OCT 18 MEETING WITH KREMLIN ECONOMIST DVORKOVICH

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E.O. 12958: DECL: 10/20/2016
TAGS: ECON ENRG ETRD KIPR
SUBJECT: OCT 18 MEETING WITH KREMLIN ECONOMIST DVORKOVICH


Classified By: Ambassador William J. Burns by reasons 1.4 (b) and (d).


1. (C) SUMMARY. In a wide ranging discussion with Economic
Minister-Counselor October 18, Arkadiy Dvorkovich, Head of
the Experts Group of the Russian Presidential Administration
exuded quiet confidence about the difficult path of economic
reform in Russia. He cited recent positive movement across a
diverse array of issues, including electricity, gas,
municipal government and tax reform, predicting as well that
long-stalled legislation on foreign investment in strategic
sectors (including energy) could move into the Duma before
the end of the year. Expressing concern about the killing of
Central Bank Deputy Andrey Kozlov, Dvorkovich predicted
Kozlov's reforms would continue. On WTO, Economic
Minister-Counselor raised USG dismay over indefensible
Russian Veterinary Service claims of substandard U.S. meat
handling and the deeply flawed Part IV of the Civil Code on
IPR. Dvorkovich expressed understanding for the situation
Russian Veterinary inspectors were creating regarding USG
sanitary and phytosanitary norms for beef and pork, and
promised to raise our concerns about the flawed approach to
IPR protection contained Part IV of the Civil Code in Kremlin
circles. Responding to questions about contract sanctity for
U.S. oil companies, Dvorkovich claimed no broad attack on
Production Sharing Agreements was in play, but that Sakhalin
II operators were seen as badly abusing their privileged
position and would need to come to a reasonable negotiated
outcome with the GOR on the cost overrun issue. He said
there were no plans to replace former Presidential Economic
Advisor Andrey Illarionov and that Illarionov,s staff had
been disbanded. END SUMMARY.


2. (C) Atmospherics. Unlike previous encounters over the
past two years, Dvorkovich was visibly less haggard and
displayed much of his hallmark enthusiasm. In contrast to
his downbeat assessment of the outlook for reform a year ago
(in the wake of the problems which plagued the monetization
of benefits in early 2005) he noted a wide range of positive
developments in motion on everything from taxes to
electricity to federal-municipal relations. He was upbeat
about overall growth prospects and did not see any serious
risks to the economy in the medium-term, including from a
softening in oil prices. The economy is developing on two
separate and independent tracks, with the non-extractive
sectors demonstrating significant sustainability, again
independent of the energy sector.


3. (C) Energy Reform. Dvorkovich conveyed a sense of steady
confidence that reforms currently in play would bear fruit
over the next 2-4 years. He said independent producer access
to Gazprom,s pipeline monopoly was still insufficient, but
that the drive to close the 2010 gap in gas supplies was
sharply changing that dynamic in favor of the independents.
Talk of freeing prices for Gazprom,s industrial users was
serious, but success was not a foregone conclusion.
Regardless, by 2010, the gas sector would have undergone
"seminal change." On electricity reform, he complained that
UES Chairman Chubays often strained the system with his

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maximalist approach to liberalization, but that the effect of
his efforts had been to drive reform much faster than might
have been expected.


4. (C) Tax Reform. For the past year, Dvorkovich has
struggled against Finance Ministry objections to advance a
plan to replace Russia,s value added tax (VAT) with a sales
tax. His position is gaining momentum, as many were coming
to realize just how open to abuse the VAT system had become
(despite the enthusiasm of the early 90,s which held that a
VAT approach was virtually corruption-proof). They had
carefully studied the U.S. model of state sales tax and had
drawn lessons, both positive and negative from our experience.


5. (C) Banking Reform. Dvorkovich, like many of his
colleagues who have risen steadily through the system since
the mid- 1990,s, shared his dismay at the death of Central
Bank Deputy Chairman Andrey Kozlov. He said the search was

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on to find a suitable replacement, with number of candidates
under consideration -- most prominently former Finance
Minister Mikhail Zadornov (who Dvorkovich considered the best
qualified of the group). Evidence was emerging to support
the theory that Kozlov,s work on cross borders bank
transfers had triggered his assassination -- which made sense
-- he doubted that Russian banks were still so heavily
criminalized as to go after a senior official in this manner.
The banking sector overall is in the midst of an intense
recapitalization, fueled by both domestic and foreign
investment, and that this will bring significant competition
to bear in the sector over the next few years to the benefit
of the economy as a whole.


6. (C) The Law on Strategic Sectors. Dvorkovich himself has
led the debate on the need to develop a CFIUS-like (i.e.,
Committee on Foreign Investment in the U.S.) approach in
Russia, and he confirmed that the draft law is now in motion
again, having been submitted last week to the Government. It
will likely reach the Duma during the current session.
Outstanding issues remain 1) the trigger threshold for
government review of an investment in a strategic sector (the
FSB is pressing for a 30% stake trigger, vs. the 50% stake
advocated by the rest of the interagency) and 2) the size of
oil and gas fields that would be automatically subject to
review (on which opinions still differ widely).


7. (C) Production Sharing Agreements (PSAs). Economic
Minister-Counselor raised USG concerns about contract
sanctity and apparent efforts to reopen PSAs. Dvorkovich
complained that the operators of Sakhalin II had abused the
terms of their generous ("the most generous") PSA through
inexplicable cost overruns. The overruns significantly
reduced the overall profitability of the project, and caused
a 2-3 year delay in the start of payments to the GOR.
Echoing an October 17 conversation with Deputy Economic
Minister Kiril Androsov, Dvorkovich said the government
expected the consortium to enter into good faith negotiations
on the cost overrun issue, a process which was now underway.
Dvorkovich confirmed the positive assessment we have heard
from others in the GOR about ExxonMobil,s Sakhalin I
project, which is seen as delivering on-time and on-budget.


8. (C) WTO. Economic Minister-Counselor impressed upon
Dvorkovich the seriousness of the emerging situation created
by the Russian Veterinary Service (VPSS) in the context of
our WTO negotiations. She complained that it simply flies in
the face of common sense for the Vets to assert that U.S.
meat exports were of substandard quality. Economic
Minister-Counselor urged that the Russian side not allow
itself to be caught up in VPSS hyperbole. Dvorkovich agreed
to try and keep the discussion balanced. He also sought
assurances that other open issues in the negotiations were
progressing, and Economic Minister-Counselor suggested that
it appeared so, given the concentrated efforts of both USTR
and MEDT since July.


9. (C) IPR. Economic Minister-Counselor expressed deep
concern about Part IV of the Civil Code on IPR. All
indications were that a deeply-flawed text was moving towards
precipitous passage in the Duma, all driven by some perceived
Presidential imperative. Better to get it right than have to
amend the text extensively after passage. Dvorkovich
expressed a clear understanding of the issue, noting that the
outcry against this legislation had been very vocal. He
agreed to raise it with Deputy Prime Minister Dmitriy
Medvedev, and would see if the Kremlin might be able to make
clear to the Duma the need for accuracy over speed. Economic
Minister-Counselor repeated USG willingness to engage on the
text, noting our July and early October USTR-led delegations
to Moscow.


10. (C) Boeing. In an aside, Dvorkovich commented that the
Boeing sale of 22 787,s to Aeroflot was explicitly tied to
the outcome of our WTO negotiations. This was true even
though depriving Aeroflot of the sale made little sense since

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Airbus simply had no competing plane to sell. Economic
Minister-Counselor drew his attention to the upcoming October
24 Aeroflot board meeting and asked if a way forward could be
found to keep this sale from an unnecessary demise after
November 1, after which Aeroflot might still be able to buy
the planes, but not at the price or delivery date in the
current package.


11. (C) Federal-Municipal Relations. Dvorkovich confirmed
that a significant effort was underway to get Municipal
reform on track. The basic idea calls for Municipal-level
(County-equivalent) units of government to become fully
operational by January 1, 2009. This entails the development
of a property tax system, which is being coupled with an ever
increasing devolution of responsibilities to town councils --
making them accountable to the populace for basic services
and maintenance. Legislation refining those responsibilities
is before the Duma even now. Unfortunately, Municipalities
have been far from uniformly successful to date at the
mechanics of establishing an independent revenue stream,
which has necessitated suboptimal Federal transfers straight
from the top to the bottom of the fiscal federalism ladder.
In select instances, federal authorities are working these
transfers through regional governments, but this was
dependent on the quality of regional officials.


12. (C) Comment. Dvorkovich clearly understands our concerns
about the meat safety, IPR protection, and the WTO
negotiations, as well as PSA contract sanctity. Looking at
the broad sweep of reform over the past two years, it was
clear that in the wake of the fiasco surrounding the
implementation of the monetization program in January 2005,
reformist elements in the GOR had scaled back their
ambitions. Yet this conversation suggests that reformers
have been quietly advancing their agenda -- although not
under the reform banner. This is all the more interesting in
light of Kozlov's murder and well-publicized actions that
seem antithetical to the trend described here. Dvorkovich
may be overly optimistic about the results, but progress is
possible over the next year on tax and electricity reform,
independent access to the gas pipeline monopoly, and perhaps
even passage of the Strategic Sectors and Subsoil laws.





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