STRATFOR, February 20, 2012
Members of the Kremlin elite had forged two plans meant to modernize and strengthen the Russian economy for the future. The twin modernization and privatization programs were to depend largely on foreign expertise and investment - particularly investment from the Europeans, who are Russia's most important trade partners. However, the European economic crisis and political instability inside Russia have complicated matters, making investment less likely. Thus, the Kremlin is reformulating its plans to better suit the current circumstances.

Analysis
The Kremlin's top political, business and economic minds are holding a series of meetings and are exchanging a flurry of private messages concerning a reassessment of Russia's economic strategy. This comes as two main factors affect Russia's economic plans: financial uncertainty in Europe and political instability inside Russia. The Russian economy is stable, but these circumstances are forcing the Kremlin to reassess its ambitious plans for modernizing and diversifying the economy for the future.

Russia has mostly recovered from the 2008-2009 global financial crisis. Russia's gross domestic product grew 4.3 percent in 2011 and is projected to grow 3.5 to 4 percent in 2012. Inflation is at a low of 7 percent, and Russia's budget deficit is nearly zero. This ability to recover from such a crisis gave the Kremlin confidence to start formulating more ambitious economic strategies.

After nearly a decade of economic consolidation, the Kremlin believed that it had enough control over domestic politics, security, businesses and the financial sector that it could allow certain foreigners to purchase pieces of Russia's most strategic enterprises and invest in and modernize many financially attractive sectors. The twin modernization and privatization programs were meant to rapidly move the Russian economy forward, with its growth financed mostly by foreign investment groups. (Russia is not lacking in funds, but the Kremlin would prefer that others pay for its plans.) The programs were to bring in more than $200 billion in investment by 2015, with most of it flowing in between 2011 and 2013. The Kremlin began shifting Russia's domestic legal framework to allow foreign firms and individuals to own more assets in the country. The government worked to make Russia more attractive to investors by purging heads of strategic enterprises who were also government ministers or linked to the Federal Security Service. It also launched an ambitious anti-corruption campaign, though the campaign has not made much progress.

However, the European financial crisis and political instability within Russia have complicated the Kremlin's plans. Some aspects of the modernization and privatization programs will be discarded, some will change and in some cases the Kremlin will have to invest its own money in the growth it wants to see.

The European Factor

Russia's main partner in both investment and trade is the European Union. An estimated 75 percent of foreign direct investment in Russia comes from EU member states, and according to EU figures, the bloc accounts for 47.1 percent of Russia's overall trade turnover in 2010. Furthermore, Russia traditionally has carried more than 50 percent of its currency reserves in the euro. Because of these ties, Russia's modernization and privatization plans were going to depend heavily on funding and expertise from Europe.

However, Europe's financial crisis is changing Russia's circumstances. The crisis has not really affected trade between the European Union and Russia: trade dipped markedly in 2009 but rebounded by 2011. But Russia was expecting its modernization and privatization programs to raise at least $10 billion in 2011; instead, investment decreased in 2011. Moreover, capital outflows from Russia in 2011 were $70 billion -- twice the predicted $35 billion -- and most of that capital went to Europe.

Thus, while the foundation of Russia's economy -- exports to Europe -- remains stable, investment is expected to continue declining, and this means Moscow will have to reassess the large-scale plans that depend on European investment and possibly scrap the plans altogether.

Political Instability

Financial analysts are paying close attention to Russia's political instability. The main focus has been the rise of anti-Kremlin protests inside Russia, the last of which attracted 290,000 protesters countrywide Feb. 4. Though the protest movements have not proved to be a real threat to the government's power, the perceived threat of the protests makes foreign investors question Russia's stability. Moreover, most large business deals require a strong government to approve them and see them through the dense Russian bureaucracy. Foreign investors are not confident that the Kremlin can focus on such deals while facing political attacks.

The more destabilizing factor in Russia is the situation inside the Kremlin. The intricate clan network that Russian Prime Minister Vladimir Putin spent more than a decade building has collapsed, and business and economic policies are at the center of the fight among the remaining Kremlin power brokers.

The era of Russia's economic, financial and business consolidation that largely scared off foreign investors was fueled by the clan of siloviki -- mostly security hawks who prioritized national security above modernizing and diversifying Russia's economy. However, the modernization and privatization programs were devised by the siloviki's rival clan, the civiliki, a group of more liberal, economic-minded strategists. The siloviki vehemently opposed the modernization and privatization programs but could do little to stop them. The clan structure has broken down and most of the civiliki were either demoted, left the Kremlin or no longer have the power to stand up to the siloviki. Due to this breakdown, the programs' futures are in question, as is the future of any evolving Russian economic policy.

Reassessing the Programs

Well before the European economic problems and Russian political instability began, the siloviki pushed back against the modernization and privatization programs. Major Russian businesses -- mostly under siloviki control -- resisted the Kremlin's moves to create more transparency in Russia's business environment. But now that Europe's economy and Russia's political situation have dampened foreign investors' interest, the siloviki have a real argument for scrapping the plans altogether.

Using the European crisis and lack of investor interest as his foundation, siloviki chief and Deputy Prime Minister Igor Sechin argued that the firms to be privatized are undervalued. His main example is oil giant Rosneft, whose stock price is at $7. Sechin and many Russian financial analysts believe it should be more than $11, and that the prevailing European economic and Russian political circumstances are keeping prices low. Sechin also believes that there is no rush to carry out the privatization program, as it was initially presented as a way to counter Russia's budget deficit (which is now at zero, due to revenue from increased oil prices). However, most of the civiliki who helped design the program want to move forward with it rather than depend on oil prices to help with budgetary problems.

Sechin's argument has received public support from independent advisers, such as Deutsche Bank, which advised the Kremlin that launching such programs in the current global market is simply too challenging. Although the siloviki have a case, the few civiliki left in the government -- mainly under Economic Minister Elvira Nabiullina -- have been working for the past month on a new modernization and privatization plan. The privatization aspect is being discussed this week inside the Kremlin, but the modernization plan has not yet been addressed. Thus far, the plan is to delay most privatization efforts until 2017. The goal is to allow enough time for the European economic crisis to play out in hopes that the Europeans will want to invest in Russia in the future. However, this delay gives the siloviki plenty of time to try to shut down the privatization program altogether. Of course it also leaves time for the Kremlin to reorganize internally and create a new civiliki clan capable of implementing the plan despite the siloviki's complaints.

Meanwhile, the Kremlin is not simply waiting for foreigners to regain interest in investing in Russia. Some efforts are under way for Russian oligarchs to participate in some of the privatizations. Stratfor sources have said that billionaire Gennady Timchenko has acquired Murmansk Commercial Seaport and steel tycoon Vladimir Lisin is investing in Russian Railways -- assets and stakes previously intended for foreign investors under the privatization plan. Russia's oligarchs have quite a bit of money to invest in privatizations, though they have been loath to do so in the past since the Kremlin disapproved of oligarchs getting too involved in Russia's strategic sectors. The Kremlin will have to reassess its view on this issue with an interest in the oligarchs investing their billions at home.

Furthermore, the Kremlin is likely to start spending its own money in several strategic sectors in which it is not willing to wait for foreign investment. Stratfor sources say the Kremlin is also now willing to pay for projects that will bring in foreign modern technology. For example, Russia's version of Silicon Valley -- Skolkovo -- is expected to receive increased Russian government investment, as it is attracting technology from foreign firms such as Siemens AG, IBM, Nokia Corp., Intel Corp. and Cisco Systems Inc. The Russian government has approximately $600 billion in its rainy day funds (although Stratfor sources say twice that amount is stowed away). The Kremlin did not want to part with those funds while others were willing to invest in Russia, but now the circumstances have changed.

Although the modernization and privatization programs for the future of Russia's economy are not altogether dead, the economic and political crises affecting investment in Russia are forcing the Kremlin to redesign its strategy.

(http://www.stratfor.com/analys... )

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