Hamish McRae: The poisoning of an ex-KGB spy must not stop us bringing Russia in from the cold

Russia carries a penalty in terms of weak inward investment...
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The poisoning of a prominent Russian dissident in London is of course a huge political story, even if we never really get to the bottom of it. But it also has real long-term economic implications, emphasising as it does how difficult it will be to bring Russia fully into the western European economy. But somehow we have to do it.

As it happens, on Friday Russia had a summit meeting in Helsinki with the EU to discuss some kind of bilateral trade agreement: the ultimate aim would be a free trade area between the two zones. I think we are some way from that outcome but this was serious stuff: the Russian President, Vladimir Putin, plus Matti Vanhanen, the Prime Minister of Finland, the country presiding over the European Union, and European Commission President Jose Manuel Barroso, were all taking part.

Whatever happens to the relationship with the EU, Russia is going to join the World Trade Organisation. Just a week ago it signed a protocol with the US clearing the path towards WTO membership. You might feel that the WTO has become a club which anyone can join, whether it follows acceptable market policies or not. China is a member but many practices there would not pass muster in most member states. However, China is the world's third-largest exporter so it would be nuts for it to be excluded and arguably WTO membership does exert a discipline.

Much the same argument can be applied to a Russia/EU free-trade agreement. To some extent, getting Russia into the tent might make it behave in a more "Western" manner. But that requires Russian business interests to perceive that it is in their advantage to do so. How could that be nudged forward?

The argument runs like this. At the moment Russia carries a penalty in terms of weak inward investment. It gets much less foreign direct investment than you would expect given the economic opportunities there. This is, after all, an economy on the EU's doorstep with growth running at 7 per cent a year, more than double the rate of the EU. Living standards are rising even faster, largely because the terms of trade favour Russia. In other words, the price of the things Russia is selling, mostly oil and gas, is rising faster than the price of the things it imports: machinery and other equipment, food and drink, luxury items and so on. The largest exporter to Russia by a large margin is Germany and the Germans make good stuff.

Thus Russia is able to increase living standards by upwards of 10 per cent a year - a process that is forecast by Deutsche Bank to continue through to 2008.

Russia has attracted quite a bit of portfolio investment and this year its financial markets have performed better than those of other emerging markets or of the world as a whole, though it is still down a bit on the May peak. So why should they worry?

There are two answers to this. One is that they don't need to as we need them more than they need us. Russia sits on the world's largest gas reserves and the second-largest oil reserves. Western Europe is energy poor. So Russia could go back to the role it had a century ago, supplying us with raw materials (mostly timber then) and buying luxury stuff in return.

But while that argument can be sustained in the short-term it makes no sense in the longer term. About 70 per cent of Russia's foreign earnings are fuels. Being so reliant on a single line of exports is dangerous because you are vulnerable to swings in the price of energy. You are also vulnerable to the natural fear in Western Europe that we are being unwise to allow ourselves to be so reliant on what has been an unreliable trading partner.

But I think the even more substantive objection is that it creates an unbalanced economy within the country. Other potentially successful sectors are neglected; other skills inherent in the Russian workforce are not developed. The country has a huge legacy of technical competence and a high level of computer skills - you have to be skilled to operate with Russian computers. But building exportable goods and services with these skills means bringing in Western know-how - and that comes in principally in the form of foreign direct investment.

In the case of China, some 60 to 70 per cent of exports involve some kind of foreign participation, either as a joint venture or as a first investment. In the case of Russia the percentage is negligible. So Russia cannot build a balanced economy without Western investment and it won't get Western investment until it has higher standards of corporate governance and better protection of property rights.

There is a further reason for seeking higher standards. It would slow the outflow of domestic capital seeking better investment prospects abroad. You don't have to be an expert in the UK property market to see the flood of Russian money coming into London, but that is just the tip of the iceberg. Russia is buying up assets all around the world. So it does not need inward investment because it needs the money: the present level of energy prices inevitably generates a huge current account surplus. But the scale of the outflow is also a function of the lack of good investment opportunities at home and that is bad for the balanced development of the economy in the years ahead.

So what is to be done? It seems to me that progress will have to take place in a series of small steps. Progress in Helsinki stalled because Russia is currently banning Polish meat exports and so Poland blocked further talks. But other small steps can be taken. One would be to have greater freedom of travel between Russia and the EU: should this be visa-free? Another would be easing of border formalities for goods. There was a deal on allowing flights across Siberia, which are still restricted - Russia recently disrupted a new air service between Hong Kong and London by refusing over-flying on what was supposed to be the maiden flight.

The central point here is that building a more comfortable relationship between Russia and the rest of Europe will be a task for a generation. Building trust will be driven by economics and the business community will have a big role to play. It may be that politics will have to follow economics but that has happened many times before. Meanwhile, we should all welcome small steps that build trust; and deplore events of whatever sort that destroy it.

How will we remember thee, Mr Brown?

We are just 10 days from what must be Gordon Brown's last pre-Budget report, which with his Budget next spring will set the seal on his reputation as Chancellor of the Exchequer.

Will he be remembered for having achieved macro-economic stability? Will it be for his "stealth taxes"? Or will it be for a wasteful expansion of spending on an insufficiently reformed public sector?

Whatever view you incline towards, perhaps the best way to view his term will be to see it from an international perspective. How will his time fit into global trends in taxation and spending? Looked at this way, I suspect he will receive a good measure of credit for stability and some criticism on taxation.

However, the expansion of public spending will be seen as running counter to the global trend for smaller governments.

Tomorrow sees the publication by the think-tank Politeia of a useful commentary that puts the UK experience into this global context. It is called "Death of an Illusion? Decline and Fall of High Tax Economies" and it is by Professor Vito Tanzi, the former head of fiscal affairs at the IMF.

He talked at a lunch on Friday about his perception that 21st-century government would shift from taxation and spending, towards regulation. There are, he argued, reasons for this shift on both the revenue and the spending sides. On revenue, a number of factors had reduced the ability of governments to increase the tax take: internet commerce and off-shore finance; competition from low-tax countries such as China and India, and the structural shift in economies, with more activities carried out by organisations that were inherently difficult to control. We can all see this happening now: the pressure, for example, for lower corporate tax rates in Europe.

But perhaps there has been less attention paid to the efficiency arguments on the spending side: the ability of a well-regulated private sector to take over state functions and deliver these at lower cost.

When he says next week that increased output of public services will have to come from a 3 per cent annual increase in public sector productivity, he will implicitly be accepting Professor Tanzi's thesis. Just don't expect him to admit it.