Roadmap to reform

By bne IntelliNews November 27, 2012

Ben Aris in Moscow -

The Kremlin is scared. As the Russian economy emerges from the 2008 crisis, it is sliding smoothly and quickly into stagnation. In response, President Vladimir Putin challenged his government to implement 22 roadmaps to finally address some of the deep structural problems that has made Russia such an unattractive place for business over the last two decades. But the stakes are high, as the economy has already headed into a slump from which it will be hard to recover.

The Kremlin has not been sitting entirely on its hands in the last ten years, but with petrodollars pouring into the state coffers, what has been done mostly dealt with immediate problems. And even this unenthusiastic effort was stymied by the reluctance of the statists that populate the upper echelons of power and undermined by the stealing.

But Russia can no longer afford to be complacent. It will soon run out of money, as the oil dollars can only be expected to finance state spending for another few years. After that, rising imports and lacklustre growth will make deficits a permanent feature of the federal budget.

Already operating on a razor-thin surplus, the government is clearly on the hunt for extra revenue. In the middle of November, a rule to force state-owned companies to pay 25% of their profits as dividends was confirmed - and this will become doubly expensive for the companies from next year when all Russia's companies will be forced to use International Financial Reporting Standards (IFRS), which will increase the amount counted as profit several-fold. It has also restarted the privatisation programme with the successful sale of a stake in Sberbank. However, neither of these measures will provide anything like the amount of money needed to maintain Russia's growth. Nothing short of fundamental change will do now.

Russia's reform efforts have moved into a new phase and President Putin got the ball rolling in February by calling for Russia to improve its standing in the World Bank's annual "Doing Business" ranking from 120th place out of a total of 185 countries to 50th by 2015 and 20th by 2018.

In addition to the set-piece reforms to things like the power sector and capital markets, a series of 22 "roadmaps" have been introduced, many of which are directly connected to lifting Russia up the World Bank's rankings, five of which have already been approved.

Moreover, a new sense of pragmatism has entered the Kremlin's rhetoric: unlike the Gref plan of 2000 (Russia's first attempt at systematic reform, named after the then-minister of economic development and trade German Gref), these are roadmaps, not plans: the Kremlin knows where it is and where it wants to get to, but concedes the path it needs to follow is not clear. Russian Prime Minister Dmitry Medvedev's cabinet is in charge of the process and already it has thrown out two roadmaps - the power sector reform and Russia's innovation strategy - because they were unrealistic. The respective ministries have been ordered to go back to the drawing board and told to do better.

Better late than never

The 2008 crisis has changed the nature of the game. During the boom years, the Russian economy was supercharged by a combination of sky-high oil prices and abundant cheap debt from abroad that kept economic growth at between 6% and 8% for most of the naughties. The crisis has changed all that and slower economic growth is now a permanent feature, leading economists to call for a new economic model that shifts the emphasis from the public to the private sector - a call the Kremlin seems to be heeding.

The Economic Forecasting Institute of the Russian Academy of Sciences published a quarterly macroeconomic preview in November saying, "the ongoing developments in the economy can already be described as a crisis of the mechanisms of growth and economic management. Other growth mechanism must be found as government and quasi-government companies currently provide up to 40% of capital investments."

If anything the task ahead will be even harder than before the crisis, which is when the reforms should have started. The government-led rescue effort has resulted in the state actually increasing its share of GDP. A survey by BNP Paribas released in November said that state-owned companies now control 50% of GDP against the global average of 30%, and are particularly strong in oil and gas (40-45%), banking (49%) and transport (73%).

The government's policy-making was paralyzed by domestic politics until May; the powers-that-be had to concentrate all their efforts on securing first the Duma elections in December 2011, then presidential elections in May this year. However, on the day of his inauguration, Putin went straight from the lectern where he gave his acceptance speech to his desk, where he signed several decrees to slash red tape in the construction sector.

And not a moment too soon, as Russia's economy is already heading into trouble. Economic growth was a relatively healthy 4.9% between January and March of this year, but slowed sharply to 2.9% between July and September. It is expected to remain at these subpar levels next year too. Economists at the Central Bank of Russia say anything under 4% is equivalent to stagnation and Russia cannot afford to fail in its reform effort this time round. "For Putin this is evidently his last chance to get on top of a situation, which is objectively not going his way. And if he does not take advantage of the moment now, he will not have such an opportunity again. It is also important that the (excessively) repressive policies of recent months allow Putin to act as if from a position of strength, and not one of weakness," says Nikolai Petrov of Carneigie Endowment.

Putin's NEP

Petrov has dubbed the roadmap reforms "Putin's NEP" after Lenin's New Economic Policy that loosened Communist Party control over commerce from 1925 to stave off economic collapse. Private commerce flourished, giving rise to the "Nepman" - very similar to the crass "Novy Russky" of the 1990s, who became rich overnight from the arbitrage created by the remaining government restrictions.

The new reform effort is still very much in the planning stages, but Russia got off to an encouraging start when it moved up eight places in this year's World Bank "Doing Business" survey to 112th place. "Whilst many changes are relatively minor, we believe that [the roadmaps] add up to a more positive environment for investors," argues Kingsmill Bond, chief Russian strategist for Citigroup in Moscow.

The fire-fighting approach to reform of the boom years quickly shows up when you drill into the ten variables that go into Russia's ranking. And so does the challenge Russia faces in completing its transformation into a "normal" country.

Russia does surprising well in some aspects. Despite its reputation for lawlessness, Russia ranks 11th out of the 185 countries polled for contract enforcement. And this year it did particularly well in tax administration, improving from 105th to 64th, overtaking the US in the process. This was partly due to the fact it has a very simple flat tax regime for the most important taxes, but also because paper work has been slashed and punters were encouraged to submit their returns online: the number of people and companies filing their tax forms via the internet has jumped from 10% in 2000 to 75% now, according to the Federal Tax Service.

However, Russia does less well in many other areas and is amongst the worst in several crucial aspects. Although Putin acted swiftly to launch reforms to regulations in the construction sector, Russia remains in 178th place for the ease of getting construction permits. No progress has been made here at all. Even more surprising, despite being one of the biggest energy producers in the world, Russia is the second hardest place on the planet to get a factory or shop connected to the electricity grid (184th). And especially damaging is the inefficiency of the customs service (162nd). "As to the negative, we have three areas that clearly stand out where the situation is very poor, and it is no coincidence that we have developed roadmaps for these three areas," Economic Development Minister Andrei Belousov said following the release of the ranking. "Customs in particular remains a bottleneck for our entire economic development."

Belousov lashed out at the Customs Service in November, which is supposed to send lists of goods categories ahead of shipping to importers that would cut the time it takes to clear cargo. However, it has only done this for only a few goods and makes everyone else wait in line. Moreover, the waiting time in those lines has not gotten shorter.

Encouragingly, it is exactly those things that Russia is worst at that have gotten the most attention from the Kremlin and the roadmap list closely matches the variables that make up the World Bank's ranking (see table).

Clearly, Putin is very serious about lifting Russia up the rankings over the next half decade. And Belousov was not unduly pessimistic, saying it is still very early days; reforms for construction, customs procedures and connections to electricity grids are only due to be implemented next year. "The roadmaps really only began to be implemented in the second half of this year - just now," said Belousov. "Of all the roadmaps, the implementation term for only five measures has come into effect. Thus we expect the main impact to be next year and in one year... The real task that I set is to become one of the top 100 countries in the ranking on these three indicators in the near future. This is completely realistic already next year."

More progress has been made at the regional level, where a parallel effort is going on. The new administration of Moscow City has taken up the baton and is dealing with the same issues. Deputy Mayor Andrei Sharonov says the average time it takes to process the paperwork for the connection of non-stationary retail outlets to power grids has recently dropped from 3-6 months to 15 days. And next year MOESK, one of Russia's largest inter-regional distribution grid companies, plans to introduce a "single window" for all applicants for 150 kilowatts or less that will reduce the delays further.

Foreign attraction

All these reforms are supposed to make it easier to do business in Russia, but they are also specifically targeting foreign investors. If Russia is to modernise, it desperately needs the technological know-how and management skills that come with foreign direct investment (FDI). However, Aton Capital recently released a paper, "Foreign investment into Russia: not that foreign, but very profitable", that showed Russia has one of the lowest levels of FDI per capita in all of Central and Eastern Europe (see "Chart of the Month").

But things are changing slowly as the crisis pushes investors out of Western Europe as much as Russia's emerging middle class pulls them in. Russia is on course to become the biggest consumer market in Europe sometime in 2018 and has already seen a raft of international fast food chains and other consumer companies arrive over the last 18 months, but the trick will be to go up the industrial weight spectrum.

The Kremlin set up the Russian Foreign Investment Advisory Council (FIAC), headed by First Deputy Prime Minister Igor Shuvalov and chaired by the CEO of Ernst & Young, James Turley. The FIAC conducted a survey earlier this year that suggests foreign investors are beginning to warm to Russia and the hope is that the roadmaps will help build the momentum. For example, the number that thought Russia was "enjoying success and attracting investment" had risen from 8% in 2007 to 35% today. Businesses that were "satisfied with the business climate" grew from 57% to 71%, and the number that thought the government was "taking the right steps" was up from 47% to 72% over the same period. Turley says he is impressed by the government's efforts to cut red tape and believes the roadmaps will reduce the administrative barriers by 94% when fully implemented.

FAIC surveyed 42 large corporations working in Russia and found that red tape is business' biggest concern, followed by corruption and then poor infrastructure. On the plus side, Russia's accession to the World Trade Organization and its large consumer base were the main attractions.

Russia is at another of its periodic crossroads, but this is by far the most serious yet. With economic growth of only 2.9%, Russia is already stagnating. Indeed, the experts at the Higher School of Economics (HSE), the intellectual force behind reforms, say the macroeconomic forecast in the draft budget for three years to come is unrealistic and Russia's economy could grind to a halt by the end of this year.

In the past, the Kremlin could afford to ignore reform because oil money more than made up for the lack of change. But even with oil currently at around $100 per barrel, the state is barely in profit and growth is slowing. And if the global economy keeps growing slowly, Russia will still only show a GDP growth rate of no more than 1.3% in 2015, predicts the HSE.

Rising pension obligations, the increasing bill for imports and the massive amounts that the government needs to spend on things like modernising Russia's infrastructure mean the Kremlin can literally not afford to fluff these reforms.

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