What's really wrong with Russia

By bne IntelliNews March 24, 2010

Ben Aris in Moscow -

Elena and Sergei live in Moscow's suburbs and wanted to open a small shop to earn a little extra money. A typically resourceful Russian couple, they breed rabbits in their back garden and built their own house. The plan was to sell rabbit meat, fur and the livers (an expensive luxury in Russia), as well as the usual corner store stock, but they ran into a problem.

"The local mayor of our mikro-rayon [a sub-region of Moscow] refused to give us permission," says Elena, who asked for her surname to be withheld, with an air of resignation in her voice. "He has a 'relationship' with another store in our village and they don't want the competition."

Permits are no longer necessary to go into most businesses in Russia (you only have to register with the taxman), but in practice you have to deal with the local authorities. "If we tried to go ahead and open the store anyway, you can't imagine the trouble we would have," says Elena.

Corruption clearly is a major issue in Russia, but all the emerging markets suffer from the same problem. For example, Ukraine, which is arguably the only true democracy in the Commonwealth of Independent States (CIS), scores even worse than Russia on Transparency International's corruption index, as parliament is riddled with local oligarchs' interests.

But there has been a lot of good news too. In terms of the standard of living or income, Russia is the best place to live in the CIS. Its per-capita income (in purchasing price parity terms) doubled in the last five years to $15,800 in 2009, twice that of Ukraine, and significantly better than in Belarus and Kazakhstan (both of which do much better than Russia in the corruption rankings). Once you start digging into the detail, the picture becomes quite confusing, begging the question: what is really wrong with Russia and are things getting better or worse?

• Infrastructure

Russia's most obvious problem is that its Soviet-era infrastructure is crumbling and won't be serviceable for much longer. A massive amount of investment is needed into pretty much everything. The hot spots are power and transport.

Before the crisis knocked the economy onto its back, the demand for electricity matched the country's ability to generate it. Any further economic growth was going to result in blackouts, which in turn would become a major drag on growth. The crisis has brought the Kremlin some time, but the problem will resurface in the next few years as the economy recovers.

Happily, the Kremlin is well aware of this problem and has already done much of the groundwork. The sector monopolist United Energy Systems has been broken up and the sector was successfully privatised, bringing in far more money than the Kremlin had dared hope for. The next stage of building new capacity has been complicated by the crisis, as no one has any money. But as soon as the economic recovery puts the pressure back on power supplies, the same economic growth will make it easier to borrow.

A similar big push to fix the transport system is also well in hand. The rail ministry (once run by Trotsky - they still have his picture on the wall of the headquarters) has been converted into a joint stock company and the state invested a massive RUB800bn ($27bn) into the sector in 2009 alone. Similar fixes are planned for ports and airports, as the state says it will turn all its holdings into joint stock companies and either invest in them itself or raise private money through public-private partnerships.

The big omission here on the Kremlin's part is that while they are spending on power and trains, they have ignored badly needed investment into social infrastructure. The president's modernisation programme is doomed to fail unless the state spends equally heavily on education. Likewise, the World Health Organisation released a study a few years ago that concluded the very best returns on investment for the economy were investments into the health system: not only does a healthy population work harder for longer and retire later, but the savings made from not having to care for sick pensioners for decades is incalculable.

And the Kremlin's botched pension reform must be fixed. The Kremlin has just hiked pensiosn by 50%. However, there is a hole in the pension fund that already accounts for a quarter of this year's deficit. As the demographic window closes, caused by the aging population, the pension system must be made to pay for itself or this problem will only get worse.

• Oil addiction

Critics dismiss much of Russia's progress as nothing more than oil money. But earning lots of money from oil is not a problem per se. True, oil has paid for a lot of progress so far, but having oil comes with a very specific set of problems that Russia doesn't share with its neighbours.

The biggest of these is very serious indeed. Russia earns more money than the economy can cope with. This sends the value of the local currency up so much that other industries are made uncompetitive - the so-called "Dutch disease." With surplus cash in its vaults, the Kremlin spends heavily (what politician in the world can resist spending a surplus), which causes more macroeconomic problems such as inflation: under the late president Boris Yeltsin, the budget's breakeven price for a barrel of oil was $14; today it is $80. Consequently, Russia's economic growth is closely tied to the price of oil.

However, the state has actually been pretty prudent when dealing with oil revenues. Oil is heavily taxed, with the state taking 90 cents on every dollar when prices for oil are over $27. The extra revenue has been used to subsidise income and profit taxes (13% and 24% respectively) in an effort to boost economic diversification. Even this largesse can't soak up all the petrodollars, so the excess cash is siphoned off into the "lockbox" of the Stabilisation Fund and kept out of the reach of free-spending MPs by Finance Minister Alexei Kudrin. It is hard to see what else the Kremlin could have done to minimize the impact of Dutch disease on Russia. Indeed, even with oil prices at $150 a barrel the government still managed to bring inflation down into single digits at the start of 2008. (Ukraine let its inflation rate soar to 25% in the same year, the highest in the world.)

Still, Russia's economy already has a bad case of Dutch disease. Russia has some the best scientists and engineers in the world, but yet it doesn't export anything of note other than oil and arms. Everything in Russia is now expensive. Choosing one example at random: according to Moscow's real estate consultants, the cost of building a distribution centre in Moscow is 34% higher than building the same thing in London, which is crazy.

• Diversification and top-down reform

Oil can be a curse and is responsible in large part for the lack of progress in diversifying the economy. Typically, emerging markets start making things cheap (look at China) before moving up the value-added chain (look at Taiwan or South Korea). But the Dutch disease means that Russian companies can't even move off square one, as their goods are expensive from the start.

The Kremlin's solution is to lift struggling sectors up by the bootstraps by pouring enough money into them so that even if they can't compete on price, they can compete on quality. The trouble is that state-led rescues of industry look intrinsically wrong-headed to almost everyone.

Katinka Barysch, deputy director of the Centre for European Reform, spoke for many recently in a recent paper when she wrote: "A genuine modernisation alliance would have to be bottom-up and driven by the private sector. The Russian leadership is pursuing a model of modernisation that is state-centric and top-down. It throws money at new institutes to foster research, it nationalises big industries, it tells state-owned banks which sectors to lend to. It does not do the things that would be required for genuine economic diversification."

East Germany is the classic example of failed top-down reforms. The German government dropped a staggering €1.25 trillion into the former East German economy after unification to bring it up to scratch - and it didn't work. Unemployment in the east is still twice that in the west. But the Kremlin is looking at different examples, such as Germany's state-led creation of a world-class automotive sector out of the post-war destruction.

Barysch assumes there is a foundation of business that will flourish if the shackles of government are removed, but the Kremlin is facing an economy where rafts of products and services are simply missing and can't get started.

State spending is inherently wasteful, but as Russia has the money thanks to oil, the issue at hand is not the efficiency of state spending, but rather its effectiveness: can the spending create sectors that don't exist now or upgrade those that can't compete now? "As there is no vibrant [small and medium-sized enterprise] sector, the only option left is heavy state spending. The Kremlin is doing this not because they want bigger versions of the existing state-owned behemoths, but because how else are they going to change the nature of the Russia economy?" says Plamen Monovski, a veteran investor into emerging Europe and CIO-designate at Renaissance Asset Management.

• Corruption and bureaucracy

State spending by itself will fail unless it is accompanied by liberal reforms, as it inevitably feeds corruption. Too much money in the hands of too few people that have no profit motive and a meagre pay packet is guaranteed to end in corruption.

When he was president, Vladimir Putin called for something to be done about corruption in every one of his State of the Nation speeches - and absolutely nothing happened. But since Dmitry Medvedev took over as president in 2009, the new president has launched Russia's first ever concerted attack on graft.

Both the Interior Ministry and the General Prosecutors Office have set up new anti-corruption units. In the last year, the government claims it has investigated 439,000 crimes of which 173,000 were serious and caused a total of RUB1 trillion worth of damage ($32bn). At least 7,000 senior officials, judges and generals have been sacked or jailed in the last year from across the spectrum, according to the government.

More recently, Medvedev has taken the fight up a gear with legislation. A bill to reform the police force was passed by the Duma in February, which was followed by a shake-up at the Interior Ministry in March. In the same month, a new law that better defined white-collar crime was passed and more legislation is clearly on the way. "Our task is to create a high-quality of justice that helps our citizens directly in our country," Medvedev said during a government meeting, adding that it would not be an easy process.

You can question the size of the official numbers, but clearly the government has gone on the offensive. However, the actual numbers prosecuted are still tiny compared to the million-plus strong army of bureaucrats. This is no anti-graft pogrom, like in Georgia where Mikheil Saakashvili sacked the entire police force (which worked beautifully). Rather, the strategy currently seems to be to fire a warning shot over the bows of government to say: "Change is coming, mend your ways." But it will take years, if not decades, to make a real dent in the problem.

• Political risk is rising

More worryingly, these nascent attempts to remake the system have already led to an increase in political risk. Up until now Russia has grown by first putting bums in empty seats, and then building new factories when the Soviet-era capacity was fully used. To go to the next stage, the system itself has to be liberalised, as it is efficiency not volume that counts now. This means cutting into the vested interests and they are already fighting back. In March, Medvedev told ministers that they had to obey orders "or take a hike" - a rare visible sign of the growing tension.

Conventional wisdom has it that Putin is a virtual dictator, but bne's sources in diplomatic, business and government circles say that Putin is visibly under an increasing amount of strain, frustrated by the government machinery's failure to implement his plans. On top of this, bringing in Medvedev has considerably weakened his position. "Two camps have formed around Medvedev and Putin. The first wants to see Medvedev go further with the liberalisation of the economy and politics, whereas the people close to Putin want to keep things as they were prior to the crisis - where they were making money," says an economist who has been advising the government at a top level. "Putin is visibly stressed, as some people are starting to ignore him and others are openly calling for him to leave."

Putin's big gift to Russia was political stability. As a lone figure at the top of the political tree, he was able to balance all the interests of the various factions. But the arrival of Medvedev has upset that balance, as now there is an alternative power centre. The key factor is where Medvedev himself stands. There is a joke doing the rounds in the Kremlin at the moment, sources tell bne: "There are two camps that belong to Vladimir Vladimirovich [Putin] and Dmitry Anatolevich [Medvedev]. The only question is: which camp does Dmitry Anotolovich belong to?"

No one knows the details of the deal that Putin obviously struck with Medvedev prior to nominating him for president. At the moment, it seems that Medvedev is still happy to let Putin take the lead. Moreover, at the end of the day no one is interested in a messy government change; Ukraine's five lost years following the Orange Revolution is staring them in the face. None of these problems are insolvable and a return to fast growth will make a lot of them go away on their own, but it's still going to be an uphill battle.

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