Russia's clan war?

The global economic crisis has hit Russia hard and the Kremlin is set to use the situation to make destabilising changes that could prompt a fresh round of conflict between the country's powerful political clans.

Stratfor.com

The global economic crisis has hit Russia particularly hard. In the second quarter of 2009, Russia experienced a 10.9 per cent gross domestic product (GDP) decline as measured from a year earlier and is expected to have its GDP decline by 8.5 per cent overall in 2009. The budget surplus gained during the years of strong commodity prices has been replaced by an 8 per cent budget deficit in 2009, which is expected to decrease only slightly to 7.5 per cent in 2010.

The state has been forced to spend a lot of its money on bailing out companies and private banks indebted to the West and has seen its hoard of foreign reserves amassed during the commodity boom decline from the pre-crisis peak of $US599 billion to the current $US417 billion. This economic situation has spurred the Kremlin to plan destabilising changes that will remake Russia's internal political scene and prompt a fresh round of conflict between the Kremlin's powerful clans.

To understand the coming evolution in the Kremlin, STRATFOR is taking an in-depth look at the effects of the economic crisis on Russia thus far and the current power structures inside the Kremlin.

Origins of the Economic Crisis

The geography of the Russian steppe is dominated by vast distances and a shortage of rivers suitable for transport. Therefore, to achieve basic economic development, Russia had to build an extensive transportation network across this territory – a task that is gargantuan in scope and cost. Furthermore, since Russia has no natural boundaries to serve as defences, it had to expand outward from its core to establish buffer regions in order to maintain security. This exacerbated the scope and cost of the development effort. No state can achieve such development cheaply or efficiently without firm direction from above – hence Russia's inclination toward a centralised economy.

Central planning is not perfect, however. It can ensure that a large proportion of state resources are thrown at a problem, but due to the vast need and the low efficiency, there is never enough capital. Capital is therefore Russia's most critical import because not only is it scarce domestically, it is also hoarded by the state during times of plenty, like the recent commodity boom. To overcome its lack of capital, Russia has traditionally turned to the West. Prior to the global financial crisis, Russian private banks and corporations gorged on cheap and readily available credit.

The August 2008 Russo-Georgian war, Moscow's increasing tendencies to nationalize portions of the economy and the onset of the global financial crisis in mid-September 2008 combined to bring Russia's credit excesses to an end. With investors terrified of emerging markets, Russian markets were almost completely liquidated. This resulted in not only the flight of foreign capital from Russia, but also market collapse and ruble depreciation. The latter was a double blow – the Russian economy had to deal with both the inflationary effects of a weaker ruble and the reality that Russian corporations and banks still owed some $US400 billion in foreign loans, the servicing of which only became more expensive as the ruble declined. The Kremlin spent at least $US216 billion of its reserves to manage the ruble's depreciation.

Having already spent more than $US200 billion to blunt the effects of the crisis, the Kremlin felt confident enough to step in and consolidate both the banking and corporate sectors which were so heavily leveraged abroad. It achieved this by issuing short-term, high-interest loans to Russian corporations and banks – loans that it was not clear could ever be repaid. As the banks and corporations faltered, terms of the loans gave shares to the Russian state, quickly granting it considerable control over them. As of June, the Russian state held 12 per cent of all bank liabilities, making the state the banking industry's largest creditor.

The Russian Economy Today

As of July, the latest data point available from the Central Bank of Russia, non-performing loans (NPL) in the Russian banking system stood at 5.4 per cent, up from 1 per cent in July 2008. The fear that the NPLs will rise is still prevalent – at one point the assessment was that they could rise to a whopping 20 per cent – and that fear is motivating Russian banks to hoard cash. Despite some improvements since the worst of the global recession in March, bank lending in Russia remains firmly in the negative.

However, there is mounting evidence that investors' confidence in the Russian economy is returning. First, the ruble has rebounded and has appreciated around 19 per cent against the US dollar from its low of 36 rubles per dollar in February/March to its current rate of 29.28. Second, the precipitous capital flight that characterized the third and fourth quarters of 2008 has slowed dramatically. Net capital outflow from Russia has recovered from $US55 billion last October to just $6 billion in September, and it even turned positive briefly in June. Third, interest in the Russian stock market has returned, particularly as investors abandon low-yielding U.S. sovereign debt and seek riskier assets that offer greater returns. Between higher oil prices (at the current $US78 per barrel, oil is at more than double its February lows) and a greater appetite for risk, investors are trickling back.

With the return of some semblance of stability in the Russian economy, the question now is: What Russia has learned from the crisis? The state has become much more involved in both the corporate and banking sectors. Since July, state-owned Vnesheconombank has provided approximately $US10.93 billion in financing to various firms in need of funding to refinance their foreign loans. However, Russian corporations' current foreign-held loans still constitute an enormous liability – at $US237 billion ($US75 billion of which is due in 2010) their levels are practically unchanged since December 2008.

Setting the Stage for a Clan War

Prompted by the global financial crisis and the economic disaster that followed, a force has emerged within Russia's power structures that seeks to use the crisis as an opportunity to reshape Russia. This force is led by the civiliki, a new term for a group of lawyers and technocrats whose main figures are Russian President Dmitri Medvedev, Finance Minister Alexei Kudrin and German Gref, former minister of economics and CEO of Sberbank, Russia's largest state-owned bank. In theory, the civiliki attempt to be apolitical and want to use the crisis to reform the Russian economy.

The civiliki exist under the aegis of the Surkov clan, the powerful Kremlin clan led by Medvedev's Deputy Chief of Staff Vladislav Surkov. Surkov intends to use economic reforms enacted by the civiliki to purge the influence of his archnemesis – Deputy Prime Minister Igor Sechin, whose political clan is backed by the Federal Security Service (FSB) – in the Kremlin's corridors of power. To do so, Surkov and the civiliki intend to go after the Sechin clan's business interests directly and blame those interests for the economic crisis.

While all businesses were guilty of gorging on foreign loans, the civiliki are zeroing in on those firms controlled by a specific set of businessmen in Russia that they see as better suited for non-business positions: those from the Sechin clan and the FSB. Their argument is that these companies are guilty of inefficiency in both their spending and management. Kudrin is particularly irked by the fact that the Russian state spent more than $US200 billion protecting the ruble due to the mismanagement of companies whose CEOs are former intelligence officers instead of experienced businessmen.

With return of foreign interest in Russia, and with credit again available, the civiliki are concerned that the Russian corporate and banking sectors will once again overindulge in foreign capital. In the third quarter, Russian companies borrowed about $US16 billion from abroad. Because locally-sourced credit will continue to be scarce, any Russian entity that cannot directly access the state's coffers will have to rely on foreign borrowing. However, the civiliki want to make sure that the companies borrowing abroad are led by people they believe to be competent individuals.

The civiliki therefore believe that there is opportunity in the effects of the economic crisis. The state stepped in forcefully during the crisis to consolidate the banking sector and to finish reining in various oligarchs, a process that began in 2004. Oligarchs have essentially ceased to exist as an independent source of power inside Russia. Their wealth has decreased precipitously, and those who were offered government bailouts are now little more than employees of the state.

But the civiliki cannot implement their plan on their own. They will need the support of their clan leader, Surkov, to help purge Sechin's forces.

The question in the Kremlin is what to do next. Having sidelined the oligarchs and tightened its grip on the Russian economy, the Kremlin can either move to establish a firm state-directed economic system or begin to compensate for some of the Russian economy's fundamental weaknesses by attracting investment and capital from abroad. To choose one over the other means a war among the Kremlin's power clans.

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