Roland Nash of Renaissance Capital -

In early 2000, the UK embassy in Moscow took a bit of a gamble. They persuaded Tony Blair to make one of his first major foreign policy initiatives a meeting with the new face in the Kremlin and heir apparent, Prime Minister Vladimir Putin. At the time it was a bit of a shocker – a popular, powerful, top-level, democratically elected leader meeting with an unelected, unknown, KGB spy who was failing to manage a bankrupt country over-run by dodgy oligarchs.

The irony of the current situation is that it illustrates what a far-sighted step the UK embassy then took. At the time, Putin was weak and Russia dangerously unstable. The UK had been kept back from influence in Russia during the nineties by the Yeltsin-Kohl relationship. As Russia gradually emerged from the hang-over of the 1990s and a shockingly competent President Putin moved onto the global stage, the UK-Russia relationship helped both sides.

For a brief period between 1999 and mid-2002, the UK was perhaps Russia's closest Western ally. Putin benefited from the political recognition, and BP, London property prices and the City have all benefited economically. In finance and business, the UK remains Russia's most important partner. The recent exchange of diplomats is important partly because the UK-Russia relationship matters to both sides.

Blair's successor seems equally keen to use Russia to demonstrate independence in foreign policy. While Blair was the first world leader to publicly accept Russia's post-crisis Kremlin, Gordon Brown appears to be the first who is ready to draw a definitive line in the sand. It has been a long time coming, but the expulsion of the four diplomats sent a clear message to the Kremlin – that the long era of making allowances for Russia's post-Soviet mess is ending. In a strange way, the Kremlin may well not be displeased. Tit-for-tat diplomat exchanges, while investment flows both ways, plays well politically to the domestic audience, demonstrates an international equality of sorts, while keeping the economy nicely fuelled.

The immediate cause of the square-off between Russia and the UK is something of a red herring. There was no way that Russia was ever going to hand over a citizen for trial in the UK. That it is unconstitutional and that the UK does not appear to have produced any evidence of Andrei Lugovoi's guilt are both useful excuses, but largely irrelevant. The decision was political, not legal. It reflects the far from incomprehensible stance in Moscow that if London will not countenance the extradition of citizens wanted for terrorism and publicly threatening assassination, then there is no good reason to cooperate in the other direction. That the UK's refusal to extradite is legal (a judicial decision), not political, seems only as relevant, from Moscow's standpoint, as Russia's constitutional position.

It is as the strongest response yet by a Western government towards Russia that the current confrontation is most interesting. The UK-Russia stand-off is the latest symptom of a larger conflict, a jockeying for position as Russia reasserts its interests internationally. As we have argued elsewhere, defining the confrontation as a Cold War is misleading. Relative to the grotesque stand-off during the Soviet era, the current confrontation is a pretty petty affair. It is a conflict of realpolitiik which is messy, irritating and ugly, but not globally destabilizing – more a global cold sore than a global cold war.

Playing the game

Russia has in recent years proved rather inventive at twisting the rules, in particular sending different messages to similar interest groups dividing opinion and undermining criticism. Appropriating Yukos while bringing down the Gazprom ring-fence. Renegotiating Kovykta and Sakhalin, while inviting Total into Shtokman and the Germans into the Baltic Sea gas pipeline. Criticising the US and the UK in the Middle East from the safe position of allies with Germany, France and Italy, while keeping options open with Iran. Building stronger ties with China while demonstrating willingness and ability over cutting energy supplies to Europe.

Alongside the inventive has been the downright irascible. Hounding the British Ambassador in Moscow. Allegedly cyber-attacking government and tourist websites in Estonia. Banning wine and water imports from Georgia. Increasing to new lows of bureaucracy the visa registration process. Banning non-Russians from selling their produce in Russian markets.

But the Kremlin in effect argues that it has learned to be more aggressive from its experience during the 1990s. Then, the Yeltsin Kremlin focused on the rather limiting tactic of threatening global destabilization through imminent self-destruction if the West did not cooperate - a sort of suicidal version of Mutually Assured Destruction. In the same period, following assurances to the contrary, NATO pushed up to Russia's borders in the Baltics. Eastern Europe moved under the NATO umbrella. The Conventional Forces in Europe Treaty was undermined in Istanbul. A series of rather one-sided Production Sharing Agreements were signed when Russia was not in much of a position to argue. On the irritating front, the refusal to revoke Jackson-Vanik is an ongoing mistake, and anybody who has witnessed the humiliation of an interview for a US visa can testify that the bureaucratic traffic is far from being just one-way.

Of course, both sides will argue that the other is at fault. Certainly, Russia's lack of institutional flexibility and the resulting difficulty in efficient implementation of policy leaves Russia looking the less polished. Similarly, the limited checks and balances in Russia's political system and the consequent lack of input into the decision making process explains some of the Russian mistrust and occasional myopia.

But Russia would probably argue that the final justification for current tactics is that they work. Unlike the Baltics, Georgia and Ukraine have been so far prevented from moving closer to NATO. The bellicose threats to retarget Russia's nuclear arsenal has slowed plans to install missile defence systems in Eastern Europe. While relations with the UK are tail-spinning, those with Sarkozy and France are improving following Total's exclusive invitation to join Shtokman.

Friendlier times

Last year was the Year of Russia in China, and 2007 is the Year of China in Russia. BP is looking for new partnership opportunities with Gazprom. Rosneft has been the best performing large Russian hydrocarbon stock since its IPO. Putin has never been more popular at home, and as our recent poll indicated, the majority of Russians wants both more influence over the CIS (79%) and believes that Russia should be closer to the West (68%).

The tougher stance of Gordon Brown's new government is, therefore, interesting. The UK's recent willingness to see its political relationship with Russia deteriorate to new post-Soviet lows is the most extreme example of a what seems to be a new determination on the part of at least the US and the UK to act more firmly towards Russia. While Italy and France still seem keen on erring towards engagement, Germany's Merkel also seems more willing to push back than her predecessor.

The Western political community seems ready and willing to be more aggressive towards Russia. The hope that the Kremlin's prickliness was a passing phase on the transition to a Western model seems to have been dropped. This will likely have consequences. Russia will continue to kick back hard on Georgia and Ukraine. Any support over Iran will be linked to Kosovo. Missile defence plans are a terrific provocation given what Moscow views as broken assurances over Eastern Europe in the past. The retargeting of missiles and the tearing up of arms agreements are designed to upset the West to the same degree. I don't believe that the trial balloon released threatening the Bank of New York over alleged money laundering was a casual undertaking.

But the deteriorating politics does not need to have an impact on business or finance.

Foreign investment

On the same day as the UK announced that it was expelling the diplomats, the Russian equity market posted its highest close ever. With $12bn of investment, the UK was the second biggest foreign investor into Russia in 2006, and roughly 50% of the investment was into retail and trade. BP announced in July that it wants to increase cooperation with Gazprom to invest more into Russia. Purportedly, 50% of all apartments sold in London above ₤1.5m are bought by Russians. There is no sign of any decline in the desire of Russian firms to list in London, and the City is a large vested interest to keep them coming. Outside of oil and gas, Russia needs massive foreign financing for the investment needed to retool after 20 years of underinvestment. Russia will be the largest car market in Europe by 2010, by which time it could be a bigger car producer than the UK, with at least 60% produced by international franchises. China expects to quadruple trade with Russia to $80bn by 2010.

The UK was right and farsighted to engage with a weak and uncertain Prime Minister Putin in 1999. Engagement then helped create a strong and self confident Russia today. As a result Russia is both able to push for its own interests internationally, and to become an increasingly important and integral part of the global financial and business community. The UK is probably as right today to be willing to face up to the stronger Russia. A politics based on self interest is evolving and is likely to continue to look rather ugly, particularly given Russia's institutional weaknesses and peculiarities. But by the same token, the business and financial relationship is likely to continue to deepen, because that's also where the mutual self-interest lies.

Roland Nash is head of research at Renaissance Capital in Moscow

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