[Senate Hearing 109-250]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 109-250
 
                       U.S. POLICY TOWARD RUSSIA

=======================================================================

                                HEARING



                               BEFORE THE



                     COMMITTEE ON FOREIGN RELATIONS
                          UNITED STATES SENATE



                       ONE HUNDRED NINTH CONGRESS



                             FIRST SESSION



                               __________

                             JUNE 21, 2005

                               __________



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                     COMMITTEE ON FOREIGN RELATIONS

                  RICHARD G. LUGAR, Indiana, Chairman

CHUCK HAGEL, Nebraska                JOSEPH R. BIDEN, Jr., Delaware
LINCOLN CHAFEE, Rhode Island         PAUL S. SARBANES, Maryland
GEORGE ALLEN, Virginia               CHRISTOPHER J. DODD, Connecticut
NORM COLEMAN, Minnesota              JOHN F. KERRY, Massachusetts
GEORGE V. VOINOVICH, Ohio            RUSSELL D. FEINGOLD, Wisconsin
LAMAR ALEXANDER, Tennessee           BARBARA BOXER, California
JOHN E. SUNUNU, New Hampshire        BILL NELSON, Florida
LISA MURKOWSKI, Alaska               BARACK OBAMA, Illinois
MEL MARTINEZ, Florida
                 Kenneth A. Myers, Jr., Staff Director
              Antony J. Blinken, Democratic Staff Director

                                  (ii)




                            C O N T E N T S

                              ----------                              
                                                                   Page

Biden, Hon. Joseph R., Jr., U.S. Senator from Delaware, opening 
  statement......................................................    29
Cloherty, Patrica, chairman and CEO, The U.S.-Russia Investment 
  Fund and chairman and CEO, Delta Private Equity Partners, New 
  York and Moscow................................................     3
    Prepared statement...........................................     6
Lugar, Hon. Richard G. Lugar, U.S. Senator from Indiana, opening 
  statement......................................................     1
Verrastro, Frank A., senior fellow and director, Energy Program, 
  Center for Strategic and International Studies, Washington, DC.    13
Wallander, Celeste A., director, Russia and Eurasia Program and 
  trustee fellow, Center for Strategic and International Studies, 
  Washington, DC.................................................    15
    Prepared statement...........................................    19

             Additional Statement Submitted for the Record

Ebel, Robert E., chairman, Energy Program, Center for Strategic 
  and International Studies, Washington, DC......................    47

                                 (iii)




                       U.S. POLICY TOWARD RUSSIA

                              ----------                              


                         TUESDAY, JUNE 21, 2005

                                       U.S. Senate,
                            Committee on Foreign Relations,
                                                    Washington, DC.
    The committee met, pursuant to notice, at 9:32 a.m., in 
room SD-419, Dirksen Senate Office Building, Hon. Richard G. 
Lugar, chairman of the committee, presiding.
    Present: Senators Lugar, Murkowski, Biden, and Obama.

 OPENING STATEMENT OF HON. RICHARD G. LUGAR, U.S. SENATOR FROM 
                            INDIANA

    The Chairman. This hearing of the Senate Foreign Relations 
Committee is called to order.
    In February of this year, the Senate Foreign Relations 
Committee held a hearing on the status of democracy in Russia. 
Today, the committee continues its examination of United States 
policy toward Russia by inviting the testimony of three 
distinguished experts: Ms. Patricia Cloherty, Chairman and CEO 
of The U.S.-Russia Investment Fund, in New York, also CEO of 
Delta Private Equity Partners; Dr. Celeste Wallander, Director 
of the Russia and Eurasia Program at the Center for Strategic 
and International Studies; and Mr. Frank A. Verrastro, Director 
and Senior Fellow of the Energy Program, also at the Center for 
Strategic and International Studies.
    As I noted in our hearing 4 months ago, President Putin's 
increasingly authoritarian style, his control of the media, his 
retribution against political opponents have left the fate of 
democracy in Russia more ambiguous than at any time since the 
collapse of the Communist system. This has complicated the 
United States-Russian relationship and called into doubt some 
of the basic tenets of engagement pursued by both the Clinton 
and Bush administrations. Responding to these troubling 
developments by attempting to isolate Russia, however, is 
likely to be self-defeating and harmful to American interests. 
Consequently, the Bush administration has pursued a policy of 
forceful engagement.
    At his February meeting with President Putin, in 
Bratislava, Slovakia, where the main agenda items were weapons 
proliferation and terrorism, President Bush was rightfully 
critical of Russia's backsliding on democracy, human rights, 
and the rule of law. The dilemma for American policymakers is 
how to strengthen Russia's respect for democracy while 
simultaneously advancing cooperation with Russia on issues that 
are vital to American security and prosperity.
    Clearly, we must continue to work with Moscow on securing 
and destroying Russia's nuclear, chemical, and biological 
weapons. Beyond cooperative threat reduction, we have a mutual 
interest in joint action on many other security fronts, 
including nonproliferation efforts outside of Russia, the fight 
against terrorism, and law enforcement measures against 
international organized crime.
    We also have a strong interest in cooperation on energy 
issues. Russia is the world's largest exporter of natural gas, 
and the second-largest oil exporter. While America's long-term 
energy security lies in domestically sourced renewable fuels, 
in the medium term we must pursue energy opportunities outside 
the Middle East. Today, only 4 percent of Russia's oil exports 
come to the United States. We need to improve our understanding 
of the obstacles to increasing that figure and determine 
whether it is in our interest to pursue additional energy 
imports from Russia.
    Economic investment is an area that shows promise, as well 
as peril. Russia's economy, thanks to the boom in energy 
prices, has grown about 7 percent in each of the past 2 years. 
Behind this overall growth rate are pockets of prosperity and 
investment opportunities, such as retailing, but also sectors 
that suffer from corruption and too much government control. 
American investors have been cautious, given the government 
confiscation of some businesses and the harsh treatment 
afforded some of Russia's own businessmen. Our commercial 
relations are also encumbered by the continuing problem of 
copyright piracy in Russia.
    We also should be working with the Russians to place 
prevention and treatment of HIV/AIDS higher on their national 
agenda. Many health experts consider Russia to be part of a 
second wave of countries--including India, China, Nigeria, and 
Ethiopia--that are on the verge of suffering an HIV/AIDS 
epidemic. Experts estimate that 700,000 to 1 million persons 
living in Russia have HIV/AIDS. There are indications that the 
disease is beginning to spread beyond sex workers and drug 
users to the general population, especially young people. A 
comprehensive response should be implemented now in order to 
stave off an HIV/AIDS crisis in Russia that could have grave 
human and political consequences.
    Our panel today is particularly well suited to help the 
committee sort through the policy implications of these complex 
issues, and we look forward to their insights.
    At the time that the ranking minority member, Senator 
Biden, appears, I will call upon him for an opening statement, 
which he may have, but, for the moment, we would like to 
proceed with the testimony of our distinguished witnesses.
    Let me mention at the outset that your statements will be 
placed in the record in full, so you need not ask permission 
for that. You may proceed to either give the statements or to 
summarize. Please proceed in any way that you want to present 
the material. We will be here to hear you, so do not be too 
economical in your use of time, although we look forward to 
questions, following the presentations. And I would like for 
you to give the testimony in the order in which you are seated. 
That would be Ms. Cloherty first, then Mr. Verrastro, and then 
Dr. Wallander.
    Ms. Cloherty, I'm delighted to see you here today. We 
appreciate your leadership, in so many ways, and we look 
forward to your testimony.

  STATEMENT OF PATRICIA CLOHERTY, CHAIRMAN AND CEO, THE U.S.-
  RUSSIA INVESTMENT FUND, AND CHAIRMAN AND CEO, DELTA PRIVATE 
              EQUITY PARTNERS, NEW YORK AND MOSCOW

    Ms. Cloherty. Thank you, Mr. Chairman.
    I am delighted to be here to talk about The U.S.-Russia 
Investment Fund, which has been known as TUSRIF since its 
inception in 1995. It is now managed by Delta Private Equity 
Partners, which is a private management company, which I own 
and run in Moscow. I am there permanently, and run the company 
from there.
    I do believe I will be addressing one of the pockets of 
prosperity and investment opportunity to which you referred. I 
am not an oil person, we are not oil people, but we do work 
with entrepreneurs.
    May I also compliment your staff, particularly Ken Myers 
and Ken Myers III, for their assistance and advice over the 
past 10 years. And I would like to compliment you, also, 
Senator Lugar, for your video keynote address that TUSRIF 
showed at our 10th anniversary celebration in Moscow in 
September. The Russian audience was deeply moved. They 
appreciated your words of encouragement to them as they go 
about the difficult task of rebuilding their economy, their 
society, and their polity.
    The Chairman. Thank you.
    Ms. Cloherty. It was very, very important.
    Like our elder enterprise-fund sibling in Poland, TUSRIF's 
mission was, and is, to assist the new Russian Federation in 
its transition from a centrally planned economy to a market 
economy--not by giving away grants, but by making investments 
in entrepreneurial companies. We started with a board of 
directors of men and women, including myself, who served pro 
bono, men and women who have made money during their careers, 
thanks to the opportunities afforded them in the U.S. economy. 
Now all of us want, quite simply, to give back to their country 
by assisting Russia in a way that the U.S. Government, USG, 
simply cannot.
    Now, about us. TUSRIF was formed in 1995 with USG as its 
sole financial sponsor, but under private management. The 
mission was to promote the development of a free market economy 
in Russia by providing investment capital, equity, and debt to 
emerging potentially high-growth entrepreneurial companies. 
This was to be combined with technical assistance to management 
teams seeking to grow productive, transparent, and valuable 
companies. Once such a program was established and working 
well--I refer to that as at the moment when the market began to 
talk back--TUSRIF's Board of Directors was to form a privately 
financed successor fund to continue the investment program. 
And, finally, the board was to propose to USG a plan for future 
use of the capital reflows from TUSRIF's successful investments 
that would seek to further accelerate entrepreneurship and 
economic growth in Russia. In other words, if we got the job 
done right, we would be able to reflow back to USG every penny 
it put to work, and hopefully more.
    TUSRIF, now, has invested about $300 million in 44 Russian 
companies, the most recent six investments of which were made 
together with Delta Russia Fund, which is the private successor 
fund, with 120 in committed capital, on which we closed in May, 
just ended.
    I am pleased to report that, in the 11 years since 
inception, the $300-plus million the government has put to work 
has been re-earned, and then some. And I would say, 
additionally, that the private fund, successor fund, in its 1 
year of life, has shown an audited 407-percent internal rate of 
return. So, we're doing great.
    2004 was a watershed year. In that year TUSRIF accomplished 
its mission. It ended its investment cycle and moved into the 
cycle of realizing returns on sales of its investment 
positions. We also formed the private successor fund, so we are 
well on our way to embedding the practice of risk-capital 
intermediation into the Russian economy. We have formed a 
legacy committee of the board, and we are planning for what we 
can do under a philanthropic umbrella, moving forward, in 
Russia.
    The chart on my right, which is gigantic, shows our 
organization. Delta Private Equity Partners, in the middle, is 
a management company. TUSRIF is up on the left. Legacy 
Committee is the ``leave behind'' in Russia, commencing in 
2007, as shown here. Delta Russia Fund, which we are investing 
currently, is there. And now I'm starting to raise the next 
one, because you can't stand still.
    Now, what have we done? We have backed companies. We have 
launched industries. We have introduced the art of equity 
investing. And, through exits, we have brought high-quality 
international investors into the Russian market.
    Example. DeltaBank is a commercial bank we founded in 2000. 
It pioneered in credit cards, which, while common in the West, 
are virtually unknown in Russia. In 2004, we sold our interest 
in DeltaBank to GE Consumer Finance, the global financial unit 
of the General Electric Company, for 4.3 times book value, the 
third-highest multiple on sale of a financial institution in 
the world last year. We were pleased to bring in such a high-
quality company. We believe that, because TUSRIF has focused 
obsessively on the issue of transparency in its lifetime, that 
we get a transparency premium on resale of our investments that 
offsets the Russian discount.
    Second example. We formed DeltaCredit, pioneer in 
residential mortgages, Russia's first mortgage bank, in 2001. 
It is the leader in its field, with 50 percent market share. 
But to put that in perspective from an opportunity standpoint, 
there are only, in toto, about 10,000 mortgages out in Russia, 
in a nation of 145 million people; and 10-million-plus in 
Moscow, alone.
    We have been active in media investments. We own two 
television networks, and we own the largest cable operator in 
the city of St. Petersburg, with 1\1/2\ million subscribers.
    Last year, we sold one of the networks to Fidelity Europe, 
at four times our cost, in a very highly successful 
transaction.
    People are behind all of this. We support entrepreneurs 
individually, and we support entrepreneurship broadly. Example. 
Andrey Korkunov is the former rocket scientist who has become 
the chocolate king of Russia. We have visited his manufacturing 
plant. We have seen his state-of-the-art quality-control 
processes, met his employees, and, of course, eaten his 
products. In fact, I can't keep my staff from visiting that 
particular company. When he accepted his Entrepreneur of the 
Year award last year in Russia, Andrey said he wanted to, 
quote, ``make life sweeter,'' end of quote, for his country. He 
is doing that by creating jobs and generating wealth for his 
employees and for his community.
    Second example, Olga Sloutsker. She was told she could 
never succeed, but she did anyway. She built a remarkable 
company, a chain of health and fitness centers that grew to 
employ hundreds of people, and reshaped Russia's approach to 
health and fitness.
    On broad support of entrepreneurship in 2001, we formed the 
U.S.-Russia Center for Entrepreneurship. It has become the 
leading entrepreneurial support organization in Russia today. 
Through it, we launched the Entrepreneur of the Year Award 
Program. We are currently mounting an Entrepreneurial Invention 
Contest among secondary-school students, and Junior Achievement 
in the city of Nizhny Novgorod. The center provides a novel 
combination of education, training policy analysis, and is 
driving the development of a culture of entrepreneurship that 
never existed in Russia.
    The--back to people--there has been a reverse diaspora of 
talented Russians who have been educated and have worked in 
other geographies, in the United States, Europe, and Japan. 
They are coming, in increasing numbers, to take advantage of 
economic opportunity in Russia and bringing with them finely 
honed skills.
    This has been a great benefit to me, with our TUSRIF staff. 
And I will give you an example. One of my partners, Kirill 
Dmitriev, from Ukraine, was honors graduate of Stanford 
University, Baker Scholar at Harvard. He worked for Goldman 
Sachs, in investment banking, and for McKinsey & Company in Los 
Angeles, Moscow, and Prague. He has been with us for 4 years, 
and he is a valued partner. At the age of 30, he is comfortable 
in two cultures and two languages, as well as the language of 
finance, and he is poised to be an international leader in 
private equity.
    I will wrap up here by mentioning the fact that, of course, 
there are negatives in Russia. The business in which we are 
seeks higher than average returns on invested capital, and 
that, frankly, is never found without risk. If it were a 
perfect world, our returns would look like the ones that I'm 
getting in the United States.
    So, in our view, Mr. Putin has a job no one should want. He 
faces an extraordinarily challenging set of circumstances, 
and--to transform a society that has been noncapitalistic and 
nondemocratic for 70 years. He faces the primary issue of 
confidence, confidence of the Russian people in their growing 
institutions. Russians, in general, have a well-grounded and 
abiding fear that all will be stolen. Yukos was a prime example 
where bribing people on an unprecedented scale, including those 
in the West, was about to work. The Russian population 
overwhelmingly supported efforts to put a stop to it.
    The weakness of the banking system is serious, is being 
addressed, though slowly. The court system is chaotic, but 
improving. It is notable that the arbitration courts' figures 
last year showed that 73 percent of the tax challenges to 
companies were, indeed, won by those companies.
    So, progress is being made in Russia. The magnitude of 
challenge the Russian citizens face is hard for most Americans 
to understand, for the Russian people must write whole new 
scripts for themselves. Every person with whom we work either 
used to be something else--a mathematician, a biochemist, and 
now they're selling apparel, or whatever--or they expected to 
be something else. It is a question of utter realignment of an 
entire society's incentives.
    At TUSRIF we have sought, over the years working with these 
Russians, to write entrepreneurship into their individual and 
to their national scrips as a key driver of economic democracy 
and growth. It is my view that, with continued support, it will 
work.
    Thank you.
    [The prepared statement of Ms. Cloherty follows:]

Prepared Statement of Patricia M. Cloherty, Chairman and CEO, The U.S.-
  Russia Investment Fund, and Chairman and CEO, Delta Private Equity 
                     Partners, New York and Moscow

    Chairman Lugar, Senator Biden, and members of this committee, I 
appreciate the opportunity to testify today regarding The U.S. Russia 
Investment Fund, known as ``TUSRIF'' since its inception in 1995, 
though it is now managed by Delta Private Equity Partners, a private 
management company. Many observers believe that TUSRIF may be the most 
successful foreign assistance program in Russia since the Soviet Union 
ceased to exist in 1991.
    I also want to compliment your staff, particularly Ken Myers and 
Ken Myers III, for their assistance and advice over the past 10 years, 
and you, Senator Lugar, for your video keynote address at our 10th 
anniversary meeting in Moscow last September. The Russian audience 
deeply appreciated your words of encouragement to them as they go about 
the difficult task of rebuilding their economy, their society, and 
their polity.
    Like our elder enterprise fund sibling in Poland, TUSRIF's mission 
was--and is--to assist the new Russian Federation in its transition 
from a centrally planned command economy to a market economy, not by 
giving away grants, but by making investments in entrepreneurial 
companies. We started with a board of directors of men and women who 
serve pro bono, men and women who have made money during their careers 
owing to opportunities afforded them in the U.S. economy. Now they 
want, quite simply, to ``give back'' to their country by assisting 
Russia in a way that the United States Government (USG) cannot.

                                ABOUT US

    TUSRIF was formed in 1995 with the USG as its sole financial 
sponsor, but under private management. TUSRIF's mission was to promote 
the development of a free market economy in Russia by providing 
investment capital--equity and debt--to emerging, potentially high-
growth entrepreneurial companies. This was to be combined with 
technical assistance to management teams seeking to grow productive, 
transparent, and valuable companies. Once such a program was 
established and working well, TUSRIF's Board of Directors was to form a 
privately financed successor fund to continue the investment program. 
Finally, the board was to propose to the USG a plan for future use of 
the capital reflows from TUSRIF's successful investments that would 
seek to further accelerate entrepreneurship and economic growth in 
Russia.
    TUSRIF now has invested about $300 million in 44 Russian companies, 
the most recent of which were made together with Delta Russia Fund, the 
privately financed successor fund that held its final closing last 
month with approximately $120 million in committed capital. That fund 
has backed another half dozen companies already.
    2004 was a watershed year. In that year, TUSRIF accomplished its 
mission. It ended its investment cycle and moved into the cycle of 
realizing returns through sales of its investment positions. 
Additionally, it formed Delta Russia Fund, the private successor fund. 
The board then organized a legacy committee and began planning for what 
it would propose to do with the proceeds from the sale of its 
investments.
    So what exactly have we done?
    We have backed new companies. We have launched new industries. We 
have introduced the art of equity investing in Russia and trained young 
Russians in that art. And, through exits, we have brought high quality 
international investors into the Russian market.
    DeltaBank, a commercial bank we founded in 2000, pioneered in 
credit cards, which, while common in the West, are new to Russia. In 
2004, TUSRIF sold its interest in DeltaBank to GE Consumer Finance, the 
global financial unit of the General Electric Company, for 4.37 times 
book value. This was the third highest multiple for a sale of a 
financial institution in the world for that year.
    We were pleased that a company such as GE paid $100 million, over 
four times book value, for a credit card business that began with a USG 
grant.
    Second example. We formed DeltaCredit, a pioneer in residential 
mortgages and Russia's first mortgage bank, in 2001, to provide 
residential mortgages to Russia's emerging middle class. Like credit 
cards, mortgages never existed before in Russia. Now, with nearly 50 
percent market share, the company is growing at 100 percent annually 
and is poised to remain a leading player in Russia's expanding mortgage 
market for the foreseeable future. DeltaCredit established a 
residential mortgage origination network of 15 Russian and foreign 
banks. In 2004, Standard & Poor's Rating Services rated the bank 
stable, reflecting the improved capitalization and diversification of 
its funding base.
    We also have been active in media investments. In February 2005, 
TUSRIF sold its stake in CTC Media, a television network, to Fidelity 
Investments, a leading European mutual fund. The sale of CTC Media at 
four times its original cost is TUSRIF's sixth successful sale of a 
company from its private equity portfolio, and it is the second deal 
with a large international strategic investor in the 15 months through 
December 31, 2004.
    We support young, talented, dynamic, ethical, and inspiring 
entrepreneurs, and we go to great lengths to stimulate entrepreneurship 
broadly. There are entrepreneurs such as Andrey Korkunov, a former 
rocket scientist who started his chocolate manufacturing company with 
his own money and has built the leading confectionary firm in Russia 
today. We have visited his manufacturing plant, seen his state-of-the-
art quality control processes, met his employees, and, of course, 
tasted his products. When he accepted his Entrepreneur of the Year 
award, in Russia last year, Andrey said that he wanted to ``make life 
sweeter'' for his country. He is doing this by creating jobs and 
generating wealth for his employees and for his community.
    Olga Sloutsker is another example. Told that she could never 
succeed, she did anyway. Olga built a remarkable company: A chain of 
health and fitness centers that grew to employ hundreds of people and 
literally reshaped the nation's approach to health and fitness.
    We have come to know these entrepreneurs and hundreds like them 
since we founded The U.S.-Russia Center for Entrepreneurship (the 
``Center'') in 2001. Since then, the Center has become the leading 
entrepreneurial support organization in Russia today. Its novel 
combination of education, training, policy analysis, networking events, 
and research and publications is driving an entirely new and effective 
culture of entrepreneurship in Russia. It truly is the centerpiece of 
TUSRIF's legacy to Russia, as contemplated in the original foreign 
policy objectives of TUSRIF.
    Moreover, the success of our Center has become a model for 
innovative, ``bottom-up'' economic development elsewhere, including in 
countries of Central and Eastern Europe, North Africa, and the Middle 
East. The State Department and USAID now are using our training modules 
in other geographies, much to our satisfaction.
    The future of Russia's non-natural resource economy is dependent in 
great measure on these Russian entrepreneurs who are effecting economic 
reform, promoting financial transparency and good governance, and 
creating opportunity for themselves, for their employees, and for their 
communities.

                            RUSSIA'S ECONOMY

    Russia's growth is attracting investors. Its GDP grew 7.1 percent, 
and industrial output increased steadily in 2004, spurred by increased 
domestic investment and an upturn in private consumption. Macroeconomic 
factors--including currency stabilization, tax reform, controlled 
inflation, an expanding service sector, and increasing exports--
contributed to political and economic stability in Russia during this 
period. The cumulative effect of these positive trends resulted in an 
upgrading of Russia's sovereign credit ratings, with Fitch Ratings 
raising Russia to investment grade BBB- in November 2004.
    The budget surplus and public finances in general held steady, the 
trade balance rose significantly, and currency reserves at the 
beginning of 2004 exceeded US$77 billion, a record figure for the 
entire post-Soviet period. Sovereign debt decreased to 33 percent of 
GDP, and the government maintained a stable repayment record. The 
Russian stock market again came out among the top performing markets 
worldwide. In 2003, the Russian stock market grew by nearly 60 percent, 
which made Russia sixth among the world's capital markets in terms of 
capitalization growth. Public confidence in the national banking system 
and the ruble began to grow, and the role of the dollar in the Russian 
economy shrank.
    It is argued that Russia's economy is too dependent upon oil 
exports. In fact, with an oil market precariously balanced between a 
slowly growing supply and surging demand, the price effect of marginal 
barrels is exacerbated. It is possible that by pumping fewer barrels, 
Russia could make more dollars.
    On the macro side, the budget of the Russian Federation is in good 
shape. It is on track for a 6.5-percent surplus; foreign reserves are 
approximately twice the total sovereign debt load; after prepaying the 
IMF, the government is now prepaying the Paris Club; the trade surplus 
is increasing; and the reserve fund, now at almost twice its intended 
target of 500 billion rubles, has not been raided, despite many 
attempts. The greatest fear is ruble overvaluation such as occurred in 
the 1990s. Inflation is predicted to hold reasonably well at about 7 
percent this year. The real (CPI-deflated) effective exchange rate is 
currently 6 percent below that of July 1998, despite the buildup of 
Russian reserves. Real incomes are increasing rapidly; the average 
Russian income increased by 12 percent last year. But with steady 
revaluation of the currency, and wages continuing to grow, a major 
improvement in economic efficiency has become imperative.
    Given these positive developments, growth expectations in 2005 are 
being revised down somewhat, to about 6 percent. Notable, however, is 
that these are downward ratchets based on a conservative oil price 
scenario, and that every year since 2000, GDP growth has exceeded 
expectations. Furthermore, Russia is increasingly integrated into the 
European economies that are growing more slowly. For example, GDP 
growth in the reform-friendly Eastern European countries of Hungary, 
the Czech Republic, and Poland, is likely to fall to less than half of 
Russia's levels this year.
    Inflation in Russia continues to exceed forecasts, so the 
government's reiterated CPI target for 2005 of 8.5 percent appears 
unattainable. Inflation reasonably can be expected to continue at about 
2004's 11.7 percent. Given the need for a massive increase in charges 
from previously government-provided services, in energy prices, as well 
as creation of liquidity from purchase of hard currency inflows and the 
continued strong growth of the Russian economy, even attaining 
nonaccelerating inflation will be a major accomplishment.

              CHANGING OF THE GUARD IN THE PRIVATE SECTOR

    The positive changes in Russia's regulatory and tax frameworks 
complement the transformation occurring within many Russian businesses 
themselves. The 1998 fiscal crisis shook out many weak links in the 
economic chain. Surviving companies, are for the most part, those with 
coherent strategic visions, rational business plans, and professional 
management. The crisis ultimately produced a new generation of strong 
young entrepreneurs dedicated to building new industries rather than 
investing or speculating in old ones. These entrepreneurs develop their 
businesses from a clean slate, avoiding the financial baggage and 
practices left over from the Soviet era and the years prior to 1998.
    Russian enterprises today generally are focused on corporate value-
building, realizing that in a competitive business environment, the 
critical imperative is satisfying customers. Such companies 
increasingly understand that, in order to keep investment flowing, 
internationally accepted principles of accounting, due diligence and 
shareholder rights must be adhered to, and that performance in a manner 
consistent with business plans is required.
    Another remarkable development has been a dramatic ``reverse 
diaspora.'' Talented young Russians who left Russia to attend 
universities and to work in Western Europe, the United States, or Japan 
in the wake of the events of 1991 and 1998, are returning, bringing 
their educations and newly honed skills with them. They are joining the 
entrepreneurs who stayed. Together, they are forming a new class of 
sophisticated business managers.
    Happily for me, these are the kind of young women and men who make 
up my investment team at TUSRIF. They, in turn, make their training and 
experience available for the new managerial elite. It forms a dynamic 
that makes identifying and partnering with innovative, responsible 
Russian management teams increasingly possible, a process that is 
starkly different from the chaotic and speculative bets of the mid-
1990s.
    Here's an example from our own staff: Kirill Dmitriev. Born in Kiev 
in 1975, he came to the United States in 1992. He is an honors graduate 
of Stanford University, a Baker Scholar at the Harvard Business School, 
and has worked for Goldman Sachs in its investment banking division, 
and for McKinsey & Company in Los Angeles, Moscow, and Prague. Prior to 
joining us, Kirill was Deputy General Director of Information Business 
Systems (IBS) in Moscow, Russia's leading IT services company. Now he 
is a partner with me and others like him in Moscow. At the age of 30, 
he is comfortable in two cultures and two languages as well as the 
language of finance, and is poised to be an international leader in 
private equity.
    The reverse diaspora serves to enrich the highly educated 
managerial base that it rejoins.

                   IMPROVING LIQUIDITY FOR INVESTORS

    In private equity, which is TUSRIF's business, liquidity is key. 
Heretofore limited in Russia, the ability of investors to secure 
liquidity at appreciated values has improved apace with the growth of 
quality companies. The June 2000 Nasdaq IPO of Mobile TeleSystems, one 
of Moscow's two largest cellular service providers, as well as its 
rival Vimpelcom's earlier ADR float on the NYSE, exemplify one path to 
liquidity for investors. In February 2002, Russian food giant Wimm-
Bill-Dann repeated these earlier successes with an IPO of American 
Depository Receipts (ADRs) on the New York Stock Exchange (NYSE). 
Furthermore, in April 2002, RosBusinessConsulting achieved a successful 
IPO on the Moscow Interbank Currency Exchange, and Seventh Continent, a 
Moscow-based supermarket chain, went public with an IPO on the Russian 
stock exchange in November, 2004. TUSRIF's successful exits over the 
last 2 years from investments as described earlier further demonstrate 
increased opportunities for liquidity in the Russian market--in this 
case, in the private market. Over the next several years, we expect 
increased demand from both capital market participants and strategic 
investors to buy into fast-growing local companies with Western-style 
management and robust transparency.
    In fact, the number of IPOs on the Russian stock market in the last 
18 months exceeded all of those for the past 8 years. This is 
significant. None of those companies even existed in Soviet times. They 
are diversified, in technology, retailing, and steel. Forty percent of 
the demand for shares is from Russian citizens. The companies offering 
shares accept the need for transparency, but, as important, are placing 
their confidence in the future. They are toning down the emerging 
markets' standard practice of ``grab now, because there is no 
tomorrow.''
    Three other factors are enhancing financial liquidity. Western 
strategic investors are seeking to acquire a foothold in the expanding 
Russian market. Russian groups are diversifying and expanding 
regionally. And there is a growing interest among midmarket companies 
in tapping public securities markets through IPOs, both in Russia and 
abroad, to raise capital to fuel their growth. The Fund's 15 successful 
exits from investments in the last 3 years demonstrate that investing 
in well-managed growth businesses can generate strong returns.

                           INDUSTRIES OF NOTE

 Consumer products and services
    With a population of approximately 145 million and an area spanning 
17.1 million square kilometers, Russia is potentially a vast consumer 
market as consumer confidence increases and incomes rise. Many segments 
of the consumer goods market are positioned to grow rapidly over the 
medium term, driven by steady growth in personal incomes. As purchasing 
power among Russia's various consumer segments has increased, a 
preference for domestically produced items also has increased. Some 
foreign manufacturers have sought to become more competitive in the 
market by building ``national'' brands out of locally produced Russian 
goods that have gained popularity among Russian consumers. Meanwhile, 
as incomes grow, some consumers have started to turn back to 
international brands, while keeping intact their positive attitude 
toward local brands.
    Consumer spending increased 22.4 percent above its 2002 value and 
it is expected to continue to increase. Real income grew by 14.5 
percent in 2003, compared with 10.1 percent in 2002. Real disposable 
income growth accelerated to a record 20.2 percent in the year to 
December.

 Technology
    Russia has a large talent pool of internationally recognized 
scientists and engineers. Some 50 percent of the country's higher 
education students concentrate on science, mathematics, and 
engineering, a higher percentage than in any country in the world. 
Russia's scientific and technological talent pool is a relatively 
untapped commercial asset in such rapidly evolving fields as optical 
and laser technology, software, coatings, and materials.
    The Russian IT sector grew 23 percent to US$6 billion in 2003, and 
is expected to grow to US$10 billion by 2007. The market is expected to 
maintain a growth rate in excess of 20 percent per annum through 2005.
    The growth is fueled by the need of large Russian industrial 
companies to enhance productivity using IT; by the emergence of rapidly 
growing medium-size companies that rely on IT systems to manage growth; 
by an increasing number of foreign companies establishing operations in 
Russia and utilizing IT heavily; and by various levels of the Russian 
Government which are retrofitting their processes with electronic 
solutions. The Russian Government has launched a massive IT spending 
program, ``Electronic Russia 2000-2010,'' that is expected to generate 
a total of over US$2 billion in IT contracts. The program is aimed at 
eliminating the gap in IT use between Russia and more developed 
countries in an effort to increase transparency as well as productivity 
in Russian companies and state institutions.
    The Russian IT market is strategically important for global 
technology players because of the significant growth potential it 
represents. Several global technology providers, such as Intel, Cisco, 
Microsoft, and Hewlett Packard, have undertaken extensive marketing 
efforts to grow the IT market in Russia and to capture market share.

 Media
    Some 300 million Russian speakers (about half of whom reside 
outside of Russia) constitute the fourth largest language group 
worldwide. As of 2003, 58.6 million Russian households (98.6 percent of 
general public) are equipped with TV sets. Russia is the largest 
television market in Europe by number of TV households and has one of 
the highest TV-usage rates in the world (over 3 hours a day on 
average). At the same time, pay-TV penetration is only 9.2 percent 
compared to 50 percent in Hungary and 29 percent in Poland. Broadcast 
media is still dominated by the state, but the private sector is 
growing fast, both in distribution of content and, in particular, in 
the development of original Russian programming. Five private 
broadcasters--NTV, STS, REN TV, TNT, and TV3--now claim 36.2 percent of 
the national audience.
    TV advertising, which commands some 47 percent of the total 
advertising market, has been growing at over 51 percent compound annual 
growth rate (CAGR) from 2001 to 2004, having more than tripled to reach 
US$1.4 billion in 2004. Still, in absolute terms, per capita TV 
advertising expenditures in Russia remain low at US$9 compared to the 
Eastern European average of US$17 and Western European of US$47.
    Consumer spending on movies grew 70 percent per annum during 2002-
2003 to reach US$190 million in 2003, up from US$18 million in 1999. 
Nevertheless, per capita spending is US$1.4 in Russia as compared to 
the US$20-$30 range in Western Europe and US$35 in the United States.
    The Russian video games market is growing due to increasing 
personal computer and console sales. The market was approximately 
US$120 million in 2003 and is expected to reach US$200 million in 2005. 
The average game price is increasing, but it is still at a level of 
about US$4 per licensed copy in comparison to the US$20-$60 range in 
the United States and the European Union.
    The magazine publishing market in Russia grew at 46 percent CAGR in 
2001-2003 to reach US$300 million in 2003. Deal activity in this area 
has intensified recently, notably the acquisition by the Swiss group, 
Edipresse, of 52 percent of Kon-Liga Press (three Russian titles); the 
launch of Russian editions of National Geographic, Forbes, and Glamour; 
the purchase of a 35-percent stake in the leading glossy magazines 
publisher, Independent Media, by Prof-Media group, which is controlled 
by Interros, a local pool of capital; and the buyout by Hachette 
Filipacchi of a controlling stake in its Russian joint venture HFS.

 Telecommunications
    Russia's telecommunications infrastructure is positioned for 
significant growth as economic prosperity extends out of Moscow and St. 
Petersburg and into the regions. The Russian telecommunications market 
grew rapidly in 2003 and is expected to continue at a healthy rate for 
the foreseeable future. Growth is driven by Russia's continuing strong 
economic performance and by the need to upgrade the inadequate 
telecommunications infrastructure. According to Russian Minister of 
Communications, Leonid Reiman, in 2003 investment in the telecom sector 
reached US$2.8 billion, a 40-percent increase over 2002. For 2003, the 
Russian market for telecommunications services was US$6.6 billion, more 
than 24 percent growth over 2002, while the number of cellular and 
Internet subscribers doubled. The voice-over-IP service volume 
increased by 2.8 times in 2003, reaching 1.95 billion minutes, or 10 
percent of all voice telephony. The estimated annual growth for the 
period 2002-2004 is 15 percent, which could result in a 
telecommunications services market of around US$10 billion annually by 
2005.
    Over the past decade, private providers have entered the market 
with newer, better, and cheaper technologies, including:

   The provision of high-quality domestic, long distance, and 
        international telecom services by private sector fixed-line 
        operators;
   The arrival of mobile network operators as the delivery 
        mechanism of choice for voice and Internet services as 
        subscriber rates grow exponentially; and
   The expectation that wireless and convergent technologies 
        will offer cost-effective solutions to Russia's massive 
        telecommunications deficit. As a result, investment 
        opportunities are emerging at a rapid pace, most notably in the 
        many cities with populations of 1 million or more.

                    KEY MARKET FACTORS FOR INVESTORS

    A number of factors point to a significant near-term opportunity in 
the financial services, consumer goods, and technology, media, and 
telecommunications sectors, among others, of the emerging Russian 
market economy. These include the following:

   An expanding consumer market with a strong and growing 
        demand for goods and services;
   A literate and technically skilled labor force;
   Scarcity of institutional investment capital;
   Attractive valuations; and
   Increasing opportunities for exit, particularly through 
        trade sales to both domestic and international strategic 
        investors.

                         EQUITY CAPITAL MARKET

    From the public securities market standpoint, the second tier of 
companies is continuing to outperform the blue chips by a wide margin. 
Several new funds are being established in Moscow, most of them focused 
on the mid caps. Because of limited supply of the better second-tier 
assets, pricing is very competitive.
    2003 and 2004 produced several landmark deals in Russia generally. 
In 2003, BP acquired a 50-percent stake in Tuymen Oil Company for US$3 
billion in cash and stock, making it the most significant transaction 
in post-1998 Russia. Templeton Fund invested in a leading retail chain, 
Perekryostok, which in turn, acquired SPA Middle Volga from TUSRIF in 
2004. Glencore committed US$100 million to acquisitions in the Russian 
agriculture sector. And toward the end of 2004, GE Capital 
International Finance bought DeltaBank from TUSRIF and other 
coinvestors for approximately US$100 million. Such deals attest to 
substantial improvements in market attractiveness and liquidity.

                            WTO PERSPECTIVE

    WTO is a mixed blessing from a Russian standpoint. The potential 
benefits may be limited, while the costs may be significant. Russia is 
mainly now an exporter of raw materials, including hydrocarbons, 
metals, weapons, chemicals, and capital goods, so the impact of tariffs 
on such exportation is limited. Oil prices are high, inviting further 
import duties. Military hardware is sold only to governments. Third-
world buyers of Russian capital goods generally have no domestic 
machinery industry to protect, except for chemicals that are subject to 
tariffs. The Europeans seek to force up domestic gas prices, thereby 
eliminating Russia's competitive advantage. Russian steel manufacturers 
are penalized by European and United States tariffs, and no relief 
would be expected under WTO. These markets are protected by a wide 
variety of ``anti-dumping'' and other tariffs, so it is very doubtful 
that Russian steel exports would thus be allowed to rise substantially. 
The Europeans are not inclined to end agricultural subsidies, or to 
drop antidumping tariffs, or to cease protection of inefficient steel 
mills. That leaves consumer goods for Russia. But it seems unlikely 
that Russia will develop into a significant exporter in this area any 
time in the foreseeable future. Nor is the Russian financial services 
industry, in its nascent state, likely to challenge either the 
Europeans or the Americans on their own turf. In the debit column, 
though, there are some significant trade effects. Whole segments of the 
Russian economy, such as banking, telecommunications, insurance, and 
automobiles, could be threatened or destroyed. This might bring 
immediate advantages to Russian consumers, but it also would reinforce 
the position of Russia as a wholly commodity-dependent economy, 
arresting development of a diversified economy, which is in the longer 
term interest of the country. European manufacturers are unlikely to 
set up export-oriented industries in Russia as long as wages remain low 
in the accession countries. Indeed, it seems most likely that they 
would supply the Russian market from their Eastern European plants.
    Similarly, the main effect of more rigorous enforcement of 
intellectual property rights relating to copyrights and trademarks 
would be an outflow of large sums per year to Western software and 
movie companies. The fact is that, despite rampant piracy, Russian film 
and music are enjoying a major renaissance. Whether WTO trade tribunals 
would bring fairness in the process for Russian producers is open to 
debate. Nevertheless, an equally great failure is the current liberal 
orthodoxy which holds that countries must encourage the flow of 
economic activity to wherever the comparative advantages are to be 
found, regardless of the consequences for domestic economic activity. 
This view ignores the need for countries to maintain, at least, some 
industrial base and to diversify their economies.
    The Russian Government is now successfully applying a growth 
strategy to the automobile industry. Russian cars, which clearly are 
two to three generations behind current international engineering 
standards, should be made extinct. But the Russian automotive industry 
definitely should not be. To do so would be to destroy a million 
industrial jobs, rendering Russia all the more dependent upon the Saudi 
oil-based model of development. Instead, by reducing tariffs on 
automobile parts while maintaining high taxation of new car imports, 
the government has sparked the establishment of several joint ventures 
with foreign automobile manufacturers, Renault, Toyota, and GM among 
them, all of which are building domestic plants. Russians will soon 
have a taste of both worlds: Safe, clean, and reliable automobiles, 
without sacrificing their industry.
    Of course there are negatives. For businesspeople and financiers, 
high returns do not occur in a perfect environment. This environment is 
not perfect, but it is in the process of defining itself, not unlike 
the days of the American Revolution or of other countries during their 
infancies. In our view, Mr. Putin has a job no one should want. He 
faces an extraordinarily challenging set of circumstances. And the 
primary issue is confidence; confidence of the Russian people in their 
growing institutions. There is an abiding fear among Russians that all 
will be stolen. Yukos was a prime example, where bribing people on an 
unprecedented scale, including in the West, was about to work. The 
Russian population, by-and-large, supported efforts to stop that.
    There is an underlying and basic distrust of government, which Mr. 
Putin must overcome. The weakness of the banking system is serious, and 
is being addressed, though slowly. It is needed to fill the long-term 
infrastructure needs of the economy, as well as those of the consumer. 
The court system is chaotic, but improving. Some 70 percent of the 
individual and corporate disputes on taxes currently are being won 
against the state, Yukos notwithstanding.
    So, progress is being made in Russia. The magnitude of the 
challenge Russians face is hard for most Americans to understand, for 
the Russian people must write a whole new script for themselves. At 
TUSRIF, we seek with them to write entrepreneurship into this national 
script, as a key driver of economic democracy and growth. With support, 
it will work.
                                 ______
                                 
    I have attached to this written statement a chart to which I will 
refer in my oral testimony which assists in an understanding of the 
organizations I am privileged to manage.




    The Chairman. Thank you very much, Ms. Cloherty.
    Mr. Verrastro, would you give your testimony?

 STATEMENT OF FRANK A. VERRASTRO, SENIOR FELLOW AND DIRECTOR, 
ENERGY PROGRAM, CENTER FOR STRATEGIC AND INTERNATIONAL STUDIES, 
                         WASHINGTON, DC

    Mr. Verrastro. Mr. Chairman, I, too, appreciate the 
opportunity to appear before you today. And, given the 
expertise on this panel, I'll focus my remarks on Russian 
energy policy and the implications for the United States and 
the rest of the world.
    Let me begin by saying that, with the current tightness in 
global oil markets and the acceleration in energy demand, all 
producers are important to world oil supply. But, as you 
indicated, Mr. Chairman, given Russia's enormous potential, in 
terms of total energy resources, they have the largest proven 
resources of natural gas, the second-largest coal reserves in 
the world, and the eighth-largest oil reserves. And Russians 
global energy role is particularly significant.
    In 2004, Russia was the world's largest non-OPEC oil 
producer and exporter, with production of approximately 9.2 
million barrels a day, and exports on the order of 6.7 million 
barrels a day, ranking it second only behind Saudi Arabia. 
Sustaining or increasing that production is critical to oil 
market stability. But, given the enormous challenges facing 
Russia, the sustainability of recent performance is by no means 
a certainty.
    In 1988, Russian oil production peaked at around 11 million 
barrels a day. Following the dissolution of the Soviet Union, 
production plummeted to around six less than 10 years later, in 
part, the result of depletion of several of the largest fields, 
due to state-mandated production practices, but also due to the 
collapse of the Soviet Central Planning System. Recovering from 
that decline has been extraordinary, to say the least, as 
production has rebounded to present levels as a result of the 
introduction of new technology, improved field practices, new 
investment, and step-out drilling, contributions that are 
unlikely to be repeated on a continuing basis.
    With internal demand fairly stable, incremental increases 
in output have resulted in increased volumes of exports. And 
that's good for the world. But what about the future?
    Beginning last August, the rate of growth for Russian 
production had begun to slow down, revealing some of the same 
symptoms that preceded earlier declines, namely, a decided lack 
of investment in new oil-field exploration, and the 
overproduction of fields currently in line, in order to take 
advantage of prevailing high prices.
    2005 production levels are expected to be about 3 or 4 
percent above 2004 output, but probably not much more than 
that. An additional 2-to-3-percent growth is projected for 
2006, an increment which is helpful, but only a fraction of the 
average growth experienced between 2000 and 2004. And it's 
insignificant when compared against projections for rising 
demand.
    And prospects for further improvements face a series of 
formidable challenges, including the need for new investment, 
improvements in infrastructure, including pipelines, the 
expertise and technology to develop the offshore fields, and a 
regulatory regime that provides potential investors with 
adequate incentives and predictability, in terms of 
transparency, rule of law, contract sanctity, and the 
opportunity to achieve returns on investment commensurate with 
the risks taken.
    Sir John Browne, the CEO of BP, has aptly characterized 
Russian risk, noting that for many potential investors, quote, 
``Russia remains a dark and hostile place, a source of risk 
rather than opportunity,'' end quote.
    In recent months, Russia has done little to allay such 
concerns. The Yukos affair has been characterized, on the one 
hand, as a thinly disguised effort to silence a well-heeled 
political rival, but, at the same time, is clearly recognized 
as part of a broader effort to restore and solidify greater 
state control over Russia's energy assets.
    The problem, in terms of global oil and energy supplies, is 
that, at precisely the time when the world appears to need 
incremental new production from virtually all sources, Russian 
policy and field practices may be headed in just the opposite 
direction. The adoption of Russia's oil export duty, the 
equivalent of a windfall profit tax, captures roughly 90 
percent of the current upside value in oil prices above $25 a 
barrel. And the proposal to require 51 percent Russian 
ownership in new projects only further discourages new 
investment and stakeholders. When coupled with the increasing 
number of idle wells, which we estimate as high as one in four, 
the inability to replace reserves, and projections for a 
significant depletion in all existing major fields by 2015, the 
5-to-7-year lead times required to bring on new production only 
reinforces the significance of the challenges facing Russian 
production in the years ahead.
    When taken in context, the decline of major non-OPEC 
producer in the current market only serves to further 
concentrate future supply availability in the hands of a select 
few OPEC member nations. A somewhat more optimistic picture 
emerges for the longer term, but it's a picture that very much 
depends on the timely discovery and development of new oil-
producing fields.
    The most recent projections prepared by the Russian 
Ministry of Industry and Energy, covering the 10-year period 
between 2005 and 2015, estimates that Russia will be able to 
produce between 10.6 and 11 million barrels a day by 2015. But 
that same analysis suggests that reaching that level of 
production will require some $270 billion in new investment.
    Analysis prepared by CSIS and others projects a decided 
shift in global oil markets within the next 10 years. With an 
increase in concentration for both producing and consuming 
regions alike, we project that the main producing areas will be 
the Middle East, Russia and the Caspian, Africa, and the 
nonconventional fuels in Canada and Venezuela. When you look at 
the major consumption regions, it's North America, Europe, and 
Asia. These are areas that are geographically segmented, and it 
puts additional strain on transportation, security, and 
infrastructure, as well as investment. Also on the environment.
    In particular, the projected rise of Asian demand, 
especially in China and India, will place increased logistical 
burdens on inter-regional movements of both oil and natural 
gas. Russia and the Caspian are counted on to play a 
significant role in that developing system, and the failure to 
realize that potential will have serious consequences for 
consumers, worldwide.
    Thank you, Mr. Chairman.
    The Chairman. Well, thank you very much, Mr. Verrastro.
    Dr. Wallander.

STATEMENT OF CELESTE A. WALLANDER, DIRECTOR, RUSSIA AND EURASIA 
     PROGRAM AND TRUSTEE FELLOW, CENTER FOR STRATEGIC AND 
             INTERNATIONAL STUDIES, WASHINGTON, DC

    Ms. Wallander. Mr. Chairman and members of the committee, 
thank you so much for this opportunity to speak with you about 
developments in Russia and the implications for United States 
policy.
    For my contribution to the discussion, I want to cover four 
topics: Political developments in Russia, the specific issue of 
HIV/AIDS, main tendencies in Russian foreign policy, and 
implications for United States policies and engagement. Since I 
can only touch on the high points of each of those topics, I've 
submitted written testimony that addresses each in more detail.
    On Russian politics--the key to Russian politics today is 
that they are not really about Russian politics today; they are 
about the Presidential elections in 2008 and maneuvering over 
who will be chosen to succeed President Vladimir Putin with 
near certainly in a political process that is neither free nor 
fair.
    This means two things. First, politics in Russia is not 
about public contestation and competition, it's about elite 
insider relationships. Second, no outside forces, whether those 
are social or civil groups, businessmen, human rights 
organizations, alternative political parties, independent 
intellectuals, or journalists, are permitted to affect the 
process. It is controlled, managed, and orchestrated. Without 
societal oversight, Russia's leaders answer to no one.
    The Putin leadership argues that it has sought control for 
good reasons--for stability and for an effective state. The 
problem is that the Putin leadership has created a state that 
may be strong in silencing independent voices and in preventing 
independent activities, but it is a state that cannot 
effectively govern a modern country. A state must have the 
enforcement power of a strong fist--and the Russian state has 
that, in very good measure--but a state cannot be only a fist 
if it is to govern; a state has to be a hand, as well, with the 
dexterity and flexibility of fingers and thumbs to manage 
social and economic challenges, and to implement policies, as 
well as decree them.
    The Russian state is very good at stamping out dissent and 
defeating independent political, social, and economic forces, 
but it has been helpless in advancing economic reforms that 
would create a promising investment climate. The state has not 
had the dexterity to use the oil prices windfall of the past 6 
years to spark growth and innovation in new sectors.
    The Russian state, as fist, has failed where fingers and 
dexterity are required. It has failed to broker a compromise on 
domestic energy prices, a necessary condition for joining the 
World Trade Organization. It has failed to develop an effective 
reform of the country's social benefits program, a reform vital 
to Russia's future fiscal health, social equity, and economic 
competitiveness.
    The Russian leadership has spent the last few years using 
the fist of state power to acquire control of the energy 
sector, to ensure that businessmen get the message that assets 
are theirs only as long as they do not act independently, and 
to eliminate oversight of the state's roll in redividing the 
spoils of the 1990s among current political leaders.
    So, the problem with the Russian state is not only that it 
is too centralized, too impervious to society, and too 
unrestrained by constitutional checks and balances; the problem 
for Russia, and for the United States, is that, in the end, a 
fist cannot do very much, other than flatten things. Although 
the United States should be concerned about Russia's retreat 
from democracy, we need to be concerned because 
authoritarianism weakens Russia.
    With that, let me turn to HIV/AIDS. For the basic numbers 
on HIV in Russia, I want to refer you to a handout we've 
provided. I just want to highlight one point about the numbers. 
The true number of HIV-infected Russians, as of 2005, is in the 
range of about a million Russian citizens. That means that 
about 1 percent of adult population is HIV-infected, a standard 
benchmark for an HIV pandemic poised to become a generalized 
national health crisis.
    The signs are becoming clear that the disease is spreading 
from high-risk groups to the general population. In 2001, 93 
percent of new infections were among intravenous drug users; in 
2003, 63 percent of newly infected Russians were IDUs. In 2001, 
heterosexual transmission was reported in just under 5 percent 
of new cases; in 2003, it was 20 percent of new cases.
    This also leads to the feminization of HIV/AIDS in Russia. 
In 2000, one in five of newly infected Russians were women; in 
2002, one in four; and, in 2003, one in three.
    Russia's HIV/AIDS problem must also be understood in the 
context of its broader demographic problems. Russia's 
population is shrinking. The combination of falling birth rates 
and rising death rates from chronic and infectious disease mean 
that, by 2025, Russia's population will fall from about 144 
million to 125 million. Add to that anywhere between 5 million 
to 15 million excess deaths from AIDS, and the country may have 
lost 20 percent of its citizens in the next 20 years. AIDS will 
have a destabilizing effect on a Russia that is already not 
healthy, and will strike at Russia's labor force and at women 
in their childbearing years, undermining the country's future.
    Now, preventing HIV and coping with AIDS is a challenge for 
any country, and Russia is, by no means, unique in responding 
slowly. However, after several years of interviews and 
research, I am convinced that Russia is particularly vulnerable 
to a generalized HIV/AIDS epidemic because of the nature of its 
political system--the excessive centralization of government 
relative to regional and local authorities, the failure of 
federal ministries to coordinate for a comprehensive public-
policy response, and the vulnerable position of NGOs, 
nongovernmental organizations, that are struggling to provide 
prevention services to stem the tide.
    More than anything, responsible officials in Russia are 
waiting for President Putin to signal that it's okay to act. On 
a trip to Russia earlier this year, on this topic, I was told, 
time and again, that, given how socially sensitive HIV/AIDS is, 
no one wants to risk finding themselves the target of the 
Kremlin fist for charting an unwelcome independent policy 
course on AIDS. By creating a state in which independent 
initiative can land you in jail, the Putin leadership has 
increased Russia's vulnerability to HIV/AIDS.
    Now, quickly, a few points on Russian foreign policy.
    Russian foreign policy under President Vladimir Putin is 
motivated by economic growth, not only for the purposes of 
growth, itself, but for the sake of power, autonomy, and global 
position. Economic interests stand alongside strategic 
interests in how Russia defines its security and status. That 
is, Russia as an influential, autonomous, and accepted great 
power. The Russian leadership seeks global engagement, but only 
in the context of state control at home and a great power 
status abroad.
    One effect of the great power focus of Putin's 
internationalist foreign policy has been the rise of 
geopolitics in Russian strategies and priorities. Russia's 
approach to the foreign-policy challenges of terrorism and 
proliferation is geopolitical, and filtered through the 
leadership's great power objectives. This means that, while 
Russia's concern about transnational terrorism is genuine, it 
also wants to act with a high degree of autonomy in regions 
around its borders. It means that, while Russia has little to 
gain from China's rise as a military power, with possible 
designs on Russian territory, it does have a very strong 
interest in selling its energy and arms and enjoining with 
China to try and balance United States influence.
    In this context, the Russian leadership, unfortunately, 
sees United States policies as part of the problem it faces in 
its objective to establish itself as a great power with 
geopolitical advantages in an environment that looks highly 
threatening. This was the filter in which the Russian 
leadership viewed the Ukrainian elections and President Bush's 
visits to Latvia and Georgia. Russian leaders assume a great 
power and geopolitical framework for United States policy, so 
they see the net of United States relationships and activities 
in Eurasia as a form of neocontainment meant to restrict 
Russian power and influence.
    Now, what are the implications for United States policies 
and engagement with Russia? Nothing--I want to emphasize this--
nothing in what I have outlined contradicts the need for United 
States engagement with Russia. Russia remains one of the most 
important countries for the United States, as both a potential 
partner and as a potential challenge. The reasons for 
engagement with Russia are very well understood by the members 
of this committee and by the U.S. Government: Nonproliferation, 
energy diversification, counterterrorism, and Eurasian 
security. None of this has changed. And with the ups and downs 
in United States-Russian relations, it is too easy to lose 
sight of these fundamentals.
    A responsible United States policy will be best served by a 
commitment to a long-term strategy of engaging Russia in order 
to secure American security and economic interests. Given 
Russia's importance in the region, and its impact on vital 
global issues, Russia must continue to be among the United 
States most important foreign partners. The analysis I offer 
above, or earlier, matters for the implications on how to 
engage Russia and for an assessment of how well Russia will be 
able to engage with the United States, not ``whether'' to 
engage Russia.
    In the short term, the United States is confronted with 
engaging a Russian leadership that is quite internally 
preoccupied. The United States faces a leadership increasingly 
in crisis-management mode because of the weaknesses of its 
government institutions in managing public-policy challenges 
and the buildup of unsolved social and economic challenges. 
I've outlined the HIV/AIDS challenge, but it is only one among 
many serious problems that have not been dealt with 
effectively, and which cannot be avoided for much longer.
    The challenge for the United States is to recognize the 
limitations on Russia's capacity as an effective state, and 
maintain its principled and practical stand on the importance 
of democracy and human rights as a way to strengthen the 
effectiveness of Russia as a country.
    Under these circumstances, probably the best the United 
States can do is to continue to work on practical programs and 
policies with a proven record of successful engagement, and, 
among those, the first we would recognize is the programs on 
Cooperative Threat Reduction.
    However, because of the limited capacity of the Russian 
State, and because, over the long run, Russia will be a 
successful, secure, and prosperous country only if Russian 
society contributes to the country's policies and programs, the 
United States should not shy away from engaging Russian society 
and independent civic and business institutions.
    Trends in the past year are not promising, but Russia is 
not the Soviet Union of the height of the cold war. It is more 
open to the world, it has a sense of the benefits of engaging 
globally. Through a consistent and principled policy, the 
United States can cope with challenging Russia in the short 
term, while building on the strengths, both in the relationship 
and the strengths in Russia itself, for the long-term view.
    Thank you, Mr. Chairman.
    [The prepared statement of Ms. Wallander follows:]

   Prepared Statement by Celeste A. Wallander, Director, Russia and 
     Eurasia Program and Trustee Fellow, Center for Strategic and 
                 International Studies, Washington, DC

    Mr. Chairman, and members of the Committee, thank you for this 
opportunity to speak with you about developments in Russia and the 
implications for United States policy.
    For my contribution to this discussion, I will cover four topics 
today. First, I consider political developments in Russia as a basis 
for understanding the country's medium-term policies and interests. 
Second, I address the specific issue of HIV/AIDS in Russia as both a 
factor in the country's potential, and as an indicator of the 
challenges that its society and government face as the country copes 
with this global pandemic. Third, I outline the main tendencies in 
Russian foreign policy. Finally, I offer some thoughts about the 
implications for United States policies and engagement with Russia.

                            RUSSIAN POLITICS

    The key to Russian politics today is that they are not really about 
politics today; they are about the Presidential elections in 2008. That 
politics in the present are about the next election is not unique to 
Russia, and, in fact, is usually a sign of a well-functioning 
democracy, because elections are the core mechanism for holding elected 
officials accountable to society.
    But in Russia today, the maneuvering about the 2008 elections is 
not about who will stand to compete in free and fair elections; it is 
about whom will be chosen to succeed President Vladimir Putin, with 
near certainty, in a political process that is neither free nor fair. 
It is about choosing the figure that will advance to effectively 
uncontested elections through a campaign process that has none of the 
features of a well-functioning democracy; that is, competing national 
political parties, civil society oversight and monitoring of campaigns 
and elections procedures, and reporting by independent media.
    This means two things. First, politics in Russia is not about 
public contestation and competition; it is about elite insider 
relationships and associations. The constituency you need to satisfy 
and serve is a constituency of your elite peers and associates. The 
public is not completely irrelevant, and the fact of President Putin's 
relatively strong (though weakening) approval ratings helps. It means 
the leadership can stop short of true authoritarian control and simply 
satisfice with what it calls ``managed democracy.''
    Second, that means the contenders prize control above all. No 
outside forces--whether those are social or civic groups, human rights 
organizations, alternative political parties, independent intellectuals 
or scholars or journalists--can have the right or resources to affect 
the process of politics from the outside. Everything needs to be 
controlled, managed, and orchestrated. This is what makes ``managed 
democracy'' work. Russia lacks the effective checks and balances of 
political competition and investigative journalism which--while perhaps 
annoying to all leaderships in power--keep governments accountable and 
honest. Without societal oversight, Russia's leaders answer to no one. 
It can pursue its policies, for good or ill, with relative impunity.
    In the past few years, the Russian leadership has achieved a 
greater degree of control in Russian political, social, and economic 
life. In addition to the erosion of competing political parties, it has 
made the upper House of Parliament, the Federation Council, subordinate 
to the Presidential administration through the power of appointment, 
and this method of eliminating political independence has now been 
extended to the Governors of Russia's 89 regions. The chances for the 
development of independent political parties to challenge the 
leadership's hold on power has been further crippled with the passage 
of new regulations on parties that make it virtually impossible for new 
parties to register, let alone to attract enough of a national 
following to win seats in the lower House of Parliament, the Duma.
    The Putin leadership argues that it has sought control for good 
reasons: For stability and an effective state. In contrast to the chaos 
of the 1990s and the hijacking of the Russian state to the interests of 
greedy oligarchs, Russia is now run by security professionals with the 
goal and capacity to pursue economic growth, improvement in social 
conditions, and Russia's status as a respected great power in the 
world.
    Thus, the argument of Russia's leadership--and even many in United 
States policy and business circles--is that Russia's retreat from 
liberal democracy is necessary for stability, and that developments in 
Russia away from the institutions of democracy (independent, political 
parties, independent judiciary, independent civil society, independent 
media, independent legislature, and independent regional and local 
governments) have been necessary to correct for the excesses of the 
1990s, in which the state was effectively captured by narrow selfish 
interests which weakened it and stole national assets.
    This is the context in which to best understand the Khodorkovsky 
case which has attracted so much attention and commentary since he was 
arrested in October 2003 and now convicted in May 2005. Whether because 
he was developing his own political ambitions and political party ties, 
or because he was criticizing and trying to influence government policy 
(notably, whether a Russian oil pipeline would go to China or to the 
far eastern coast), or because he had created his own foundation 
supporting nongovernmental organizations, or because he was negotiating 
foreign ownership of Yukos and thus putting part of the country's 
strategic assets outside of the government's control, Mikhail 
Khodorkovsky failed to heed the key to Russian politics today: State 
control and the impermissibility of independent influence or interests.
    This is not to argue that Yukos had not been acquired and built 
during the 1990s through insider practices and possible illegal 
practices that warranted investigation and legal redress (although the 
question arises why other massive, wealthy Russian companies acquired 
and created in the same way have not been the target of Russian 
justice). It is to argue that the case ought to be understood in light 
of other political uses of the legal system to punish or prevent 
independent forces in politics and society. Or another way to put it: 
Analysts of Russia are often asked why we should feel sorry for Mikhail 
Khodorkovsky, a man who became wealthy through illegal schemes. Perhaps 
we should not. But there are plenty of victims of the Russian 
leadership's use of the legal system to control and prevent dissent and 
competition: Igor Sutyagin, the international relations scholar 
sentenced to 15 years in prison for writing a research paper using 
nonclassified and open-source materials on Russian submarines; or the 
physicist, Valentin Danilov, who in November 2004 was convicted of 
spying for China (after being acquitted but then having his verdict 
overturned by Russia's Supreme Court) and sentenced to 14 years in 
prison. International governmental and nongovernmental organizations 
(Amnesty International, Freedom House, Human Rights Watch, and the 
Council of Europe's Commissioner for Human Rights among them) have 
documented a pattern of use of the Russian legal system to limit and 
imprison independent political, social, scientific, and media 
activities, not merely the high profile prosecution of a billionaire.
    Other aspects of the Yukos case point to state control as the 
overwhelming motivating factor in Russian politics today. To pay the 
back taxes claim resulting from the investigation, the Russian state 
seized Yuganskneftegaz, a valuable subsidiary of Yukos, and announced 
an auction. When Gazprom, the privatized Russian natural gas monopoly 
(owned in part by the Russian state) could not raise the financing 
necessary to successfully bid on the auction, an unknown new company, 
Baikal Finance Group, won the government tender, and then was promptly 
bought by Rosneft, a Russian Government-owned oil company chaired by 
Igor Sechin, deputy head of the Presidential administration. With one 
of the most valuable assets of Yukos now owned by the Russian state, 
the wealth it produced cannot be used by an independent businessman, 
nor can an important energy company be sold to foreign investors.
    Meanwhile, the Russian natural gas monopoly Gazprom (the chairman 
of which is Dmitry Medvedev, head of the Presidential administration) 
recently bought Russia's largest independent national newspaper, 
Izvestia. And then this week at its shareholders' meeting, Gazprom will 
agree to a Russian Government purchase of Gazprom shares which will 
give the Russian state 51 percent ownership and thus control of the 
single most important sector of the Russian economy.
    The problem is that the Putin leadership has created a state that 
may be strong in silencing independent voices and in preventing 
independent activities, but it is a state that increasingly cannot 
effectively govern a modern 21st century Russia in a complex global 
environment. A state has to be strong to defend the country against 
external threats, and to insure domestic peace, security, and rule of 
law. A state has to have the strength and enforcement power of a strong 
fist, and the Russian state has that in good measure.
    But a state cannot be all fist if it is to govern a country 
effectively. A state has to be a hand as well as a fist, with the 
dexterity and flexibility of fingers and thumbs to manage social and 
economic challenges, to implement policies as well as decree them.
    The Russian state is very good at stamping out dissent and 
defeating independent political, social, and economic forces. But it is 
virtually helpless in advancing economic reforms that would create a 
promising investment climate on a national scale outside of the energy 
sector (and the state has even failed to attract serious investment in 
the energy sector, as evidenced in problems with stalling production in 
2005). The state has not had the dexterity to use the oil prices 
windfall of the past 6 years to spark growth and innovation for small 
and medium enterprises, and in modern industrial sectors where Russia's 
enormous human capital of highly educated scientists and engineers 
could make the country a global competitor.
    Instead, the Russian leadership has spent the past few years using 
the fist of state power to acquire unquestioned control of the energy 
sector, to insure that businessmen get the message that their assets 
are theirs only as long as they do not act independently, and to stamp 
out any outside oversight that might question the state's role in 
redividing the spoils of the 1990s among current political leaders.
    The Russia state-as-fist has failed where you would expect; where 
fingers and dexterity are required. It has failed to broker a 
compromise of domestic energy prices, a necessary condition for joining 
the World Trade Organization. It failed to develop an effective reform 
of the country's social benefits programs, a reform vital to Russia's 
future fiscal health, social equity, and economic competitiveness. By 
failing to engage local leaders, social groups, and nongovernmental 
experts in its plan for overhaul of the social benefits programs, the 
government failed to anticipate the mass protests across the country 
which resulted from its unilateral announcement of a reform that was 
perceived by society as unfair and a threat to the poor and vulnerable.
    So, the problem with the Russian state is not only that it is too 
centralized, too impervious to society, too unrestrained by 
constitutional checks and balances. The problem for Russia--and for the 
United States--is that in the end a fist cannot do very much other than 
flatten both genuine threats, and also genuine dissent. Although the 
United States should be concerned about the excessive strength of the 
Russian state relative to Russian society, media, and independent 
political forces, the United States needs to be very much as concerned. 
Russia needs a state that can grasp problems or challenges. It needs a 
political system to craft policies that meet the challenges and solve 
the problems. And Russia needs to be able to use the fingers of an 
effective bureaucracy--regional and local government, civil society 
groups, a professional media, and an engaged business community--to 
implement and manage rules of the game that create a healthy market 
economy that can compete in the real 21st century global environment.

                           HIV/AIDS IN RUSSIA

    Russia's HIV/AIDS is a perfect example of such a challenge for 
which a strong state is not enough, and in which Russia is vulnerable 
precisely because of its centralized, insulated political system.
    Russia does not have the world's highest prevalence rate, nor the 
largest number of people living with AIDS. Compared to large population 
countries such as China or India, Russia (with a population of 145 
million) is unlikely to contribute dramatically to the global burden of 
tens or even hundreds of millions of victims living with, and dying of, 
AIDS.
    But for the past few years, Russia has had the sad distinction of 
having one of the highest rates of growth of HIV infection in the 
world. At the end of 1999, there were 31,000 officially registered HIV-
infected Russians. By February 2005, Russia's Federal AIDS Center 
reported 305,000 officially registered HIV-infected persons. Arguably, 
while the growth rates could be viewed as a statistical artifact (any 
increase from a low number will result in a high-growth rate), the 
spread of the disease in Russia over the last decade has been 
explosive. Although reliable numbers are impossible to come by, 
credible professional estimates are that the true number of HIV-
infected Russians is in the range of 1 million. That means that about 1 
percent of the adult population is HIV infected, a standard benchmark 
for an HIV pandemic poised to be a generalized national health crisis, 
not one concentrated merely in high-risk groups such as injection drug 
users (IDUs) or men who have sex with men (MSM).
    And the signs are becoming clear that the disease is spreading from 
limited high-risk groups to the general population. In 2001, 93 percent 
of new infections were IDU-related. In 2003, the figure had fallen to 
63 percent. In 2001, non-IDU related heterosexual transmission was 
reported in 4.7 percent of new cases; in 2003 it was 20.3 percent. In 
addition to clear trends to non-IDU related heterosexual transmission, 
the spread of the disease from limited high-risk groups to the general 
population is suggested by evidence of increasing numbers of HIV-
infected women giving birth. In 2000, there were 374 new cases of HIV-
infected children born to HIV-infected mothers. In 2003, the number of 
new cases was 3,111.
    The trend toward heterosexual transmission also means the 
feminization of HIV/AIDS in Russia. In 2000, one in five of newly 
infected Russians were women; in 2002, one in four; and in 2003, one in 
three. Given that Russia's HIV demographics also are characterized by a 
high concentration in younger age cohorts (80 percent of registered 
HIV-infected Russians are between 15 and 29), the potential societal 
impact of a growing rate of HIV infection among young Russian women is 
substantial.
    Russian and international experts understand the HIV/AIDS situation 
and threat it poses to Russia's future quite well. Russian scientists, 
activists, and health officials have been working to prevent the spread 
of HIV within high-risk groups and from such groups to the general 
population for years. Select regional and local governments, the 
appropriate U.N. agencies, and international foundations and NGOs have 
launched pilot programs for the study and prevention of HIV's spread. 
Many devoted and brilliant people have labored for years in their 
determination to spare Russia the experience of denial and inattention 
that plagued countries like the United States some 20 years earlier.
    However, in the context of Russia's post-Soviet transition, HIV/
AIDS is just one of many pressing political, economic, social, and 
health problems. It is not easy to convince national leaders that HIV 
requires more attention and resources when other health crises, such as 
a shrinking population due to cardiovascular disease and alcoholism, 
appear to be a more immediate and tangible threat to the country's 
future. It requires truly visionary leadership to devote political and 
financial resources to a disease that is perceived to be a problem of 
socially ``maladapted'' and marginal people when Russia's children 
attend crumbling schools and are taught by underpaid teachers. And 
while it is true that Russia's economy has been growing the past few 
years, it is important to note that the explosive growth in HIV 
infection began in the 1990s, when the economy was still suffering from 
a 50-percent reduction in GDP, near-hyperinflation, and low real 
incomes.
    As a result, Russia, like so many--too many--countries before it, 
has been terribly slow to confront the problem of HIV and take 
effective action to prevent its spread to the general population. 
Although President Vladimir Putin has made reference in several 
speeches to the problem of Russia's demographic and health decline, he 
has publicly mentioned HIV/AIDS in this context only once, in May 2003. 
Russia faces many challenges in mounting an effective response to the 
problem of HIV, but none is more important than the failure of the 
country's national leadership to fully grasp the essence of the 
problem, which is the first step to mounting a national policy to 
prevent Russia from becoming a high prevalence country. The key to a 
national response lies in the Kremlin, which has been silent.
    Because of the vertical nature of the HIV/AIDS health services 
structure in Russia and the ambiguous connection between the regional 
and city AIDS centers and the remainder of the Ministry of Health and 
Social Development, there is an internal debate about the accuracy and 
significance of the national HIV/AIDS numbers. The uncertainty and 
unreliability of government figures hampers effective efforts to 
characterize the scope and shape of the challenge facing Russia in the 
coming years. These structural and statistical ambiguities command a 
lot of attention of Russians and foreigners alike and--while they may 
not be a direct obstacle to an effective national response, they 
certainly do not contribute to its framing. The credibility of outside 
experts, who points to higher projected numbers in the coming years, is 
undermined by the unreliability of the basic numbers that the 
projections are based upon. By the same token, more sanguine 
assessments are no more credible since they are based upon official 
numbers which are the result of an inadequate public health 
surveillance system.
    Russia's HIV/AIDS problem must also be understood in the context of 
its broader demographic problems. Russia's population is shrinking; the 
combination of falling birth rates and rising death rates from chronic 
and infectious disease means that Russia is losing approximately 
400,000 to 840,000 people each year. By 2025, Russia's population is 
projected to fall from about 145 million to between 125 to 135 million. 
Some studies project that by 2050 Russia's population could fall to 
less than 100 million.
    These projections are based on Russia's low fertility rate and high 
rates of cardioviscular and alcohol-related disease. These projections 
do not include the effects of a generalized AIDS pandemic. Taking into 
account AIDS is difficult given the unreliability of current numbers, 
one can project that by 2020 Russia will have anywhere between 5 
million to 15 million excess deaths from AIDS. Specific numbers are 
less important than the trends. With Russia already suffering a 
fertility rate too low to replace the current population, and suffering 
from high levels of other diseases that will increase the burdens on 
the health system, AIDS will have a destabilizing effect on a weak, not 
a healthy, Russia. In particular, AIDS will strike at Russia's labor 
force and at women in their childbearing years, undermining the 
country's future.
    A widely reported World Bank study projects that in the absence of 
an effective HIV prevention campaign, the effects of HIV/AIDS on 
Russia's economy will be substantial. Because of a smaller and less 
productive labor force and because of the diversion of societal 
resources to cope with a generalized pandemic, Russian GDP would be up 
to 4.15 percent lower by 2010, and 10.5 percent lower by 2020, than it 
would be in the absence of HIV infections and AIDS deaths in Russia. 
More fundamentally, if trends in the spread of HIV in Russia continue 
without effective public policy intervention, the effects of the 
disease will be to reduce Russia's annual growth rate by 1 percentage 
point by 2020.
    These are the kinds of projections that should grab the attention 
of national leaders, but they have not in Russia. There are several 
possible reasons: The perception that those sick and likely to die are 
undesirable ``socially maladapted'' drug users whose loss is not 
perceived as a national problem; the low priority of HIV as a social or 
health problem given more immediate crises such as poverty, crumbling 
infrastructure, and health problems that already afflict the general 
population. But among the reasons cited was also the uncertainty of the 
numbers used in such projections. That is, the projections lack 
credibility because officials focus on the aforementioned officially 
registered numbers of 305,000 with declining rates of incidence 
reported in the past few years.
    It is difficult to escape the conclusion that the problem of 
unreliable numbers and a nonfunctioning surveillance system is key to 
the challenge of an effective Russian public policy to prevent a 
generalized HIV/AIDS pandemic. Much of the effectiveness of any 
national response to HIV/AIDS--in any country--depends on political and 
other factors usually well beyond the control of health policymakers 
and technical experts. And, of course, having accurate information on 
the spread and impact of HIV/AIDS is not sufficient to ensure an 
effective response in the absence of addressing related societal 
issues. However, there is little doubt that accurately measuring 
aspects of the spread and impact of HIV/AIDS can contribute immensely 
to the effectiveness of a society's control efforts once the decision 
to mount such a response has been made. In the current situation, 
important information necessary to craft an effective comprehensive 
response is out of date or otherwise lacking. The ability of Russians 
and foreigners alike to act effectively will be handicapped until, at 
least, some of these issues are addressed.
    The Government of Russia has been reluctant to discuss, let alone 
confront, the fact of its HIV epidemic. The predominant mindset has 
been that HIV is a problem of developing countries, not industrial 
powers like Russia, and that Russia is properly seen as an 
international donor helping to solve the global AIDS problem rather 
than as a country suffering from it. It is emblematic that President 
Putin has mentioned HIV/AIDS to a domestic Russian audience on only a 
very few occasions, even while he has engaged United States President 
Bush as a partner on the issue many times on the international stage. 
Russia has pledged USD $20 million to the Global Fund while allocating 
only USD $4-$5 million per year from its federal budget to its own 
targeted fight against HIV/AIDS. A handful of government agencies, 
particularly some related to law enforcement, remain hostile to 
established international norms in the fight against HIV. Russia still 
has no dedicated national strategy to tackle its epidemic. No public 
figure has emerged as the kind of spokesperson who might destigmatize 
the virus and catalyze the formation of a coordinated national effort.
    Preventing HIV and coping with AIDS is a challenge for any country 
and political system, and Russia is by no means unique in responding 
slowly and ineffectively. However, after several years of interviewing 
and working with Russian and international experts on the disease in 
Russia, I am convinced that Russia is particularly vulnerable to a 
generalized HIV/AIDS crisis because of the nature of the political 
system I outlined earlier. Russia suffers many vulnerabilities common 
to other countries dealing with AIDS (including the United States) such 
as limited financial resources, a failure to embrace programs with 
proven effectiveness for prevention (including health education and 
needle exchange). But Russia's greatest vulnerabilities to HIV/AIDS 
today are political. The excessive centralization of government 
relative to regional and local authorities and the failure of federal 
ministries to coordinate and cooperate for a comprehensive public 
policy response that involves the health, justice, interior, defense, 
education, finance, and economic ministries. And more than anything, 
responsible officials in Russia are waiting for President Putin to 
signal it is OK to act. On a trip earlier this year I was told time and 
again that given how socially sensitive HIV/AIDS is as an issue, no one 
wants to risk taking the initiative only to find themselves the target 
of the Presidential administration's fist for charting an unwelcome 
independent policy course, however important or well conceived.
    By creating a state in which independent initiative can land you in 
jail, the Putin leadership has increased Russia's vulnerability to HIV/
AIDS.

                         RUSSIAN FOREIGN POLICY

    Russian foreign policy under President Vladimir Putin, like Russian 
foreign policy under President Boris Yeltsin before it, involves 
participation in the global economy in order to stimulate growth. 
Unlike Yeltsin's foreign policy, however, which sought global economic 
integration for leverage in reforming the domestic political economic 
system, the role of economic growth in Putin's foreign policy has a 
different immediate primary objective. Economic growth and 
international integration as a means to Russian development and 
national security and well-being remains the core of foreign policy, 
but the Russian Government is no longer as vulnerable as it had been. 
However, economic interests do not stand alone in defining Russian 
foreign and security policy; they stand alongside strategic interests 
how Russia defines its security and status, that is, Russia as an 
influential, autonomous, and accepted great power.
    The enmeshing of this core economic and strategic national interest 
is perfectly expressed in phrases from Putin's May 26, 2004 ```State of 
the Union'' address to the Russian Federal Assembly:

          Now, for the first time in a long time, Russia is politically 
        and economically stable. It is also independent, both 
        financially and in international affairs, and this is a good 
        result in itself. We want high living standards and a safe, 
        free and comfortable life for the country . . . We want to 
        strengthen Russia's place in the world. We must grow faster 
        than the rest of the world if we want to take the lead within 
        today's complex rules of global competition. We must be ahead 
        of other countries in our growth rate, in the quality of our 
        goods and services and level of our education, science, and 
        culture. This is a question of our economic survival. It is a 
        question of ensuring that Russia takes its deserved place in 
        these changing international conditions.

    That is, Russia's is not a foreign policy driven by economic growth 
for economic growth's sake. This is a foreign policy driven by economic 
growth for the sake of power, autonomy, and global position. Economic 
interests do not drive Russian foreign policy, although they are 
important to Russian foreign policy. Russian interests in expanding its 
energy exports explains its relations with Europe, its increasing 
interest in CIS neighbors, its attention to Japan and China, its 
commercial relations with Iran, its concerted efforts to nurture and 
increase commercial arms sales (which amounted to over $5.5 billion in 
2003). Foreign trade, particularly in the energy sector, is very much 
in the commercial and economic interests of its business people, and 
through general growth in the economy, its citizens.
    What this meant for foreign policy was a change in tone, direction, 
mode, and tactics. The United States remains important, but it is not 
all encompassing. More importantly, U.S. preferences and criticism 
matter far less to a Putin government that can pay its own bills and 
count on domestic support. The reduced focus on the United States, and 
the increased appreciation of the power and economic value of energy 
assets and transit corridors, contributed to a greater, and more 
strategic, focus on Europe, Asia, and the newly independent countries 
on Russia's borders. Russia's interest in international trade and 
business is not limited to interest and activity in the West, but 
applies as much to relations with the countries of what Russia 
continues to conceptualize as the Commonwealth of Independent States.
    Russia's foreign policy strategy by 2005, therefore, is 
internationalist, but it is also statist, and most certainly not 
liberal. Rising trade is fine; foreign ownership of Russian oil or gas 
is not, because the globalization of international business brings 
transparency and the primacy of commercial interests to policy. 
International summits and modern global media technologies are useful 
benefits of the globalization of technology and communication; but only 
if their message is controlled by the Russian state. Opportunities for 
great power partnership to address global security and political 
challenges such as transnational terrorism, proliferation, and 
trafficking are part of Russia's proper status as a great power member 
of the U.N. Security Council and the G-8, but the international 
community is not welcome to offer its views on whether Russia's 
elections are free and fair, or to play any role in the resolution of 
conflicts in the countries of the former Soviet Union. High profile 
international conferences involving leading Western scholars and policy 
figures are welcome in Russia, but Russian NGOs and civil society 
groups are suspect if they receive funding from international 
foundations.
    The result is a foreign policy that is active but not expansionist, 
sensitive to asserting prerogatives but cautious in exerting Russia's 
still quite limited power. Most importantly, it is a foreign policy 
based on a strategy of growth through international trade, but with the 
increasing role of the state in controlling the economy, society, and 
globalization's influences.
    One effect of the great power focus of Putin's internationalist 
foreign policy has been the rise of geopolitics in Russian strategy and 
priorities. As essentially a 19th century European great power approach 
to security and diplomacy, Putin's foreign policy is more attuned to 
the value of regional bilateral relationships for their security, 
political, and economic value. While trade with any country is 
important if it increases Russian economic well-being, trade with 
regional powers such as China and Iran is all the more important for 
the political relationships it helps to build. While good relations 
with the United States is important as part of the Russian goal for 
membership in the World Trade Organization and the economic benefits 
membership brings, economic growth cannot trump Russian understanding 
of its need for strategic stability and security in Eurasia. Expecting 
Russia, for example, to trade close economic and political ties with 
Central Asia or Ukraine for WTO membership is fruitless, because both 
are high priority components of Russia's strategy for rebuilding and 
reinforcing itself as a great power.
    Therefore, to understand Russian foreign policy in 2005, it is 
necessary to understand both the great power concerns and methods that 
form the overall objectives and strategy, as well as Russia's tangible 
experience with what is truly not merely a 21st century emerging-threat 
environment, but a real world immediate-threat environment. The Russian 
leadership understands and responds to 21st century threats in a great 
power and geopolitical framework in which the reestablishment of 
Russian power through economic growth and political relationships is 
paramount.
    Specifically, Russia's approach to the foreign policy challenges of 
terrorism, proliferation, international criminal networks, and other 
aspects of the ``emerging-threats'' environment is geopolitical and 
filtered through the leadership's great power objective. This means 
that while Russia's concern about transnational terrorism is genuine, 
the concern is not only to prevent 9/11-type or Beslan-type attacks, 
but also to maintain its prerogatives to act with a high degree of 
autonomy in regions around its borders, not to mention with full 
autonomy within its borders. It means that while the Russian leadership 
has no interest in seeing countries like North Korea or Iran obtain or 
expand their WMD capabilities, it does have a very strong interest in 
both profiting from sales of technology to Iran and maintaining strong 
political relations with its leadership given the multiple political 
and security challenges in the region. It means that while Russia has 
little to gain from China's rise as a military power with potential 
designs on Russian territory or with the capacity to counterbalance 
Russian influence in Asia, it does have a very strong interest in 
selling energy and arms to the Chinese leadership, and in joining with 
China to try to balance United States influence in Asia and to insist 
that the United States live within the rules and constraints of 
international law.
    In this context, the Russian leadership has unfortunately 
increasingly seen United States policies as part of the problem it 
faces in its objectives to establish itself as a great power with 
geopolitical advantages in an environment that looks highly 
threatening. Instead of viewing United States perspectives on the 
nontraditional nature of the ``emerging threats'' of transnational 
terrorism in Eurasia and the problem of proliferation as a genuine 21st 
century perspective, the Putin leadership views it through a 
geopolitical and traditional 19th century great power perspective and 
imputes that perspective to what, in the Russian view, must be the true 
basis for United States policies and actions. In this perspective, the 
establishment of United States political-military relationships in 
Eurasia, for example, is rooted not in an effort to respond to 
transnational terrorist and criminal networks that can intersect as 
well with proliferation vulnerabilities. Russian leaders assume a great 
power and geopolitical framework in United States policy, so instead 
they see the net of United States relationships in Eurasia as a form of 
neocontainment meant to restrict Russian power and influence.
    Similarly, Russia's response to United States involvement in 
transatlantic efforts to support free and fair Presidential elections 
in Ukraine, in fall 2004, was related to its assumption that the stakes 
were geopolitical and related to its relative status as a great power, 
rather than accepting that United States policy was genuinely motivated 
by the United States belief that the establishment of democracies 
throughout Europe and Eurasia serves the long-term goal of undermining 
the sources of emerging threats--weak, corrupt, and failed states. 
There are other important reasons for Russia's self-defeating and 
failed policy on Ukraine in late 2004--not least the closed and 
nondemocratic nature of its political system--but in thinking about 
future United States-Russian interactions in Europe and Eurasia it is 
most important to understand (if not to agree with or condone) the 
Russian leadership's suspicions that the United States is primarily 
motivated by a great power strategy meant to enfeeble and constraint 
Russia in its own backyard.

           UNITED STATES POLICIES AND ENGAGEMENT WITH RUSSIA

    Nothing in what I have outlined contradicts the importance of 
United States engagement with Russia. Russia remains one of the most 
important countries for the United States, as both a potential partner 
and as a potential challenge. The reasons for engagement with Russia 
are very well understood by the members of this committee, and by the 
United States Government. Securing Russia's active cooperation in 
coping with the multiple threats of WMD proliferation remains as vital 
as it was when the United States Congress created the Cooperative 
Threat Reduction Program with the leadership of Senator Sam Nunn and 
Senator Richard Lugar. Expanding Russia's energy production and 
participation in global energy markets will help to improve and 
diversify energy supplies. Cooperating for security and development in 
Russia as well as Ukraine, Georgia, Kyrgyzstan, and the other countries 
of the region is necessary for long-term global security. In the short 
to medium term, Russia's geopolitical location and its own interests 
mean that effective cooperation in counterterrorism continues to hold 
great promise for meeting what has become a prime security challenge of 
the 21st century.
    None of this has changed, and with the ups and downs in United 
States-Russian relations it is too easy to lose sight of these 
fundamentals. National interests and geopolitical realities do not 
change that quickly, and a responsible United States policy will be 
best served by a commitment to a long-term strategy of engaging Russia 
in order to secure American security and economic interests in Eurasia 
and the region's global importance. Given Russia's importance in the 
region and its impact of vital global issues such as energy, 
proliferation, and terrorism, Russia must continue to be among the 
United States most important foreign partners.
    The analysis, I offered above, matters for its implications on how 
to engage Russia, and for an assessment on how well Russia will be able 
to engage with the United States.
    In the short term, the United States is confronted with engaging a 
Russian leadership that is quite internally preoccupied. A visit to 
Moscow results in long conversations with Russian experts focused on 
speculation about various scenarios by which President Putin may stand 
for a third term (considered by most not very likely), or the process 
by which his hand-picked successor will be identified and positioned to 
win in 2008. Speculation also centers on whether the results of the 
Khodorkovsky trial will create some stability in state-business 
relations, or whether the ongoing maneuvering for control of assets by 
key political figures will continue, further complicating the 
investment climate.
    The United States is also confronted with a leadership that is 
likely going to be increasingly in a crisis management mode, because of 
the weaknesses of its government institutions for effectively managing 
public policy challenges, and the buildup of unsolved social and 
economic challenges. I have outlined the HIV/AIDS challenge, but it is 
only one among many serious problems that have not been dealt with 
effectively and which cannot be avoided for much longer. Others include 
Russia's crumbling infrastructure (roads, utilities, and public works 
systems), the unresolved reforms and modernization of the Russian 
defense forces, and the effects of underinvestment in education and the 
scientific-research institutions that were a backbone of Russia's 
relative economic capabilities, even through the difficult years of the 
post-socialist transition.
    As a result, Russia's leadership is likely to be focused on 
internal challenges and short-term objectives in the coming years. That 
matters for the United States, because a longer term strategy and 
commitment is necessary in nearly every area the United States could 
and should seek cooperation and engagement with the Putin leadership. 
Accepting painful and controversial requirements for WTO accession, for 
example, requires a strategic focus on the long-term benefits of freer 
trade and global integration. That will be difficult for a Russian 
state that has proven itself ineffective in social reform. Cooperation 
in controlling WMD technology requires a long-term commitment in the 
face of short-term commercial interests in maximizing sales.
    The challenge for the United States is to recognize the limitations 
on Russia's capacity as an effective state, maintain its principled and 
practical stand on the importance of democracy and human rights as a 
way to strengthen the effectiveness of Russia as a country, and to 
solve practical problems in the short term with a Russian leadership 
that views such a stand as a pretext for weakening Russia.
    Under these circumstances, probably the best the United States can 
do is to continue to work on practical programs and policies with a 
proven record of successful engagement, which means primarily 
cooperative threat reduction and related programs for professional 
exchange and training. It means engaging, and working with, those 
ministries and departments of the Russian Government that are 
interested in, and capable of, effective policy, including in 
counterterrorism, military exercises, and scientific research.
    However, because of the limited capacity of the Russian state and 
because over the long run Russia will be successful, secure, and 
prosperous only if Russian society contributes to its country's 
programs and policy, the United States should not shy away from 
engaging Russian society and independent civic institutions. Although 
support for NGOs may be a sensitive issue for the Russian leadership, 
this is one area where it is important for the United States to take a 
long-term approach to engagement. The United States would do Russia no 
favors in bowing to the Putin leadership's views on centralization and 
the illegitimacy of independent thought and activities on the part of 
its citizens, because as I have argued that is exactly what is 
weakening Russia's capacity for effective policy and development. 
Russian NGOs, scientists, students, and businesspeople are eager for 
engagement and cooperation with the United States, on both official and 
nonofficial levels, and that kind of engagement, as we saw in Ukraine, 
has long-term beneficial consequences.
    In sum, the United States needs to find a balance in its policies 
of holding to principles of the importance of democracy in Europe and 
Eurasia with the practical engagement in global economic growth and 
security cooperation with the Putin leadership. The United States needs 
to think in terms of a long-term commitment and strategy in its Russia 
policy, and avoid the cycles of excessive optimism through rose-colored 
glasses to lows of bitter recrimination and failure to appreciate 
Russia's challenges and limitations. The next 3 years will probably 
define the kind of Russia that the United States will be dealing with 
over the next few decades. Decisions on investment, health and 
demographics, and economic reform will define Russia's ability and 
willingness to cooperate reliably on the global stage. Trends in the 
past year are not promising, but Russia is not the Soviet Union of the 
height of the cold war. It is more open to the world, and has a sense 
of the benefits of global engagement, if not always the right answers 
on how to do so. Through a, consistent and principle policy, the United 
States can cope with a challenging Russia in the short-term while 
building on strengths in the relationship and within Russia itself for 
the long term.
                                 ______
                                 

               THE BROOKINGS INSTITUTE-CSIS NEWS RELEASE

          Russia & HIV/AIDS: Stark Realities; Reason for Hope

    Washington, June 7, 2005.--The HIV/AIDS pandemic in Russia has 
reached serious proportions and is at risk of becoming generalized. But 
according to a new joint Brookings-CSIS report released today, the 
important work of researchers and NGOs gives reason for hope, if the 
Russian leadership mobilizes in time.
    The report, ``Russia and HIV/AIDS: Opportunities for Leadership and 
Cooperation,'' (http://www.csis.org/hivaids/russiahivaidsreport.pdf), 
recommends that the Russian Government:

   Elevate HIV/AIDS as a national priority;
   Establish a comprehensive HIV/AIDS control strategy;
   Upgrade Russia's public health systems, with HIV/AIDS as a 
        critical priority;
   Increase the space for the operation of NGOs, who sometimes 
        feel marginalized; and
   Improve access to effective antiretroviral treatment.

    The report, written by J. Stephen Morrison, director of the CSIS 
Africa Program and executive director of the CSIS Task Force on HIV/
AIDS, and Celeste Wallander, director of the CSIS Russia and Eurasia 
Program, examines the findings and recommendations from a CSIS 
delegation that traveled to Russia in February. The delegation was 
cochaired by CSIS President and CEO John Hamre, and Strobe Talbott, 
President of the Brookings Institution, and consisted of scholars and 
experts.
    The delegation met with Russian national and local officials, 
persons living with HIV/AIDS, United States officials, representatives 
of U.N. agencies active in HIV/AIDS in Russia, representatives of 
Russian and international nongovernment agencies (NGOs), Russian media, 
university officials, scholars, and experts. The report makes 
recommendations in two key areas, to the Russian Government and to the 
international community, and stresses the necessity of committed, high-
level leadership to effectively address the threat posed by HIV/AIDS.
    The report recommends that the United States, international 
organizations, and other members of the G-8:

   Identify how to best support capacity building in Russia and 
        how to help sustain it;
   Support the Russian Government as it expands its leadership 
        and financial commitments on HIV/AIDS;
   Strengthen nongovernmental organizations, which often feel 
        marginalized;
   Ensure multilateral cooperation to secure the success of 
        UNAIDS, Global Fund, and World Bank programs; and
   Collaborate with Russian medical professionals to share best 
        practices and accelerate training.

    In response to the role of the Russian administration, the report 
states that ``If activated, the leadership can further enlarge the 
possibilities for significant achievements both in meeting Russia's 
economic, health, and social goals, and on a global plane, in promoting 
a healthier world.''
                                 ______
                                 

                    HIV/AIDS in Russia: Basic Facts

Number of officially registered HIV infected as of April, 2005: 313,000

    Range of estimates of actually infected: 420,000 to 1.4 million

                    Newly registered in 2004: 28,391

              HIV/TB coinfection cases (registered): 7,678

Change in IDU-related infections as percentage of total: Decrease from 
              93 percent (in 2001) to 63 percent (in 2003)

 Change in heterosexual transmission as percentage of total: Increase 
from 4.7 percent (in 2001) to 20.3 percent (in 2003), to 25-27 percent 
                                 (2004)

Distribution of newly registered cases of HIV by sex (2003): 62 percent 
                        male, 38 percent female

   80% of those registered with HIV are between the ages of 15 and 30

         Prevalence in the adult population: 1.0 to 1.2 percent

    Fatalities from AIDS and AIDS-related illnesses by 2004: 13,722

                  Russian population 2003: 145 million

                 Russian population 2004: 144.2 million

                     Population growth: -.6 percent

 Experts estimate that 50,000 HIV-infected Russians need treatment in 
            2005: 1500-2000 currently receive ARV treatment

                                 ______
                                 
[Note.--The Brookings-CSIS report ``Russia and HIV/AIDS: Opportunity 
for Leadership and Cooperation'' was too large in length to print in 
this hearing. It will be retained in the permanent record of the 
hearing in addition to being available on the CSIS Web site mentioned 
above.]

    The Chairman. Well, thank you very much, Dr. Wallander. I 
appreciate, as I'm certain all viewing this hearing do, the 
extraordinary depth of the analysis of our three witnesses. 
These have been extraordinary papers, and they will be of great 
use, not only to Members of the Senate and our staffs, but, I 
would think, to the general public. And we're hopeful that 
distribution can be made. It would be helpful.
    Now, I want to recognize the distinguished ranking member, 
Senator Biden, for an opening statement and/or initiation of 
questions that he may have.
    Senator Biden. Well, thank you very much, Mr. Chairman. 
I'll withhold my opening--I'll ask unanimous consent that it be 
placed in the record; much of it will have been redundant now. 
And I appreciate the testimony of the witnesses, apologize for 
being here a little late, and I'll follow you in your 
questioning.
    [The opening statement of Senator Biden follows:]

   Opening Statement of Hon. Joseph R. Biden, Jr., U.S. Senator From 
                                Delaware

    Mr. Chairman, thank you for convening this hearing. I, too, want to 
welcome our witnesses and thank them for sharing their expertise with 
us.
    Fifteen years ago this summer, we all watched with awe--and a bit 
of uncertainty--as the Soviet empire receded into history. At the time, 
we hoped that a vibrant, democratic Russia could rise from the rubble 
of the old Soviet Union and, for a while, such hope seemed justified.
    Unfortunately, recent developments have brought an unsettling 
conclusion to that era of high expectations. The consolidation of 
political power in the hands of Russia's President, the declining 
independence of the judiciary, and the Kremlin's increasing involvement 
in Russia's energy sector are all causes for serous concern.
    In recent years, economic growth has been a rare bright spot for 
the country. However, I am worried that recent Kremlin actions will 
eventually undermine this positive trend as well.
    At a Cabinet meeting on June 16, Russia's Economic Development and 
Trade Minister said that capital flight from the country may reach $7 
billion this year. He also indicated that foreign investment, oil 
production, and economic growth are all slowing. At a time when roughly 
one out of every six Russians still lives in extreme poverty, the 
nation and its citizens can ill afford such losses.
    No recent event in Russia has exemplified these disturbing trends 
more clearly than last month's sentencing of businessman Mikhail 
Khodorkovsky.
    While Mr. Khodorkovsky rose to wealth and prominence amid dubious 
circumstances, by the time Russian authorities arrested him in October 
2003, the oil company he headed, Yukos, had an outstanding reputation 
for good corporate governance.
    In addition to introducing Western business practices, Mr. 
Khodorkovsky sought Western business partners. He used his wealth to 
fund a broad range of civil society projects and also provided 
financial support to political opponents of Russian President Vladimir 
Putin.
    Mr. Khodorkovsky's backing of President Putin's political rivals, 
his close ties with Western energy companies, and his success as a 
businessman all seem to have been major factors in the decision by 
Kremlin authorities to go after Yukos and its leadership.
    In the wake of the Yukos affair, the Kremlin's influence in the 
country's energy sector grew again last week when the government took a 
controlling stake in Gazprom, Russia's lucrative gas monopoly.
    I am concerned that the timing of Mr. Khodorkovsky's prosecution, 
the declining independence of Russia's judiciary evidenced at his 
trial, and the government's efforts to gain control of Russia's energy 
sector are all moving the country in the wrong direction.
    President Putin has used his control of Russia's broadcast media to 
portray these developments as a victory for Russia's citizens. However, 
in doing so, I fear he is creating a Potemkin village on a national 
scale.
    In addition to Russia's pressing political and economic challenges, 
health problems are devastating the population and threaten to throw 
the country into a demographic tailspin.
    Russia's current population of 144 million is likely to decrease by 
more than a third in the next 50 years and much of this decline will be 
due to rampant alcoholism and the spread of HIV/AIDS. Unfortunately, 
the Russian Government has been slow to acknowledge the extent of these 
epidemics and reluctance to confront health issues has diverted 
attention and funding away from the country's problems.
    I want to conclude where I began, by invoking the great optimism 
that attended Russia's transition to democracy. I am not drawing 
attention to these problems with the goal of weakening Russia. If 
anything, the reverse is true. Now, as in the summer of 1990, I hope 
for the emergence of a Russia that is respected and prosperous. I hope 
for a Russia that can address its health crisis and become a real 
partner for the United States in promoting global peace and security. 
However, experience shows these goals are unrealistic without the 
protection of political liberties, the strong rule of law, and judicial 
and economic independence.
    Few countries can match Russia's history of scientific, literary, 
and cultural achievement, but history also shows us that the people of 
Russia will never fulfill their potential in the absence of basic 
freedoms.
    We have all lived through dark decades of authoritarian rule in 
Russia, and I remember that period too well to stand by and watch as 
the country's leadership reverts to old behaviors. For that reason, I 
hope our discussion today can focus on how to help bring Russia closer 
to a free, democratic future. I look forward to hearing your testimony 
and ideas for how we can reach that goal.

    The Chairman. Well, thank you very much. We'll proceed with 
questioning.
    And let me begin by pointing out a topical item in the 
Financial Times today. It has the headline, ``Russian Economy 
Loses Steam Amid Falling Oil Output,'' as the testimony today 
has either indicated or prophesied. But the 6-or-7-percent 
growth that we've been discussing was more like 5.2, at least 
in the current estimate. And worse still, for reasons that you 
have discussed, there does not appear to be any particular 
promise as to why this would pick up. The Russian authorities 
have indicated, and Mr. Zhukov is quoted as saying, that 
perhaps tax changes and stimulants in fiscal policy in Russia 
might be helpful; which, indeed, they might. But I'm wondering 
whether the tail-off that was indicated by your testimony, Dr. 
Verrastro, is already occurring, or whether this is just one of 
the blips in the charts, as opposed to being a trend, at this 
point.
    Mr. Verrastro. Mr. Chairman, it's probably too early to 
call it a trend, but a lot of the symptoms that we saw in the 
eighties have come back; lack of new investment--and part of 
that's policy-driven. It's also acreage that's available. 
Russia's future is probably in the Siberian fields, in Sakhalin 
Island, and in the offshore. And, quite honestly, they need new 
investment. They need technology, especially offshore drilling 
and enhanced recovery technology. And they need a regulatory 
system that actually works to protect investors.
    The Chairman. Now, how does that regulatory system fit with 
what Dr. Wallander is describing, as this internal-driven 
governance, without too much talkback from the outside--you 
know, conceivably, as you say, firms allowed to run their 
affairs, manage their businesses? The considerations you were 
just giving are more systemic, with regard to governance in the 
country, some management of the total resources. So, how do 
these issues intersect?
    Mr. Verrastro. We think the policy's heading in absolutely 
the wrong direction, as Celeste indicated. The Russian economy, 
for the last 5 years, has been driven. The engine that's 
driving it is by oil and gas and export sales. President Putin 
certainly has realized this, and he has stepped back to 
reassert control. There is no private pipelines, on the oil 
side, in Russia. Transneft controls the monopolies, Gazprom 
controls the gas side. They need to step back and allow foreign 
investment. And we think that a lot of the production increases 
in the recent past were the result of what we call ``step-out 
drilling.'' It's development drilling. You're not bringing on 
new resources; you're putting more wells in the ground, and 
you're producing for rate. And that will allow you to increase 
production in the short term, and take advantage of the higher 
price, but, over the long term, it just depletes your fields 
faster. And, I believe, for every dollar increase in the price 
of oil last year, it meant $1,400,000,000 to the Russian 
treasury. So, it was very price sensitive, and production 
declines will hurt them significantly.
    The Chairman. Just following up one more oil question: What 
effect does this have upon foreign investment? Are foreign 
investors already so embedded in the system that they just 
suffer the consequences of having fixed investments?
    Mr. Verrastro. Mr. Chairman, that's an excellent question. 
I spent 20 years in the industry. I was the senior vice 
president at Pennzoil before coming to CSIS, and we were in the 
Caspian and in Russia. And, in a lot of companies, once you 
have sunk costs it's very difficult to walk away from that 
investment. It's increasingly difficult when you look at the 
fact that 70 percent of the world's resources are now in the 
control of national oil companies. So, it's a place of where 
you can go to develop new reserves, and whether the terms are 
commercially attractive or not, and what's the alternative if 
you're a major company trying to replace reserves. And we've 
seen that in the case of BP and in Chevron and in Exxon. 
Companies are very reluctant to walk away, so you kind of 
suffer through. The industry byword has always been ``contract 
sanctity.'' But, as a practical matter, the best deal you ever 
get is the first one you negotiate, and it goes downhill from 
there.
    My sense is, though, that Russia needs the United States, 
as well. One of the basic policies that the Russians are 
looking for is to increase oil exports to the United States, as 
well as LNG exports. They need market entry, they need 
technology, and they need capital investment. And they're 
looking to do that with companies like Shell and Conoco.
    The Chairman. Ms. Cloherty, you presented a lot of good 
news from investments that have occurred, from enterprising 
Russians, aided and assisted, perhaps, by the funds that you 
have managed. And yet, in the midst of this situation, you also 
pointed out the reforms that the United States has suggested, 
strongly, from the time of Ambassador Strauss onward, when he 
talked about the need for bank reform, for banks that look 
like, perhaps, banks in the rest of Europe, quite apart from 
the United States; or rule of law in the courts, certainly to 
title minority shareholder interests. All of these things were 
part of his agenda, which he regularly indicated. He was quite 
forceful. However, that was then; this is now--say, 15 years 
later, more or less. And as you're pointing out, the court 
situation, I think you've characterized, is chaotic. And the 
banks, certainly with considerable deficiencies, in terms of 
intersection with world banking. What kind of an investment 
climate does this make, not only for Russians, but for 
Americans who might think about going into Russia? I ask this 
on the basis of visits to Russia, where I have talked to 
business people. I remember one situation, a very interesting 
one--a man who had made money on the Chicago Merc. He was a 
risk-taker and interested in Russia. And he told me he had over 
100 different investments in quite a variety of situations. The 
basis for this was, he had fully anticipated that through fraud 
and abuse, he would lose some of his money. Some of his 
investments would simply dissipate or disappear; but he hoped 
that by having a broad enough number of chances, that some of 
them might come home.
    Now, most American boards and corporations of publicly 
managed firms do not have the luxury of what amounts to almost 
a lottery system of investment, as he was describing. How would 
you describe the approach a normal American business, large or 
small, might take to this situation?
    Ms. Cloherty. Well, Mr. Chairman, he probably lives in Las 
Vegas. I don't know. We do not pursue that particular program. 
The--I must say, I suffer cognitive dissonance from sitting on 
panels with--Celeste, forgive me--political scientists. I mean, 
it makes me want to withdraw my own personal little millions 
that I put in Russia. But the--I mean, I'm an actor there, and 
I see the change. I mean, I've been there since the early 
nineties. The mid-1990s were chaotic. Speculation was rampant. 
Carpetbaggers were everywhere. And the ruble had to be 
devalued, which it was, when the--the debt default occurred, in 
August of 1998. Since then, companies--import substitution has 
been occurring apace. I mentioned the new breed of managers 
that are coming on. I think it is terribly important for Russia 
to diversity its economy. We had the great advantage, in the 
United States, early in our history, of having people like 
Abraham Lincoln look across a vast wealth, the fertile land of 
the Nation, and saying, ``There must--we cannot be a commodity 
country; we must provide an incentive to invent, whether it's 
for increased productivity in animal husbandry, farming, 
mining, or all kinds of inventions, from the--with the book, 
``From the Steam Engine to the Search Engine.'' Russia does not 
have that. And I think for them to become wholly dependent on 
oil would be inappropriate.
    I also, as a--almost a detailed matter--do not believe a 
lot of the government statistics. I think they have no means of 
tracking the diversified economy. I think that is not in the 
numbers. It's, like me, in the venture capital business for the 
past 35 years, I never backed a company that had an SIC code, 
just didn't exist. Now, the fact that it became the world 
leader in HIV protease inhibitors, worth billions, is a whole 
other matter. It just couldn't be tracked.
    And so, I think there is, in the investment program, let me 
say, the early years of our fund, the proposals for investment 
were all fruits of a military economy. They were rocket 
launchers, satellite launchers, deicing aircraft wings, what 
have you. I mean, now its chains of apparel stores, chains of 
supermarkets, which are new to Russia. These are all new.
    From the standpoint of our investors--and I just closed a 
fund in--a private one--USG is in, also, as a seed investor in 
that fund. The investors are--it's led by General Electric 
Pension Trust, not foolish people. They are investing. It has 
people like George Russell, from Frank Russell Associates, 
money management, in Tacoma. And it has a Russian group. In any 
event, the--and the way that has gone from the first--this is a 
year-old fund. The investors of each dollar committed to the 
investment put up 52 cents, and, within the first year, got 96 
cents back. That just is not terrible. I mean, they are almost 
off risk within 12 months.
    So, I kind of look at--I mean, I--the macro is helpful. It 
so depresses me, I think I ought to withdraw my investment. But 
we're making--we're doing too well. There's not a company in 
our portfolio--there's 19 companies right now, in two 
portfolios--only two companies of those are experiencing less 
over the last 3 years than high, double-digit rates of growth. 
The two that are not is one financial software company, whose 
primary market is the United States. It's growing at a rate of 
2\1/2\ percent. And the second one is a hotel, where you have 
only so many boxes for people to sleep in. And so, that can't 
grow. But all of the other ones, it is astonishing.
    And--Celeste and I were talking about this before--if 
there's one area of real opportunity in Russia, which is not 
being commercially developed now, that is in knowledge-based 
industries. And that is the absence of intellectual-property 
protection. But, in those areas, are--you know, buried in some 
of the Russian research labs is very important intellectual 
property, most notably in the life sciences. And it's extremely 
difficult to tease out and invest, when you cannot be assured 
of a chance at IP enforcement in world courts. And that happens 
to be my own particular area of specialization. We are mounting 
a scientific investment group, consisting of myself and two 
Russian scientists, and we are determined to break the back of 
that issue.
    Just one final comment, because I am going--I'm in a 
business that is predicated on change. That is, the venture 
business. And the key is to use all of your wits to make the 
change work for you, undaunted by obstacles, or, preferably, 
getting rid of them. And, I mean, over the years, that is how 
small American companies took on IBM and ATT. And if they said 
it was just too difficult to start with, then you just hang it 
up. But if you say, ``We know there's a way to do it''--and 
that's what we do with our small amounts of money, recognizing 
the negatives. But, to me, they're just, sort of, Everests to 
climb.
    The Chairman. Let me just ask one more question of Dr. 
Wallander. The expertise of this panel, and the extraordinary 
depth of your experience, is truly remarkable. I'm fascinated 
by what you're saying, as I'm certain other Senators are. Let 
me just ask you, Doctor Wallander. You presented a very grim 
picture of the AIDS business, on top of a declining population 
trend. This is a very sizeable country, a very strong country, 
which you pointed out. But you suggest that it might be 
diminished by as much as 20 percent in its population in the 
course of 20 years or so, and with a central government that's 
not intersecting very well with others, but perpetuating 
itself, worried about authority.
    Let me superimpose on this a question totally from the 
outside. What is the position of Russia with regard to the WTO? 
What should be the position of the rest of the world? And if 
not the WTO, how can this kind of country work with other 
countries in the so-called sharing? How do I obtain a good bit 
of transparency or trust or adjudication of disputes? In other 
words, will it be a factor in globalization, in a broader sense 
than simply the export of energy resources?
    Ms. Wallander. Thank you, Mr. Chairman.
    Yes, the Russian policy on WTO is that officially--and, I 
think, genuinely--WTO membership which was supposed to be this 
year; it's looking like it might be, at best, next year--is a 
priority goal of the Putin leadership. They have been engaged 
in--they succeeded in agreeing with European countries about 
the terms of its accession, and they're now engaged primarily 
with the United States in those negotiations. And the key 
questions remain in the area of things like intellectual-
property rights, and in the area of internal subsidies for 
different industries--not only energy; also steel and different 
industries. And I think that the delays, themselves, are 
indicative of the problem, which is: To be able to negotiate to 
world standards on those issues, someone's going to have to 
lose, inside Russia. And, increasingly, those who may lose 
inside Russia are those who are actually in the government, in 
the leadership, themselves. And so, the need for transparency, 
in particular, in gas--in the natural-gas industry, but also in 
other areas of the energy industry, is something that is a--
it's tough to give something away that you're holding or you're 
acquiring at the moment.
    I wouldn't necessarily argue that there won't be a 
successful negotiation of those terms in the next year, given 
how important WTO membership is to Russia's future. But I think 
that that points to the key aspect of your question, which is: 
What should the outside world do, or how should the outside 
world view this? And I think the outside world should view this 
as, Russia, like any other country, shouldn't get a free pass 
on membership. It's important for the United States to be a 
member--for Russia to be a member of the WTO, but it's 
important for the United States for Russia to be a qualified 
member of the WTO, one that meets the agreements, meets the 
standards. Because it's not being a member of the WTO that 
makes you prosperous and able to integrate in the international 
economy, it's negotiating those terms, it's creating the 
transparency, it's creating a better investment climate, it's 
learning how to operate on international markets, it's being 
willing to submit disputes to a World Trade Organization 
process to adjudicate those.
    Those are the things that we can give Russia--expecting it 
to live up to great-power standards in being a member of the 
WTO, and that should be the focus of the United States, not 
ideas that, ``Well, Russia's too important to let fail.'' 
Russia is important, and it's important not to let Russia fail, 
so we have to help Russia meet those standards so that it can 
continue to move to a higher level of participation in the 
international economy.
    The Chairman. Thank you.
    Senator Biden.
    Senator Biden. How do you do that? I listened to your 
testimony, and just listened to the answer to your question, 
and, speaking of cognitive dissonance, I don't get it. In the 
picture you painted, what possibly can the United States do in 
the next year that will, quote, ``help Russia'' meet the 
qualifications, the standards, necessary for WTO, unless they 
have a blind eye and pretend that things are happening that 
aren't? Both you and your colleague have indicated that this is 
a black hole. No pun intended. There's no transparency, or 
virtually no transparency in major industries and there's 
confiscation of assets. So, how do you get there?
    And then, Ms. Cloherty, I'd like to know what your largest 
investment is. I don't mean--just the amount, not where or what 
company, but, I mean, what kind of dollars are you talking 
about, in terms of investments? It's one thing to walk into a 
lot of countries and invest in relatively small enterprises 
that are under the radar of the government, that actually can 
make money and grow; it's a very different thing talking about 
the kinds of enterprises that your colleagues have been talking 
about.
    So, my two questions are, number one: Doctor, how do you 
get from where you said Russia is to being able to, quote, 
``help them'' in the next year, in light of every action Putin 
seems to be taking, which seems to be counterintuitive to what 
you're suggesting? That's the first question.
    Ms. Wallander. I think the way to think about it is, right 
now the Russian leadership is too focused on dividing an 
existing pie, or redividing an existing pie, in both political 
terms and economic terms. There's a moving around of the 
assets. They need to be focused on--they need to be encouraged 
to recognize that there's more promise in----
    Senator Biden. But, Doctor, how do you encourage them? I'm 
just a plain old politician. How do you--you're Secretary of 
State, and you're advising President Lugar, here, how to 
encourage it. How do you encourage that? I think you're 
brilliant, but you sound like you're from the State Department. 
It's very compelling what you say, but there's no meat. How do 
you do it? What is the recommendation to President Lugar as to 
how you do what you're suggesting? Give me something concrete.
    Ms. Wallander. There is greater--although I've described 
the Russian political structure as nontransparent, and so on--
there's diversity of interests and arguments within the 
leadership.
    Senator Biden. Right.
    Ms. Wallander. For example, it is interesting that Minister 
Gref and Minister Kudrin are both still in the leadership, and 
still primarily responsible for macroeconomic and financial 
policies. Those are the partners to speak to within Russia to 
create incentives and leverage within the Russian leadership, 
the marginal arguments for negotiating WTO membership, the 
reasons for negotiating the kinds of agreements necessary.
    There are individuals within the Presidential 
administration, the Kremlin administration, as well, who seem 
to ``get it.'' It's just not clear how influential they are and 
how often they get the ear of President Putin.
    So, speaking to the individuals to ``get it,'' reinforcing 
their arguments, and making their arguments credible, and 
appear to be successful, were they to be pursued, as well as 
speaking as frankly and as often to President Putin, himself, I 
think, is the only hope for waking up the Russian leadership to 
the opportunity that it's about to lose.
    Senator Biden. But to wake up to the opportunity, they've 
got to give up part of their grip. They've got to open the fist 
and actually be a little more dexterous. And that seems 
counterintuitive, based on the way they're going.
    Ma'am, what is your largest investment, in terms of dollar 
amount, in a particular company or----
    Ms. Cloherty. Well, Senator Biden, in my business that is--
forgive me--is not relevant. It's what it's worth at the end.
    Senator Biden. I got what it's worth----
    Ms. Cloherty. Five million in, and a hundred out, is better 
than a hundred in and a hundred----
    Senator Biden. No, no, I'm not stupid, ma'am. I understand 
that part. I got that. You know what I mean?
    Ms. Cloherty. Good.
    Senator Biden. But, I'll tell you what, there's a 
difference between investing a hundred million in and investing 
five million in, in terms of your degree of confidence in what 
you're investing in, and the size of the enterprise. All I'm 
trying to figure out is, what are the size of the enterprises 
you're investing in, in your hope and expectation that they 
quadruple or, you know, ten times--increase tenfold. What is--
what are the size of the enterprises?
    Ms. Cloherty. The----
    Senator Biden. Because my observation in the past, if I may 
continue just for a second, is, whether you are talking in some 
Asian countries, and smaller Asian countries in, you know, 
microinvestments that----
    Ms. Cloherty. No.
    Senator Biden [continuing]. Or whether you're talking--in 
Eastern Europe, in the beginning, when we started this process, 
in 1993, we were focusing on smaller investments in areas that, 
quite frankly, were under the government's radar. There wasn't 
a whole lot of focus. There's a whole lot of focus by Putin on 
Gazprom. There's a whole lot of focus by Putin on these mega-
industries, only really one, that they seek to control, for a 
whole range of reasons. There may not be.
    What I'm trying to get at is: Is your success related to 
the fact you're under the radar, or is your--and I know you're 
brilliant, and I know you make a lot of money, and I know all 
that--but my point is that if you're under the radar, as 
opposed to being engaged in investing in those enterprises that 
the former vice president of a large energy company found 
himself shackled with, when you make investments? That's the 
essence of my question.
    Ms. Cloherty. I understand. The--we are under the radar 
scope, from a size standpoint. I think the--but the reason we 
are in the segment we are, is that the natural-resource base is 
too capital intensive. It is not--in fact, we've done financial 
institutions; they are not logical for the kind of capital that 
we represent.
    Senator Biden. No, that make sense. I'm just trying to deal 
with the cognitive dissonance here.
    Ms. Cloherty. No, no, I----
    Senator Biden. That's all----
    Ms. Cloherty. No, I----
    Senator Biden [continuing]. I'm trying to figure out here.
    Ms. Cloherty. Yes, I understand that. The--I guess we do a 
couple of things. First, it's interesting to me, from a policy 
standpoint, that the--in truth--the public servants in Russia 
do not know, nor do they have any reason, from their own 
experience, to know the entire policy fabric that goes into 
creating an entrepreneurial economy and risk-capital flows to 
it. They ask me for counsel on that, because it really involves 
everything from how they evolve their institutions for 
aggregating and deploying savings and pension assets. It has to 
do with rules in the financial markets and disclosures, has to 
do with transparency. It even has to do with bankruptcy laws. 
We work very closely with a group called OPORA, which is an 
association of growth companies, that basically--and it's very 
interesting--they have a hotline for business people to report 
predators in the bureaucracy, so that you can tabulate, every 
year, who's the biggest crook in the tax--and this is a rather 
courageous act--and this is reported back. And Mr. Gref takes a 
great deal of interest in these kinds of regulatorially related 
things.
    So, we have been working with them in filling out that 
policy fabric, including this area I mentioned, on the 
intellectual property, because it is--has always been my view 
that the majors, notwithstanding oil, aluminum--because we do 
deals with the various oligarchic groups, in basic elements and 
others--but holding those aside, it is our objective to figure 
out the wealth-creating formula, whereby that which is resident 
in the Russian brain becomes a more valuable source of 
capitalizable value than an oil well.
    Senator Biden. Thank you.
    Last question, Mr. Chairman, if I may.
    Doctor, I understand Dr. Feshbach is a colleague of yours--
or you've worked with--and I found the statistic, I think 
produced by him, somewhat startling, looking out to the year 
2050, in terms of population declines. I believe this is his 
work. He indicated that the current population of 144 million 
Russians will decrease to between 77 and 100 million by 2050, 
and a significant portion of that decline will be due to 
rampant alcoholism and the spread of HIV/AIDS. Russia and 
Ukraine have the fast-growing rates of new AIDS cases in the 
world. If current trends continue, between 5 and 14 million 
Russians will be living with HIV in the year 2020, and that 
infection rate would result between a quarter of a million and 
600--or 250,000 to 650,000 annual deaths from the disease. Is 
that accurate, to the best of your knowledge? Or, do you agree 
with those statistics?
    Ms. Wallander. I do. Dr. Feshbach is a recognized expert. 
And, not only that, he is a legitimate expert, because he was 
looking at this long before it became interesting to the 
broader population. So, I think that those are quite solid 
numbers.
    Senator Biden. I thank you.
    The Chairman. Senator Murkowski.
    Senator Murkowski. Thank you--I thank you for the hearing 
this morning.
    Our Russian neighbors are about 3 miles from us in Alaska; 
so, we pay attention to what's going on, and the U.S. policy as 
it relates to our neighbors there.
    I want to ask a few questions this morning about energy. As 
you know, we're focused on developing a national energy policy 
for this country, something that I feel has certainly been long 
overdue. So, it's interesting to understand your comments this 
morning, Mr. Verrastro, as it relates to Russia's production 
levels, your comment that sustained production is not a 
certainty, citing, apparently, to the lack of investment and 
the lack of predictability, essentially, for those that are 
looking to develop in Russia, and Russia's policy of not 
encouraging new production. I was not aware of this--of the 
Russian export duty and how that operates.
    How does this export duty--or, how will this affect the oil 
pipeline that is being built from Russia to Japan, possibly a 
spur to China, as well? How will this work as it relates to 
that specific project?
    Mr. Verrastro. I think there's a question that--in terms of 
policy, there's two things going on. One is the desire, while 
you have the leverage and with higher prices, to gain economic 
rent, if you will, and take advantage of the higher prices. 
There's a second issue, in terms of Russian policy objectives 
with respect to energy. And, going back to Celeste's fist and 
five fingers, I would just argue that I think two components 
are to expand LNG sales to the United States in oil shipments, 
but also to look to the Asian market. And it's just critically 
important. You know, Bob is familiar with me saying that when 
we look north, we see Canada. Well, when China looks north, it 
sees Russia. So, there's a logical nexus between those two 
countries.
    But, in terms of pipeline distances that have to be built, 
these are multibillion-dollar infrastructure projects, and 
they're railing some 200,000 barrels of oil a day now, which 
can't be economic. But, just to look at it as a growth market.
    So, in terms of Russian policy, on the one hand it's to 
gain the advantage of price and increase the revenue for the 
state; on the other hand, if you look a little bit longer term, 
you have to look at LNG exports and oil exports to the United 
States, increased gas exports to Europe, and then also opening 
up corridors to Southeast Asia and to China.
    Senator Murkowski. So, what is Russia doing with regards to 
encouraging the predictability, encouraging that investment 
that will be so necessary? You know, Exxon had come in, not too 
long ago, negotiated a contract over in Sakhalin, and that has 
been canceled. What incentives are there for foreign companies 
to come in and provide this level of investment? What is Russia 
doing to encourage, or to help facilitate----
    Mr. Verrastro. Yeah, I think, in terms of Russian policy, 
there is no positive at this point. Companies will invest 
there, (a) because they have noplace else to go, or they have 
sunk costs already in country. And when they look to replace 
reserves, they can book reserves in Russia because of the 
substantial resource base. So, you don't want to not be there, 
but in terms of economic incentives, as I indicated, I think 
they're heading in the wrong direction. Now, it may be a short-
term phenomena to just take advantage of the higher prices and 
increase revenue stream, but eventually it's going to catch up. 
A lot of the increase in production that we've seen in the last 
3 or 4 years was literally a result of infield drilling or 
step-out drilling. It's not developing new fields. And their 
future really is in the offshore--in the Bering Sea, at 
Sakhalin Island, and in Siberia--and that will take massive new 
investments, new technology, and new partners. And----
    Senator Murkowski. And if----
    Mr. Verrastro [continuing]. Unless they're willing----
    Senator Murkowski [continuing]. If companies----
    Mr. Verrastro [continuing]. To free up, it won't happen.
    Senator Murkowski [continuing]. Though, are looking to make 
their investment matter----
    Mr. Verrastro. Absolutely.
    Senator Murkowski [continuing]. They know that there's no 
predictability, no reliability, coming out of Russia, they're 
going to look elsewhere before they make that effort to put 
more into their project, whether it's in Sakhalin, or wherever.
    Mr. Verrastro. That's absolutely true. The question is: 
What are your alternatives? I mean, we see people investing in 
Venezuela, currently; and they've increased the royalty rates, 
as well as gas taxation rates. In Kazakhstan, they've changed 
the terms of some contracts, but there's only a few select 
places in the world that have the potential for increased 
production----
    Senator Murkowski. So, do you think that----
    Mr. Verrastro [continuing]. The amount of exports----
    Senator Murkowski [continuing]. That Russia is looking at 
it from that perspective, saying, ``They don't really have many 
other options, so we don't necessarily have to do much here.''
    Mr. Verrastro. I think that's right.
    Senator Murkowski. ``We don't have to do anything to 
encourage it, because there's really no place else for anybody 
to go''?
    Mr. Verrastro. I think, Senator, at this point, there's a 
lot of host governments that think they have leverage right 
now, and they'll extract whatever they can, in terms of 
contract terms of ownership rights or additional taxes. And 
until that situation changes, quite honestly, they're in the 
driver's seat.
    Senator Murkowski. And you're not--are you willing to gaze 
into your crystal ball and give me a determination as to how 
long that might be?
    Mr. Verrastro. I think if you look out the next 2 years and 
see how steep the decline rate is, and that needs to be 
corrected, that may be one of the things, whether it's with 
HIV/AIDS, that the problems get so immense and the revenue 
streams look like they're changing, that it forces you to do 
something different. But, in the current climate, I've got to 
tell you, at $55 oil or $60 oil, you can ride the upside just 
on price, and keep your production level, and still benefit 
year to year.
    Senator Murkowski. So, you think it's probably those other 
impacts--perhaps the social impacts to the economy, not 
necessarily what's happening in the energy sector, that can----
    Mr. Verrastro. May drive it first.
    Senator Murkowski [continuing]. Ultimately drive it.
    Mr. Verrastro. Yes.
    Senator Murkowski. Yeah. What about environmental 
standards? Is there any movement to upgrade or to really take 
steps toward environmental safeguards, when it comes to energy 
production?
    Mr. Verrastro. I think the best option for Russia, as for 
most of the Caucasus in Central Asia, was investment by Western 
companies. And what they brought with them, even though there 
were no environmental standards to speak of, was Gulf of Mexico 
or North Sea standards. To the extent that you don't require 
that, you'll see pipelines that don't have the integrity, or 
production platforms that have less environmental restrictions.
    Now, going back to the World Trade Organization, this idea 
of Kyoto, and Russia's participation in Kyoto, it'll be 
interesting to see how they play that. If you take the base 
year, given the decline in consumption, they're already below 
it, so they have tradable credits. But if increased pollution 
occurs, they're going to find themselves in the same boat as 
everyone else.
    Senator Murkowski. But, once again, you think that their 
situation is such that, if you don't have anyplace else to go, 
they don't need to focus on the environmental safeguards or 
standards.
    Mr. Verrastro. I think it's a----
    Senator Murkowski. It will be external forces----
    Mr. Verrastro [continuing]. It's a lower priority for them 
right now, but it's got to be gaining, in terms of importance. 
We've seen the same thing in China. If you talked to the 
Chinese 5 years ago, it was economic development, employment, 
and security; environment wasn't even on the top-ten list. But 
if you've been in Beijing anytime recently, you know that it's 
got to be a stronger considerations. So, that's coming, as 
well.
    Senator Murkowski. Thank you.
    Thank you, Mr. Chairman.
    The Chairman. Well, thank you very much, Senator Murkowski.
    Senator Obama.
    Senator Obama. Thank you very much, Mr. Chairman.
    Thank you for--the members of this panel. I apologize for 
coming in late. So, I may end up asking questions that have 
already been asked. If so, I apologize.
    I know that one area of interest for this panel is the 
issue of Russia's shift in--fits and starts toward a market 
economy. And I am interested in how the three of you see what 
appears to be contradictory trends. On the one hand, an 
aggressive move toward the market sector, in some areas; at the 
same time, President Putin seems to be cracking down where he 
thinks that the market is creating competition for his power 
base. And, obviously, we have--you know, we're not expecting 
the same levels of transparency or respect for private property 
that we might have attained over the course of 200 years here 
in the United States. Having said that, it does seem that the 
trends are--have been moving in the opposite direction.
    I suspect this is something that's already been touched on, 
but if somebody wants to just give me a sense of how--where 
we're at right now, and how the United States could most 
usefully intervene, in encouraging a movement toward--continued 
movement toward transparency and rule of law in how the economy 
operates.
    Ms. Wallander. Thank you, Senator. This also--it wasn't 
quite asked this way, but Senator Biden referred to ``cognitive 
dissonance'' he was experiencing between Patricia's discussion 
of investment opportunities and my discussion of a sobering 
political situation. And I think the cognitive dissonance is 
resolved by your question, exactly, which is that you--foreign 
investors and Russian investors can make money in the Russian 
economy. There's a lot of exciting stuff going on in the 
consumer--especially in the consumer sector, in different 
smaller sectors of the economy.
    Where the problem comes, in terms of the role of the state 
and the activities of the Russian leadership, are in the big 
sectors, the strategic sectors, the sectors that are important 
for a large portion of the Russian economy, and also that have 
implications for Russia's foreign policy and for its power, and 
that's where energy comes in. Energy is not just a growth 
sector; energy is a foreign policy--is foreign-policy leverage. 
Foreign--energy gets you attention from the United States, from 
China, from Japan, and so on.
    Arms sales are not just about profits, although they're 
there for Russian industry, as well, it's about--it's 
maintaining a base in the Russian economy so that, when Russian 
military reform, someday, ever gets done, and the Russian 
military is able to rebuild itself into a modern military, it 
has a defense industrial base left to work with.
    So, the dissonance comes between what is, as we talked 
about, under the radar screen--under the radar--small 
enterprises, enterprises that are not in what the Russians 
think of as strategic sectors, versus those that are larger, 
that have more importance, from a political point of view, and 
for an ambitious Russia that wants to play a role in the world 
as a great power.
    Senator Obama. Does that mean that we can anticipate, sort 
of, a two-tiered economy in which--or a carve-out--where these 
strategic areas are going to be tightly controlled, essentially 
nationalized, and, beneath the surface, or outside of those 
carve-outs, you have a functioning free-market economy? Is 
that, sort of, what we should anticipate and strive for? Or do 
we--or do you think that we will never arrive at the kind of 
free market that we need, so long as those particular sectors, 
strategic sectors, are so tightly controlled that they end up 
infecting the rest of the economy with, sort of, old-style 
command-and-control approaches?
    Ms. Wallander. Yeah, I think we're seeing the emergence 
right now, in the short to medium term, of that kind of two-
tiered economy; and we're seeing a little bit of the emptying 
of the middle. One of the reasons--or the main reason for the 
decline in Russian growth rates in the last year is that 
Russian industry, heavy industry--the manufacturing industry--
is failing because of the appreciation of the ruble, because of 
Russian exports. And so, the consumer sector is doing well. The 
energy sector is doing well. And all the stuff in between, 
other than defense, is disappearing. It can't compete, 
internationally, or within the former Soviet space.
    But I think that it's not a stable equilibrium, that a two-
tiered economy doesn't work in Russia, partly because the 
country is too well educated, people are too well educated, and 
you will get ambitious entrepreneurs, who work with Patricia 
and do extremely well in their sectors of the economy, and they 
want to do more. You know, they have this experience, and they 
want to do more. They want to grow the economy larger. They 
want to see an integrated Russia, not just merely, you know, 
their very successful factory in their town. And so, I think 
the political implications of the strategic sectors, and state 
control in the strategic sectors, doesn't work with a market 
economy that's working on a lower level, over the long run. And 
that's the challenge--more for Russia than for us. But it is 
part of the challenge for us, because I think the Putin 
leadership would like us to accept that kind of two-tier 
approach. And I don't think we're doing Russia any favors by 
letting them think it'll work.
    Senator Obama. So, in terms of what we would--in terms of 
our foreign policy, what would be some of the steps we could 
take to encourage better integration across the board here? 
Another way of asking it, I guess, is: Is Putin paranoid, or is 
his assessment accurate, that if he lets go of the reins on 
these strategic areas, that that potentially undermines his own 
power base, over the long term?
    Ms. Wallander. I've already done this. I will just observe 
that I think--I don't know if he's paranoid, because I am a 
political scientist, not a psychologist, but----
    Senator Obama. Well, do you----
    Ms. Wallander. Yeah. No, I know.
    Senator Obama [continuing]. Understand what I'm saying? I 
guess--you know, another way of putting it is, people who are 
paranoid may actually have enemies. [Laughter.]
    Ms. Cloherty. Can I comment?
    Ms. Wallander. But I do think, unfortunately, that the 
Russian leadership has overlearned the lessons of the late 
1990s, the dangers of lack of control--that the late 1990s was 
important, and it was a tragic set of developments for the 
Russian people, but the solution to the crash of 1998 wasn't 
the degree of state control, that they had asserted. Sorry.
    Senator Obama. Ms.----
    Ms. Cloherty. Yes--Cloherty--I think he probably should be 
paranoid. This is a very Shakespearian situation over there, 
and the--but I think to portray it as two-tiered is too rigid. 
I think that there is a retrenchment going on, and it--in many 
ways, it is a--both an economic and politically tactical 
retrenchment. The first--Mr. Putin's first term, from the 
standpoint of the economy, was characterized by truly major 
reforms, steps to reform the banking system, the change in the 
tax rate, individual and corporate tax rates, and a whole 
series of those, plus regular statements regarding 
diversification of the economy--remember, the plan to achieve 
the GDP of Portugal in 10 years. And so--now, in the second 
term, with the events such as Ukraine intervening, and others, 
they got a bit derailed, and the administration--reform of the 
administration, of government, has gotten bogged down. And it 
is imperative--because I do think that a problem with the 
Russian Government is not that it is overarching and reaches 
everything; I think it is weak. It, many times, looks like the 
gang that really couldn't shoot straight. We had the--they 
don't hear markets and they have no reason, from the history to 
do so, but when there was a mini run on banks last fall, the 
deputy head of the Central Bank made statements that made it 
worse, so that offices, such as my own, were vacated by the 
employees, who were running to withdraw their money from the 
banks. So, they don't hear the markets. I mean, Mr. Greenspan 
can speak for 2 hours, and no one knows what he's saying; so, 
markets don't move. And so, they don't have that--yet--that 
capability, but what I do--I will say this, because I think 
they will retain some control on certain strategic areas, sure, 
and regain control--that was the Yukos thing--as an example to 
the other centers--in aluminum--and the other people.
    But, in the meanwhile, what is happening is, the private 
market is developing. And I reiterate something I said earlier. 
After the fall of the Soviet Union, you had a country where 
every single person had to become an entrepreneur. I'm not 
talking disciplined entrepreneurship; I'm talking often crooked 
entrepreneurship. But survival was at issue. People traded 
whatever was there to be traded--chocolate, cigarettes, 
whatever.
    And so, now there's another generation coming along, and 
with--and they are, sort of, push--there's a push and a pull--
they're pushing the process. There have been more IPOs in the 
Russian stock market in the last 18 months than there were in 
the previous 8 years, and--because companies are raising 
capital. And these are not ones that are going to be 
permanently small; they are going to be ones that have legs and 
can grow and achieve billions in values.
    So, I think it is happening. I think that the policymakers 
are trying to shape the concept of the fabric of policies that 
can make that work. But everywhere you look, there's more to be 
done.
    Senator Obama. Mr. Verrastro.
    Mr. Verrastro. Senator, if I may make one comment and echo 
some of the sentiments that have been expressed here.
    I think, in terms of energy, energy is a strategic 
commodity, and it's recognized as that. It's not only a revenue 
stream for the government, but it allows them to play a 
geopolitical role in the region, and especially at this time, 
when energy is in short supply, both oil and natural gas.
    Second, to recharacterize the Yukos affair, I--part of it, 
I think, was political. I think it was a policy-driven issue. 
But one of the lessons learned was process. And, where Exxon 
might have gone, you know, to Khodorkovsky and talked about 
investment in Yukos, Conoco went to the Kremlin first, got it 
blessed, and then made their investment in LUKOIL. So, it 
didn't totally freeze investment at that point. You just 
approach it in a different manner.
    Senator Obama. Right. Just on the energy issue, to pick 
this up--and, again, this may have been answered before--I am 
curious, given the scope of the energy sector in the Russian 
economy, and the degree to which hard currency is obtained as a 
consequence of the energy sector, is that money being used 
wisely in order to--is it being reinvested in, first of all, 
the energy infrastructure, itself; second, to branch out and 
diversify the economy in some fashion? I mean, is there any 
planning process, or is it basically being used just to 
subsidize the existing economy, and to prop it up?
    Mr. Verrastro. I'd say the answers are no, no, no, and yes.
    Senator Obama. Okay.
    Mr. Verrastro. It's a situation where there's not a lot of 
investment being put back in the fields at this point; it's 
just extracting additional production. The government, in terms 
of centralized control, decides what to do, certainly with the 
tax revenue and the export tariffs. We have not seen any sense 
of going out and trying to encourage new investment, change 
taxes or royalty rates, bring on new partnerships. So, in that 
sense, at least at this point, I would say that it's revenue 
driven, and it's a strategic commodity.
    Senator Obama. How sustainable is that in the long term?
    Mr. Verrastro. I don't----
    Senator Obama. Or, let me ask you a different--even just 
within the energy sector, itself, is that a sustainable model? 
Or are they just--are they going to strangle the goose?
    Mr. Verrastro. I agree. I think it's short-term gain for 
long-term pain, unless you remedy the situation, not only in 
infrastructure on pipelines, but also on reworking some of the 
old fields.
    Senator Obama. Are there technocrats within the economy 
that----
    Mr. Verrastro. That understand that?
    Senator Obama [continuing]. That recognize that?
    Mr. Verrastro. Yes, I think so.
    Senator Obama. But they just--their voices, right now, are 
not prominent.
    Mr. Verrastro. I think their voices aren't prominent, and 
the way they're approaching it is somewhat piecemeal. It's been 
expressed that if you can bring in some minor investment and 
new partners with some technology on a limited basis, you can 
forestall a dramatic decline.
    Senator Obama. Right.
    Mr. Verrastro. And that, kind of, remains to be seen.
    Senator Obama. Okay. And, on the energy sector, as well, 
the----
    And I know we've got a vote coming up, but, Mr. Chairman, 
is it 11 o'clock? So, the--I'll wrap up in a second.
    What arrangements are being--how is this impacting the 
Sino-Soviet relationship? Obviously, China's huge hunger for 
energy--the Soviets are a geographically----
    Mr. Verrastro. Proximate?
    Senator Obama [continuing]. Proximate source for that 
energy. How is that shaping up right now?
    Mr. Verrastro. As I indicated earlier, Senator, I--we think 
that the global energy market on the map is shifting, and it's 
shifting east. In the past, when the United States, for 
example, as the largest consumer, needed heating-oil supplies 
or gasoline-blend stocks, we could get it from Europe, or we 
could get it from Latin America. Now we have another major 
competitor out there--and, soon, maybe two, when India steps 
up--that are willing to put money on the table, do deals, and 
maybe engage in bilateral discussions with governments offering 
arms sales--diplomatic benefits that companies, private-sector 
companies, can't offer. If you look at that region, the intent 
5 years ago, even with the BTC pipeline, was to look West, to 
the Europe and United States markets. We had just come off the 
Asian recession, and China hadn't yet emerged, as a major 
energy consumer, with new development. And if these pipelines 
were to be built today, I see, increasingly, the options to go 
south, toward Iran, integrate and if these pipelines were to be 
built today, I see, increasingly, the options to go south, 
toward Iran, integrate supply and demand within a region, and, 
certainly, for the Russians or the Kazakhs to provided 
increased energy supplies to China.
    Now, there's enormous infrastructure constraints when you 
start building a pipeline from the Russian border to a Chinese 
consumption center. That's thousands of kilometers. So, these 
are multibillion-dollar investments, and it won't happen 
overnight. But you can see the Chinese, whether it's in Canada 
or in Venezuela, looking at additional sources of production--
or Sudan or Iran--and it's diversify their supply.
    Senator Obama. A final question, and I'll direct this at 
Ms. Wallander, although if any of you want to chime in, please 
feel free.
    You know, on this committee, the issue of proliferation is 
something that takes up a lot of our time. Our chairman, I 
think, is one of the foremost experts, and has done more 
constructively in this area than just about anybody. And, you 
know, Russia obviously has an important relationship with both 
Iran and North Korea, or at least has potential influence in 
those two areas. You know, Russia's been involved in Iran's 
nuclear program. And we know that. They're, potentially, part 
of the six-party talks with respect to North Korea, and could 
have some influence there. And, obviously, they're still on the 
Security Council.
    Can you just talk a little bit about how we have used our 
relationship with Russia, in a constructive way, around those 
proliferation issues? And the--have we been as adept as we 
should be in using both carrots and sticks to advance our 
strategic interests in these areas of proliferation with 
Russia?
    And I guess the last part of that question would be: Do we 
have to sacrifice our concern for human rights issues, 
democracy issues, if we're going to get progress on those 
fronts, or are there some other levers and buttons that we can 
push? Big question. Two minutes.
    Ms. Wallander. No problem. [Laughter.]
    Russia probably doesn't have an awful lot of leverage on 
North Korea. China's more important. So, we'll use Iran as our 
test case.
    United States/Russian cooperation on Iran is probably--
maybe this is a bad statement on United States/Russian 
relations, but I think it's been better than I would have 
expected. The willingness to seriously engage Russia on the 
issues of working out and addressing concerns about Iran's 
legitimate--at least under international law--interests in 
peaceful nuclear technology, which is the Russian position, has 
evolved toward a greater engagement with the United States to 
talk about the political incentives which might be leading an 
Iranian leadership towards seeking nuclear capabilities. The 
Russians have shown themselves willing to negotiate 
modifications in how the nonproliferation regime works--so, 
say, to require the return of spent fuel, and to make that part 
of their commercial deals with Iran--which I wouldn't have 
necessarily guessed, that they would have been willing to go 
down that road.
    So, I think that the lesson, so far--and we're still in the 
middle of the story--the lesson, so far, is that engaging--
Russia has its own interests on Iran, commercial interests and 
political interests. I don't think that Russia has any interest 
in proliferation. And Russia, in fact, has a strong interest in 
nonproliferation. But we have to manage those commercial and 
political interests, as well, and the nonproliferation regime 
doesn't do a very good job of that right now. So, by engaging 
Europe and Russia we made it a lot easier for Russia to 
cooperate with us, because it made it part of a larger package, 
of politics and economics in the region. And I would say that 
the course we're on right now, in engaging with Russia and 
Europe, is probably the right one and the best that can be 
done.
    Senator Obama. Thank you, Mr. Chairman.
    The Chairman. Let me just raise one question about 
farming--agriculture, land ownership, land reform. We haven't 
touched upon that, and I'm just curious as to the panel's view 
of how those issues are proceeding. Apparently, Russia now is 
self-supporting, from the standpoint of nutrition, and in some 
degree of trade with the rest of the outside world. There has 
been much popular writing on the evolution of farming. Who is 
doing it? How many people? What comments might any of you have 
about this?
    Ms. Cloherty. Well, I will comment, simply because that 
is--we are starting an initiative there to--I am a former 
Agricultural Extension agent from Brazil, and I know everything 
there is to know about the conversion ratio of feed to meat and 
swine. Anyway--or poultry--so, we are planning to take a look 
at it. I will say, they began a process of privatizing 
agricultural land a couple of years ago, and there were 
fisticuffs in the Duma over the issue. It's a tough one.
    But what has happened around the centers--whether it's 
Nizhny Novgorod, St. Petersburg, Moscow, whatever--is a lot of 
that farmland, as you could anticipate, is being bought up in 
vast hectares by real estate developers. So, I think that the 
agricultural areas are moving further out. But we are planning 
to take a look specifically at that, working with the Embassy, 
to see if we can begin to introduce productivity enhancements 
in crops and animal husbandry.
    The Chairman. Yes.
    Ms. Wallander. One--I don't know about the numbers of who's 
still engaged. I do know that they had some of this controversy 
over private property. But one of the success stories in the 
Russian economy has been agricultural production, the producing 
of products for the market, and that, in fact, there have been 
a number of companies that have--Russian companies that have 
been quite successful, and produce not only for the Russian 
market, but actually also export to neighbors, former Soviet 
countries, as well. And it seems to me that that's one of the 
sources of, sort of, growth that could regenerate--or 
rejuvenate agriculture in Russia, and is possibly a promising 
area, outside of the strategic view of the state, where there 
might be that kind of investment promise and growth.
    The Chairman. Well, I raised the question because, 
obviously, the land mass of Russia, the huge dispersal of 
people, don't mean that people who are not in the cities are 
engaged in agriculture, but it is a focus which, perhaps, is 
less concentrated by many people looking at Russia, including 
all of us here. I'm just curious, because, in many cases in the 
world, a large part of the population is still engaged in 
agriculture, and some of them are not doing very well.
    But let me just ask a quick question, likewise, about such 
things as student exchanges, tourism back and forth, quite 
apart from business people or labor unions. What sort of 
engagement is occurring? And is it increasing or decreasing, in 
terms of citizens in various walks of life, or people who might 
come from Russia? Perhaps they learn from us as we learn from 
them. This has usually been a healthy sign, when this type of 
thing increases, as opposed to decreasing. How would you 
characterize the Russian/American relationships in that 
respect?
    Ms. Wallander. I would argue that these are important--we 
see the long-term benefits of these kinds of exchanges--that 
funding for these programs is important, but the real obstacle 
to a healthier relationship in this area has been problems of 
Russians, especially young Russians, in getting visas----
    The Chairman. Visas.
    Ms. Wallander [continuing]. To come to the United States, 
as you well know. My understanding, from my Russian friends--
and every now and then I get an e-mail horror story of a 
Russian professor either sending students or coming themselves, 
and, at the last minute, the system has, kind of, gone awry. My 
understanding is that the system is now working better, that 
there's a more predictable and transparent system of the United 
States visa approval system, but that improvements still could 
be made, and that this is a sore spot, that Russians who 
encounter that visa system do tend to have a very bad view of 
the United States. And it's not something we want to let 
continue.
    The Chairman. I mention it simply because it appears that 
we've talked about ways in which we might be influential with 
the Russians. This doesn't always occur from state to state. It 
occurs because Russian individuals enjoy something in our 
educational system, have special expertise, even affection, for 
the country, and return and do some things there as Russian 
citizens. I think the visa problem is one that we have been 
trying to tackle aggressively in this committee, with some 
success, incrementally, but we will keep at it.
    Ms. Cloherty, did you have a thought to----
    Ms. Cloherty. Just in--agree profoundly with the visa 
issue. And--but if you measure--just take indicators of hotel 
occupancy, in terms of tourists and conference schedules, there 
are a lot of Americans and American associations coming. I 
mean, I was in St. Petersburg, and we all were--in June, White 
Nights--you could not find a room. And the--you just--if you 
want a good indicator, just check out the Marriotts in Moscow. 
You have to book 6 months in advance, unless you've got some 
edge. So, this is a change from many years ago. So--and the 
other thing, I think the--I mentioned the reverse diaspora. 
There are many, many young Russians who are returning because 
they see the kinds of opportunities we do. And that's all a 
plus. Needs more encouragement.
    The Chairman. Well, I thank you all very much. As the 
indicators on the clock show, we're in the second half of a 
rollcall vote--and so, we will bring the hearing to conclusion, 
with a lot of satisfaction. Very important ground has been 
covered by each of you, and we hope that the questions have 
illuminated the topic even more.
    And, so saying, the hearing is adjourned.
    [Whereupon, at 11:12 a.m., the hearing was adjourned.]
                              ----------                              


             Additional Statement Submitted for the Record


Prepared Statement of Robert E. Ebel, Chairman, Energy Program, Center 
        for Strategic and International Studies, Washington, DC

    Thank you, Mr. Chairman. My name is Robert Ebel and I chair the 
energy program of the Center for Strategic and International Studies. I 
welcome the opportunity to discuss with you, and members of the Senate 
Foreign Relations Committee, the current and likely future direction of 
Russian energy policy and how this policy is impacting its relationship 
with the United States and the rest of the world.
    As background, I was a member of the first oil delegation the 
United States sent to the Soviet Union. The year was 1960. Since then I 
have visited every oil-producing region of the country. I must say that 
analysis of the Soviet oil and energy sector was much easier then, than 
it is today. For then, one could write and say almost anything about 
the subject and few could argue with your findings, because we knew so 
very little about what was going on.
    Today is very much different. We are overwhelmed with information 
and data, and the task to separate the good from the bad is a difficult 
one, from the spin offered by a government official to a spin offered 
by a company representative.
    For the past 18 months or so, the attention of oil producers and 
consumers worldwide has been captured by just one simple word. And that 
word is ``sustainability.'' Is growth in oil production and exports by 
Russia, second only to Saudi Arabia, sustainable?
    Russia is very much in the news today. The volumes of oil Russia 
has been able to place into the world oil market have helped keep world 
supply and demand in balance. Because of that, it very much matters to 
all of us whether Russia's oil sector continues to expand as it has the 
past number of years, whether it cools off, as it has been since late 
summer of 2004, or whether the Russian oil boom truly is over. That is, 
should we anticipate a decline in production and in exports?
    If Russian oil export growth cannot keep up with world oil demand 
growth, for whatever the reason, then the burden on OPEC to balance oil 
supply and demand becomes even greater. Is this a responsibility that 
OPEC can readily assume? No, it is not. Is this scenario in the best 
national interests of the United States? No, it is not.
    We have witnessed the loss, over time, of spare producing capacity 
worldwide, capacity that can be called on to respond to an expected 
gain in oil demand. Other than for Saudi Arabia, there is very little 
spare producing capacity available among OPEC-member countries. Russia, 
for example, has never developed spare producing capacity, and never 
will by choice. In their judgment, spare capacity is a frozen asset.
    Adding to capacity takes time, and exporting countries always will 
want to be reassured that a market for that new capacity will be 
available. Today it is, but there can be no assurance for the future.

                  RUSSIAN OIL COLLAPSE, THEN RECOVERY

    In mid-1988, Russia was producing at a rate of about 11.4 million 
barrels per day, well above Saudi Arabian production. Then the oil 
sector began an unprecedented collapse in production. Unprecedented 
because it was not caused by developments in the market place or by 
war, but rather by a lack of investment capital and mismanagement of 
the oil fields. The production collapse took the oil sector to a low of 
some 6 million barrels per day in 1998 before it began its slow 
recovery.
    Last year, Russia produced about 9.2 million bbl/d, close to 
matching Saudi Arabia. Of that production, Russia was able to export 
around 70 percent, that is, both crude oil and petroleum products, 
because domestic requirements have held relatively stable. Indeed, 
virtually all of the increments in production the past years have been 
available for export.
    Despite the successes of 2004, signs of trouble had begun to 
appear. Rates of growth in production began to slow, beginning in 
August 2004 and have continued through to today. The causes of this 
fall in growth rates--little investment in oil field exploration and 
overproduction of producing fields--match the causes behind the 
collapse that began in 1988.
    Moreover, past successes in expanding oil output derived in large 
part from the massive application of advanced technology. This one-time 
gain is no longer available.
    Yet, we are not anticipating an annual decline in production nor 
are we watching a decline in oil export levels. I would venture that 
oil production in 2005 will exceed the 2005 level by 3 to 4 percent, 
averaging about 9.5 million barrels per day, and matching the current 
Saudi level. Oil exports should also show a modest expansion.

                       BUT WHAT ABOUT THE FUTURE?

    It is the Russian oil future that is of concern. Before the 
collapse of the Soviet Union in December 1991, the Caspian Sea had been 
viewed as representing the oil future of the country. But the collapse 
took that future away and gave it to Azerbaijan and Kazakhstan.
    Given that, where does Russia see its oil future today? In East 
Siberia and offshore. But three obstacles stand in the way of 
converting this future to reality. These obstacles are the lack of 
experience in exploiting offshore oil resources, a lack of investment 
capital, and a lack of the kinds of technology required.
    Where to turn? To international oil companies, of course. For 
national oil companies, the name of the game is access; access to new 
oil reserves. Russia has unquestioned oil potential, and the national 
oil companies can bring the needed experience, technology, and 
investment capital to the table.
    But, will they? We should add a fourth obstacle to foreign 
investment in Russian oil. That is the failure of the country to offer 
the potential investor what he needs and expects: Transparency; rule of 
law; sanctity of contract; and equally important, opportunities where 
anticipated returns on investment reflect the risks that lie ahead. Or, 
do they need be only relatively better than alternatives? In sum, the 
rules of the game must be clear and secure.
    In the words of Lord Browne, CEO of BP: ``For many potential 
investors and for many commentators and observers, Russia remains a 
dark and hostile place, a source of risk rather than of opportunity.''
    A portion of investment risk derives from perceptions of the Yukos 
affair. Was the Yukos affair really about eliminating Khodorkovsky as a 
factor in the economic and political life of the country? Yes, it was. 
But was it also part of an effort to restore control over the country's 
oil resources? Yes, it was.

                         OIL SECTOR CONSTRAINTS

    Current Russian oil sector prospects are troubling:

   A rather high number of idle wells, possibly one out of 
        every four wells.
   Inability to replace oil reserves produced.
   Almost all existing major fields are likely to be depleted 
        by 2015.

    There is an oil export duty to be paid, a Russian version of a 
``windfall profits tax'' that in effect discourages exploration and 
production. This tax, at present, is $18.66 per barrel when the selling 
price is above $25 per barrel.
    Given that it usually takes 5 to 7 years or so from field discovery 
to development, means that time is not on Russia's side if it is to 
avoid a production decline.

                          PIPELINE CONSTRAINTS

    Then, there is the more obvious constraint, that of pipeline 
capacity limitations.
    Russian oil exporters complain that pipeline capacity limitations 
have in turn limited volumes that could be exported. That means a 
considerable share of exports must move by more expensive rail and 
water. All oil pipelines are currently under the control of Transneft. 
There are no privately owned pipelines. Khodorkovsky wanted to build a 
private line to China and there were plans to build a private line to 
the port of Murmansk, to facilitate oil exports to the United States. 
Both plans, for now at least, have been consigned to the trash can.

                      SHIFTING PIPELINE DIRECTIONS

    Russian oil pipelines face the west. But that is not where the 
growth markets are. Oil demand growth is found to the east, in 
Southeast Asia and the Far East. How to respond to this market? Build a 
pipeline to the Pacific Ocean port of Nakhodka, in the Russian Far 
East, with a branch line going to China, a line that eventually would 
have a carrying capacity of 1.8 million barrels per day.
    One small problem, though. Where would sufficient oil be found to 
fill this projected pipeline? Some volumes could be made available from 
West Siberian fields, but large new sources of supply would have to be 
discovered and developed in East Siberia, geologically attractive but 
completely lacking in supporting infrastructure, inhospitable terrain, 
and weather conditions.
    Nonetheless, when a thirsty China looks north, it sees Russia and 
its tremendous oil and gas reserve base. Just as when a thirsty United 
States looks north, we see Canada, our leading supplier of foreign oil 
who also provides one-sixth of the gas we consume.
    Russia-China is a natural linkage, especially in terms of 
geography. Current plans now anticipate construction of an oil pipeline 
eastward from a point near Irkutsk, in East Siberia, to a point some 
1,700 kilometers eastward, and just 70 kilometers from the Russian-
Chinese border. Then by rail to the border. And beyond, by rail to the 
port of Nakhodka, assuming available oil. When available volumes 
permit, the pipeline will then be extended to the Pacific.
    Until this planned pipeline to China becomes a reality, oil will 
move to China by rail, some 200,000 barrels per day this year, rising 
to 300,000 barrels per day next year. Rail shipments can expand to a 
limit of 600,000 barrels per day, at which point pipelines are more 
financially viable.
    But East Siberia is more than oil, it is also a storehouse of 
natural gas. The largest known gas field is Kovykta, and TNK-BP holds 
an interest in this field. Indeed, Lord Brown of BP has called Kovykta 
``the tomorrow'' for TNK-BP. But that tomorrow has been stalled by the 
efforts of Gazprom to see to it that development and planned export 
pipeline construction to China and South Korea do not proceed without 
their involvement.
    Russia is very jealous of its prerogative as a transit country. 
That is, it would like to see all oil and gas exported from Central 
Asia, Azerbaijan, and Kazakhstan to be channeled through Russia. The 
recent completion of the oil pipeline from Baku through Georgia to the 
Turkish port of Ceyhan, on the Mediterranean, bypasses Russia, much to 
their displeasure.

                               NEAR TERM

    Russian officials, public and private, have been comparatively open 
as to how they view the oil sector's future. Their forecasts portray a 
Russia that, at least in oil, will essentially be marking time within 
the next several years.
    Economic Development and Trade Minister, German Gref, recently 
outlined the near-term future of the Russian oil sector, and his views 
generally reflect a consensus.

   Oil production growth should be around 3.5 percent this 
        year, declining further to 2 or 3 percent in 2006. That 
        compares with an average growth of 8.5 percent during 2000-
        2004.
   In his opinion, oil exports would increase by 5 percent in 
        2005 and by 3 percent in 2006, down from an average of 14 
        percent during 2000-2004.

    Again, it is important to note that production and exports are not 
expected to decline. Rather, it is the rates of growth that decline. 
Moreover, export increments continue to match production increments.
    That approach is very much in line with Russian marketing 
philosophy. Oil is not withheld from the market as a way of supporting 
price. Any and all volumes surplus to domestic needs are exported, 
regardless of the current market price.
    Nonetheless, as Russian oil growth rates fall while world oil 
demand increases, the market will increasingly look to OPEC to fill the 
gap. That, of course, brings increasing concentration on a select few, 
geographically separated countries. That in turn gives rise to inherent 
logistical, infrastructure, and security concerns.

                              LONGER TERM

    A somewhat different picture emerges for the longer term; a picture 
that very much depends upon the timely discovery and development of new 
oil fields.
    The most recent evaluation comes from the Ministry of Industry and 
Energy. An oil and gas sector development strategy reportedly was drawn 
up in 2004, and covers the 10-year period between 2005 and 2015. 
According to an official of the Ministry, ``in 2015 Russia will be able 
to produce 10.6 million barrels per day . . .'' To reach that level, he 
noted, would require up to $270 billion investment in the sector.
    He added later that in 2015 Russia may export 6.2 million barrels 
per day of crude oil alone. If so, crude oil exports will jump by 1 
million barrels per day in 2015, compared to about 5.1 million barrels 
per day last year. Not much, considering the prospective growth in 
world oil demand.

                            A FINAL COMMENT

    The head of LUKOIL, the largest oil company in Russia, recently was 
asked about the prospects for foreign investment in Russia's petroleum 
sector. His answer was forthright: ``You are doomed to invest in 
Russia.'' But that can work both ways. Russia is ``doomed'' to seek 
that investment.
    But, what if that investment is not forthcoming? Then consumers 
could well be faced not only with high prices but as well with physical 
constraints on volumes available for purchase.

                                  
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