Russia After The Financial Crisis 04nov09

Russia after the Global Financial Crisis Clifford G. Gaddy1 Barry W. Ickes2 November 4, 2009

1. Well over one year into the global economic crisis, it is still not clear how events will ultimately play out in the coming months and years. The crisis has certainly been dramatic, no less for Russia. Although we cannot be sure when or how the crisis will end, we can start to think about how it will impact Russia’s economic future — both the structure of the economy and the policies that the leadership will pursue in light of the lessons they draw from recent events.

2. Three facts are essential to understand how Russia was drawn into the crisis, how it has been affected by the crisis, and how its future economic policy, including its relationship with the outside world, will evolve.

3. First, Russia has been and will remain dependent on oil and gas. No single factor is more important for Russia’s future than the volume of rents that will accrue to the country from these resources. The size of the rents depends in turn on the world price of oil and gas and on the quantities that Russia will produce. Russia’s influence on the price is weak in the short term but possibly important for the long term. Russia will itself choose how much oil and gas to produce. But that choice will depend crucially on its perceptions of the long-term price and the extent to which arrangements can be made to share the risk of low prices with the rest of the world.

4. Second, the structure of the Russian economy is still predominantly shaped by its Soviet legacy. That makes it susceptible to what we describe as “rent addiction.”3 By that we mean the political and social imperative to use the oil windfall to support noncompetitive enterprises in other industrial sectors. Rent addiction intensified over the period of the boom preceding the global crisis. It did not disappear when rents collapsed in late 2008 and early 2009. It remains a major problem for the future of the Russian economy.

1 The Brookings Institution and CRIFES at PSU ([email protected]). 2 CRIFES at The Pennsylvania State University and the Brookings Institution

([email protected]). 3 [Gaddy & Ickes, EGE article on Rent Addiction]

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5. Third, economic policy under Vladimir Putin continues to be guided by two central priorities, priorities he has had since the very beginning of his tenure as leader of Russia: to maximize the efficiency of the Russian economy, on the one hand, and to ensure strategic state interests — beginning with state survival — on the other. The first of these imperatives, efficiency, dictates Putin’s preference for a free market, private ownership, and the country’s participation in the global economy. The latter imperative, national security and “survivability,” dictates a model of not absolute but contingent private property rights. There has always been a tenuous balance between the two imperatives. The current crisis has exacerbated the tension. OIL AND GAS

6. The crisis has made abundantly clear that the key element of the Russian economy is the oil and gas sector. Resource rents drive the economy. During the boom this was hidden from view, to some extent, by the rapid growth in virtually every sector in the economy, not just those connected to oil and gas, including industries that supplied inputs to or performed services for the resource sector. Also apparently unconnected sectors such as retail trade, telecommunications, real estate, and others saw their sales, profits, and share prices rise sharply. Some observers argued that this was evidence of the emergence of a non-oil economy. But the abrupt collapse of oil prices in the summer of 2008 made it evident how dependent these other sectors were on the continued high oil prices.

7. Russia’s stock market indices show the correlation. The benchmark RTS index has tracked the oil price for the past ten years, but never more closely than in the most recent 18 months. The oil price soared to record heights in the summer of 2008, collapsed by about 70 percent by the end of the year, and then has risen back to a price roughly half of what it was at the peak. The RTS index behaved in the same way and continues to do so.

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8. One might object that since such a large share of the index’s value is from oil and gas companies, it is not strange that it is strongly correlated with the oil price. In fact, at present (the fourth quarter of 2009), oil and gas companies account for only slightly more than half of the index. Sectoral indices for the non-oil and gas industries have behaved largely the same as oil and gas. Perhaps even more persuasive graphic evidence for the “everything is oil” argument we are making is in Figure xx, which shows the annual sales revenues of Russia’s largest (by sales) companies outside the oil and gas sector, matched with the annual average oil price.

9. Retail sales (figure 2) show a similar picture. While oil prices were rising, the growth in retail sales was taken to be an independent

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source of economic growth — a sign of success if not of economic diversification. When oil prices collapsed in the summer of 2008, however, retail sales collapsed as well. The dependence of the latter on the former became evident as the oil price regime switched.

10.Not only financial indicators but also indicators of the physical economy followed the oil price. This is clearly seen in Figure X which displays the world oil price and the production of rail freight cars in Russia. The collapse in oil prices led to an almost immediate and similar collapse in railway freight cars.

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Policies in the Boom

11.The historic growth in oil prices up to July 2008 led first to a boom, then a bubble in the Russian economy. In the first phase, recovery from the very low oil prices of the 1990s fueled real economic growth and genuine improvements in economic performance. Many of Putin’s policies were sensible in the face of the rent expansion. His first priority was to get rid of the sovereign debt. [Kudrin quote back when he was appointed to Finance Ministry.] Putin inherited a public foreign debt of USD XXX bns. He began reducing it as soon as he entered office. [Table] But it was the boom in oil prices that began in early 2004 that allowed him to in effect fully retire the government’s foreign debt. In January 2005 Russia paid off the entire balance of its debt to the IMF — three and a half years ahead of schedule. He then began to build reserves, in the form of foreign currency assets accumulated in an oil stabilization fund on the Norwegian model, and in international exchange reserves more broadly. The currency reserves grew by $55 billion in 2005, $120 billion in 2006 and $170 in 2007, bringing the total to nearly $600 billion by mid-2008. Only China and Japan had more.

12.If one plots the paydown of the government’s foreign debt and the simultaneous buildup of its foreign exchange reserves, an informative picture results. (See figure 3). It was in the second half of 2004 that the state debt was exceeded by the forex reserves for the first time in the history of the Russian Federation.

13.[The boom allowed Putin to eliminate Russian sovereign debt and enhance financial independence. The collapse of the oil price experienced in the summer of 2008 does not wipe out all those gains.]

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14.As clear as his priorities for use of the resource rent were in this initial period, problems began to arise as the world asset bubble led to a bubble in oil prices. Rent began flowing into Russia at a rate that was no longer as simple to manage as before. The problem was to prevent a new wave of addiction arising from the explosion in rents, a problem that had plagued the Soviet Union in the 1980s after the first and second oil shocks. To restrain rent growth in an environment of soaring prices — a factor beyond Russia’s control — Putin sought to restrain Russia’s own output through tax and other policies for the oil sector. [See Gaddy & Ickes EGE]

15.Nevertheless, Putin’s policies to manage the windfall were not entirely successful. Three problems arose. The first was that even while the state foreign debt was being paid down, private sector debt began to grow sharply in 2003 and by 2005 was reaching bubble proportions. Second, despite efforts to curb rent growth and to sequester the windfall in the reserves, Russia suffered from overconsumption. Third, because of the specific, “addictive” nature of the Russian economy, much of the rent that was invested rather then being consumed ended up being used counterproductively. It helped preserve the so-called dinosaur industries. We discuss each of these problems in turn. Private Sector Debt Bubble

16.Putin began with a sensible policy of recycling surpluses and foreign capital inflows. Rory MacFarquar has advanced the thesis that private sector borrowing offset balance of payment surpluses.4 Putin’s idea was to rely on foreign capital since it would be invested better than domestic capital. This was a recycling phenomenon, not unlike the 4

[Need source footnote on Rory]

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case of China (Bretton Woods II).5 But the bubble led to an explosion in capital inflows as private borrowing expanded. The belief that high oil prices would persist, combined with low interest rates abroad, made foreign borrowing attractive. Over time the process led to an overextension of lending, and to a deterioration of the collateral that was held. Borrowers became more extended, and the system became more vulnerable to sudden stops of capital inflows. This is what happened to Russian in the summer of 2008. What began as a sensible process ended up creating more systemic risk.

a. Figures on private sector borrowing vs sovereign debt, EM ratings improved [Table] b. The story is the following: oil prices improved Russia’s credit standing. This fueled capital inflow, further causing RTS to rise. But it is not an independent cause, since without oil no credit inflow. This was shown completely in the crisis, beginning in July when oil prices plunge. c. Consider the counterfactual of global credit crunch but oil prices remaining high. A temporary shock due to de-leveraging might have hit RTS, but it is hard to believe this could be sustained since Russia would have been a great buying opportunity. This is evident in the subsequent movement in RTS and oil. RTS and oil jointly recover before credit crunch is over. Consumption Bubble

5 A key difference, however, is that the household savings rate in China was much

higher than in Russia, and the financial system in China is more controlled, especially with regard to capital flows. These differences made Russia more sensitive to a sudden stop than China. This difference did not seem important when capital was flowing in.

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17.The rise in oil prices led to an expansion in retail sales (figure x) and imports (figure x). Especially high-end consumer imports soared. Personal automobiles are the starkest example. Imports grew from five billion dollars in 2004 to over 30 billion dollars in 2008 — a rate nearly twice as fast as all other imports.6 [Table with types of imports?] In some sense increased consumer spending was a natural response to rising incomes. Import growth reflected the inability of Russian producers to respond to the rise in demand.7 The problem was that these tendencies were dependent on the level of oil prices — an exceedingly volatile price. If prices came down so would consumption and imports. That is precisely what happened.

ADDICTION

Before the oil price collapse in July 2008, Russia was on a pace to import USD 34 billion worth of cars for for the year. The average reported import value of the imports also rose: from under USD 10,000 per car in 2004 to over USD 16,000 in 2008. 7 The import share of the Russia car market (measured by number of vehicles), which had risen from 6 percent in 1999 to 35 percent in 2004, climbed further to around 65 percent by mid-2008. By value, imports accounted for 8 percent of the Russian market in 2000, 54 percent in 2004, and around 80 percent by mid-2008. 6

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18.The third problem stemmed from the addictive nature of the Russian economy.8 In a rent-addicted economy, the resource boom filters into the economy through production. Part of the rent was used to preserve the so-called dinosaur industries. In the recent boom, the rents allowed enterprises to expand production capacity without restructuring. But their production is dependent on those rents. As the rents are then withdrawn from the system these enterprises find themselves in similar conditions to those they faced in the early 1990s.

19.The following thought experiment suggests why addiction made the bubble and its subsequent collapse more problematic for Russia than a mere consumption bubble would have been. Imagine an oil producer identical to Russia without addiction. Instead, assume that all of the excess income had been spent on imported consumption goods. When oil prices collapse, the consumption boom ends. But there are no knock-on effects from declines in railway car production, housing construction, and other sectors fueled by the boom. In Russia’s rentaddicted economy, a large part of the windfall had been invested in the production sector — and much of that was for purchase of new equipment abroad. But the key thing is that rather than investing to replace old obsolescent plants, investment merely added to total capacity. 20. As a result, the number of claimants on the rent increased. This made it more difficult to implement policies to cope with the bubble bursting.

a. Adjustment in consumption is natural – just falls as income falls. But in addicted production sectors the adjustment is not restructuring, just shrinking of output but not structural adjustment.

b. Another reason for less structural adjustment is the Roland Nash hypothesis. Inadequate institutions (in terms of market efficiency) lead to banks rolling-over rather than claiming collateral. This could be beneficial if the crisis is external and it prevents over-reaction. Good for short-run macro, bad for longrun productivity.

21.Depending on how skillfully the addicts were in claiming the rent during the windfall, they will then be better positioned to “recover” after the collapse. That is because the adjustments they made during the boom give them an advantage to claim rents in the future. The best example of this in Russia is the railroad industry. We look again at the relationship between railway car production and the oil price, now 8 [Gaddy & Ickes on addiction]

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using monthly data to see the most recent resurgence in oil prices. Notice how the recovery in oil prices has generated a recovery in railway car production as well. 9

i. Industrial production is still below y/y, but it is recovering in time series. Year to year comparisons are misleading as we approach the anniversary of the start of the crisis.

22.Notice that if the economy were not addicted and had just engaged in the consumption boom, it could have avoided the creation of a financial system dependent on foreign capital inflows. The system would have been less sensitive to a sudden stop of capital flows and would now be in a better situation to cope with the crisis. The Illusion of “Diversification”

23.While some argue that Russia's crisis is “home grown,” this argument is rather absurd. If one considers how large a crisis Russia would have with $120 barrel oil, the answer speaks for itself. Some then argue that if indeed Russia’s crisis is due to collapsing oil prices, then Russia should have been less dependent on oil and gas. Then it would have experienced less of a shock from the international financial crisis. This is not clear. Eastern European economies that are not oil exporters are also suffering dramatically from the crisis. Ukraine (which one can think of as Russia without oil and gas) and Hungary have already received bailouts from the IMF. Russia avoided this fate thanks to the [Yakunin interview. He admits that there is overcapacity in freight cars now, but still the orders continue to flow to the plants. It is rent-sharing. The Russian Railways are key.] 9

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large dollar reserves it was able to build up precisely because it was a large petroleum exporter. 24.Disregarding for a moment the experience of other economies, let us

suppose that Russia had undertaken a diversification program in 2000. What is the likelihood that this would have resulted in success by the summer of 2008? How could such a program of “diversification” have been financed if Russia had not focused on exporting oil? Moreover, one must think hard about the meaning of diversification. To have helped, the performance of the “new” sectors developed in a diversification effort would have to had fluctuations uncorrelated with oil and gas. Sectors that are positively correlated would not lead to any diversification. It is not clear what Russia could have diversified into that would have dampened fluctuations. What we do know is that to the extent that the Russian economy grew in the last eight years, it did so in sectors dependent on oil and gas revenues. The sectors that supposedly signaled an economy that relied less on oil and gas — retail, construction, real estate, finance, consumer goods, and especially, heavy manufacturing — turned out to be totally dependent on oil and gas income. Had Russia devoted more investment funds to manufacturing or to greater expansion in capacity in the retail sector, it is likely that the shock to GDP from the world crisis would be even larger. a. Energy and growth. China and India. Why would you diversify away from the big prize? Makes no sense whatsoever. Only if prices fell to $10 per barrel. b. Volatility is not a problem, only level is. Volatility can be dealt with by diversification, not of production, but financially and via investment in the oil sector. i. Show chart on oil and gas producers [what is this?] 25.Therefore, the relevant question to ask as regards pre-crisis policy is:

Given an unavoidable dependence on oil, how do you best manage your oil and your revenue from oil? The accepted wisdom is: create a petroleum fund. Russia did just that. Some forty percent of gross export revenues were channeled into its various petroleum funds. Moreover, the government acted properly with these funds. It did not invest inside Russia. It put the funds it in foreign securities, because the point of such a fund is to diversify risk. Had it instead used the funds for domestic investment, Russia would be in an even more serious position today: consider that every single non-oil sectoral index in the benchmark Russian stock market , the RTS, fell more than the oil and gas sector index since the market’s mid-2008 peak. (The oil and gas index fell 68 percent, while the overall RTS index fell by 76 percent from peak to trough. The telecom and consumer goods indexes fell by

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around 80 percent, and the manufacturing and financial sectors by over 90 percent.) a. Add chart of RTS without oil and gas, though market capitalization would be tiny b. Then look at Ukraine and Hungarian stock market. Could sufficient diversification have happened to insulate Russia from the global crisis? Look at global stock markets. The US stock market fell 50% — far less than the Russian stock market — but it had not grown as fast as Russian market did prior to the crisis. Moreover, the Russian market has rebounded much faster.

[add EURO350 and GLOBAL1200 to this] c. The depth of the Russian market crash was indeed dramatic. But

it is easy to focus only on the downside. One needs also to remember how much Russia gained during the boom: retail sales did grow, consumption rose, and reserves rose.

26.To sum up, the crisis in Russia is all about the oil. Russia has experienced a large fall in asset prices because it had the largest appreciation prior to the bubble. As oil prices fell this caused Russian asset prices to fall dramatically. At the same time, the international financial crisis led to a net outflow of capital and increased the difficulty of servicing dollar-denominated debt. This problem is common in many emerging markets. The difference in Russia is that this is accompanied by the direct impact of lower oil prices and thus export revenues. RESPONSE TO THE CRISIS

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27.By all indications, Putin has chosen not to prioritize using the reserves for a social safety net for Russian households. Rather, he appears to be counting on Russians to turn to traditional self-defense mechanisms for dealing with internal crises. Experience with the so-called virtual economy of the 1990s suggests that Russians have coping mechanisms. These include not just barter and other arrangements but growing food on private plots.

28.Exchange rate policy has been the most notable means of support for households and companies. Again, the apparent intent was to let people fend for themselves, but giving them time to adjust to the shock through gradual devaluation. In the period from early October through mid-December Russia spent around $100 billion of its foreign exchange reserves to keep the ruble’s value up as the oil price plummeted.10

29.More important, is the fact that using Russia’s vast foreign exchange reserves to support the ruble allowed Putin to provide protection for key oligarchs — a key element of his system. As Putin considers private ownership to be critical for efficient management, he does not want them to fail. Nationalization is not a preferred option for Putin. Protection in this environment ties them even closer to him. a. Putin needs oligarchs now to step up and shoulder burden. Pikalyovo.

10 Between October 3 and December 19 the oil price fell by 64 percent, while the ruble lost only 6 percent against the dollar.

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b. Put Putin quote here.11 Less than in US stimulus package. Putin is more resolved than ever to stick to his fundamentals. And to coping with addiction. c. No evidence yet that he wants to abandon system. Rather he wants to put more pressure on oligarchs to perform as intended. Keep to the deal, they have to pull their weight. d. Putin is asking himself now is whether they acted correctly in the crisis – not hard to look good in the boom, but were there actions in the boom robust to crisis which is what concerns him. THINKING ABOUT THE FUTURE

30.[The future is about (1) priorities; (2) the Model; (3) the means.] The Priorities

31.Putin’s priorities are stability and sovereignty. Stability has come from currency intervention. Oligarchs sharing rents. Incomes better supported now than in 1998, thanks to strong state – no government wage arrears. In private sector. Jobs are main concern. 32. Sovereignty is about foreign economic policy. The debt-reserves issue was key.

33.The idea that this crisis will cause Russia to turn back towards the situation of the 1990s — dependence on western finance and advice, and submissive in its international behavior – is wrong.12 There is a

11 Speaking to members of Russia’s Chamber of Commerce and Industry on May 27, 2009, Putin said: “We often hear variations on the theme of import substitution. I would like to reiterate my opinion on this matter. I do not believe import substitution is an end in itself. And in general, when we speak of import substitution, we tend to say that in this or that plant we produce goods of no worse quality than one or the other of our competitors. That’s a faulty approach to addressing the issue of innovative development. What does "of no worse quality" mean? We must manufacture our better and cheaper goods, or not manufacture them at all. Maybe it’s easier to buy them from abroad? “I understand full well that when we are speaking of the country's defense capabilities and about areas of state activity that must be developed for the sake of national survival, then we do have to produce those goods domestically, even if it is more expensive. ... But if we are speaking in general about the economy then there is no reason to engage in import substitution if we can buy things more cheaply abroad. Because if we always just try to play catch up, we will always be behind.” 12 The experience of this crisis makes this less likely than ever. The rapidly

intensifying crisis in Eastern European economies only reinforces his conviction that his way was correct. Where he might have trusted western economic expertise before the crisis (though never western intentions) he is less likely to trust it now.

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misconception in the international community about Russia’s resurgence. Missing quadrant argument. a. Oil prices have not fallen back that far b. Putin tries to change the nature of the game, though reserves etc., to avoid going back. The missing quadrant argument is mechanical; it ignores behavioral responses such as Putin’s actions to avert the threatened outcome.

34.The issue for Russia’s international behavior is not overall economic health but primarily the issue of financial independence (sovereignty). Putin will defend this at all costs. Having built up international reserves of over $600 billion Putin was better able to cope with the financial crisis than would otherwise have been the case. He thus views the crisis as validation of his model. The Model 35.[Two elements: (1) Rent-sharing; (2) Protection Racket] 36.[Will he try to control addiction?]

37.Putin will continue his model of private ownership of key strategic resources but under his firm control.13 This will continue his policy of balancing the two imperatives of strengthening the State and enhancing economic efficiency. The essential point of his model is that Putin will make this choice. a. The crisis has called into question, for Putin, the notion that these guys are really efficient. Banking crisis and Deripaska mess could suggest otherwise. The Means

38.Any forecast for Russia’s economic future depends on the flow of rents from oil and gas. For analysis, it is crucial not to get distracted by other issues. Key is oil and gas, investment in oil and gas, and rent distribution from oil and gas. Other issues are ephemeral. 39.[Rent is product of (1) Price; and (2) Quantity]

40.The Oil Price. In the short term the volume of rents available to Russia is almost entirely a question of the oil price.14 Only a view of the long historical perspective shows how anomalous the recent price 13 The mechanism is Putin’s protection racket. Putin provides insurance against

expropriation in exchange for submission to his directions. 14 See, for example, http://www.wtrg.com/prices.htm

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spike was. [See Figure] From 1947 thru May 2008 the median world price of oil was $19.04 in 2007 dollars, and the mean world price was approximately $27. The growth in oil prices by 2006-7 already reached levels only seen in oil spikes previously caused by wars. The maximum price of $147 per barrel was almost double the price reached during the Iran-Iraq war, the previous maximum price observed.

[I’ll add 2009 to this – around $62.]

41.Let us suppose that we are in a new price regime. This seems to be the consensus forecast from agencies like the EIA or IEA. What does this imply about the political economy of Russian resource dependence? Russia owns the world. Huge SWF’s from resource producing countries. Huge transfers of wealth from industrialized countries.

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a. Under this scenario, the folly of Russian diversification away from oil and gas is self-evident. It is also clear that in this scenario Putin’s Protection Racket System would remain very robust. i. It will be more vital for him to maintain it, and it will be easier to sustain because of the wealth transfer. b. Is this really a robust forecast for the global economy? Can the global economy adjust to such a rapid reversal of fortune? While these seem to be consensus forecasts for oil prices, the consequences they imply for the distribution of world wealth makes us skeptical about the robustness of this scenario. i. The necessary adjustments in exchange rates, trade flows, and patterns of capital flows make us skeptical.

42.Investment in Future Oil. In the medium term, the key issue for maintenance of the rent flow is the quantity of oil and gas produced. This requires investment in new reserves, primarily located in Eastern Siberia. Development of these new reserves raises a whole new cost dimension. The eastern oil is in regions that are colder, more remote, and geologically more complex. It also introduces a significant additional risk dimension. Obtaining the new reserves requires large, non-discrete investments, something that exposes Russia to a huge risk if prices return to low levels. Russia needs to share this risk to avoid being hostage to persistent low oil prices. This point is central to thinking about Russia’s future relationship with the global economy. a. This is a problem because of the uncertainty about future oil prices. Investments are irreversible so price shocks can be costly. Primarily because of fear of a return to a low oil price. b. The supposed fear of volatility (e.g., Sechin) is really fear of a return to a low price regime, which is the historic pattern. The last six years of oil prices have been historically anomalous. The key question for Russia, and others, is whether we have in fact entered a new price regime, or will prices return to the historical norm? i. Price pictures here 43.The big problem is that Russia cannot control oil prices and must anticipate various scenarios for how long prices will be low. Because it cannot control prices it has to worry about the level. Volatility is an additional issue. Volatility can be addressed through diversification of income risk.

44.What happens, on the other hand, if oil prices return to the historic pattern? This makes it much more costly to expand to Eastern Siberia.

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If they cannot diversify this risk they will not be able to sustain current levels of production. a. There are two possible futures with low Russian investment and future production i. Russian output falls, but demand and supply are such that prices remain in the historical price regime. This means low future Russian resource rents. This is the worst future for Russia. ii.Russian output falls, the world energy balance suffers because of no other demand or supply shifts, and the EIA scenario becomes true. This is obviously less problematic.

b. Consider the following payoff matrix. There are two price scenarios (low = LP, high = HP) and two possible future production levels for Russia (LO, HO). LP

HP

LO

Bad for Russia Good or bad for World

Good for Russia Bad for World

HO

Bad for Russia Great for World

Russia Rules the World Bad for the World

Figure 11: Payoffs with no Diversification

c. The important point of the payoffs in figure 11 is that with no diversification the interests of Russia and the “World” differ. The states where Russia is better off are those where the “World” is worse off and vice versa. When there is no diversification interests diverge.

d. Now compare this to the payoffs in figure 12 when the risk of investing in high output is shared between Russia and the rest of the world. Obviously this case is only relevant in the high output cases. In the diversification case the risk of price volatility is shared between Russia and the “World.” Therefore, there is a convergence of interests.

e. One might argue that one can achieve the same outcome with investment in claims against incomes, rather than in oil output. Thus, the “World” could buy securities that pay off in the state (HO,HP) and sell securities that pay off in the state (HO, LP).

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Russia would be on the other side of the transaction, and risks could thus be hedged financially. Financial diversification may be an alternative means of achieving a convergence of interests.

HO

LP

HP

Shared Low Gains for Russia and West

Shared High Gains for Russia and West

Figure 12: Payoffs with Diversification

1. Russia will remain part of the global economy because of its dependence on oil and gas and its role as an exporter. Attempts to diversify into other sectors is not a practical solution in this situation. It is how Russia chooses to share the risks involved in future oil development, and the opportunities that the outside world provides for such risk sharing, that will determine the nature of Russia’s relation with the global economy.

2. If the relationship between Russia and the West remains only that of seller to buyer, then integration will be minimal, Russia will bear all the risk of reserve expansion, and it will consequently be less likely to expand reserves. Global energy security will be weakened. Russia will have little incentive for cooperative behavior in general.

3. A positive development would involve sharing the risk with western oil companies. At the same time, Russia would be able to diversify its income risk by investing in global assets (e.g., Sovereign Wealth Fund). Such an outcome would tie Russia’s interests more closely with the global economy. This would lead to more reserve expansion and future rents, enhance global energy security, and provide an incentive for Russia to cooperate more fully with the global economy. 4. Missing Quadrant.

5. The idea that Russia will become compliant now that oil prices have fallen significantly misinterprets Putin’s system. Russia was compliant in the 1990’s when oil prices were low and Russia was weak. Putin built up reserves and paid off the foreign debt when oil prices increased. This was a strategy to gain independence of action. For Putin the optimal level of reserves is higher than it would be for a normal country with access to international capital markets. The latter would use this access as insurance, borrowing in bad times and saving in

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good states. For Putin, however, the optimal level of reserves is higher because he will not forego the independence that high reserves bring him.

6. But this does not mean that low oil prices reverse behavior. First, oil prices are not all that low. They have only returned to the 2004 level, and in that period Putin was already paying off all external debt. Second, during the boom years Putin built up reserves. He is maintaining them at a still high level even after bailing out many oligarchs.