situation: it has passed a law making it very difficult for foreign governments to fund NGOs; it has harassed the tiny opposition movement for fear it is funded by the US; it has set up its own youth movement, Nashi, which has hounded the Estonian and British ambassadors; and it has exerted an ever-tighter grip over the Russian media.
Other factors have further muddied the relationship with the West. The EU doesn't like Russia's bullying of countries that use its gas supplies, and turning off the gas to Ukraine in January 2006 awakened the EU to how its dependency on Russian gas could be exploited for political gain. The world was also startled by the lurid assassination of Alexander Litvinenko, a former KGB security guard, in London last year. The UK has accused another former KGB security guard, Andrei Lugovoi, of poisoning him and demanded his extradition, something the Kremlin is unlikely to authorise.
Many think the Kremlin itself was behind the poisoning, and are concerned by the rising influence of the FSB, successor to the KGB: Putin is a former member of the KGB, as is his likely successor, Sergei Ivanov. The railways, the largest oil company, the second-largest bank and the largest military industrial company are all controlled by the FSB, which, in effect, has created a perfect capitalist oligarchy for itself.
This political situation "doesn't make doing business in Russia any easier for foreign investors", as a source at one of the largest UK companies in Russia admits. The relationship with the West has become so bad it is beginning to impact on foreign investors' business relationships. Although the EU has strong trade links with Russia and is the biggest buyer of Russian gas, the worsening political relationship is causing strains. Professor Jonathan Stern, expert on Russian energy at the Oxford Institute for Energy Studies, predicts that relations will become so bad that the EU will have no choice but to find alternative sources of energy.
This bad atmosphere hurts Russian companies too. They have claimed that they face 'Russo-phobia' when they expand abroad and try to buy assets in Western markets. Gazprom has complained that the Italian government discriminated against it in a recent auction for gas suppliers, and Severstal said the same when its bid to buy a stake in Arcelor failed last year. The Russian government has made much of the principle of reciprocity in trade relations with the West. Arkady Dvorkovich, special economic advisor to Putin, said at a recent conference: "If Russian companies find resistance to gaining access to European or American markets, unfortunately we will have to respond in a similar way."
In fact, in the domestic market it's increasingly unclear if the Russian government wants or needs foreign investment. As Cliff Kupchan, director, Europe and Eurasia, at political risk consultancy Eurasia Group, says: "This is a country with over $300 billion in reserves. It's not short of money." The three largest banks in Russia - Sberbank, Vneshtorgbank and Gazprombank - are all state-owned, with Sberbank alone accounting for about 40% of deposits. Foreign banks account for barely 10% of assets.
The Kremlin has supported the rise of 'national champions' - large conglomerates that are either directly controlled by the state, with top bureaucrats on their boards, or controlled by tycoons loyal to the Kremlin. Examples include United Aircraft Corporation, oil company Rosneft, Vneshtorgbank and military industrial conglomerate Rosoboronexport, which appears to be buying up assets in almost every sector. The thinking is that these national champions will be better able to compete internationally, and thus to project Russian power abroad. They enjoy competitive advantages over other companies, such as state guarantees on borrowing and capital injections from the state budget for acquisitions.
The Kremlin is also using its petro-dollars to set up several state-managed investment vehicles, including an investment fund for infrastructure projects, which has an annual budget of about $1 billion, several venture funds to invest in the hi-tech sector, again for a total of $1 billion, and a Russian development bank, which will have a starting capital of $2 billion.
In some sectors, it appears as though the role of foreign investors will be seriously reduced. John Baldwin, senior Russia advisor to BP, says: "It looks to be a matter of policy that Russian firms will take a leading role in oil and gas projects in future." That was made clear last year, when state-owned Gazprom forced its way into the $20 billion Sakhalin II project, buying a controlling stake from Shell for $7.5 billion in December 2006. Shell complained that this was an abuse of its investor rights, but the Kremlin replied that Shell abused the terms of the very favourable production-sharing agreement it had signed in 1994 by doubling the costs of the project.
Baldwin says the best strategy for foreign investors in an environment where national champions are stomping around is "to pick your ground carefully and find somewhere they don't want to stomp". Many foreign investors are doing just that, focusing on areas where the state is not a big player, such as the consumer sector.
European real estate companies are investing heavily in developing shopping malls. One such is Meinl European Land, which has built seven shopping malls around Russia and plans to build 12 more over the coming year. It has just started work on a 60-hectare shopping centre outside Moscow, which will cost $300 million and give a return of 15%. Meinl spokesman Francis Lustig says: "Russia is now at the heart of the company's investment activities. It is still possible to achieve yields that significantly exceed those in more established markets, such as the Czech Republic or Hungary."
The financial services sector is also attracting a lot of FDI. The insurance sector, in which there is no state-owned monopoly, has seen about $2 billion in FDI so far this year, with Allianz buying a controlling stake in Rosno, Russia's largest insurance company, Generali reportedly buying a minority stake in Ingostrakh, and the EBRD buying 10% of RESO-Warranty. Foreigners are also buying up Russian banks - KBC bought Absolut Bank, a mid-size bank, for $1 billion earlier this year, Raiffeisen International bought Impexbank for EUR550 million last year, and Societe Generale bought 20% of Rosbank last year and is likely to buy a controlling stake soon.
Oxana Panchenko, head of corporate banking at Raiffeisen-bank, says: "Large Russian industrial and financial groups cannot be serviced by one bank only, so there are opportunities for foreign players to offer their resources and technologies." Foreign banks are also particularly attracted to the retail market, where their lower cost of funding and better services should give them an edge over state-owned banks.
But as strong as it appears, the Russian state will need foreign investment. The country's infrastructure is desperately in need of capital injections: the electricity sector is running at maximum output and needs about $250 billion in investment over the next 20 years, much of which will have to come from the private sector; the shabby railway system needs hundreds of billions spent on it, and the roads need yet more billions. Transneft, the state pipeline monopoly, needs at least $20 billion just for one planned pipeline to China, and Gazprom will require billions of dollars once it stops buying other companies and starts developing its own resources.
The state is hoping to get much of this money from Western portfolio investors. Electric utility UES plans to raise as much as $20 billion from IPOs in London this year, and Russian rail plans a multibillion-dollar IPO next year. Transneft issued its debut eurobond earlier this year and is set to raise billions more in the years ahead. Although foreign investors will be given exposure, the state will retain a controlling stake.
But if such large amounts of money are to be raised on foreign markets, foreign investors will need to be confident that their interests will be protected. They will need to believe in Putin's model of bureaucratic capitalism. That model might work now while the oil price is high and favourable economic conditions prevail, but it is not clear how efficiently it will perform in harder times.
OIL & GAS SECTOR, 2006 (DOLLARS BN)
Market capitalisation Revenues
Gazprom 206.5 79.9
Gazprom Neft 18.0 18.3
Lukoil 61.7 68.1
Novatek 14.3 1.8
Rosneft 76.9 33.1
Surgutneftegaz 47.3 25.6
Tatneft 9.2 10.6
TNK-BP Holding 28.6 35.8
Transneft 10.2 7.4
NOMINAL GDP (DOLLARS BN)
2007 (estimate) 1,180.0
Source: Troika Dialog