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RUCPDOC/DEPT OF COMMERCE WASHDC PRIORITY

C O N F I D E N T I A L MOSCOW 002615

SIPDIS

STATE FOR EUR/RUS; NSC FOR MWARLICK

E.O. 12958: DECL: 08/28/2018
TAGS: ECON PREL PGOV ETRD EINV RS
SUBJECT: AFTER THE WAR WITH GEORGIA: RUSSIA'S ECONOMIC
FUTURE MORE UNCERTAIN

REF: MOSCOW 2563

Classified By: Ambassador John R. Beyrle for Reasons 1.5 (b) and (d).

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Summary
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¶1. (C) That Russia is "back," at least economically, has been
an insistent theme of the Kremlin the last few years.
Russia's economic recovery from the depths of its financial
crash in 1998 is indeed impressive. High growth, burgeoning
international reserves, and rising living standards were the
result of luck in the form of a five-fold increase in the
prices of oil and gas, Russia's main exports, but also the
result of prudent macroeconomic policies that stressed fiscal
and monetary stability.

¶2. (C) We would argue, however that the Russian government
has overstated the extent of this economic restoration and
its sustainability. After seven years of 7 percent growth or
better, per capita income remains below $10,000 a year and
only last year did Russia's GDP finally surpass its level in
¶1991. Moreover, unlike other emerging markets such as China
and India, Russia's impressive growth has not been fueled by
its manufacturing sector but rather by rising but volatile
commodity prices.

¶3. (C) The underlying fragility of the Russian economy and
its uncertain future have been brought into sharp focus by
the war in Georgia. Some of our contacts agree with the line
from the Russian government, that the economy will quickly
recover from its current turmoil. Other observers believe
that higher political risk has returned for the foreseeable
future -- bringing with it lower economic growth. However,
all of our contacts are increasingly pessimistic about the
ability of the GOR to pursue the reforms needed to modernize
and diversify the Russian economy.

----------------
Short Term Costs
----------------

¶4. (C) One of the persistent myths that Russian government
officials press publicly about the Russian economy is that it
is "decoupled" from the global financial system, by which
these officials mean its growth and stability are not
affected by global developments and specifically are immune
to the effects of the sub-prime crisis in the United States.
A corollary of this argument is that Russia is a "safehaven"
for international investors. However, the performance of
Russia's stock markets over the past two months and
especially since the war with Georgia erupted belies these
claims.

¶5. (C) As we have reported elsewhere, the Russian stock
market began its slide in mid-May. Global conditions -- a
strengthening dollar and softening demand for commodities -)
were contributing factors. However, a series of government
actions culminating in the decision to invade Georgia and
recognize Abkhazia and South Ossetia's independence are
principal causes that have driven the stock markets to their
lowest levels in nearly two years, in the process wiping out
hundreds of billions of dollars in shareholder value.

¶6. (C) With military activities subsiding, local newspapers
have been increasingly filled this past week with articles
about the economic cost of the war and its aftermath for
Russia, citing especially the stock market losses and the
downturn in business confidence. The Kremlin has seemed
oblivious to these concerns, claiming that the economy is
fundamentally strong and will quickly recover. Some local
analysts agree, citing in particular Russia's status as the
world's largest exporter of hydrocarbons. Chris Weafer of
Uralsib noted in an August 27 e-mail to clients that Russia
has $1 billion in oil and gas revenue coming in each day and
tensions with the West, including possible sanctions, will
not affect this.

¶7. (C) However, other analysts are less sanguine. xxxxx told us that the decline in the
stock market is "how the business community gets to vote
about the government's economic policies." He said foreign
and Russian investors' bet on the Russian economy is on its
"convergence" with Western economies. With that now in
question, he and other analysts see the return of "high
political risk" to the Russian economy and worry that it may
be permanent. Although they don't see a 1998-style collapse

coming, they do see lower growth over time. In fact, most
analysts have been systematically cutting their forecasts for
2008 growth over the past two weeks.

¶8. (C) The effect of the global credit crunch has been
magnified by increased political risk in Russia, further
raising the cost of capital. More expensive capital will
cause Russian and foreign businesses here to delay or cancel
expansion and improvement plans, lowering growth. The
Russian economy is particularly vulnerable in this regard
because it is heavily reliant on foreign capital for its
long-term financing needs. Russian corporations reportedly
have $500 billion in increasingly expensive short-term
foreign debt.

¶9. (C) According to xxxxx lower growth in turn ultimately
puts at risk the grand bargain the GOR has made with the
Russian people -) rising living standards in return for
political quiescence. He believes, as do many of our other
contacts, that a likely outcome is that the GOR will
intervene and recapitalize Russian companies in place of the
expensive foreign loans. Norilsk Nickel's Vladimir Potanin
had a highly publicized meeting last week with Medvedev in
which he reportedly asked for this. While xxxxx thought
this might spark a market rally and ease the short-term costs
to the Russian economy, he acknowledged that the long-term
economic consequences would be negative.

----------------------
Long Term Consequences
----------------------

¶10. (C) A second myth about Russia's economy is that it has
been moving beyond dependence on exports of natural resources
and that its current prosperity is now driven by a
self-perpetuating growth in consumer spending. In fact, the
boom is threatening to go bust. Inflation has risen rapidly
over the past year, exposing the underlying disconnect
between supply and demand in the economy. Simply put, the
energy bonanza has fueled sharply increased domestic demand
and in the absence of an adequate supply response, prices
have soared.

¶11. (C) The GOR explicitly acknowledged that economic growth
was off kilter in the run-up to the presidential election in
March. President Medvedev made a series of statements, the
most famous his February "four I's" speech at the Krasnoyarsk
Economic Forum, at which he called for fundamental reforms to
the Russian economy, including: strengthening institutions,
improving infrastructure, moving to a value added
"innovation" economy, and improving the climate for
investment. The net result, according to Medvedev and his
inner circle, would be a more modern and more competitive
economy.

¶12. (C) Medvedev's agenda appears to be one of the casualties
of the war in Georgia. There was already entrenched
opposition to the reforms within the ruling elite, and
especially to Medvedev's emphasis on fighting official
corruption and reducing state control. Much to the dismay of
the majority of the business community, Medvedev's apparent
loss of influence (reftel) would seem to put paid to the
reforms, at least for the time being. It has also raised two
very important questions: who is in charge of Russian
economic policy and what are their objectives?

¶13. (C) The easy answers in the wake of the Georgian conflict
would be Vladimir Putin and that his goal is maximizing the
economic power of the state. However, it is more complicated
than that. There are three primary economic tendencies or
groups that are discernible within the Russian government
elite. All of them enjoy some degree of support from the
"tandemocracy," and all of them have influence and shape
policies.

¶14. (C) Two of these groups are generally characterized as
economic "liberals" who favor market solutions: one group
centered on Finance Minister Aleksey Kudrin and the other on
President Medvedev in the person of his principal economic
advisor, Arkadiy Dvorkovich. For Kudrin's group, which
includes his Finance Ministry and the Central Bank, the
watchword is stability. They favor more moderate growth and
more gradual reforms. Dvorkovich's group, which includes the
Presidential Administration and most of the Ministry of
Economic Development, favors faster growth and faster
reforms.

¶15. (C) These two groups probably agree on more issues than

they disagree on, especially on the need for the
modernization, integration and diversification of the economy
encapsulated in Medvedev's reform agenda. However, a month
ago it was their disagreements over inflation and taxes that
were driving economic policy. Kudrin thought the economy was
overheating and wanted to slow growth and rededicate the GOR
to fiscal discipline. Dvorkovich argued for lower taxes to
stimulate even faster growth which, when combined with
structural reforms and infrastructure investments, would
unleash the supply response he thought was needed to restore
equilibrium to the economy.

¶16. (C) The result of the competition between these two
groups seemed to be a healthy debate within the GOR that was
likely to lead to a set of compromise economic policies that
would have promoted Medvedev's reforms while emphasizing
continued stability. xxxxx that the
government's policies could be summed up as: legal reform,
leading to reduced corruption, leading to increased economic
freedom, leading to a surge in small and medium sized
enterprises, leading to faster and better economic growth,
the benefits of which would be more widely and evenly
distributed.

¶17. (C) However, the third group within the governing elite
that has a great deal of sway over economic policies -- the
so-called "siloviki" -- has very different goals. They are
not easily identifiable as a group and have no natural leader
on a par with Kudrin, since their members are driven
primarily by self-interest. They do, however, share two
overarching characteristics: a preference for state control
and a high tolerance for official corruption. They are often
closely linked or overlap with another amorphous group, the
"oligarchs," Russia's fabulously rich billionaires, most of
whom made their money out of political connections, are loath
to challenge the government in the wake of the Yukos affair,
and an increasing percentage of whom, like Deputy Prime
Minister Sechin or the head of state corporation
Rostechnologia, Sergey Chemezov, have backgrounds in the
security services.

¶18. (C) The siloviki are by all accounts the big winners out
of recent events. There were reports that Medvedev was
planning to move many of them aside in a fall government
reshuffle. If such plans existed, they are now shelved. The
siloviki are also the main opponents of modernization and
integration, which would have limited their ability to
extract rent from the economy. These individuals are now
more likely to succeed in arguing for continuing state
control, and therefore their control, over the commanding
heights of the economy, especially the energy sector -- where
the profits are high and the profit margins even higher.

¶19. (C) The Kremlin's consistent rejection of the economic
consequences of its action, whether over the TNK-BP investor
dispute, the Mechel incident, or the conflict with Georgia,
has played into the siloviki's hands, reinforcing their
authority and their ability to delay reforms. That said, the
weakness of the siloviki's position, according to xxxxx and
others, is that the long-term uncertainty about the GOR's
commitment to market economics and international integration
) to playing by the rules at home and abroad ) will
inevitably reduce the economic resources at the government's
disposal and that in turn will put their two principal
objectives, personal enrichment and continued control of the
country, in direct competition.

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Comment
-------

¶20. (C) There are two economic futures for Russia. The first
is the one that Medvedev and the economic liberals have
sketched out in the government's ambitious "2020" development
plan. This future is that of an "innovation" economy that
has diversified away from a reliance on commodity exports
toward industries where Russia can add value. In this
economic future, Russia's enormous revenues from oil and gas
would have been used to transform and modernize the economy.
60 percent of Russians would be "middle class" providing a
lasting force for political and economic stability. This
future seemed poised to emerge as a central government
priority just a few months ago; now it is clearly on a back
burner.

¶21. (C) The darker future is one all too familiar to many
countries that are blessed with natural resources and cursed
with poor governance. It is a Russia still dependent on

volatile commodity exports, the surplus of which is easily
captured by an entrenched and self-interested governing
elite. It is a country of income extremes and unstable
politics. And it is a country that, with its resources being
rapidly depleted or with the world moving toward other energy
sources, may have missed its chance at lasting prosperity.

¶22. (C) Both of these futures pose opportunities and threats
for the U.S. A prosperous, more self-confident Russia is one
that will require the intensive engagement and policy
give-and-take that characterizes our relations with our
European allies. It is less likely to be a Russia that
threatens its neighbors and fears their stability and
prosperity. A Russia still dependent on commodity exports
will likely be intrinsically weaker and less influential
globally, but lacking domestic accountability, it will pose
more of threat to its neighbors and therefore to
international order.

¶23. (C) Without doubt, the U.S. has a clear interest in the
first future: for a more prosperous, better integrated, more
stable Russia. With that in mind, we would argue that the
U.S. needs to be careful that our efforts to demonstrate that
Russia's actions vis-a-vis Georgia have real consequences do
not play into the hands of the anti-reform circles who are
promoting that other future.

¶24. (C) The Russians of course, especially the progressives
around Medvedev, also face a difficult choice. Medvedev's
recent public statements, especially the harsh rhetoric that
Russia has nothing to fear from economic isolation, are
contradicted by privately-expressed hopes that we not take
steps to isolate them. They will ultimately have to decide
when and how to confront their domestic opponents if they are
to avoid this fate and if they are to resume their efforts to
transform Russia's economy.
Beyrle