To decipher Russia's riddle, watch its oil

After communism in the Soviet Union collapsed in 1991, Russia was told to go for it - a market economy.

Many economists, the World Bank, the International Monetary Fund, the United States, and others advised Russia to take the "big bang" approach: Privatize state-owned enterprises - the bulk of the industrial economy - in one fell swoop.

Russia did. It was a disaster.

Gross domestic product (GDP) - Russia's output of goods and services - tumbled 40 percent between 1991 and 1998. Poverty went up, encompassing about a third of the population, while a few private individuals with political connections managed to snap up key state properties at bargain prices. They became the infamous billionaire "oligarchs," despised by most Russians.

This divergence between the rise of a few and deepened general poverty puts the conviction of Mikhail Khodorkovsky into context. Last year, he was one of Russia's most outspoken oligarchs and one of the world's richest men. Now, Mr. Khodorkovsky sits in prison, sentenced last month to nine years for embezzlement, fraud, and tax evasion. In the West, the sentence is widely seen as a step backward in economic reform. But in Russia, the sentence and the stripping away of most of his assets are viewed as justice after a period of wide-open capitalism and corruption.

But Russia's economic progress doesn't hang on the controversial Khodorkovsky. It lies heavily with what his company, Yukos, exploited: oil.

After a financial crisis and a major devaluation of the ruble in 1998, Russia has begun to snap back, helped greatly by rising oil prices. By last year, its GDP had climbed back to about 88 percent of the 1991 level. The improvement is a bit better for the average Russian because there are fewer of them to split the economic pie - roughly 5 million fewer since 1991, it's estimated. For Russians with money, life has greatly improved. Moscow shops are brimming with goods, unlike in the Soviet era. Boutiques are bustling.

The Russian economy is highly dependent on oil. It provides roughly 20 percent of GDP - maybe as much as 40 percent, if its impact on the rest of the economy through orders for machines, pipe, steel and other goods and services is included, estimates Marshall Goldman, longtime Russia analyst and author of "The Piratization of Russia: Russian Reform Goes Awry."

Oil and gas revenues have enabled Russia to boost the pensions of its senior citizens, prepay some $17 billion of Soviet debts to foreign nations and institutions, and build up a government "stabilization fund."

That oil dependence is one reason President Vladimir Putin has moved to take back control of Russia's national resources, including oil and gas. A poll indicates that only 18 percent of Russians would oppose renationalization.

Such moves are crucial to the economy's future. Mr. Goldman charges that Mr. Putin's actions in the oil and gas industry signal that the state will once again become a strong, if not dominant, voice in energy policy and economic planning.

Such a policy is understandable, given the poor overall results of privatization in the 1990s, but it probably has serious risks, according to recent research.

Privatization "did not markedly improve the efficiency" of domestic Russian firms in the past decade, conclude three University of Michigan economists in a recent paper. Those firms are not catching up to world standards and are falling further behind.

"It's saying that privatization didn't work," says Katherine Terrill, one of the coauthors. "That's depressing."

By contrast, those firms with some foreign investor involvement have increased their productivity faster than those owned and managed by Russians alone, the professors' research shows.

This leaves Russia's economic leadership in a quandary. Nationalistic and political sentiments call for retaining or winning control of key elements of the economy. Yet managers of purely domestic firms appear to be slower than those running foreign-influenced firms in learning the skills and technology that can keep them in the economic race.

Putin has announced the goal of doubling Russia's GDP in 10 years. That would require 7 percent annual growth after adjusting for inflation. If achieved, that goal would lift Russian living standards to that of Portugal - one of Western Europe's poorest nations.

But real GDP, after rising by more than 7 percent in the last two years, slipped to a 5.2 percent rate in the first quarter of this year. Finance Minister Alexei Kudrin warned last week that doubling the size of the economy would take economic reforms.

Progress may be difficult. The Yukos-Khodorkovsky affair has damaged Russia's reputation as a place to invest, despite Putin's efforts to reassure US and German executives. So far, foreign direct investment remains relatively tiny. The Organization for Economic Cooperation and Development counts only a $16 billion inflow over the past four years.

More ominously, the growth in oil production has slipped. After a 13 percent surge in 2003, growth slowed to maybe half that pace last year and is even slower so far this year, despite prices around $60 a barrel.