By Chris Weafer, chief strategist at Alfa Bank in Moscow -

In his first annual address to the joint houses of parliament in early 2000, the then newly elected Putin declared that among the key goals for his presidency would be the creation of a new economic model that could sustain long-term growth, lead to a diversification of the drivers for that growth and, ultimately, allow for much broader wealth distribution across the population. It was acknowledged that this was the only way Russia could break away from the debilitating economic and social structures of the past.

But the president also made it very clear that he would not push major economic or industrial reforms until he was sure the state could control the process. He wanted to avoid a repeat of the inefficiencies and waste of the 1990s. Over the past seven years we have seen the Kremlin first prioritize the recovery of its previously unchallenged political role in the country and, since 2004, in the economy via the creation of national champions in the strategic industries that had been identified. While pursuing these objectives, the Kremlin has not only been slow to give support for major reform initiatives, but in many instances has actually stalled progress until its national champion company was in place to lead the reform. So today, for example, several vast deposits of oil and gas that were identified more than a decade ago remain snugly underground while the country faces a potential gas shortage and both oil and gas export growth is negligible.

There is no question that the state has ridden its luck with regard to oil and gas revenues during the seven years of Putin’s presidency. This has paid off handsomely so far, by virtue of the approximately $600 billion in export earnings from this source since 2000. Today, the Kremlin has at its disposal almost $300 billion in financial reserves, including almost $100 billion in the stabilization fund. In 2007, the plan is to add another $80 billion to the fund from a projected budget surplus of $120 billion.

But despite the very healthy and enviable position the economy is in today and almost certainly will continue to enjoy in 2007, the clock is ticking ever louder. Given Russia’s substantial fiscal reserves and the fact that the price of a barrel of oil required to fully finance federal expenditures requirements is less than $40 per barrel, a sharp drop in the price of oil would not cause any real crisis. But because oil and gas revenues currently account for over 60 percent of federal budget revenues and almost 70 per cent of the value of exports, a large portion of investment inflows, monetary growth and spending confidence is still very dependent on high oil prices. The major concern for investors should be that if budget revenues start to dip below the expected level then, despite healthy reserves, the process of economic, industrial and social reform could easily stall as the government moved to preserve its savings base rather than increase investment spending.

As President Putin begins his last full year in office, there actually has been relatively little progress in achieving some of the key goals that he identified in early 2000. Despite growth in other sectors the economy remains very dependent on, and vulnerable to, fluctuations in oil and gas revenues. The unequal distribution of wealth amongst the population remains a very critical problem that simply cannot be left unresolved without risking social and political instability in the future. On the positive side, and despite having taken far too long, most of the preparation phase is now complete and the indications are that it is with the arrival of the next president in March 2008 we will start to see this combination of financial strength and political control being used by the Kremlin finally to move more aggressively toward realizing these long-term goals.

For both portfolio and strategic investors one of the critical issues is whether the Kremlin can define more clearly what role it sees the state playing in this next phase of economic renewal. Is the state’s role intended to be industry, event and time specific, or, is to be a more wide-ranging, non-defined and permanent role? The more defined approach offers the attractive scenario of substantial state financial and political support for industries to help them move ahead into a new productive phase, followed by a more orderly privatization process. The less defined scenario offers the longer-term prospect of the increasing politicization of strategic investment decisions and continued inefficiencies. This year the debate will also center on issues such as how the stabilization fund should be formally structured and used, and also how the government should adapt its fiscal management policies to an oil price that is unlikely to keep rising beyond budget expectations.

2007 should be the final one in the preparation phase and lead into the implementation phase that it is hoped will start with the next government in March 2008. But if this time next year we are still debating the same unresolved issues and facing the same uncertainties, then investors and participants in the economy will again have to hope for higher oil and hope that the country’s luck holds out for yet another year.