2018 may be Russia’s year of deep reforms that will determine the country’s future for years to come – or not.

The old petro-fuelled model, relying on a torrent of raw material export revenues to pay for transformation, is clearly exhausted. The economy began to slowdown in 2011 despite oil prices remaining persistently over $100 per barrel and by 2013 GDP growth had dropped to nothing – well before the showdown with the West over Ukraine’s future and the imposition of international financial sanctions could do their damage. Now a new model is desperately needed.

But the arrest and jailing of former deputy head of the Central Bank of Russia (CBR) Alexei Ulyukaev in December is a bad sign and one of several that strongly suggest whatever new model is adopted in 2018 – after the March presidential elections are over – will be at best a fudge.

As bne IntelliNews reported in 2013 in a cover story “Rekindling the Cold War as Russia rearms”, President Vladimir Putin had already decided to sacrifice the population’s prosperity to pour every spare kopek into modernising the armed forces in 2013. Then Finance Minister Alexei Kudrin protested and was sacked as a result.

All said and done Putin’s plan went pretty well, from the Kremlin’s perspective. Russia secured the ownership of its main warm water naval base at Simferopol in the Crimea as well as preventing Ukraine making much progress in its turn to the West. The Kremlin’s drive to increase its influence in the Middle East (and break the US diplomatic dominance there) starting with a military campaign to support the regime of Syrian President Bashar al-Assad has been an outstanding success. Russia is now punching at the same diplomatic weight in the oil-rich region as Washington.

However, with these foreign policy successes under his belt and the Russian military now able to achieve most of the tasks assigned to it, the Kremlin realises it's time to turn back to restoring that prosperity or face the danger of widespread popular unrest.

The Russian middle class has become more vocal in the last year, mainly thanks to regional rallies organised by anti-corruption blogger and opposition leader Alexei Navalny, who has been touring the country for most of the last six months.

What is surprising is the regional authorities have been unable to stop these meetings attended by thousands of regular Russians. The rallies show the shaky hold the central has over the regions: the Kremlin could send in the OMON riot police and break the meetings up, but it is more scared of radicalising the regional populations and sparking Russia’s own version of a Maidan revolution than it is of allowing disgruntled voters to blow off a little steam. Despite the thousands-strong crowds, the protestors still represent a small share of the population and Navalny, even if he were allowed to run in the March 2018 presidential race, still only enjoys less than 2% in the latest presidential election polls. Russia is not yet ripe for a “colour revolution”.

Will reforms happen and what will they look like?

So will the reforms happen and if they do what will they look like?

Reforms are definitely coming. Over the last year several groups have been asked to draw up plans and in May this year the outlines were presented to Putin personally – and privately; no details of what is being suggested were released and there has been no public debate on what model to choose next.

But the broad brushstrokes are known. There are two main camps. Kudrin heads the liberal camp that wants to invest carefully into economic multipliers such as health, education, infrastructure and most of all improving labour productivity. The second camp, championed by presidential ombudsman for business Boris Titov and the Stolypin Club wants to borrow and spend heavily to give the economy a New Deal type shot in the arm.

Kudrin’s model could work, but only if he is given the power to implement it. That almost certainly means a new prime minister; a job Kudrin himself has long lusted after. But bne IntelliNews sources say that if he were to be offered the job he would not take it unless it came with the considerable political power formerly attached to the role.

That seems unlikely, as Putin would be taking a big political gamble if Kudrin were to become a real PM. Not that anyone remembers now, but the bulk of political power is supposed to rest with the Duma and it gave former president Boris Yeltsin hell in the 1990s, culminating in his constitutional coup in 1993. Even after Yeltsin watered down the Duma’s powers with a new constitution, the Communist-led Duma was still a major thorn in his side for the rest of his term. One of Putin’s first acts was to defang the Duma with a subsequent string of weak prime ministers that effectively moved political power to the presidential executive.

Titov’s plan is unlikely to work as it assumes the only problem with the Russian economy is it lacks a stimulus. It ignores the corruption, lack of confidence because of the weak rule of law, Gordian red tape, and the inefficiencies that are the real drag on growth. However, as the Kremlin equates high sovereign debt (it is currently in the low teens) with lack of sovereignty, Titov’s plan will only be partially implanted, if at all.

The upshot is there is going to be a fudge – parts of both plans are going to be implemented and that means no radical change Russia will muddle along as it always does, making incremental progress but failing to impress anyone, with all that means for direct and portfolio investment. The only people that will invest are Russians themselves and indeed this is already happening. Foreign direct investment (FDI) jumped this year to $17bn, but this was dominated by offshore havens such as Cyprus – Russian flight capital returning home.

Hybrid model

Russia under Putin has developed a hybrid model that mixes an oligarchy with a free market.

Apolitical sectors such as retail and telecoms already sport some world-class companies and competition is cut throat. As 2017 comes to an end the leading mobile phone companies have started a price war, and only this week the ever-innovative Oleg Tinkov announced a new service that combines bank accounts with mobile phone services, where the tariffs are about 10% less than those of the incumbent mobile phone companies. These sectors are doing all the things Kudrin wants to see: investing in infrastructure, improving productivity, and pursuing meritocratic management policies. A World Bank study from several years ago found that Russia’s economy could double in size if Russian companies were simply organised better.

However, the political sectors, such as oil and gas, are dominated by state-owned enterprises (SOE) that are above the law and dominated by men close to Putin. These companies are about using the state’s funds to build empires. The Ministry of Finance tried to force all SOEs to pay out 50% of profits as dividends but in December was overruled and told that the per cent paid by the very largest companies will be decided on a “case-by-case” basis. Both state-owned gas monopolist Gazprom and oil major Rosneft have announced massive investment plans for 2018 over the protests of Ministry of Finance, analysts and investors. This is Titov’s spending plan in action.

Politically Russia also has a hybrid system. Russia is not a democracy, but more than most of its eastern neighbours,  the Kremlin needs to genuinely win about half the vote in elections to maintain its legitimacy or face social unrest. Specifically, Putin needs to win a large mandate to maintain his legitimacy, not with the people (although that comes with the territory of a big win) but with the elite; as long as Putin enjoys sky-high popularity he is immune from a palace coup.

So going into 2018 the issue is not which model will be chosen, but what the balance between the two will be?

And that is why the arrest and jailing of Ulyukaev is so troubling. Ulyukaev has given multiple interviews to bne IntelliNews and is a true liberal reformer and a competent pair of hands. His old boss, CBR governor Sergey Igantiev, was so camera shy that Ulyukaev took on the job of transmitting the CBR policy statements following rate decisions and did a sterling job. Russia’s battle-hardened regulator has executed its functions with aplomb in recent years and its staff are amongst the most competent talent Russia has to offer. It's no coincidence that the chief economists at both Renaissance Capital and VTB Capital are ex-CBR officers.

But there is no getting away from the fact that Ulyukaev probably took the $2mn bribe offered him by the second most powerful man in Russia and top stoligarch, Rosneft CEO Igor Sechin.

Corruption is unacceptable in any form, but in all the countries of the east it is a fact of life; indeed to be a player amongst the elite you have to take bribes. It is the same in the police force: new recruits have bribes thrust on them by their colleagues, as a clean cop represents a danger to the others, if they decide to come clean and expose their workmate’s scams.

For Putin corruption is a much simpler and more convenient way to control the elite: the carrot is enrichment; the stick is jail. But again this is a hybrid system: while the elite, the stoligarchs, can steal with impunity, one or two tiers down Russia is running a real anti-graft programme and thousands of tax officials and police officers have been imprisoned on graft charges as well as regional governors and now an ex-minister. 

Sechin is building an empire using state cash and Putin is letting him do it. Moreover, Sechin has shown himself to be vindictive. Ulyukaev’s bribe was purportedly to encourage the government to drop objections to Rosneft’s takeover of oil minor Bashneft, but Ulyukaev could not block the deal. The whole case is clearly a set up by Rosneft to punish Ulyukayev, who was a vocal critic of the deal. Moreover, Rosneft has also gone after AFK Sistema, which was the previous owner of Bashneft, previously an investors’ darling, with lawsuit after lawsuit. The shares of the London-listed company, which owns some of the most attractive assets in Russia, including Mobile TeleSystems (MTS) and children's store Detsky Mir, have tanked.

These unnecessary attacks have done massive damage to Russia’s already battered investment image and increased the already high political risk calculations. As far as reforms are concerned, they could also derail the 2018 reform campaign as large and important sectors of the economy are effectively off limits to reforms. Moreover, they also hurt the Ministry of Finance’s efforts to balance the budget, as these companies could also be the source of large amounts of revenue needed to close the federal budget deficit. In short these political companies represent exactly the sort of corruption, inefficiencies and non-market forces that the reforms in 2018 would be meant to eradicate.