COMMENT: Pragmatism prevails at G8; glass half-full again

By bne IntelliNews June 14, 2007

Chris Weafer of Alfa Bank -

In the run-up to the G8 meeting several issues were identified as having the potential to extend the rift between Russia and both the EU and US. The perception of this deteriorating relationship with the West is one of the reasons why the equity market has underperformed the Global Emerging Markets asset class since mid-April, when many of these issues appeared to escalate.

The fear was that several of these issues might dominate the G8 summit and cause the perception of risk in the investment case in Russia to be extended.

Among these issues was the row with the US over sites for the missile shield, the row with the UK over BP's Kovytka license and the Litivenko case, and the several issues that have cooled relations with the EU this year.

Over the past several months, it was definitely a case of the glass appearing half-empty as investors questioned whether the Russian government was capable of using its financial and strategic industry infrastructure built over the past seven years to pursue its ambitious plan to create a more diversified economy with less dependency on commodities and a broader distribution of wealth among the population.

In simplified terms, the question asked was whether the same government that successfully fixed the problems inherited from the Yeltsin era and built up such a strong fiscal and control platform is now equally qualified to move to the next stage of development. The disputes with the US and the EU were seen by many as evidence that this transition would not be smooth and might even be derailed. However, today we can say that the perception has shifted back to one of the glass being half-full. There is optimism that these troublesome issues will be resolved and won't be allowed to disrupt the expected transition.

The big issues

-- The offer of a compromise on the missile shield issue, regardless of the technical or practical merits, has at least diffused the issue for now. Undoubtedly it will be one of the main subjects at the forthcoming summit between Presidents Putin and Bush in the US in early July, but the fact the compromise was offered substantially reduces the Cold War atmospherics that were building. The Kremlin now looks like a more reasonable neighbour than it did when it was threatening to point nukes at Europe.

-- The issue of the London poisoning case has not been resolved, but it appears to be less of an issue post-summit than it was even one week prior. The analysis of the tough statements from UK Prime Minister Tony Blair suggest this is probably part of a "good cop, bad cop" routine, as Blair has nothing to lose by taking such a tough stance with Russia when he is leaving office later this month. His successor Gordon Brown, and the EU in general, can benefit from having raised the issues, but then retiring the more provocative aspects with Blair's departure.

-- The question of Kosovo remains a very real threat to the relationship between the EU and Russia. As it stands right now, the UN negotiator has tabled a proposal that would have to be presented to the Security Council, and thus likely be vetoed by Russia. That would result in a serious rift with the EU and delay any substantive progress on a new trade and energy deal. However, new French President Nicolas Sarkozy has raised the issue of a compromise which seemed to be repeated by senior members of the President Bush's entourage during his visit to the Balkans following the G8 summit.

-- The timing of the $3bn Boeing order, announced at the St Petersburg Forum, was of course not coincidental. It reinforced the message that, while the political rhetoric may have cooled on the practical level, the business relationship is good and improving.

Critical issues yet resolved

Of course, there are several major issues still to be resolved, and any one of these could yet result in a more belligerent relationship between Russia and either the US or the EU. The best case scenario for Kosovo would be a compromise resolution that satisfies Serbia (and hence, Russia) and thus stops the Kosovars declaring independence. This seems very unlikely in the medium term so the best realistic case is that the issue continues to be delayed and not brought before the Security Council until at least after the March 2008 Russian presidential elections.

Even though Putin downplayed the issue of WTO membership, there is enough evidence to support the view that Russia wants to end the process this year and be admitted to the organization in 2008, as much for national image (ie. it is difficult to justify a place in the G8 if the country is not a member of the WTO) as for financial reasons. This is the final box to check in terms of international trade relations for Putin's presidency.

The 1994 Agreement on Partnership and Cooperation (APC) between Russia and the EU expires this year, and Russia wants a new deal that removes some of the restrictions that, it alleges, is blocking trade, especially from Russian non-commodity exporters. The EU is linking this to a new energy cooperation deal.

The whole issue of investment access came to a head with the reaction to Russia's VTB acquiring a 5% stake in EADS. Part of the Kremlin's vision for economic development is that Russian companies be able to conclude joint venture deals (often with strategic equity stakes) in international companies. Publicity concerning Gazprom's plan to become involved in downstream distribution in the UK has regularly provoked a negative political reaction. Hence when a result of the EADS reaction was Putin stopping Shtokman, very quickly the issue of energy for trade/investment access was placed firmly on the table.

Finally, how the Kovytka dispute is resolved is very important. The critical issue for investors, and for the Kremlin's plan for moving on to the development phase for new projects in hydrocarbons and other natural resources, is that BP is able to stand up after the resolution and declare itself satisfied with the outcome, no matter what that outcome might be.

Chris Weafer is Chief Strategist at Alfa Bank, Russia

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