For markets that have grown accustomed to political stability almost being “enshrined” on Putin’s watch, this has created some unease and confusion, especially in the wake of unexpected political changes rolling through the Middle East. Could Russia be next?

Indeed, perceptions (real or otherwise) of divisions within Russia’s ruling elite are given as one of the prime reasons why Russia has seen an upsurge in capital flight in recent months — perhaps reaching as much as $30 billion in the first few months of 2011. The argument is that uncertainty over the leadership at the top of the country, and prospects of competition between elites around the two respective leaders, has acted to un-nerve local business leaders, who prefer to stash the oil/commodity windfall overseas. Are these concerns justified?

Evidence of divisions at the top are building.

In Russia’s specific case rumors of ‘trouble at the top’ have been fed by a series of events over the past few months which have suggested divisions at the heart of the government — previously not known for allowing ministers/officials to go “off message.”

First here was the removal from office of the former Mayor of Moscow, Yuri Luzhkov, and his downfall has extended to investigations of connected business interests/parties. Luzhkov himself was not thought to be particularly close to Putin, but was very much seen as part of the establishment, which makes his departure — apparently at the behest of President Medvedev all the more interesting/intriguing.

Following on shortly from this were apparent divisions between the Medvedev and Putin camps over support or otherwise for NATO action in Libya. Medvedev appeared far more sanguine/supportive of his new found friends across the Atlantic, while Putin trod a very much old school Russian approach of defending the status quo in the region.

Medvedev has yet to fully emerge from Putin’s shadow

And, finally we would highlight Medvedev’s more recent efforts calling for economic and indeed political liberalization in Russia (see the FT interview with Medvedev on June 18, 2011) which at first glance would appear to set him at logger heads (even in competition) with Putin given the latter politician’s now well established vision of Russia as a managed democracy and where the state prior and thru the global crisis had an increasingly important role in the economy (e.g. through the promotion of national champions).

Over the past week Medvedev has even gone as far as to suggest changes in the electoral rules, reducing the barrier for political parties to compete in elections from 7 percent at present to 5 percent, so as to increase political pluralism. This stands in some stark contrast to Putin’s “successful,” and tried and tested, model of political centralization around United Russia, and indeed “approved” political parties.

Interest in the potential for division between the two politicians is made more topical by the electoral calendar, with parliamentary elections due by December 2011, and presidential elections the following March. That the two politicians have thus far failed to declare their intentions, or otherwise, to run in the presidential poll has added extra spice, and allowed rumors to intensify that the two are somehow in competition for the top job in the country, and that Russia might have a closely contested presidential election in 2012, with Medvedev and Putin possibly even running against each other.

Proponents of this view would hence argue that Medvedev’s attempt to portray a more liberal image, as a supporter of political pluralism, market reform and of modernizing/opening up the economy to foreign investment, is part of his attempts to differentiate himself from his ‘former’ boss.

So what is going on in Russia?

As a starting point, it is important to note that as an analyst covering Russia it is difficult to get an easy feel as to the balance of power within the Kremlin. While Russia in general has undergone a remarkable transformation in many respects over the past 20 years, Kremlinologists are probably as much in demand today as they were in the Soviet era. It is thus perhaps fair to say that only a small handful of observers (participants) have a real grip on the balances of power within the administration, and they tend to keep their powder dry. Views are thus derived more from experience/track records and nuances to public commentary/spin than of any cast iron insight.

That important caveat added at the offset, we tend to view with some considerable degree of scepticism the contention that President Medvedev and his prime minister are somehow in competition. Instead we would tend to view the new found distance in terms of the platforms of the two politicians as part of the administration’s strategy for ensuring its continued domination of the political scene at the next elections and beyond. Our "bias" is thus to assume that the perception of division, or differences, rather at the top are being closely stage-managed.

The bond between Medvedev and Putin remains strong

First, it is important to understand the incredibly close bond between the two leaders, who both hail from St Petersburg, and who both earned their spurs working alongside each other under the reforming former Mayor of St Petersburg Anatoly Sobchak. Their bond dates back close to two decades, and President Medvedev’s career has closely dovetailed with that of “his” prime minister. Putin’s appointment from relative obscurity in St Petersburg, by former President Boris Yeltsin, to become his prime minister in 1999, only then to be catapulted into the presidency, led the way for Medvedev’s own rise into the Kremlin elite. Medvedev subsequently followed Putin to Moscow, and his career progress very much followed in Putin’s slipstream.

Second, it is generally recognized that Putin has managed to transform Russia, from the chaotic end to the Yeltsin presidency where centrifugal forces were building throughout the Federation, and risked Russia’s unity itself. Putin brought Russia back from the brink, brutally suppressed these centrifugal forces in places such as Chechnya, and centralized power back in Moscow.

The political stability provided by Putin was one of the factors which underpinned the remarkable growth of the Russian economy over the decade to 2008; true, other important factors were also at play including the rally in oil/commodity prices and the success of the debt write-offs from 1998-2000, which essentially wrote the debt slate all but clean for Russia inc.

Nevertheless, Medvedev and the Kremlin elite owe Putin a debt of gratitude for bringing the country back from the brink and also delivering a successful political machine, and putting a weight of political capital in the bank — as evidenced by electoral success for Putin in winning two terms as president, a first term for Medvedev in 2008, and domination of the legislative scene by United Russia. Putin’s success was partly that he made Russians feel good about themselves again, and Medvedev continues to rely on the Putin legacy for some of his enduring public popularity.

Third, the relationship between the two politicians is close, and evolving, and very different to previous relations between the country’s prime ministers and president. Indeed, during Yeltsin and then Putin’s own presidency prime ministers were very much seen as expendable. Few managed to survive as Putin has through an entire president’s term. Up unto Medvedev’s presidency, the president was very much the supreme leader with the premier very much being in the subservient role. This has absolutely changed under Medvedev, with Medvedev and Putin very much working as part of a partnership, dividing up responsibilities according to their respective strengths.

Medvedev, for example, who has cultivated an image as a liberal – albeit there probably is not that much clear blue water between the two — projects the role as the leader on the international scene. His fluent English language skills come in useful in meeting and greeting leaders on the international scene at G7/8/20 meetings. Putin by contrast seems to have lost interest in international affairs, beyond China and Germany, during his prior two terms as president. Instead he seems much more focused on domestic affairs, transforming the domestic economy/society.

Perhaps the litmus test of the politicians’ two respective positions in the elite can be gleaned from anecdotal impressions. Herein we would use the example of visits to state owned companies, where typically on the wall of meeting rooms are images of not just President Medvedev, but also of his prime minister, Putin. I can never remember a time during the Putin presidency when such meeting rooms would have any portraits of ministers, aside from President Putin himself. Now either this shows these enterprises edging their bets, or it shows that there is indeed a division of power within the administration and state enterprises are acknowledging that the two operate as a team. We tend to go with the latter interpretation.

Medvedev has political capital assumed from his role as president, and indeed winning that role at the ballot box. Putin has equal, if not more political capital, acquired from his success in two terms as president, building the United Russia political machine which is still also Medvedev’s power base, and also for bringing Russia back from the brink in 1999/2000, to a situation where it is still perceived as an EM powerhouse within the BRICs — albeit perhaps the weakest link herein.

Net-net Medvedev probably has yet to fully emerge from Putin’s shadow, and incredibly there are still questions as to where power lie in Russia, i.e. with the presidency or Putin. Under Putin’s presidency the question was simply irrelevant as he was the supreme leader. Now it is less clear cut.

So why the perception of difference between the two camps?

I would argue that Putin’s track record in office shows a leader whose natural instinct is to centralize power, but also one of pragmatism. Russia’s handling of the global financial crisis was everything if not pragmatic — the hard rouble policy was not maintained at all costs in late 2008/09. And like other leaders across the CIS there is a desire to be popular, and to win respect from the electorate, even via a managed democratic process.

Putin and those around him see the advantage of the political capital/legitimacy from winning elections, and winning those well. They recognize though that the electorate can be fickle — their learning experience from the Orange revolution in Ukraine. There is also recognition that their success at the ballot box is built from providing something of a social contract with the population. Herein, in exchange for a somewhat restricted political system — sovereign democracy — they have provided the population with stability, security and growth/development.

Opinion polls would suggest that United Russia, and either Medvedev or Putin would still win a majority (first round) in any presidential elections. But for the ruling camp in Russia, "just" winning is not enough, they want to continue to dominate the political system and very much see the size of their victory as a signal of their success on delivering to the population — they want to win well.

In a nuance to the above, the Arab spring has certainly un-nerved the ruling camp in Russia — given that well established, seemingly “secure” but authoritarian regimes in the region have been rolled over by people power. There is recognition that Russia is quite different — Putin and Medvedev seem genuinely popular in Russia — but there is no complacency, especially given that Russia operates with a somewhat restricted political system. The ruling camp in Russia is use to winning and winning well.

Put this lack of complacency with an underlying pragmatism and it translates into a willingness to mix things up on the political front, to try different combinations, so as to “refresh” their offering to the population, to ensure victory in both the parliamentary elections in December and the presidential elections in March 2011. This is our best call in terms of what is happening at the moment.

We certainty do not think that this reflects a significant division between the Putin and Medvedev camps, but by allowing Medvedev to talk more about making the political system more pluralistic, the administration hopes to broaden its appeal and head off potential opposition/challengers.

So who will stand as president in 2012?

Our base case is that the current division of responsibilities between Medvedev and Putin suits both men well — as noted above. Putin may well eventually aspire to some more ceremonial leadership role in perhaps a reconstituted presidency — some years from now. But at the moment he probably prefers managing his current portfolio, leaving Medvedev to do his stuff on the international scene and with foreign business.

That said, they are likely monitoring their respective opinion poll ratings, and whoever stands the significantly better chance of polling well come next March, will probably emerge as the presidential candidate. At present we would still probably guess Medvedev will run for a second term, but if Putin ends up putting his name in the ring (instead of Medvedev), the administration is clearly showing it is worried.

What is the market spin?

While developments in the Middle East have underlined that almost anything is possible given the new found openness provided by the worldwide web, mobile phones et al, we think that the incumbent regime in Russia will likely continue to dominate the domestic political scene for some years yet to come. Indeed, as argued above, we think that rumors of divisions within the Kremlin are overdone, and if anything reflect an attempt by the region to broaden its appeal as we move into an election year.

More important in our view for Russia, than the shuffling of the pack at the top, is the need for policy makers to focus on meaningful reform, including working to improve the business environment, cut corruption and red tape, create a level playing field for foreign investors, work to address the demographic time-bomb, diversify the economy away from commodities, and to reform public finances (reducing the dependency on oil/commodities) and public administration, improve institutions around credit (courts/legal system, willingness to pay, et al). Meaningful reforms across this broad reform agenda, seems unlikely to progress in any significant way this side of elections.

Timothy Ash is global head of emerging markets research at the Royal Bank of Scotland in London.