Roland Nash of Renaissance Capital -

Amidst the international criticism, the election of Dmitri Medvedev to the Russian presidency was as entirely unexciting as the Kremlin must have hoped. Although incumbent Vladimir Putin chose not to play by Western rules, and despite all the obvious issues, it is at least worth nothing that for the first time in Russia's history, a leader has chosen to step away from the pinnacle of power.

And it was a choice. Unlike former president Boris Yeltsin, Putin could quite easily have chosen to retain the presidential mandate which has now passed to Medvedev. Indeed, polls suggested that a clear, democratic majority of the population both wanted and expected Putin to remain as president. There are obvious arguments on both sides, but in the end, the transition of power from Putin to Medvedev-Putin will be judged by results.

So what should be expected from a Medvedev presidency? The running assumption both domestically and internationally seems to be that little will change under Medvedev. But events outside of the Kremlin's direct control make that assumption questionable. The investment needed to rebuild Russia's infrastructure makes the fiscal austerity of the Putin years less of an option. At the same time, inflation is rising, necessitating a more active monetary policy, with interest rates likely to be pushed eventually into positive territory These are major changes. Moreover, the best (but not the only) way to control price increases as the investment boom takes hold will be to complete the under-appreciated reform agenda begun under Putin.

The difference between a Putin-Kremlin and a Medvedev-Kremlin is likely to involve more change in style than substance, but that itself can actually be rather important. Without meaning to over-simplify and while recognizing there are clear and much publicized counter-examples, much of the substance of the Putin presidency in the economic sphere has been impressive, often overshadowed by a presidential style which, while playing well domestically, has often proved confusingly abrasive abroad. A less combative Kremlin with the same focus on generating economic growth as the principal strategy for a resurgent Russia should be welcomed.

Reforms

The range of reforms begun under Putin, particularly (although not only) in his first term has been under-appreciated. When Putin became president in March 2000, Russia was verging on ungovernable. At a very basic level, taxes could not be levied, revenues could not be collected, government could not make policy, the judiciary was ignored and the administration was too weak to implement any decisions that were made. Some 25% of the population was surviving on less than $2 a day, propped up by massive subsidization through the energy sector and housing and social infrastructure inherited from the Soviet era.

Putin instituted budget, tax, judicial, pension and land reform, which helped make Russia function again. I would also add to the list, reform of the administration, reform of the electricity sector and the major steps taken towards shifting the responsibility for social policy from Gazprom and power utility UES to the budget through the lifting of utility prices to households. None of the reforms have been 100% successful. Most are still work in progress. The oil price has definitely been a major contributor to what success has been achieved. But there were some very difficult decisions taken on economic reform under Putin, particularly when put in the context of first-rate fiscal discipline and the rapidly expanding private sector.

The reforms facing Medvedev are no less difficult, but they are less immediately necessary and tend to be more technical. Electricity, pension, judicial and, in particular, land reform need to be shepherded to successful completion. The two perennial Russian bugbears of bureaucracy and red-tape, and the resulting corruption, need to be faced. Legislation on intellectual property rights must be tightened before Russia can finally enter the Wold Trade Organisation. Taxes will probably again be rebalanced to enable a fairer social system.

Like Putin, Medvedev could well use his first years in power to create some momentum. While he is unlikely to change Putin's general strategy, Medvedev will likely want to establish his own brand of tactics as soon as he can. I think that he will want to implement some quick successes early on which could prove surprisingly positive. WTO membership, a new order at the Central Bank of Russia (CBR), changes to taxation of the hydrocarbon sector, perhaps more focus on land reform - all could happen in a relatively short time frame.

Loose monetary-tight fiscal to tight monetary-loose fiscal

The biggest, most immediate problem facing Medvedev is inflation. Not so much the level - which at 12% is high but not disastrously so - but rather the direction. For the first time since 1999, inflation is increasing. While it was falling, there was no need to change macro-policy. Targeting the nominal exchange rate while growing the money supply and accumulating reserves was fine as long as demand for money more than kept pace and the rate of inflation declined. Rising inflation, however, necessarily entails a big shift in policy.

Fiscal policy under Kudrin's Ministry of Finance was adaptive to the exchange rate-targeting monetary policy of the CBR. Very tight fiscal policy (the budget surplus in 2006 was 7.4% of GDP) sucked money out of the economy allowing the CBR to run highly negative real interest rates (companies borrowed in roubles at several hundred basis points below inflation).

Starting from 2007 and certain to accelerate under Medvedev, this combination is turning on its head. Fiscal policy has loosened considerably. Even within the impressive three-year budget put together for precisely this reason, the budget surplus is set to fall to 3.5% of GDP this year and further out to 2010. Moreover, the automatic fiscal dampener of the stabilization fund in the face of higher oil prices is less effective now that it has reached its capacity of 10% of GDP.

Given the increasingly parlous state of Russian infrastructure, it is more or less inevitable that oil income needs to be spent in roubles rather than saved in dollars, but as a result, fiscal policy is no longer adaptive to monetary. The pressure is therefore now on the CBR to tackle inflation through tougher monetary policy. This appears to be exactly what is happening. The CBR is raising all of its financing rates, and that other branch of monetary policy, Sberbank, seems to be actively attempting to push nominal interest rates above inflation.

Although more by coincidence than design, this is a major change in policy from one president to the next and will have substantive consequences for the economy and the markets. As we have described in much detail elsewhere, the fiscal stimulus will likely lift investment and economic growth, at least in the short-term. The nominal exchange rate is likely to become more adaptive to inflation targeting with clear implications for exporters and therefore, quite possibly, the tax regime facing exporters. If handled correctly, the shift in emphasis could push Sberbank towards becoming a much more effective state savings bank, raising interest margins and potentially greatly improving the intermediation of capital towards small and medium-sized enterprises (SMEs) and households.

Rising inflation together with the chronic need for investment in infrastructure means that it is impossible for Medvedev to follow the same economic policies as Putin. Changes in fiscal and monetary policy are inevitable. Similarly, the best way to bring down inflation will be to encourage competitiveness and a more efficient allocation of capital. There are also other, more draconian measures, including price controls and capital restrictions. Either way, pressures that Putin did not face will mean that Medvedev will have to change economic policy.

State vs private sector

Arguably, the economic policy under Putin that received most publicity was the state's remarkable ascendancy over the still ill-defined 'strategic' sectors of the Russian economy. The state had remarkably little control over the majority of Russia's most lucrative companies when Putin came to power. Through tax changes, confrontation, Bassmannoe court rulings, personnel changes and the audit chamber, the state now has remarkably large control.

The state's hegemony over the strategic sectors is unlikely to change under Medvedev. But within that relationship, there is room for a shift towards greater cooperation. Many of the state's aims are becoming increasingly aligned with those of the private sector. As the energy sector becomes less responsible for subsidizing the economy, efficiency becomes a more realistic target. Both the state and the private sector want to see investment. In some sectors (electricity for example), the necessary investment will be difficult without foreign capital and there are already plenty of signs that international companies will be welcomed There seems a genuine desire among certain important parts of the Russian administration to see the market capitalization of state owned companies to rise.

Medvedev has repeatedly stated that the private sector will have an increased role to play under his presidency. I don't see any reason to immediately write off that commitment. I think Rosoboronexport's takeover of the remarkably defunct Avtovaz, its restructuring of the notoriously incumbent management and its recent sale of 25% of that asset to Renault for $1bn is a positive development - and under-appreciated by the market.

The friction between the state and the private sector has increased as both have expanded. The state remains cumbersomely inefficient, acquisitive and long cash, while the private sector is getting increasingly frustrated as the market becomes more competitive. However, now that the rules of the game have been established by Putin, there is room for an increasingly cooperative relationship under Medvedev.

Power sharing

Perhaps the biggest unknown about the Medvedev presidency is how power will be shared between the Kremlin and the White House. Theories range from Medvedev as a puppet president to Putin stepping down at the first opportunity. A regime with two centres of power clearly has the potential for confusion and conflict, neither of which bode well for policy or the markets.

But in retrospect, given the regime that Putin has built, I'm not sure how a smooth transition could have been managed without Putin's subsequent involvement. The balance of power established under Putin was very much centred on himself. Pushing anybody into the presidency before giving him the opportunity to create his own power base risked creating a power vacuum which could well have overwhelmed the new president. None of this sounds tremendously democratic, but it does reflect the focus on a smooth transition of power that has dominated the Kremlin for much of Putin's second term.

My view is that Putin's main responsibility as prime minister will be to continue to manage the balance of power while Medvedev builds up his own web of patronage and personnel. Putin found and fought a lot of enemies while in power. He will probably continue to manage relations with the oligarchs, the power ministries and the FSB from the White House, freeing Medvedev to focus on a more consensual approach to tackling economic and foreign policy.

From Rule of Putin to Rule of Law?

One important example of where a change in the style of government can mark a major change from Putin to Medvedev is over their approach to maintaining order. For both, the goal of maintaining stability in Russia is a dominant strategy. Historic experience in Russia and the coloured revolutions of the near abroad go a long way to explaining why stability has tended to trump other social goals, such as democracy and freedom of expression, in both public opinion and the Kremlin's policy agenda.

From his speeches, Medvedev would seem to share Putin's focus on maintaining stability. But where Putin has created stability through establishing a Rule of Putin, Medvedev has continually emphasized the need for the rule of law. It is clearly possible that Medvedev's commitment to law is nothing more than rhetorical campaigning. But his background in law, his focus on process in the presidential administration and what little I know about his personality suggests that the commitment, at least, is credible.

The opinion of the West, and its historic experience, is obviously that the best guarantees for stability are precisely the democracy and freedom of expression that Russia has been loudly, repeatedly and unrelentingly criticized over the presidential campaign for lacking. It should not be immediately discounted, in my view, that Medvedev's election marks a voluntarily choice to loosen the rule of Putin and hand power to somebody who will endeavor to move towards a rule of Law.

Consensus seems to be very much that the shift from a Putin regime to a Medvedev-Putin regime will have little impact on policy. Medvedev has certainly campaigned almost exclusively on a message of more of the same. But there is likely to be change. Medvedev's style of government is likely to be less confrontational both with business and abroad. The new president will probably focus on diversifying the economy and rebuilding infrastructure, rather than on establishing control over the strategic sectors of the economy. This itself will entail major changes in both fiscal and monetary policy, and focus on the unfinished reform agenda. If the Putin presidency could be characterized by consolidating power, then the Medvedev presidency will perhaps be characterized by the attempt to make its utilization more effective.

Roland Nash is Head of Research at Renaissance Capital in Moscow.

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