Kingsmill Bond of Citigroup -

The fear of Russia Imperialism is back– The recent decision by Vladimir Putin to return to power in Russia for up to another 12 years has caused fear of a revival of imperialism amongst some investors, who think back to the 1980s when the Soviet Union still was a global power.

But there are no grounds for it – However, we think such fears are groundless. Russia is a middle-sized power accounting for around 3% of global GDP, and this share is unlikely to rise significantly. In our view, investors should not over-react to colourful messages by Russia's leaders intended for internal consumption only.

Russia will have to modernise to survive – The real geopolitical driver for Russia is the relative rise of China which may eventually oblige it to modernise in order to stay relevant. Just 20 years ago, Russia and China had similar levels of GDP, while today China's is five times higher and rising; a degree of superiority not seen since the Middle Ages.

The lessons of history – Russia's share of global population peaked in 1913 at 8.7% and of GDP in the 1960s at over 10%. The fall from influence in the last 20 years has been unprecedented, and explains both local and global misconceptions.

The risk is populism – We believe the risk to the Russian story is that of a charismatic leader who seeks to recreate past glories.

Plays on change. The election and the continuing instability in Belarus and Ukraine may spark further fears of Russian imperialism, and investors should be ready to take advantage of sharp market movements. We continue to argue that Gazprom is the reform proxy for Russia and the way to play the hope for change.

The past

Russia

Below, we present Russia's share of global population and GDP, taking data mainly from the famous historical series put together by Angus Maddison, the economic historian. We look at the Russian Empire, the Soviet Union and now the Russian Federation.

A number of interesting facets stand out:

- Population peaked in 1913 at 8.7% of the global total, and in 1940 was still at 8.5% of the total. It is widely argued that, without the many tragedies visited upon the country in the course of the twentieth century, the population of Russia would be comparable to that of the US today, or over 300 million.

- GDP peaked in the 1960s at over 10% of the global total (14% if satellite states are included), and even as recently as the end of the 1980s it was nearly 8%. However, with the end of the Soviet Union, the decline of oil and the failure of the communist model, it fell to 2% of global GDP in 1998.

- Over the course of the recent commodity boom, GDP has risen to 2.5% of global GDP, taking data from Angus Maddison. The IMF data, which takes a later date for the calculation of PPP, and is more likely to be accurate for the future, shows Russia having a slightly higher share of GDP, at 3% for 2011. For the purposes of this piece, we use the Maddison data as it of course has a longer history of estimates

Russia and China

The most telling point of comparison is of course between Russia and China, where we show below their percentage of global GDP as well as Chinese GDP as a multiple of Russian.

Points to highlight from this are:

- Russia overtook China as a percentage of global GDP in the early twentieth century, and maintained that lead until the end of the Soviet Union.

- However, the twentieth century in retrospect looks anomalous, a brief period in which Russia had a larger economy than China.

- Since the end of the Soviet Union, China's share has risen fourfold while that of Russia has more than halved. China now has an economy nine times the size of that of Russia if we take the Angus Maddison data; the IMF data is slightly different, and implies that Chinese GDP is five times higher.

- Within this context, the age-old Russian fear about the vulnerability of its sparsely populated Far Eastern territories on the Chinese border is understandable.

Russia and Europe

We can also examine this process of GDP peaking and contracting for the major powers of Europe.

Points to highlights are:

- France peaked round 1870, the UK in 1900 and Germany before the first world war. However, Russia did not peak until the 1960s.

- The speed of Russia's decline was unprecedented, falling from 8% to 2% in the course of ten years and leaving the majority of the population impoverished.

- In contrast, in the UK, it took 70 years for the country's share of global GDP to halve, a period in which living standards for the mass of the population increased dramatically.

The future

The question of course is whether Russia can reverse this relative decline. Leaving aside the potential for expansion through mergers with its neighbours, there are two key variables to consider: population and GDP per capita.

Population

The population decline has been arrested thanks to immigration, a rising birth rate and a falling death rate. However, even with relatively optimistic assumptions, it is hard to imagine Russia's population growing significantly. For example, the UN forecasts Russia's population will only rise if the fertility rate increases to well over 2 children per woman, compared to a little over 1.5 today

GDP per capita

This leaves GDP per capita as the main potential source for revival. However, as projected world GDP per capita is growing at 3.5% per annum, Russia would have to grow significantly faster than this to increase its share of global GDP, as it did from 2000 to 2008. Looking forward we believe that this is unlikely for three reasons: first Russia is no longer coming from such a low base; second, oil prices are unlikely to rise as much over the next decade as they did in the last one; and third, it is notoriously harder for middle income countries to grow as rapidly as low income ones

Conclusion

The conclusion then is that Russia has been able to reverse its decline, but is likely to struggle to increase its share of global GDP to much beyond 3%. The implication of this is that Russia is unlikely to be able to challenge the US or China in economic terms.

This by no means implies that the country will no longer have importance or capacity to influence the world. IMF data still shows it as the world's sixth largest country in terms of GDP, Russia is the world's largest repository of commodities, controls the largest land mass, and has the second largest number of nuclear weapons. The country certainly has the capacity and desire to be a regional power.

However, it does imply that Russia will be unlikely to embark on a new imperialist course. Moreover, in order to modernise successfully, it is likely to seek to improve relations with Europe in order to attract its technology and capital. Therefore it will be likely, as the UK and other European countries have done before it, to tailor its foreign policy to suit its capacity to act.

The risk to this benign framework is that a domestic leader arises who ignores the economic weakness and seeks to challenge once more for global hegemony. However, from our analysis, such a course would be unlikely to succeed, and could simply lead to some kind of Suez moment as faced by the UK.

Investment conclusions

We would argue that there are some facets of the way that markets operate that are best explained with reference to this historical background.

- Russia's Imperial mindset. Investors are often puzzled by the gigantist ambitions of certain Russian leaders. The reason why of course is that their frame of reference remains one in which the country is a global superpower, or can aspire to that status again. As recently as the 1980s, Russia had nearly 10% of global GDP as well as an internationalist ideology.

- The West's fear. For a whole generation of policymakers, Russia was of course the enemy. The last remnants of this attitude can be seen in books like 'The new Cold War' by Edward Lucas, which raise the spectre of a resurgent Russia once more menacing the West. And again this explains why a small conflict in Georgia sparked the colossal panic which so damaged the market in 2008.

- Nostalgia for the Soviet Union is understandable. Apart from its own consequences, the end of the Soviet Union nearly coincided with the rise of China, a factor which redoubled the speed of Russia's decline.

- Russia is no longer a threat. Even after a decade long boom in commodity prices, Russia is still only 2.5% of global GDP using the Angus Maddison data or 3% using the IMF data. As the population is at best flat and GDP per capita is no longer rising at much faster than the global average, Russia will likely struggle to increase much from this level. And without a larger share of GDP, Russia is unlikely to present an imperialist threat.

- Russia has little to offer to its potential satellites. In order to become even a regional power, a country has either to offer an attractive ideology, possess military power or have a strong economy. While the Soviet Union had the first two factors, modern Russia arguably does not, and has struggled even to attract Ukraine into its sphere of influence.

- Russia must modernise to survive. Faced with the inexorable rise of China, it is highly likely that Russia's leaders will embrace real modernity so as to increase GDP per capita growth rather than simply paying lip service to it.

- Russia's future lies in Europe. As argued by Dmitry Trenin, Russia will be likely to seek its future in a Europe as an equal partner rather than with China as a junior partner.

- The risk is that populists appeal to nostalgia. As outlined by Gaidar, the risk to the Russia story is that a populist leader arises who appeals to nostalgia for the past and seeks somehow to recreate its perceived glories. Within that context, investors should perhaps see the relatively known quantity that is Putin in a more favourable light. Investors should also realise that it is quite rational for a Russian leader to play a double game, appealing to nostalgia to get support from the population and at the same time being quite constructive with the West. Aggressive statements are usually made 'for internal use' and often have limited implications for real foreign policy