by Charles Grant

After several years of chilly relations between Moscow and western capitals, a little warmth is detectable. At both the Davos Word Economic Forum in January, and the Munich Security Conference in February, the Russians’ exchanges with Americans and Europeans were fairly polite. Of course, this change in the political weather may prove to be short-lived. Indeed, some commentators argue that even if the style is softer, the substance of Russian foreign policy is as hard as ever (see Quentin Peel in the Financial Times, and a forthcoming CER policy brief by my colleague Bobo Lo). Thus in recent weeks Russia has announced plans for a new naval base in Abkhazia (which is legally part of Georgia) and encouraged Kyrgyzstan to close the American airbase at Manas.

But in international politics, style matters. Russia’s leaders know that their economy is being harder hit by the economic crisis than most others in Europe. One adviser to the Russian government recently said that a GDP shrinkage of 10 per cent could not be ruled out this year. Russia’s leaders know that the modernisation of their country will require western capital and technology. So perhaps it is not surprising that they have become less inclined to display the swaggering arrogance that was so visible at certain moments last year, and again during the gas crisis in January.

Even on substance, the Russians appear to be making an effort to be nice on a few issues. Russia’s threat to put short-range missiles in Kaliningrad – in response to American plans to install missile defence systems in the Czech Republic and Poland – has been withdrawn. And Russia is offering to help the US to get civilian supplies to its forces in Afghanistan. As Sergei Ivanov, Russia’s deputy prime minister, said in Munich: “Russia is ready to improve relations on a range of issues, including talks on reductions of nuclear arms.”

Ivanov was responding to the olive branch that Vice President Joe Biden brought to Munich. “On NATO-Russia relations, it is time to press the reset button,” said Biden. “Let’s co-operate on fighting the Taliban, securing nuclear facilities, and cutting numbers of nuclear weapons…of course we’ll disagree on some issues but we should work together where our interests coincide.”

Some of this new US approach to Russia merely reflects the realism that now dominates some – though not all – policy-making circles in Washington. Russia can help on several important issues, so it should be engaged, flattered and treated like the super-power that it wishes to be seen as. Iran is particularly important in shaping US policy on Russia. President Obama sees the challenge of Iran’s nuclear programme as one of his very top priorities. His administration thinks that Russia may be able to lean on Iran. Therefore it is willing to ‘give’ Russia some of the things it wants, like a review or postponement of plans for missile defence and NATO enlargement.

The Europeans are now willing to help the US on Iran. They share the American view that the best way of preventing Iran from pursuing its nuclear programme is to offer a combination of bigger incentives and stronger penalties. The bigger incentive is American engagement: Obama has indicated that he is ready to talk. The stronger penalties are more stringent economic sanctions against Iran. Germany was reluctant to consider these but Chancellor Angela Merkel indicated in Munich that she was ready for new sanctions.

Tougher sanctions are unlikely to achieve much unless Russia and China support them. Currently they do not, but American and European diplomats believe that if Russia moved, China could well follow. “We need Russia’s help on Iran, so that sanctions are effective,” said President Nicolas Sarkozy in Munich. “We don’t have much time, the recent Iranian satellite launch [which showed Iran’s mastery of some ballistic missile technologies] is very bad news. Russia must show whether it really wants peace [in the world], and whether it is prepared to behave like a great power.”

There are two big unknowns about Russia’s relationship with Iran. First, could Russia really influence the country, if it wanted to? Would the Iranians listen to Russia’s advice, or respond to pressure from its leaders? Second, if the answer to the first question is yes, does Russia really want Iran to abandon its nuclear programme? In public, of course, Russia’s leaders say they do not want Iran to develop nuclear weapons. And that may well be the case. But one may suppose that some Russians think that the Iranian nuclear programme suits them very well. It creates huge problems for the US, Russia’s principal strategic competitor, by amplifying tensions between America’s allies and radical regimes across the broader Middle East. The activities of pro-Iranian groups in Iraq, Lebanon and Palestine help to weaken American (and European) soft power in the region. And so long as senior western policy-makers regard Iran’s nuclear programme as a major geopolitical headache, they will see Russia as a potential source of assistance, and thus treat it with respect. And that suits Russia very nicely.

Russia will probably tell the US that it will try to help with Iran. But if the answer to either of those two questions turns out to be no, President Obama will be disappointed. Of course, there are many important strands to the US-Russia relationship other than Iran. But a falling out over the Iranian nuclear programme would put a chill back into the entire relationship.

Charles Grant is director of the Centre for European Reform.

by Charles Grant

Like the US, China and India, Russia has never been a big enthusiast for multilateral global governance. When the Russians believe that working through multilateral institutions will suit their interests, they will do so. But Russia’s history, size and traditions make it sceptical of multilateralism. Only with great reluctance did then President Vladimir Putin sign the Kyoto protocol on climate change – when he realised that Russia would benefit financially through the sale of unused carbon allowances.

Russia has never shown a lot of interest in multilateral institutions, other than the privileged clubs it is a member of, such as the G8 and the UN Security Council (UNSC). Presidents Yeltsin and Putin have had similar views on global governance, both preferring to talk of multipolarity rather than multilateralism.

As a G8 member, Russia has not been in favour of broadening the membership to include countries like China. But now that the G20 has become an important group, in some ways replacing the G8, Russia willingly takes part. Russia evidently likes the UNSC, being one of five veto-wielding members. But it has shown less interest in the UN as a whole and stayed on the sidelines during the discussion of UN reform at the end of Kofi Annan’s tenure as UN secretary-general. When Russia does take part in global bodies, it often seems more interested in the status of membership than in active participation.

Russia is ambiguous on whether it wants to join the World Trade Organisation – its membership talks with the WTO have dragged on since 1993. Earlier this month Russian trade officials told EU negotiators that they hoped to join the WTO this year – but then Prime Minister Putin said that Russia would want to join only as part of a grouping with Belarus and Kazakhstan. That is likely to delay membership.

Russia is more comfortable with regional organisations than global bodies, perhaps because it can play a leading role in them. It likes the Collective Security Treaty Organisation, which links a number of former Soviet countries, and the Shanghai Co-operation Organisation, which brings together most of the Central Asian countries and is dominated by Russia and China. There has been talk in the Kremlin of a ‘gas OPEC’, hooking together Russia, Iran and other producers such as Turkmenistan.

Russia strongly dislikes NATO for several reasons: the US leads the alliance, Russia believes the West would not allow it to join, and NATO’s expansion symbolises Russia’s strategic retreat since the Cold War. In recent years Moscow has taken against the Organisation for Security and Co-operation in Europe, whose observers have criticised the conduct of elections in former Soviet states. That is one reason why President Dmitri Medvedev came up with the idea of ‘a new European security architecture’ last year. Medvedev has said this should bring together Russia, the US, European countries and European security organisations. But his government has not yet produced any specific proposals.

The economic crisis is spurring governments around the world to think seriously about reform of global governance. For example the membership of the Financial Stability Forum is being broadened to include the leading developing economies. The IMF and World Bank are preparing for another round of reform. The effort to combat climate change is likely to lead to new global institutions. Yet Russia has been reluctant to put forward its own proposals on global governance. Why?

Russian foreign policy is hyper-realist. Russian diplomats tend to believe that countries are most likely to achieve their objectives through being tough and unyielding rather than by compromising or working things out in international organisations. Their worldview focuses on power rather than rules. It is natural for large and strong countries to be realist; it tends to be smaller and weaker states that see multilateral institutions as a bulwark against bullying by the powerful. And perhaps Russia’s difficult history – it has never had defined frontiers and has usually got on badly with its neighbours – has encouraged the realism.

The fact that Russia is big makes it reluctant to cede much authority to multilateral bodies. For in international organisations small countries can wield disproportionate influence. One thing that Russian diplomats find infuriating about the EU is that small countries can veto its decisions – for a while Lithuania blocked the negotiation of an EU-Russia trade agreement. Tiny Georgia could, if it really insisted, stop Russia joining the WTO. Seeing itself as a great power, Russia has – ever since the Congress of Vienna, almost two hundred years ago – liked the idea of a concert of powers. Thus it enjoys its role in the ‘quartet’ that is supposed to handle the Middle East peace process: Russia sits alongside the US, the UN and the EU.

Russians should rethink their scepticism towards multilateral institutions. The Russian economy is globalising. Sberbank’s recent purchase of a major stake in General Motors Europe is just one indication of this trend. Gazprom is buying energy infrastructure in many EU member-states. Russia’s leading metals companies are building global networks. The long-term prosperity of the top Russian firms depends on their buying companies and raising money in the world’s major financial centres.

Russia is developing global economic interests and will need to defend them. This is best done through strong multilateral institutions. If Russia joined the WTO it would be harder for other countries to impose anti-dumping duties on Russian exports. As a leading exporter of energy, Russia has an interest in joining the International Energy Agency, and helping it to develop into a body that can smooth out volatility in oil and gas prices. Russia should also take more interest in the future of the IMF and the World Bank, and in the emerging institutional framework for regulating global financial markets.

The Europeans – who, unlike the Russians, Indians, Chinese and Americans are instinctively multilateralist – should encourage the Russians to view multilateral institutions as a tool for promoting their national interests. The WTO is the prime example of an organisation that would deliver tangible benefits to Russia, and the EU – as Russia’s biggest trading partner – should urge the Russians to made up their minds to join it.

Charles Grant is director of the Centre for European Reform.

by Katinka Barysch

Russia’s economy has been hit hard by a triple whammy of capital outflows, collapsing oil prices and falling global demand. In the first three months of the year, output was down by 10 per cent compared with a year earlier. The retail boom that had fuelled growth in recent years has turned into a slump. The output of the manufacturing sector is contracting at a rate of over 20 per cent year on year. Construction is in deep recession. The current-account surplus has melted away.

However, the latest economic indicators suggest that the economic contraction is at least slowing. The oil price has recovered to over $70 a barrel. Surveys show that credit conditions are easing and managers are a bit less gloomy. Capital outflows have slowed. So has inflation, which has allowed the central bank to finally cut rates. International reserves, although down from 2008 peaks, still stand at $410 billion. The government is making plans for recapitalising some of the country’s banks.

Investors still remember the rapid, V-shaped recovery that followed Russia’s last financial crash in 1998. In the following nine years, the Russian economy grew by an average of 7 per cent a year. Will Russia be able to pull out of trouble this quickly again?

On the plus side, Russia’s government finances are in incomparably better shape than they were ten years ago. Back then, it was short-term public borrowing that triggered the crisis, ultimately forcing the government into default. Since then, the budget has shown a healthy surplus, allowing the government to stash away $140 billion in a reserve fund. So although revenue has collapsed (half of it comes from the oil and gas sector), the authorities have room for fiscal manoeuvre. Public spending will also have a bigger impact on the economy, simply because the Russian state is much bigger than it used to be (federal budget revenue was 13 per cent of GDP back in 1998, today it is over 20 per cent, according to Erik Berglőf from the European Bank of Reconstruction and Development).

Also, in 1998 the Russian economy had only just returned to growth, following years of severe post-transition recession. Now, after ten years of uninterrupted expansion, fewer Russians are living hand to mouth and many should be able to draw on savings to tide them over the most difficult period.

However, there are also reasons to expect the current crisis to be more severe and drawn-out. The 1998 crisis mainly affected emerging markets. This time, the recession is global, which means that no country will be able to export its way out of trouble. (Russia exports mainly raw materials, as well as some metals, timber and heavy industrial goods. But it is the collapse in demand for non-oil exports, such as steel products, that is causing the most trouble since these are often produced in isolated one-industry towns.)

Depressed global demand also means that the rally in oil prices is likely to be short-lived. After 1998, the oil price climbed steadily from around $10 a barrel to a peak of $140 last summer. Many forecasters expect oil prices to linger around $50-60 this year and next – not disastrously low but not enough to fuel a strong Russian recovery either. Moreover, Russia’s economy today is much more dependent on oil and gas sales than it was in 1998. Back then, oil and gas sales accounted for 44 per cent of export revenue, now the share is over two-thirds. Many manufacturing and services industries are directly or indirectly linked to the resource sector.

Perhaps the biggest difference lies in the role of banking and borrowing. Although both crises originated in the financial sector, in 1998 this sector was still so small that its collapse barely affected the wider economy. Then, credit to firms and households stood at 9 per cent of GDP; today it is over 40 per cent.

In recent years, much more of that borrowing came from abroad so the drying up of global liquidity in 2008 hit Russia hard. The World Bank estimates that in 1998-99, the reversal in foreign capital flows amounted to less than 2 per cent of Russian GDP. In 2008-09, it was close to 12 per cent of GDP.

Domestic banks cannot take up the slack because a rising share of bad loans will constrain their ability to start lending again. The health of the banking sector is difficult to assess. Official numbers show that the share of non-performing loans has climbed from 1 per cent at the start of the year to 4 per cent today. Given the sorry state of Russian industries, this is still an implausibly low number. Independent assessments put the share of bad loans at anywhere between 10 and 20 per cent.

As a result of these factors, the Russian economy is likely to take longer to come out if its slump than it did ten years ago. The World Bank predicts a contraction of almost 8 per cent this year, but some forecasters thinks even this is too optimistic and they question whether Russia will be able to make even timid recovery in 2010. Most economists agree that Russia stands little or no chance of returning to the 7-8 per cent growth rate that it enjoyed before the crisis struck

The big question is what the changed growth outlook will mean for Russia’s internal stability and the government’s willingness to implement economic reforms. In 1998 Russians expected very little from their leaders in Moscow. They were positively surprised when the Putin administration after 2000 started to implement some useful reforms, such as simplifying the tax system and cleaning up regulations.

Since then, Putin’s muscular rhetoric, combined with Alexei Kudrin’s sound macro-economic management, have raised expectations. The people that took to the streets in Russian cities in recent weeks and months did not so much protest against government policies as demand government help. The government could react either by getting serious about modernising and diversifying the economy. Or it could resort to economic nationalism and populist spending increases. So far, there is more evidence of the latter than the former. Prime Minister Putin has personally instructed companies to clear wage arrears and criticised shops for overcharging struggling families. On June 29th, he told the managers of Russia’s biggest banks that they should not go on summer holiday before they have significantly increased lending to the corporate sector (he even gave them a numerical target of $16 billion). With this kind of crises response, Russia’s growth prospects could end up being lower not only in the short term, but for many years to come.

Katinka Barysch is deputy director of the Centre for European Reform.