Ben Aris in Berlin -

What will Russia look like in 2020? If Prime Minister Vladimir Putin has his way, then glittering skyscrapers will tower over Moscow, home to the Russian banks that are the nerve centre of one of the four biggest financial markets in the world. Gazprom will be the world's most valuable company and Russia will be by far the largest consumer market in Europe. Some 60% of the population will count themselves as middle class. Cars produced in St Petersburg will be shipped across the continent. Murmansk and Sakhalin will be buzzing ports with bulbous, low-temperature liquefied natural gas (LNG) tankers shipping Russian gas to the four corners of the globe. And as for politics, Putin's critics believe that Russia will look like Aldous Huxley's "Brave New World", whereas the Kremlin (and especially Russian President Dmitry Medvedev) say it would be closer to his utopian "Island" - albeit without the magic mushrooms.

Is this a fantasy? Until the current crisis hit, many aspects of this vision didn't look that unlikely. Construction on the Moscow City project - the Russian capital's answer to London's Canary Wharf - was well underway. LNG is already being delivered to Japan and plans for a second plant on the west coast are in hand. Foreign carmakers are still investing in Russia even though sales are down by over a half in the first quarter of this year. Moving two-thirds of the population into the middle class bracket in the next 10 years is a tall order indeed, but Russia's middle class has grown from about 14% in 1998 to an estimated 22% of the population in 2007. In short, Russia might fall short of Putin's vision, but it will certainly get further down the road that leads there.

This is a bold statement, especially in the current climate, but the reason why all the governments of Central and Eastern Europe (CEE) can be confident of another decade of strong growth is that they have barely scratched the surface of improving their productivity where huge gains can be made at little cost.

Productive gains

The crisis has stopped the investment boom that was driving growth in recent years in its tracks. The main thrust of the current rescue efforts has been to get banks lending to the real economy again. But the silver lining in the crisis is that companies will switch their focus from debt-financed expansion to improving productivity, which could reap far bigger benefits.

During the boom of the last eight years, little attention was paid to productivity. Most owners were totally focused on growing as fast as possible in an effort to seize market share while it was still up for grabs. But these same firms are extremely wasteful and productivity in CEE is typically between one or two fifths of that in the West. Fat margins in young markets made the issue of efficiency irrelevant until now, but gains to be made from small improvements in management are huge. "If as little as 10% of the working population in Russia worked at the average productivity level of those in the USA, then the total output of the Russian economy would increase 1.4 times and the GDP would increase 1.5 times," says Alexander Idrisov, who's consultancy Strategy Partners recently released a report on productivity in Russia.

Most countries have been more interested in boosting the wealth of their populations. While per-capita incomes in the region are still well below those of the rest of Europe, in purchasing power parity (PPP) terms, some countries in CEE have almost caught up with their older EU cousins.

A year after Poland entered the EU in 2004, its GDP per capita had already reached 43% of the average EU27 average (in PPP terms), while Hungary was 55%, Czech Republic 61% and Slovenia 72%. And as most of the investment tends to go to large cities, some capitals in the region have already overtaken their Western European peers: Prague boasts a per-capita income that is 153% of the EU27 average, Bratislava is at 120% and the region of Kozep Magyarorszag in Hungary was at 96% of the EU27 average in 2005, says the Kiel Institute for the World Economy, citing the latest data available on the region.

But if you look at productivity in emerging Europe, then a very different picture emerges. Ironically, some of the countries that won laurels for their rapid reforms have done very little to improve productivity, which has contributed to their sudden collapse in the current crisis.

Hungary is amongst one of the most productive CEE countries, but still only 42% of the EU27 average level in 2005, just behind Portugal, according to the Kiel Institute. Slovenia is arguably the best managed economy in the region, but productivity in the manufacturing sector is still only just over 40% of the EU15 average in 2005, according to Raiffeisen International. Going further east and the problem becomes progressively worse: Russian workers may cost a fraction of a western worker, but the labour cost savings are all lost when you consider it takes a Russian four days to make a single car, while most western factories are churning out a car in the same number of hours. Russia, Romania and Bulgaria all have extremely low productivity levels of 16%, 17% and 12%, respectively, of the EU27 average.

Climbing out of the hole

In the short term, the resumption of bank lending should stop the rot in CEE that has been caused by the collapse in consumer spending. But in the long term, the only way for most of these countries to resume their strong growth is to switch their focus to improving the productivity of their companies. The good news is that this should be surprisingly easy to do.

Most assume that the low levels of productivity is due to outdated factories, but Idrisov says blaming old technology is a "myth" and the main problem is simply bad management. Idrisov is backed up a recent report by consultants McKinsey & Company that found 30-80% of the productivity gap with the US, (depending on the sector) is simply due to inefficient business administration. Old technology plays a role, but accounts for just 20-60% of the difference with the US. Most surprisingly of all is that the structural differences due to simply being in Russia or another CEE country as opposed to the US make hardly any difference at all - only 5-15% of the productivity gap. In other words, the changes companies need to make to massively boost their productivity are simple things that make better use of the resources they already have.

McKinsey found that a few sectors of the Russian economy are already out-punching their international peers in terms of productivity. Surprisingly, some of the biggest gains have been made in Russia's steel sector, where average productivity is now a third of US levels and the best steel mills are already as good as anything you can find in North America. Retail has been an obvious growth sector, but few realise that Russian retail has been growing faster than that of China or Brazil, where productivity was also at a third of the US levels in 2007. Progress has been slower in construction, retail banking and electricity production, which all stand at between a fifth and a quarter of US levels, but are still more productive than the rest of the economy.

People vs techno

Gains from improving productivity will have to work against the drag caused by declining populations, which has been much written about and is a problem that will start to bite next year. "The demographic situation in CEE is at least as bad as in the old EU and in some places worse due to emigration. The working age population in the CEE countries will start to strongly decline from 2010 on, resulting in a deceleration of potential growth," analysts at Raiffeisen said in a recent report.

But the problem isn't universal. In Russia, the fall in the size of the population has already begun to slow, while in other countries like Georgia, Kazakhstan, Azerbaijan and Uzbekistan the populations are actually growing and will give a extra kick to growth in the next decade - Uzbekistan is on course to overtake Ukraine to become the third most populous country in the Former Soviet Union by 2020, according to the World Bank.

However, population decline should be outweighed by the increasing use of modern technology. Economic growth is produced by a combination of capital investment and labour productivity, which combine in inverse proportions. What this means is that at the start of a country's development, simply finding good, cheap workers is the key to growth. Later as wages rise, the growth driver switches to finding capital for investment. However, there is a cap on both the available labour and capital, so there is a ceiling on growth - or so the theory runs.

More recently, economists have added a third factor to growth: technology. Unlike capital and labour, there is no limit to the gains that technology can produce as it has no physical limits, so the growth of an economy can be infinite, given the right gizmos.

New Europe has already gone quite a long way towards shifting from a labour emphasis to a capital one. In the 1990s, the first industries to arrive in the new markets were light industries looking for cheap labour. Since then, middleweight flat-screen TV factories set up shop in the Czech Republic and elsewhere, and more recently heavier carmakers invested in places like Slovakia and Russia. But the most dramatic changes have been in the highly productive service sector, which didn't exist under central planning. "The contribution of services to GDP increased substantially after the beginning of the transition, now ranging from 43% in the low-income CIS countries to 62% in the EU8 and Southeastern European countries. Services' share in GDP among the middle-income countries of the region during 2001-2004 varied from around a third in Serbia and Montenegro and Macedonia to more than half – higher than the average in the EU15 – in Estonia and Latvia," the World Bank said in a report released earlier this year.

The raft of new companies has also been pushing productivity up. New companies are fast learners, but the productivity gains they make vary widely across the region. Georgia's start-ups see their productivity soar in their second year of operation. In Romania and Ukraine, productivity begins to tail off after four years, while young Russian companies continue to improve over seven years when they become some of the most productive in the region, according to the World Bank. This suggests that Georgia now has one of the most fertile investment climates in the CIS, while Russian managers are amongst some of the most skilful.

Keeping up the pace

Thanks to the 6-7% annual GDP growth in all these markets, little attention was paid to productivity, but now markets are at a standstill attention will be inevitably refocused on getting the most out of what you already have.

The key to keeping productivity gains high is to bring in new technology. The traditional way of doing this is to attract foreign direct investment (FDI). The Kremlin has clearly singled out the automotive industry as one area where Russia can be a leader, and in the last two years pretty much every major manufacturer in the world has set up a plant just outside St Petersburg. Likewise, the state's United Aviation Corporation (UAC) is supposed to act as a seed crystal for aviation technology, something Russia is actually pretty good at thanks to the legacy of military applications during the Cold War.

But the Kremlin is casting around for ideas to accelerate the process. Putin personally launched the Russian Venture Company in 2006 as a way of tapping the country's latent intellectual capital, which has been lifted more or less wholesale from the highly successful Israeli experiment to create a venture capital industry from scratch 20 years ago. Likewise, the Kremlin-controlled Rostechnologii holding that is supposed to fund Russian high-tech industries is more of the same.

More recently, the Kremlin has launched an even more aggressive plan. Buried in the crisis news flow of recent weeks was the announcement that the state is setting up a fund to buy foreign assets or stakes in important companies. Impatient with the slow pace of FDI, the Kremlin looks like it is attempting a short cut by simply taking over companies with technology that Russia wants. Natasha Tsukanova, former head of JPMorgan Chase's business in Russia, has already been hired to head a sovereign M&A team and is chief adviser to the Russian government for the expansion into western markets, reports Kommersant.

The Kremlin has latched on to the right idea, but the question is whether they can make it work. Certainly the productivity gap means that the region as a whole will outperform the developed world for years to come. Liam Halligan, chief economist of Prosperity Capital Management, points out that in 2007 a quarter of global growth came from emerging markets, half in 2008 and this year 100% of global growth will be produced in these markets. This fact alone should attract investors who are becoming yield-hungry again.

Raiffeisen predicted in a recent report entitled "CEE in 2020" that the region will outperform the developed world for least the next decade. Central Europe will grow about 4.3% per year for the next five-eight years, then slow to 3.2% after 2020. Eastern Europe will average about 4% to 2015 and then fall to 3% due to the demographic problems, while the Balkans will benefit from a young and growing population and should put in 5.5-6% growth a year through to 2020. The star performer will be Kazakhstan, Raiffeisen predicts, which has the benefits of both strong reforms and strong demographic growth, resulting in an average growth rate of about 7.5-9% for most of the next decade. However, these numbers are at best guesses and everything will turn on how effective managers are at improving the way they work.

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