TCS Daily

Oil Only? Nyet!

By Dominic Basulto - August 12, 2002 12:00 AM

The Bush administration has been a willing accomplice in Russia's current push to ramp up oil production, claiming that Russia will provide a viable alternative to OPEC exports of oil to Western markets. While the notion of an alternative to volatile Middle East markets is commendable, the policy is inevitably short-sighted, since it will only increase Russia's historic reliance on the export of natural resources, especially oil and gas. Due to a legacy of Soviet economic planning that celebrated the large, bloated state enterprise, Russia remains an unbalanced economy dangerously reliant on behemoth gas & oil exporters such as Gazprom, LUKOil, and Yukos. Current economic estimates suggest that oil- and gas-related industries account for nearly 15-20% of total Russian GDP and close to 33% of all tax revenues.

A better policy would be to encourage the diversification of the Russian economy. One model could be the structural transformation of the Texas economy during the 1980s and 1990s, when the state shifted away from an unhealthy reliance on oil and gas after a crippling economic shock. Without economic diversification, Russia faces the prospects of permanent dependence on natural resources and an unstable, commodity-based capitalism. One key centerpiece of any economic diversification could be a revitalized technology sector, which includes software companies specializing in IT outsourcing and a host of new telecom players. After all, Russia boasts a well-educated population, world-class scientific talent, and real expertise in sectors such as telecommunications, aerospace and defense that was developed during the heyday of the Soviet Empire. (Moreover, as firms such as Adobe or Citibank can well attest, Russia's more illustrious computer hackers are also world-class).

The Texas Economic Development Model

During the late 1980s and 1990s, the Texan economy faced many of the same problems now confronting Russia. In short, Texas resembled a developing nation dependent on natural resource exports: it experienced a "boom-and-bust" economic cycle directly correlated to the price of one underlying commodity: oil. By 1981, for example, the oil and gas industries accounted for approximately 27% of total Texas economic output. When oil prices precipitously fell in the 1980s, the Texas economy lurched into a steep recession. In Houston, unemployment soared to 12%, and many of the glittering downtown buildings in Dallas financed with oil money suddenly experienced record low occupancy rates. By the mid-1980s, the Texas real estate market and energy sector had collapsed, which in turn led to a string of bank failures during the period 1986-1990.

The bust during the 1980s made clear that economic diversification was a strategic imperative for the Texas economy. As part of a statewide effort to reduce reliance on the oil and gas sector, the Texan state government encouraged the growth of companies in the services, high technology, and manufacturing sectors. Aggressive bank lending and new capital infusions led to the creation of new businesses. By the mid-1990s, oil and gas accounted for only 6% of gross state product. More importantly, both Austin and Dallas now rank as two of America's Top 10 high-tech hubs. Dallas boasts the Telecom Corridor, while Austin has nurtured a number of computer industry giants, such as Dell Computer. The growth prospects for the Texan high-tech sector has attracted private equity capital and the creation of a highly trained, diversified work force.

Russian Commodity Capitalism

The signs of the dominant role that natural resources play in the Russian economy are hard to miss. In the Russian equity market, the top five leading companies by market capitalization are in the oil & gas sector: Gazprom, Yukos, Surgutneftegaz, LUKOil, and Sibneft. Moreover, oil & gas companies such as Gazprom typically own controlling stakes in a number of different companies, including media properties such as NTV. Former oil barons and other titans from the aluminum, timber, and nickel industries routinely wield influence on the government, especially at the regional level. In fact, the former chairman of Gazprom, Viktor Chernomyrdin, is a former Prime Minister. Even the leading Russian corporate sponsor of the 2002 Olympic team in Salt Lake City was a natural resources giant: Russian Aluminum.

Yet where has this unhealthy dependence on oil placed Russia? In terms of per capita GDP, Russia has the dubious honor of being sandwiched between Libya and Thailand. While some oil companies such as Yukos have been willing to invest in new technologies and adopt more efficient oil production processes, the bottom line is that the Russian economy remains overly dependent on the price of oil. When oil prices are high, everyone wins: the oil oligarchs make money, the Russian government boosts its tax receipts, and foreign lenders collect on Russian debts.

But what happens when oil prices fall? The Russian economy, while posting impressive 5-8 % annual GDP growth rates since the epic default and devaluation in August 1998, has been kept afloat by relatively high crude oil prices that have fluctuated between $18-to-$25/barrel. The annual budget remains balanced at a price of $18/barrel. You do the math if prices fall below this level. According to Business Week, every $5 drop in the price of crude oil costs Russia 1% in GDP.

The Texan Model, Applied to Russia

The path to economic diversification is not an easy one, to be sure. While oil prices remain relatively high, Russia has little incentive to introduce tough structural reforms. In fact, the newest overtures from the Bush administration would appear to provide even fewer incentives. There are at least three steps, though, that Russia can take to emulate the successful Texas economic development model:

  • Encourage the development of a banking system that places an emphasis on small business lending. Currently, small- and mid-sized enterprises (SMEs) do not have access to equity capital, and even larger companies can not find the necessary financing to replace old capital equipment, invest in new technologies or expand into new product niches
  • Rationalize the tax system. Already the Russian government has taken a number of progressive steps, such as capping the corporate profit tax at 24%. Further steps can provide tax incentives for the creation of new industries.
  • Reduce the level of bureaucratic red tape and corruption. According to one estimate from The Economist, setting up a business in Russia requires 20 different licenses and permits and takes an average of nearly two months. Moreover, the Russian economy is staggering under a maze of federal and local regulations that creates the unhealthy prospect for corruption and bribes. For example, under federal law, there are more than 500 different economic activities that require a license. Bureaucrats, always on the look out for possible ways to line their pockets, check the licenses of Russian retail businesses an average of 120 times each year!

In Texas, these three steps paid immediate dividends. An infusion of capital into Texas after the S&L crisis led to the creation of a well-capitalized banking system that was willing to make loans and relieve the "Texas Credit Crunch." Moreover, Texas government officials pushed for an economic development tax credit for R&D activities as well as tax credits related to job creation and capital investment. The North Dallas Telecom Corridor took root, bolstered by the arrival of companies such as MCI, Nortel, Fujitsu, Ericsson and Alcatel. The simplicity of establishing new businesses led to the creation of the thriving Austin technology sector and an entrepreneurial culture that rewards risk-taking. Instead of an economy dominated by state government and a local university, Austin now boasts over 2,000 technology companies in three main clusters: semiconductors, computers, and software.

The Texan economic development model provides a number of lessons for Russia. First and foremost, it is clearly possible to reverse a long-standing economic dependence on natural commodities such as oil and gas. It required a devastating economic shock, however, for Texas to consider the benefits of economic diversification. Secondly, Texas was able to make the change and still maintain an image of "Texas exceptionalism" - a notion that surely appeals to a former imperial power such as Russia.

It would be a shame if the events of 9/11 have created an impetus for the Bush administration to think of Russia in terms of oil only. If the US and Western Europe continue to encourage Russia's development as a natural resource giant only - rather than encouraging a more balanced economic growth - it may require a global financial shock before Russia reconsiders its unhealthy commodity capitalism.



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