Russia’s economy is not performing badly. Thanks to the high oil price, economic growth is likely to stay at 4 per cent or a little less for the next few years – respectable by West European standards. The problem is that Russia’s rulers do not appear to have a plan for modernising the economy, which is alarmingly unbalanced. Oil and gas provide half the government’s revenue and almost 70 per cent of export earnings. Output of oil and gas is flat and few new fields are coming on stream. Even if the oil price stays high, Russia is heading for current account and budget deficits in the years ahead.

But Vladimir Putin, now in his third term as president, seems unconcerned. I recently attended the Valdai Club, a group of Russian and foreign think-tankers, academics and journalists that meets Putin and other Russian leaders once a year. Compared with six or seven years ago, when I first attended these meetings, Putin’s attitude has evolved. He has become increasingly relaxed, to the point of complacency. He displays little sense of urgency about tackling the challenges facing Russia.

One participant, former German defence minister Volker Rühe, asked Putin an easy question: “Historians will say that in your first two terms as president, you brought stability to Russia. What would you like them to say about your third term?” Putin answered that he did not care what historians said, and that he was a pragmatist. He was happy that personal incomes had doubled during his time in charge, that Russia had $500 billion of foreign currency reserves and that the demographic decline had been arrested. He had nothing to say about his vision for Russia’s future or his own role in shaping it.

Asked whether it was important for Russia to reform its institutions, Putin merely talked about some legal reforms that were underway, adding that the central bank was an efficient body and that the tax administration had improved. Probed on the brain drain from Russia, he was insouciant: he said it was normal for people with skills to move from one country to another, in the way that many Britons went to the US. He told us that Russia was enticing lots of foreign academics to spend periods at its universities by offering them scholarships.

Putin was particularly upbeat about economic co-operation with China. It is now Russia’s biggest trading partner, with $83.5 billion of trade a year, compared with Germany at $70 billion, according to Putin. He said that both sides wanted trade to reach $100 billion a year. “This will happen as we are happy to buy more Chinese goods and they will buy more oil – and in the future, gas.” That last point is debatable: the Chinese seem unwilling to pay the price for gas that Russia is demanding. Putin added that there would be more co-operation on nuclear power – the first plant built by Russia in China was running and there would be more to come – as well as aviation and space technology. Other Russian leaders told us that growing economic ties to China – plus co-operation over Syria at the United Nations – would not extend to security (in Beijing there are reports that Russia proposed closer military relations earlier in the year, but had been rebuffed by Chinese leaders).

“We don’t need to go east or west, we are in a good place in the centre of Eurasia,” asserted a senior parliamentarian. Russian leaders are proud of the initial success of the Customs Union with Belarus and Kazakhstan, which has boosted trade (by 40 per cent, according to the parliamentarian). Russian economists say the Customs Union has led to regulatory competition between Russia and Kazakhstan, as they seek to attract investment. This competition may have helped them move a little way up the World Bank’s ease of doing business index – Kazakhstan has climbed to 47th place, and Russia to 120th.

The Russian economy can certainly benefit from more trade within the Customs Union and with China. But neither will bring about the structural changes that it needs. Russia’s liberals are in a gloomy state. On my previous visit to Moscow, last March, some of them – both within the government and outside it – were optimistic about the prospects of change. Following the winter demonstrations, Putin seemed to have understood that Russia needed political reform. He had announced that regional governors would be elected and that it would be easier to register political parties. But now the state is clamping down on opposition leaders. While the Valdai Club met, Leonid Razvozzhayev, a leftist opposition politician, was kidnapped in Kiev, taken back to Moscow and charged with various crimes.

There are still plenty of economic liberals in positions of power, either as ministers or advisers inside the government, or think-tankers on the outside who provide reports for ministers. But they see that Putin is leaning in an authoritarian, statist direction and that improving the rule of law is not his priority. They know that so long as the judiciary remains subject to pressure from the state or special interests, foreigners will think twice before investing in sectors other than oil and gas.

One senior figure in the Russian system summed up the liberals’ despair: "Russia needs a new model of economic growth, and a new system of governance – the current one is not suited to meet new challenges. Putin has been an outstanding leader. But the destiny of Russia depends on the mind of a single person and his ability to change the paradigm of how he sees things."

The ‘tandem’ system of government – when Prime Minister Putin shared power with President Dmitri Medvedev – has been replaced by what the Russians call an extreme vertikal of power. Although the presidential elections were not conducted fairly, Putin’s victory reflected the popular will and has enhanced his legitimacy. This has facilitated the concentration of power in one person’s hands to a greater degree than ever happened in the Soviet system, post-Stalin. President Putin alone decides foreign policy. On economic policy, according to some observers, Medvedev, now prime minister, still has a little influence.

Everyone in government pays lip service to the idea that the economy should rebalance, so that manufacturing and services play a greater role. But nobody seems to have a convincing plan for achieving that objective. One minister admitted: “We don’t understand how to break the dependency on oil and gas, since different players have different interests.” In fact, the hard-liners in the security establishment and some of the clans around Putin probably do not want rebalancing: it would curb the rent they extract from the natural resource industries and would have to be accompanied by a strengthening of the rule of law, which would constrain their freedom of action.

The Valdai Club heard two views on how the economy could rebalance: top down and bottom up. Some senior figures said simply that the state needed to invest more in high-tech industries like space-science, biometrics, pharmaceuticals, nano-technology and nuclear energy. Putin said the government had found an extra $60 billion for a special fund that would invest in hi-tech industries.

The bottom-up view, which is much more plausible, was well expressed by one of Putin’s advisers: "The only way to rebalance the economy is to improve the investment climate, so that we get more foreign investment into non-oil and gas sectors. That means tackling corruption." 

One leading banker was extremely critical of the government: "Russia is a big exporter of oil and gas, entrepreneurial talent and capital." He described the customs administration as "totally corrupt". He complained bitterly about Putin’s election promises to raise the salaries of public sector workers, which had led to knock-on wage inflation throughout the economy. Several ministers expressed worries about the economy’s declining competitiveness – one of them reporting that Russian wages were now 2.5 times comparable ones in Ukraine.

Another senior banker said the government did not have a mechanism for implementing decisions except by shouting at people. Since German Gref had departed as economy minister in 2007, he said, the government had had no comprehensive vision; now each ministry did its own thing.

A year ago Alexei Kudrin, an economic liberal, resigned as finance minister, partly because he disliked plans for a massive boost in defence spending. Many Russian economists agree with Kudrin that the boost will harm the economy. In the ten years to 2020 the defence budget is due to grow by 23 trillion roubles (more than $700 billion) – at the cost of spending on infrastructure, health, education and R&D. The share of government spending taken up by the defence, interior and emergency ministries is due to stay in the range of 18-20 per cent from 2011 to 2015. But the proportion spent on education, science, healthcare, justice and culture is due to fall from 8.3 per cent to 5.8 per cent. 

Putin, predictably, defended the military build-up. “We see the growing application of force in the international arena, and this is revitalising international relations, so we are strengthening our defence and military capabilities.” Also, he pointed out, a lot of Russia’s defence systems were old and needed replacing.
 
Amidst all the gloom over the Russian economy, some of the more liberal ministers took a brighter view. They talked of the seven-year plan for selling off stakes in state companies that would run to 2019. Its purpose, they said, was not only to make companies more competitive but also to raise money for the budget.

These liberals also pointed to the benefits of membership of the World Trade Organisation (WTO), which would subject Russian industries to increased competition – though more from China than from the West. The WTO will force Russia to lower its average tariffs from 9.5 per cent to 6 per cent by 2015. WTO membership will also make the government curb subsidies to some industries and to farming. “We will have to learn how to apply government support in ways that don’t break the rules,” said one senior minister, who predicted disputes over cars and agriculture.

But the liberal ministers know that Russia cannot properly modernise its economy without progress on the rule of law and democratisation. "We have a working judicial system and democratic rules, though they’re not ideal," said one. “Many people are unhappy about that, but the majority don’t care – they are focused on their wages, children and housing, rather than the political system. That is an argument for more democracy.” He is almost certainly right that less than half the population cares about political freedom. This is the root of Putin’s power and bodes ill for the economy.

Charles Grant is director of the Centre for European Reform