Alexei Kudrin

When Alexei Kudrin was appointed finance minister of the Russian Federation by then newly elected president Vladimir Putin, his in-tray was still dominated by the fallout from the financial sector meltdown and government default of 1998. After eight years and a promotion to deputy prime minister, Russia’s foreign exchange reserves are at more than $580bn after a sustained period of high oil prices, financial sector asset growth is close to 50% per year, and ratings agency Standard & Poor’s (S&P) forecasts Russian GDP to overtake that of Brazil in 2010, becoming the world’s ninth-largest economy.

But just in case anyone should think the job is getting easier for The Banker’s 2005 European Finance Minister of the Year, 2008 has served up timely reminders that investor perceptions and market conditions can change all too quickly. The global credit crunch exposed high levels of external borrowing by Russian banks and companies, triggering banking sector illiquidity despite the petrodollars. Inflation is doggedly in double figures, and critics warn that government efforts to bring down food and raw materials prices by price controls, or price-fixing charges against companies such as coal producer Mechel, could make things worse by jeopardising production.

The banking shock came after a stock market slide following the conflict in the breakaway regions of South Ossetia and Abkhazia in neighbouring Georgia. Mr Kudrin is entirely in step with his cabinet colleagues in blaming Georgia for escalating the conflict. In the middle of the interview, coincidentally or otherwise, he receives a call from the Russian conductor Valery Gergiev, about to give a concert in South Ossetia, who apparently exhorts the finance minister to “tell the world” about the damage done by the Georgian army in the region.

In keeping with his own financial remit, Mr Kudrin focuses on Georgia’s request for IMF and World Bank reconstruction finance amounting to $1bn.

“The sum of this loan is about as much as Georgia has spent in the past year on its military budget – fuelling this conflict would not be good for Georgia or Russia,” says Mr Kudrin. But he emphasises that the impact of prolonged tensions over South Ossetia and Abkhazia would “be more considerable for Georgia, rather less for Russia”. He projects national defence expenditure at $41bn for the forthcoming fiscal year, and says he does not expect this number to change in the wake of the conflict.

Keeping faith in globalisation

However, he is more exercised by apparent pressure from some World Trade Organisation (WTO) members, including Georgia itself, to obstruct Russia’s entry. This would, he warns, be “certainly counter-productive” in terms of integrating Russia more closely into the international community. Accession was originally scheduled for 2005 but has faced what Mr Kudrin, who previously led Russia’s negotiating team, calls “purposeful delay”.

He argues that Russia today meets higher economic parameters than Ukraine – which was allowed to enter this year – and points out that the Russian government had already signed tariff agreements with the EU on agriculture and financial services, and pre-accession agreements with the US “and even Georgia”, a deal which is now frozen.

Subsequent to this interview, Mr Putin publicly cast doubt on the value of WTO entry for Russia, but by contrast, Mr Kudrin clearly still considers it important. “We are interested in entering the global economy, accessing global goods and technologies, and we are increasing our imports,” he says. Ominously, however, he indicates that existing arrangements with the US “might have to be revised” if WTO entry is delayed again.

There are, he points out, many business interests in the US which would be disappointed if diplomatic tensions between the two countries spilled over into the commercial arena.

Other governments are also showing increased suspicion of Russia’s behaviour. Most recently, the German government began considering restrictions on foreign sovereign wealth funds (SWFs), which would prevent them buying more than 25% of any company in certain strategic sectors.

However, Mr Kudrin says this threat has “no influence” on his policy for Russia’s National Welfare Fund, as he intends to be “very conservative” in placing the funds. He repeatedly emphasises his intention to follow the Norwegian SWF model, which includes rules limiting investments in any individual company to 5% of that stock’s market capitalisation. He notes with a smile that Norway is now considering doubling that limit, as the size of its fund begins to complicate portfolio management, but says Russia will not automatically follow suit.

All this may offer reassurance to foreign governments, and Mr Kudrin adds that he is happy to participate in the IMF-sponsored international working group of sovereign wealth funds, which published a draft set of generally agreed principles and practices after a meeting in Chile in early September 2008. “I used to be more sceptical on the matter, but now I have seen that the group has been very constructive in its work. Initially, it was all very emotional, representatives of different countries would talk about restrictions, but now they are talking about transparency and commercial motivation”.

Mr Kudrin acknowledges that “the confrontation with Georgia of course damages the image. Russia has an interest in preserving peace and stability on its borders”. Nonetheless, in terms of country risk, he evidently feels that the case for investing in Russia largely makes itself.

He announced capital outflows of $7bn in just two days at the height of the fighting in Georgia, but says he has “no concerns that Russia might lack capital this year”, and still expects full-year capital inflows to be “in accordance with” his original forecast. At the start of the year, he forecast net capital inflows for 2008 at $40bn, less than half the $82bn in 2007, but he emphasises that this decline is “the result of the world financial crisis and outflow of funds from all countries with transitional economies”.

“There are no new or additional risks that have emerged in Russia recently, therefore I see no reason for concern,” says Mr Kudrin. “We have 215 banks with foreign capital participation in ­Russia, and over the past three months there have been more purchases, which demonstrates that foreign banks are still interested in investing in a growing market with good profits,” he adds.

This assessment was made before the dramatic events of mid-September, when investment bank KIT Finance had to be taken over to stave off bankruptcy and billions were pumped into the banking system in government deposits and liquidity injections. The episode strengthened pressure on Mr Kudrin to unlock the NPF and invest it in the domestic banking sector and stock market, but speaking before the banking shock, he seemed reluctant to pursue that strategy. “We are limited in terms of internal investments. That is related to monetary policy, as we do not want to add too much money supply,” he warns.

Money flows in

Russia’s bankers remain convinced that the country is too well integrated into the international economy for any profound breakdown. Oleg Pankratov epitomises that integration: recently appointed co-head of global banking at Russia’s VTB Capital, the investment banking arm of 77.5% state-owned bank VTB, the former Merrill Lynch banker is now based in London.

“In terms of the project finance we are involved in, I certainly did not get a single call from our foreign partners saying they are now thinking of doing something else or changing their pricing,” he says. “The concerns are there in the market, but what encourages me is that the bigger companies like our partners, who are long-term investors in Russia, are still looking to play in this market.”

However, says Ivailo Vesselinov, Russia economist for Dresdner Kleinwort in London, the nature of inward investment in Russia is patchy. “A lot of investors will still decide, despite the risks, that they are better off participating in an economic success story than staying away,” he explains. “But there will be an impact at the margins, it depends on the region and on the sector where you are seeking investment.”

Wealth divide

While the natural resources and retail sectors are booming, the manufacturing sector is underperforming overall GDP growth.

“If you look at the breakdown of industrial production, output has been supported mostly by heavy manufacturing – railways, pipelines, construction equipment,” notes Mr Vesselinov (see chart, page 109). These activities enjoy reliable demand from state-owned companies in the natural resources sector. “The light manufacturers are struggling more, and they are much more exposed to foreign competition,” he adds.

The high inflation rate is a significant factor eroding the competitiveness of Russia’s tradable goods, and Mr ­Vesselinov argues that the fiscal stance has played its part in stoking inflation. “Mr Kudrin is prudent, he has been opposing further cuts in taxes, but the opposite view seems to be prevailing,” he says. “The budget in its current version is expansionary, and it is contributing to the inflation overshoot – if you strip out volatile food and fuel prices, you still get an inflation rate of about 10%.”

Belt-tightening strategy

In setting out a three-year budget plan starting from 2009, Mr Kudrin hopes to address directly concerns over expansionary fiscal policy and oil dependence. He is not counting on any dramatic increase in oil and gas output – in fact, his budget assumptions are based on oil production remaining almost flat, with gas output rising by a modest 2% per annum, far less than overall GDP. He projects Urals crude oil prices to decline from an average of $112 per barrel in 2008 to $88 in 2011.

On this basis, his plan is to lower transfers from the oil and gas revenues account into general government expenditures from 4.9% of GDP in 2008 to 3.7% by 2011, where it will be fixed by law. This will necessitate budget cuts, and like so many finance ministers, Mr Kudrin is hoping that efficiency savings will form part of that package.

“Savings from better governance should be about 1% of GDP, housing subsidies will be another cut of about 2% of GDP, and subsidies to the regions another 1%,” he explains. At present, these subsidies can account for as much as 15% of the regional budget in some of the Far Eastern republics such as Tyva on the Mongolian border.

It is a tall order. “Already, from what I have mentioned, you can see we are talking about big cuts,” says Mr Kudrin. At the time of this interview, the budget was still to be sent to the Duma for consideration. Asked if he has the political support to push ahead with budget cuts, Mr Kudrin replied simply “this is still a proposal, it has not been approved yet”. By the time this article went to press, he was already under pressure from the Russian Union of Industrialists and Entrepreneurs to cut oil levies further – taxes are charged on volumes of hydro-carbons produced, which critics argue is an obstacle to companies investing to increase output.

Indeed, with foreign exchange reserves so large and market conditions volatile, Mr Kudrin seems to be finding it harder than ever to convince his colleagues of the need for fiscal prudence. All the more so, after last year’s departure of his longstanding reformist ally at the Economy Ministry, German Gref, who has since become chairman of Sberbank.

­­­Mr Kudrin recalls fondly his own time outside politics, as an academic economist at the Russian Academy of Sciences, before he joined the St Petersburg city administration in 1990. But he emphasises that he is not yet ready to think about life after politics: “It is too early to say, and I have too much on my agenda.” Investors in Russia will be relieved to know he has no plans to take his eye off the in-tray just yet.