House of Lords - European Union

Select Committee on European Union Fourteenth Report

CHAPTER 2: RUSSIA TODAY

13. Russian domestic policy has taken an illiberal direction which is unwelcome in the West and its foreign policy is increasingly assertive and pugnacious. There is unlikely to be much improvement, at least until Russian politics has settled down following the installation of the new President.

Russia: a European Country?

14. Whether Russia is European or not is a question which has exercised Russians and Russia-watchers for centuries. President Putin insisted in his annual Address to the Nation in 2005 that Russia had played her part in the development of European values and that "the ideals of freedom, human rights, justice and democracy have for many centuries been our society's determining values." The Russian Ambassador in London emphasised to us that "Partnership with the EU and leading European nations has always been and continues to be a sine qua non, a necessary prerequisite for a successful foreign policy of Russia" (Ambassador Fedotov Q 413). Officials whom we met in Moscow echoed this line. Alexander Grushko, the Russian Deputy Foreign Minister, told us that Europe was "our house" and Russia was part of Europe. Europe, he said, was more than the EU. Russia was not planning to join the EU or NATO: Russia was too big and had to consider its relations with other neighbours such as China. Russia's settled policy was nevertheless to build a general strategic partnership with Europe: everything, he thought, but membership.[3] Mikhail Margelov, Chairman of the Foreign Affairs Committee of the Federation Council, Russia, reminded us that hundreds of thousands of Russians now live and work in Europe, and that the economies of Russia and the European Union are inextricably entwined.[4]

BOX 1
Russia Population Statistics

The population of Russia is some 142 million. Most Russian citizens live in the part of Russia which is geographically Europe: only one fifth live in Russia's Asian territory to the East of the Urals. People are drifting steadily from Siberia to European Russia. Most of the Federation's citizens—some 80%—are ethnically Russian. Another 4% are other Slavs—Ukrainians or Belorussians.

Practising Muslims are estimated to make up 10-15% of the population of the Russian Federation although some make the figures substantially lower. The largest single ethnic group among these are the Tatars, who have their own region within the Federation, and make up 3.8% of the total population.[5]

15. The aspirations of the current EU strategy outlined in paragraph 3 above are laudable. They beg a central and much debated question: Is Russia a European country, whose political and economic systems, like those of the new Central European members, can be harmonised with those of its neighbours to the West through its own efforts and those of the European Union; or is it special, a country which will retain its own unchanging attitudes and values despite the similarities of its history and culture?

16. This paradox lies at the heart of the frustration and confusion which surrounds European policy towards Russia today. In the 1990s the EU failed to appreciate that Russia's transition to the "European values" of democracy, the rule of law, good governance, and respect for human rights and fundamental freedoms—which she accepted in joining the Council of Europe and the OSCE[6]—would take generations, not decades. Faced with a more assertive and increasingly prosperous Russia, which is not willing to be patronised and expects to be treated as an equal, the EU's more ambitious early aspirations look less easily attainable and European policy is in some disarray as a result.

17. Many of the Russians to whom we spoke took a very categorical line: Russia is inescapably a part of Europe by history, religion, and culture.[7] Russia adopted Christianity before many of its European neighbours and the Russian contribution is an integral part of modern European culture. Ambassador Fedotov told us in London "Russia is Europe, from any possible point of view, be it geography, history, culture, economy, politics, ideologies … philosophy, human values, relationships, family ties, et cetera. Secondly, Europe without Russia is not Europe in all its inclusiveness, so any dream of creating a pan-European cooperation without Russia is a myth" (Q 412).

18. Ties at the level of the general population are also close. According to one source, there are now up to ten million people who speak Russian as their first language living inside Russia's EU neighbours. Russia lies sixth among the European countries in terms of the number of its citizens who travel to other European countries, and the number is increasing.[8]

19. Some western observers argue that Russian attitudes to a whole range of issues in the field of civil society, human rights and the rule of law, show that Russia is not attached to "European" values. It is true that these values do not have secure roots in the Russian past, nor are they fully reflected in the present. Russia's political regime has historically always been of an autocratic nature. However, the history of the European continent in the twentieth century shows that "European values" have proved fragile even in European countries where they seemed most deeply rooted.

20. Some, both inside and outside Russia, argue that Russia is not Europe but Asia, or "Eurasia". Russia's interests are in part defined by its Asian territories where lie many of its richest mineral deposits. Its southern frontier is the longest in the world, and borders on some of the world's most unstable regions. Russia's relationship with the great Asian powers, China, Japan, and India, and with other neighbours such as Iran and Korea, inevitably distinguishes its foreign policy from its western neighbours. From the time of the Tartar yoke in the thirteenth century, Asian culture and history have had a powerful influence on the growth of the Russian state.

21. Recent figures seem to show that the Russians are far more pro-European than they were in 1998-9 at the time of Russia's economic collapse and the Kosovo war. Other figures paint a different picture.[9] Given the roller-coaster of the past two decades, it is perhaps not surprising that Russian opinion should be uncertain.

These considerations affect attitudes, and therefore policy-making, on both sides.

22. Russia is a country of substantially European history and culture whose government and many of whose political elite regard it as a European country. However, most Russians do not think in these terms because they regard themselves as Russians, first and foremost. Russia shares a border with the European Union, with which it is bound by numerous ties of practical interest. Consequently, the EU and Russia have a mutual interest in building a close relationship, and the need for a practical cooperation with Russia in areas such as border controls is greater than with, say, India or China.

23. The EU should resist any attempts to isolate Russia, which would not be in the interests of the EU, but should rather pursue a policy of engagement at all levels and in all policy areas. In practice what matters are the concrete measures for developing that cooperation between Russia and the European Union which both know is necessary. The EU should recognise that the illusions entertained in the 1990s about the speed of Russia's transition to democracy have hampered the EU's efforts to deal with a newly assertive Russia. The current difficulties in the relationship should not weaken the EU's determination to build a long-term partnership with Russia, based on dialogue, trust and common interests.

Recent Russian History

THE COLLAPSE OF THE SOVIET UNION

24. The attitudes of Russians today to their domestic politics and to international affairs are profoundly affected by what has happened to their country in the last two decades.

25. For nearly 40 years the Soviet Union was one of the two superpowers. The Soviet Union was victorious in the Second World War. Soviet scientists were at the forefront of knowledge. A Soviet citizen was the first man in space. The Soviet Union was feared and respected throughout the world, uniquely able to meet America as a military equal. These glittering successes masked poverty, an economic system incapable of modernising or sustaining itself, a political system that stifled initiative and, towards the end, a growing weariness with the burdens of empire.

26. In 1991, in a reversal without precedent in history, the Soviet people lost their political and economic systems, their cradle-to-grave welfare system, their empire, their ideology, and their position in the world without significant bloodshed and in a matter of months. The command economy was replaced, on the advice of Western advisers, by a market economy which was unsuited to Russia's immediate needs and which resulted in poverty, hunger and chaos. Vladimir Mau, Director of the Working Centre for Economic Reforms of the Russian Government described it to us as a turbulent time.[10] The oligarchs profited from the sell-off of the nation's wealth. The West provided food aid, and lectured the Russians on the virtues of democracy and they were expected to be grateful. The Chairman of the Foreign Affairs Committee of the Federation Council, Mikhail Margelov, described the time following 1991 as one of humiliation.[11]

27. For Russians of all classes the 1990s were a time of national and personal humiliation. For many of them, it was also a time of deep poverty. However unfairly, many Russians attribute their troubles to the attempt to impose on them a system which they now consider as unsuited to Russian conditions. They put the blame not only on the Russian politicians of the 1990s and their Western supporters, but on Western ideas of democracy.

THE PUTIN ERA: STABILITY, RESTRICTIONS ON FREEDOM

28. In 2000 the new President, Vladimir Putin, promised stability and prosperity. He also promised democracy and the rule of law—when Russia was ready for it. He brought order out of political chaos, although at the cost of the second war in Chechnya, and presided over eight years of rapid economic growth, considerably helped by rising oil prices, and prosperity which is trickling downward even in the provinces. He curbed the oligarchs though in legally questionable ways. He partially restored Russia's perception of its position in the world while not pursuing the interventionist policies of the Soviet Union in Africa, Latin America and south-east Asia.

29. Much of this has been achieved at the expense of clipping back the fragile shoots of democracy. This is seen in the curbed press, the weak parliament, the arbitrary courts, the corruption,[12] the murders of journalists and political activists, the intrigues which surround politics from the Kremlin downwards, the ubiquitous secret policemen, now often deeply involved in the more lucrative parts of the economy. Regional government has been recentralised: regional governors are no longer elected but are appointed directly by the Kremlin. Mr Jim Murphy, MP, Europe Minister, told us that "the democratic space in Russia continues to contract" (Q 394).

30. Katinka Barysch of the Centre for European Reform (CER) thought that Russia was not particularly democratic: "the striking thing about Putinism for me is that [President Putin] always insists on leaving the full institutions of democracy in place. He hollows them out but he has not touched the formal system of checks and balances" (Q 101). Referring to the recent Russian elections, she added: "I would be somewhat reluctant to call it an election, it is a changeover or handover of power" (Q 133). Following the Russian parliamentary elections of December 2007, the Duma would probably remain a "rubber-stamp parliament" (Q 134).

31. For Sir Roderic Lyne, formerly British Ambassador to Russia: "The general attitude to democracy in Russia is that democracy equals the 1990s, equals a complete nightmare, and if that is what you are offering the Russian population, they do not want that. They would like to have more law and order. They would like to have much less corruption. Corruption is very high on the list of complaints of the Russian populace, but they are much more comfortable with Putin and the sort of rule he has given them than with what happened in 1990s, and anyway they think that those leading democratic figures were all tainted and a lot of them were allied with big business and oligarchs. I think there is a very important distinction to be made between freedom and democracy. Essentially what Gorbachev and Yeltsin gave Russia was freedom. Although Gorbachev did institute what has probably been the fairest election in terms of voting that Russia has had in the 1989 elections to the Congress of People's Deputies, democracy in Russia has never ever happened; it has no history. The country has not yet really started down the road to democracy" (Q 170).

32. Charles Grant (Centre for European Reform) said: "I think sovereign democracy for Putin means autonomy and it is defined in relation to the US. It is about Russia not having to do what the US wants it to do. There is a paranoia about the US that is very strong in the Russia ruling elite, and sovereign democracy is an answer to the problem they have about America dominating the world and CNN ruling the airwaves and so on" (Q 170).

33. The Foreign and Commonwealth Office (FCO) annual report[13] on human rights for 2007 lists Russia as a major country of concern. It states that "the past 18 months have seen a shrinking of the democratic space in Russia, primarily through the recent non-governmental organisation (NGO) and anti-extremism laws and the restrictions imposed on political parties." It cites concerns about allegations of electoral malpractice in relation to the December 2007 parliamentary elections, on which the EU Presidency published a statement on 4 December 2007 which referred to harassment of opposition parties and NGOs in the run-up to the election, and concluded, inter alia, that "procedures during the election did not meet international standards and commitments voluntarily assumed by Moscow". The FCO report lists four other areas of concern:

restrictions on media freedom and increased risks to journalists' safety;
the rise in attacks on ethnic, racial and religious minorities;
the increasing use of forced psychiatric treatment and detention; and
the ongoing reports of extra-judicial killings, torture, abduction, and arbitrary detention in Chechnya and the North Caucasus.

34. Many Russians, in the centre as well as in the provinces, are doing what they can to sustain the democratic values which they believe are essential for the future well-being of their country. They are often harassed by the authorities, who find little difficulty in portraying them as stooges of the West.

35. The fate of what the Russian business paper Vedomosti enumerated as the 227,577 non-governmental organisations[14] which have grown up in Russia since the last years of the Soviet Union, and especially the recent laws regulating their activities and requiring them to re-register with the authorities, has attracted much critical attention in the West. In practice most have re-registered successfully. About two thousand of them, however, deal with issues of politics, human rights, and democracy, and these are unpopular with the authorities, especially at election time. Most, including the ones receiving foreign funding, have survived, according to François Bellon, Head of the Moscow Delegation of the International Committee of the Red Cross.[15] They are, however, regularly harassed, and in early February the European University of St Petersburg suspended its activities, ostensibly because it could not meet health and safety regulations, but it has been suggested that its EU-funded election monitoring project had fallen foul of the authorities. It has subsequently been reopened.

36. Nostalgia for national greatness does not mean a desire to return to the Soviet system, as Yevgeni Primakov, a former Prime Minister, assured us during our visit to Moscow.[16] The state's near monopoly of the media is not complete. Information circulates widely through foreign broadcasting and foreign travel. The number of Russians on the internet has grown from 8.7 million in 2002 to 25 million in 2007, about 28% of the population over 18.[17] This is not a large figure by Western standards, but it is still growing fast. Russian internet users are not inhibited in expressing their views, either through self-censorship or, so far, by the Russian authorities who, unlike the Chinese, have made no serious attempt to interfere with them.

37. President Putin brought stability back to Russia. Associated with this has been an increasing trend to restrict the freedoms of political opponents and the media. Russia is not going back to the days of Stalin, or even to the days of Brezhnev. It is now more open than ever before. For many Russians the restrictions on political freedom have been a price worth paying. That is why Mr Putin was able to command popularity ratings of 60-70% for most of his two terms of office, and why a majority of Russians wanted him to remain at the head of affairs even though he was obliged under the Constitution to relinquish the Presidency after two terms.

38. Russia's failure to fulfil the high hopes of the early 1990s that Russia would become a democracy, working under the rule of law, and with human rights, a free media and civil society have led to disappointment in the West. The changes needed to transform an authoritarian continental empire need to go very deep, and are likely to take decades if not generations. The sense of disappointment is mutual. For many Russians the West's moral standing has been severely diminished. They are disillusioned by their experience of the market economy and the Western model of democracy and see little reason to listen to western criticism or prescriptions.

THE POLITICAL PROSPECT FOLLOWING THE MARCH 2008 PRESIDENTIAL ELECTIONS

39. Our visit to Moscow followed the elections to the Duma on 2 December 2007 in which Mr Putin's United Russia party won a large majority with 64% of the vote. During our visit Mr Putin also announced that Mr Medvedev was his preferred successor as president, an outcome which was confirmed in the 2 March presidential election. Both elections were criticised by opponents of Mr Putin, and such outside observers as were not prevented from entering the country, as flawed. Mr Medvedev announced that he would appoint Mr Putin as Prime Minister once he became President. Mr Putin has since been elected as president of United Russia.

40. Mr Medvedev is an academic lawyer and administrator who has been close to Mr Putin throughout his career. He has been Chairman of the state gas monopoly Gazprom since 2002. Medvedev's publicly expressed views have been reported as liberal and realistic. He said at Davos in 2007: "We realise the problems we are facing—excessive dependence on (natural resources), corruption, a declining population."[18] He has also remarked that true democracy needs no adjectives, and on another occasion that "no non-democratic state has ever become truly prosperous for one simple reason: freedom is better than non-freedom." However, Dimitri Suslov, Russian Higher School of Economics, warned us not to interpret Mr Medvedev's success as a victory for liberalism.[19]

41. In a recent interview with the Financial Times,[20] Mr Medvedev stressed that it will be important for Russia to build on its economic success and to make sure that it translates into social programmes, with the aim of improving the lives of Russians. In particular, he pledged to modernise the healthcare and education systems, as well as housing conditions. In response to a question about what steps he would take to strengthen the rule of law in Russia, Mr Medvedev set out his three objectives: the assertion of the supremacy of the law in Russian society; embedding a culture of law-abidance in society; and making progress towards an active and effective court system, with independent and objective courts.

42. The relationship between the President and the future Prime Minister following the March election will not necessarily be simple to establish. Under the Russian Constitution, as under the French, the president is responsible for foreign policy, defence, and security, and the prime minister is an executive. It is the President, not the Prime Minister, who represents the country at the highest level, including at the annual meetings of the G8. Both President Medvedev and Mr Putin have declared that they will work together, but such a system of operating in tandem is a new departure in Russian political life and may lead to some uncertainties in the EU's dealings with the Russians.

43. Professor Anatol Lieven (King's College, London) reflected in evidence to us in November 2007 on how Mr Putin might manage his future position relative to the next President and whether the President would escape from Putin's control and decide to continue with a strong presidency. Professor Lieven speculated on the consequences of two possible roles which were open to Putin under the Medvedev presidency: the premiership, when power might migrate from state institution to state institution leading to uncertainty and delay in decision-making with increased corruption; or as head of United Russia which might emerge as a serious mass political party either run by local middle-class people in the Russian provinces, or as a vehicle for the top elite (Q 205). Since these comments were made President Medvedev has asked Mr Putin to be Prime Minister and Mr Putin has become Head of United Russia.

44. All indications are that the initial period of Mr Medvedev's presidency will be characterised by a high degree of continuity with the policies of President Putin. Mr Putin, whom Mr Medvedev has appointed as Prime Minister, will continue to exercise substantial power and influence. The extent to which Mr Medvedev will follow up his recent statements, including those on strengthening the rule of law, with concrete action remains to be seen.

The Economic Situation in Russia

RUSSIA'S ECONOMIC RECOVERY

45. Central to Russia's new found self-confidence has been its remarkable economic performance from its nadir in 1998, when the Russian economy was by some measures no larger than that of a medium-sized Member State of the EU. World Bank figures for 2006[21] indicate that Russian GDP was US$986.9 billion, whereas per capita income, at US$5780, was still well below the EU average. The economy which Russia inherited from the Soviet Union was weak. Systemic problems had already begun to appear by the early 1960s. The crude methods of forced industrialisation which had worked for Stalin were no longer adequate. Growth had slowed almost to a standstill. Production was still heavily skewed towards heavy industry and defence, at the expense of welfare and the consumer. The striking achievements of Soviet science reflected a well developed system of higher education and research. Their fruits, too, were directed to defence, and rarely penetrated into the civilian economy. Investment was hugely inefficient. Agriculture was still, as it had been throughout the Soviet period, a disaster.

46. President Khrushchev's attempts at creating a market economy had little success and he was removed from office in 1964. By the end of the decade the impetus for reform had petered out. During the 1970s the Soviet leaders were able to ignore the pressure for change because of high oil prices; the country was able to afford to import the advanced technology, the machine tools, and the grain that the Soviet economy could not produce for itself. As the oil price began to fall in the 1980s, Mr Gorbachev was elected, in 1985, but failed to grasp the economic nettle, and was pushed aside in 1991. His successor, Mr Yeltsin, privatised much of industry; imposed strict, even brutal macro-economic disciplines; and opened the economy to foreign trade and foreign investment.

47. Unscrupulous private speculators, often linked to the Kremlin, acquired substantial sections of the economy at low prices and became immensely rich. For ordinary Russians the results were disastrous. Inflation rose to 3000% in the first year. Large numbers of ordinary people sank below the poverty line. As the result of a rouble kept artificially high, much domestic industry was put out of business by a flood of foreign imports. Corruption, crime, and capital flight all flourished. In 1998, partly as a result of the Asian economic crisis, the rouble collapsed and the country defaulted on its domestic debt of US$40 billion. The price of Russian oil rose from around $10 to above $20 a barrel. Local products substituted for imports. The Russian economy began to rise from the ashes.

48. Since then, sound macroeconomic management by the Putin government, and the rising price of oil, have been in great measure responsible for the continued growth of the economy. Professor Julian Cooper of Birmingham University commented that Putin had been a fortunate President, having overseen the growth of the economy by 6-7% a year during his entire presidency, though this figure would probably begin to slow down (Q 48).

49. During President Putin's first term, he launched an initial programme of economic reform which was much praised in the West, including a radical tax reform, whose implementation was selective and slow. Laws which had already been prepared to allow for land sales, the liberalisation of the railway and electricity monopolies and a reform of the mortgage system were implemented slowly or not at all. Strategic sectors including gas and banking are dominated by State owned companies, including the gas company, Gazprom, the oil group Rosneft, the pipeline monopoly Transneft, and Russia's largest retail bank, Sberbank.

50. We deal in Chapter 5 with the central role which energy plays in Russia's domestic economy and the implications for the European Union.

51. Mr Putin's centralisation of political control damaged business confidence. He cut the autonomy of provincial governors and reduced the power of the oligarchs, especially those who had displayed political ambitions. The media barons Gusinsky and Berezovsky left the country. The oil magnate Khodorkovsky, who had engaged in independent political activity displeasing to Mr Putin, was imprisoned after a ruthless and highly questionable set of court cases against him and his business associates. His company Yukos was bankrupted and most of its assets fell into the hands of the state-controlled Rosneft.[22] These actions were popular among ordinary Russians; however, they seriously damaged Russia's reputation abroad as a country ruled by law, and helped to trigger a shift in Western attitudes towards Russia as a whole.

52. The current economic situation in the Russian Federation is strong. Russia's foreign exchange reserves and current account balance of payments are strong, according to Professor Hanson (Q 61). Professor Cooper said Russia had foreign currency reserves of $425 billion and a stabilisation fund of another $140 billion. The Government's foreign debt had been reduced substantially and was about 4% of GDP. He did not foresee any crisis in relation to the public finances or another banking crisis in Russia in the next 2-3 years although private sector and banking debt with the outside world could create some problems (Q 61).

53. There are some current and longer term weaknesses which the Russian leadership is seeking to address (see paragraphs 55-64 below). The government is developing a "Concept for Long-term Social and Economic Development of the Russian Federation to the year 2020". The key idea of the "Concept" is to make Russia a global leader through transition to an innovation economy. This strategy is based on several major points: taking advantage of existing global opportunities; forming competitive high-tech sectors in the economy and further diversifying its structure; and developing human capital, democratic institutions and assurance of personal freedoms. It will be for the new President and his new Prime Minister to see if they can turn these ambitious plans into a reality. We were told by Vladimir Mau, Director of the Working Centre for Economic Reforms of Government in Moscow, that the trouble with cheap money, such as Russia now enjoyed, was that people saw no reason for painful reform. High oil prices were an impediment to economic development, and prevented structural and institutional reform.[23]

54. The Russian government has not abandoned its consistently declared objective of modernising the Russian economy so that it can compete with the best. However, the pressure to take painful reform measures has diminished.

Problems for the Economy

55. Two major challenges affect the economy: population decline and the need for diversification, which we deal with below. In addition to structural weaknesses, the Russian economy is suffering from a number of more immediate problems: an appreciating rouble which is now once again beginning to make domestic production unprofitable, rising inflation and the possible knock-on effect of the economic slowdown in the West. Inflation for 2007 was 11.9%, slightly less than had been feared, but significantly more than the 7-8% originally predicted. It is also a reversal of the recent downward trend: 12% in 2003, 11.7% in 2004, 10.9% in 2005, 9% in 2006. Significantly from the political point of view, food prices went up 16% last year, and the cost of services went up by 13%. This has already had an impact on public opinion, and the authorities are having to take account of it,[24] with some staple foodstuffs now having their prices fixed. One reason for food price inflation may be that agriculture also continues to be a weak sector in the economy. Sir Anthony Brenton, British Ambassador to Russia, commented that there was "one bit of the Russian economy which really does need to develop or redevelop … agriculture, the black earth; they have some of the richest farmland in Europe which is scandalously underused at the moment" (Q 231).

DEMOGRAPHY—THE CHALLENGE OF POPULATION DECLINE

56. One important problem that Russia faces is continued demographic decline, which is likely to have both political and economic consequences. Professor Cooper told us that the UN's latest forecast is that by 2050 Russian could have only 110 million people compared with 142 million now (QQ 48-53). Professor Lieven, however, estimated that the future population figure was more likely to be 130 or 125 million (QQ 181-189). A low birth rate and a high death rate (particularly among men from age 20 to 35-40 because of alcohol, smoking and a high level of industrial and road accidents) painted a worrying demographic future for Russia. The economic and security consequences were already beginning to appear with questions over whether Russia would be able to maintain the size of the armed forces. It was particularly seen in a serious shortage of skilled workers and managers. Ethnic Russians living abroad had mostly either returned already or lacked the financial incentive to return. On the other hand one obvious source of labour, China, was causing concern, with anxiety about possible large-scale Chinese and Far Eastern immigration into the sparsely populated Siberian and Far Eastern provinces. Professor Lieven thought that the long-term existential threat for Russia was Chinese and Muslim immigration.

57. In his May 2006 Address to the Nation, President Putin described the demographic crisis as "the main issue". He presented a detailed plan for improved childcare benefits to encourage women to have more children. Vladimir Mau, was sceptical that a higher birth rate and greater immigration would provide the answer.[25] Economic growth was indeed always associated with population growth. Like Professor Cooper, Vladimir Mau thought that most Russians who wished to immigrate from the former Soviet Union had already done so. Russia would be unlikely to attract skilled immigrants in the way that Australia had succeeded in doing. The Russian birth-rate was not significantly lower than the European norm. There were no successful precedents for Government attempts to stimulate the birth rate. What could be done was to limit the population decline by reducing the early death rate, especially among younger men.

58. The problem of demographic decline and its impact on the Russian economy, and security policy is likely to exercise Russian governments and to influence a whole range of their policies for the foreseeable future.

ECONOMIC DIVERSIFICATION—SLOW PROGRESS?

59. Another problem for the Russian economy is the heavy dependence on the production and export of energy and raw materials, including such commodities as wood. United Company Rusal, an aluminium conglomerate, is now the world's largest producer, worth an estimated US$30 billion.[26] This is, in the medium and longer term, a weakness rather than a strength. Professor Cooper thought that the Russian leadership was increasingly realising that Russia should move up the value chain for minerals, materials and commodities as the best way to diversify, rather than exporting them in an unprocessed form or trying to jump into high-technology areas such as electronics and information technology where Russia is very backward by international standards (Q 64). We were told in Moscow, by Yegor Gaidar, the former Prime Minister, that a degree of diversification is in fact going ahead. Manufacturing, vehicle construction, telecommunications, agriculture, housing construction, retail trade, and financial services are all contributing to this additional growth.[27]

60. The process of diversification is happening in two broad ways. The first is at the "para-statal" level, including large concerns directly or indirectly controlled by the government. At least six new state companies were recently created in the defence, aircraft (the United Aircraft Corporation), shipbuilding, high-tech and construction sectors, with more proposed for other sectors of the economy. Exports of state-produced Russian arms—among the few competitive manufactures—have been stepped up, especially to India and China. By the end of 2007, state-owned banks accounted for 43% of total banking assets, while state-owned corporations together with regional and municipal governments now account for more than half of all Russia's assets.

61. More generally, the Russian banking system is now one of the fastest growing in the world. From 2002 to 2006 the average annual growth in assets was 25-30%. Consumer credit was practically non-existent in Soviet days, and the experience of the 1990s made consumers very wary of entrusting their savings to banks; in the years immediately up to 2005 consumer credit doubled every year, and in 2006 it increased by 75%.

62. The Russians are also diversifying in another way. On 1 February 2008 Mr Medvedev in his Financial Times interview indicated the government's support for Russian companies seeking to acquire assets abroad. This would "allow us to retool Russian enterprises with technology, boost their production culture, and grant them the opportunity to diversify investments and win new markets."[28] In other words, the Russians will acquire foreign know-how not by allowing foreign firms to control strategic assets at home, but by acquiring control of leading-edge companies abroad.

63. Western liberal economists might believe that this would lead to inefficiency and waste, but for the time being the Russians apparently believe that they can best achieve their economic objectives through a form of state capitalism. A fully-fledged liberal economic model is considered by them not necessarily right for a backward economy emerging from decades of state planning. Yevgeni Primakov, Chairman of the Chamber for Commerce and Industry, told us that there was a dilemma in the 1990s: Russia had had to choose between macroeconomic rectitude and a free market; or state involvement in the real economy. Now the dilemma was over. The macroeconomy was working and the state was now involved, both of which were necessary for Russia, even though the market was still working inadequately. He agreed that Russia needed to move away from a commodity-based economy, a change which was beginning to happen: two-thirds of Russian GDP was created on the basis of the domestic market, not on the basis of commodity exports.[29]

64. Other things being equal, Professor Hanson's measured conclusion on the Russian economy remains plausible: "On balance a slow-down over a few years to growth rates closer to 5% a year … is a quite persuasive scenario. It is less dramatic than either a collapse or an acceleration towards Chinese rates of growth … Western commentary has tended for years to over-dramatise Russian prospects, both up and down. The country itself has tended to muddle through, fulfilling neither our fondest hopes nor our darkest fears."[30]

The Climate for Business

65. There is a public perception in the West that doing business in Russia is very difficult and barely profitable because of the degree of state control of the economy, the bureaucracy, the lack of a reliable system of commercial law, and corruption at every level from the top down. The 2007 Report of the Association of European Businesses (AEB) in the Russian Federation, whose representatives we met in Moscow, did indeed identify a number of obstacles to doing business, but their overall view was positive:

"According to the 2006 survey by the Foreign Investors Advisory Council, the majority of foreign investors in Russia are planning to expand their activity in the country over the next three years; 94% plan to expand their business operations; while 91% plan to increase investments into Russia. The overwhelming majority of respondents to the survey believe that their businesses are developing successfully and were able to report a considerable increase in sales and profits over the past year."[

66. In 2007 foreign investment in Russia grew at an unprecedented rate. "Some $100 billion was invested in Russia from abroad over the last 12 months, an all-time record for any emerging market country and a milestone of great historical and psychological significance for Russian business."[32] Most of this foreign investment—70% in 2006—came from the European Union (only 3% came from the United States). After Cyprus (a special case: investment flows from Cyprus mostly represent returning Russian capital) the largest investor was Britain, with 12.7%.

67. A great deal of business activity takes place at a level which, in Professor Hanson's words, is "below the political radar", where the state interferes comparatively little (Q 48). This was confirmed by members of the AEB[33]. They were positive about business prospects in Russia. Business was growing at a double digit rate: KPMG's Russian business was the fastest growing of anywhere in the world. The financial sector had recently been growing at 40%. Foreign banks such as Deutsche Bank and Société Générale were doing well. They had good relations with the Central Bank regulators, and room to manoeuvre within the Russian banking regulations. The system of commercial law was slowly improving: it was being pushed forward by the authorities and companies were increasingly defending themselves with success, even in cases involving the tax authorities. Corruption was a problem but not a major issue. The Russians were gradually adopting many of the principles set out in the European acquis communautaire, and from best practice elsewhere, though they were sensitive about anything that seemed "not Russian."[34]

68. Professor Lieven also commented that Western businessmen he had spoken to still believed that there would be opportunities in many fields in Russia in the years to come (Q 192). Sir Anthony Brenton added some provisos: "First of all, Russian bureaucracy is horrendous. The corruption constraints, which add huge additions to industrial costs, remain very high … But these are bright guys running these things at the top now and they are very internationally oriented and they are keen to make themselves internationally competitive and respectable and, as they do so, so Russia's economy will grow stronger" (Q 227).

69. At the same time, Russian businesses are increasingly looking to operate abroad. According to Katinka Barysch, "Russian officials routinely complain about EU protectionism but the figures do not support them. Officially recorded outward investment from Russia reached $20 billion in 2006, and once unrecorded transfers are taken into account, the true figure could be twice that. Most of this has gone to Europe. Gazprom now has investments in 16 out of 27 EU countries. In three of the biggest EU markets—Italy, Germany and France—it already has direct access to end consumers. In the UK, Gazprom hopes to raise its market share to 10% by the end of the decade."[35] Professor Lieven thought that the Russians were interested in Western investment in Russia and "in their investment in us, and our markets. It is not a Russian policy to disrupt or destroy that" (Q 204). (We deal with some of the potential problems to which these developments could give rise in Chapter 5, Energy). The value of IPOs (initial public offerings) launched on the London Stock Exchange by Russian companies rose from $4.8 billion in 2005 to $14.5 billion in 2006.[36]

70. The Russian economy is currently growing, buoyed up by high energy prices, but the prospect for the medium and long term is uncertain. Many questions remain about potential weaknesses and the threats these hold for its future prospects. Among these are demographic decline, which has implications for both Russian economic and security policy; the failure so far to diversify away from reliance on natural resources; and the failure to press ahead with market reform. The EU should continue to support Russian reforms in the economic sphere, which should be of benefit to both Russian and EU firms.

71. The Russians are unlikely to change their views on the need for substantial state involvement in the economy in the near or medium term. They seem, however, to accept that large parts of the private sector should operate free from state control. Both of these aspects of Russian policy have implications for EU policy and they are important for European business, which has largely and enthusiastically invested in the private sector of the Russian economy, and is generally making large profits as a result. The EU should where possible encourage further Russian steps towards improving the climate for foreign investment to provide the best environment for continued investment by European businesses in Russia.

3 Meeting, Mr Alexander Grushko, Moscow, 12 December 2007, see Appendix 4 Back

4 Meeting, Mr Mikhail Margelov, Moscow, 12 December 2007, see Appendix 4 Back

5 The Foreign and Commonwealth Office figures are: 81.5% Russians, Tatars 3.8%, Ukrainians 3% (more than 100 nationalities in all). Source: FCO website at www.fco.gov.uk. Back

6 The commitments that Russia has entered into are set out in the Helsinki Final Act and the Charter of Paris for the OSCE and the Statute of the Council of Europe, as well as in a number of Conventions and secondary texts, including in particular the European Convention on Human Rights (ECHR). Back

7 For example Ambassador Likhachev, Meeting, Moscow, 12 December 2007, see Appendix 4. Back

8 Interview, Vyacheslav Nikonov (President of the Politika Foundation, Moscow) London, 14 January 2008. The figures for Russian speakers living in the EU are very approximate. Many of these are not ethnic Russians, but Ukrainians and other Russian speakers from the former Soviet Union. Four million Russian speakers are said to live in Germany, many of them ethnic Germans from Central Asia. The figures for tourism come from European Tourism Insights 2006, published by the European Travel Commission, www.etc-corporate.org/resources/uploads/ETI_2006_new_final_version.pdf. Back

9 Figures from the Levada Center, an agency that carries out public opinion and market research, website: http://www.levada.ru/interrelations3.html). One poll conducted by the Levada Center for the EU-Russia Centre in February 2007 shows that 71% of the Russian respondents did not consider themselves Europeans. Nearly half thought the European Union was a threat to Russia and its financial and industrial independence. One third perceived Europe as a neighbour and partner, though only 15% thought the perception was reciprocated by the Europeans. Nearly half thought that Russia could learn from European culture and democracy, but a third thought that European democracy did not suit Russia. (See "The Russians' perception of European Values", EU-Russia Centre study entitled: "Voices from Russia: Society, Democracy and Europe", 15 February 2007, website: http://www.levada.ru/press/2007021501.html). A study by Aberdeen University (based on polls conducted in 2005) says that, by a majority of more than two to one, Russians see the country's future linked with other CIS states rather than with Western Europe. R Rose and N Munro (Centre for the Study of Public Policy, University of Aberdeen), Do Russians see their future in Europe or the CIS? Europe-Asia Studies, 60, 1, 49-66, 2008. Back

10 Meeting, Mr Vladimir Mau, Moscow, 12 December 2007, see Appendix 4. Back

11 Meeting, Mr Mikhail Margelov, Moscow, 12 December 2007, see Appendix 4. Back

12 Professor Phil Hanson, Centre for Russia and East European Studies at Birmingham University described two measures associated with the World Bank: the Ease of doing Business ranking, where Russia looked poor on an international perspective on a range of different indicators, including corruption; and the Business Environment and Enterprise Performance Survey (in association with the EBRD) which showed an increase in corruption between 2002 and 2005. This survey asked businesses what their experience was of paying bribes. Professor Hanson thought bribe frequency had gone up in the period when there had been an increase in state control. He saw this as an unpromising situation (Q 50). Back

13 Command Paper 7340, March 2008. Back

14 Vedomosti, 8 April 2008. This paper reported that of the 227,577 NGOs (Vedomosti's figures) operating in Russia, 11,000 had been refused official registration in 2007. About one sixth had been checked so far and the Russian authorities had filed court appeals seeking the closure of some 8,274 since 2002. Many NGOs had closed of their own accord since strict new registration requirements were introduced in 2006. Back