War and sanctions have forced Russia to make long overdue reforms

War and sanctions have forced Russia to make long overdue reforms
Pain focuses the mind and Russia has had plenty of that recently, but the unintended consequence of war and sanctions has been to spur the Kremlin into making some long overdue deep structural reforms. / bne IntelliNews
By Ben Aris in Berlin March 4, 2024

The pressure of the war in Ukraine has forced the Kremlin to push through a raft of long overdue reforms as its struggles to raise more revenues for the budget, increase the efficiency of the economy and keep the people happy.

Despite Russia’s reputation for crony capitalism and greedy oligarchs, since about 2014 when sanctions were first imposed on Russia after the annexation of the Crimea, the Kremlin has been trying to revamp the economy with some success.

Now the economy is under pressure again as the weight of funding a major full scale war weighs on the federal budget which has pushed the government into improving things further. After two years of fighting, the economy is doing well and grew by 3.6% in 2023, making Russia the fastest growing of any of the G8 wealthy nations.

Russia’s reform programme has been encapsulated in the 12 National Projects that were launched in 2019 and are designed to deal with some of Russia’s biggest social problems and improve the quality of life of the population. With presidential elections looming, Putin announced a National Projects 2.0 update with a raft of new initiatives during his state of the nation speech on February 29 that include swaths of new affordable housing and a renewed push on poverty reduction, amongst other things.

The clash with the West and the extreme sanctions on Russia has had the unintended consequence of focusing the Kremlin on pushing through more effective reforms. After two years of reengineering the economy for war, the Kremlin has now turned its mind back to making sure the population is happy and has the leeway to return to the topic of the national projects.

Wake up call

It seems that Russia only makes deep structural reforms when it is in trouble. Russia boomed in the noughties when growth was running at around 6% a year and the size of the economy doubled in that decade. Russia began to feel like a normal country, until it all started to go wrong. In 2013 annual growth dropped to zero despite the fact oil prices were still over $100 per barrel; the petrodollar-driven catch-up was over and that economic model was exhausted.

The problems came to a head when Russia’s budget was missing RUB2 trillion ($31bn) in 2016 leaving the Finance Ministry scrambling to find more cash and failing. The federal government still had large foreign exchange reserves, but many of Russia’s regions are teetering on the edge of collapse and a major debt crisis was looming.

In the end the Kremlin was saved when it “privatised” 19.5% in oil major Rosneft to Glencore and Qatar in a surprise deal, which later transpired to actually be a bail out loan by Qatar’s sovereign wealth fund.

The 2016 budget crisis coupled with the threat of more sanctions was a wakeup call that spurred the Kremlin into action. The reform process began with the so-called May decrees signed by President Vladimir Putin in May 2012 that imposed a heavy social spending plan on Russia's regions to improve the lives of the average Russian.

With the economy in the middle of a four-year recession and relations with the West rapidly decaying, the government turned its full attention to solving some of its long-standing problems. Putin cracked down on corruption in government with his deoffshorisation program in 2014 that banned government officials from holding offshore bank accounts or assets, that widened into a general anti-corruption drive that resulted in a big reshuffle of the regional administration in 2016. In parallel the government launched a big offensive to reduce the size of the shadow economy and reduce grey payments of wages that grew into a revolutionary overhaul of the tax system starting in 2018 and led by Mikhail Mishustin, who was later appointed Prime Minister in 2020. Mishustin introduced a new and highly efficient tax IT system that put all records and payments online and stamped out the legion of tax scams such as the “fly by night” companies that would accumulate tax obligations but then declare bankruptcy the day before tax payments became due. In two years, Mishustin increased the government’s tax take by 20% while the tax burden only increased by 2% in the same period.

Banking sector clean up

Similar reforms to clean up the banking sector were launched in 2013 when Elvia Nabiullina took over as governor of the Central Bank of Russia (CBR). She began closing three banks a week and kept that up for about five years at the same time imposing stricter regulation and reporting requirements on the survivors. Nabiullina’s reforms came to a head in 2017 when she closed several of the so-called Garden Ring banks, some of the largest privately owned commercial banks in the sector, and almost sparked a major financial crisis in the process.

I turned out later that the Garden Ring Banks were compromised by cross ownership and guilty of milking their pension fund assets to fuel side investments in things like real estate. The CBR took most of them over as well as cleaning out the state-owned banking deposit insurance agency (DIA), which was also rife with corruption. From the major commercial banks, only Alfa Bank, owned by oligarch Mikhail Fridman survived the cull, which left the banking sector a lot healthier, more transparent, and well capitalised. The banking reform came to an end before the war in Ukraine started, allowing it to weather the shock the start of war caused and quickly recovered by the summer of 2022.

Plan K

Between 2014 and 2018 the reforms dealt with big and obvious issues such as rampant corruption in the regional administration and commercial banks, but starting in 2016 there was an effort to codify more fundamental root and branch reforms for the whole country.

That task was given to the former Finance Minister Alexey Kudrin, who’s claim to fame is to set up the National Reserve Fund that is now the National Welfare Fund (NWF), Russia’s rainy day fund to cover budget deficits in difficult years, and successfully ring fenced hundreds of billions of dollars from the avarice of corrupt Duma deputies.

Based on Putin’s May decrees, Kudrin worked out a comprehensive program, dubbed Plan K, that deal with some of Russia’s biggest social problems such as eradicating poverty and doubling the amount of affordable housing. It took another two years, but this plan was eventually enshrined in the 12 National Projects that were launched in 2019 and remain the government’s official reform programme.

It's tempting to believe that all these changes were part of Putin’s grand plan to confront the west over Ukraine’s fate and prepare Russia for the inevitable economic war that would start with the West.

Kudrin was sacked as Finance Minister in September 2011 after he objected to Putin’s order to divert the greater part of state spending from investment to modernising the military as Russia began to rearm to get ready for war.

The other piece of the puzzle is around the same time the CBR began to accumulate large amounts of foreign exchange into a cash pile that would eventually reach $600bn as well as pay down most of its external debt. Russia had a debt-to-GDP ratio of 12.4% in 2020, by far the lowest of any major economy in the world, which is expected to rise of 18.1% this year as a result of the war. Putin sanction-proofed the economy by building a Fiscal Fortress that was ready by 2021.

It was only then the Kremlin went on the offense, starting with Russian Foreign Minister Sergei Lavrov’s ““new rules of the game” speech in February 2020 when he told the West Russia would no long tolerate Western sanctions dished out with one hand and seeking big business deals taken with the other. That culminated with the massing of Russian troops on Ukraine’s border in the autumn of 2021 and a eight-point list of demands issued by Russian Ministry of Foreign Affairs in December that were the precursors to the current war.

New National Projects

The Kremlin is back at the drawing board to continue improving the health of the Russian economy by updating the 12 National Projects, during his state of the nation speech on February 21.

Budget reform: Putin proposed to extend the budget planning from the current three years to six to improve the long-term planning of the state finances. The current three-year planning period and the use of the so-called budget rule to siphon off excess oil and gas revenues to the National Welfare Fund (NWF) has been highly successful.

Progressive taxes: the first thing that Putin did on taking office in 2000 was introduce flat income (13%) and corporate (24%) taxes that brought some order to Yeltsin’s chaos and put the government’s funding back into the black. The Kremlin has been extremely reluctant to raise taxes, but now after more than two decades Putin is finally suggesting that the rich pay and big business carry a bigger share of the load and pay more taxes.

Industrial production: Putin called for the state and private companies to invest more into the production of key goods, that Russia should make for itself. He said that importing somethings was ok, but Russia should expand its production of things like consumer goods, pharmaceuticals, equipment, lathes and motor vehicles, as well as opening 100 new technology parks.

Capital markets: To pay for the investments, Putin set ambitious targets to expand the capital markets. Putin called for accelerated and simplified IPO for Russia’s high-tech companies and the capitalization of the capital market should double by 2030 to 66% of GDP, Putin added. He also called for more than doubling public and private investment in research and development to 2% of GDP by 2030.

Housing: A key element of the projects is the construction of new affordable housing, and during his speech Putin boasted that new residential construction had expanded by 1.5 times in 2023, beating all Soviet records. The government has been promoting the sector’s development with generous subsidised mortgages that have led to a boom in construction.

Family project: A program to support families with lots of children that also a disproportionally represented amongst Russia’s poorest families, as well encourage higher birth rates.

Long and Active Life project: A programme to extend life expectancy in Russia to at least 78 years by 2030, with ambitions to reach over 80 years in the future. Federal projects targeting major health concerns such as cardiovascular and oncological diseases, as well as diabetes are included in the plan.

Russia’s Youth project: A programme to nurture the younger generation's aspirations, successes and life values, which Putin said are crucial to the country's sovereignty and historical continuity.

Human Resources project: A programme that focuses on professional development, education, and training, aiming to equip Russia's growing younger generation with the skills needed for the 21st-century economy.

Data Economy project: With a budget of over RUB700bn ($7.6bn) for the next six years, this programme aims to integrate digital platforms across various social and economic sectors.

How much of this will be implemented. In the past Russia has been famous for having lots of good ideas, but always falling down on the implementation. The 1990s were marred by the chaos of the Yeltsin administration. In the noughties companies began to invest and focus on profitability, especially after oligarch Mikhail Khodorkovsky started a widely adopted fad of improving corporate governance.

The first serious systematic reforms like the changes to the banking sector and tax system only really began in the following decade, but the more general reforms enshrined in the National Projects have not been a success.

And Russia has some serious obstacle to overcome. While Russian are very good at things like tech – Russian internet giant Yandex is a world class company and still the most valuable the company in Europe even after its market capitalisation was halved after the war started – but on things like precision tools and electronics, Russia remains hopeless far behind the other advanced economies and heavily dependent on imports.

Progress has also been made on rooting out corruption and improving the rule of law, but Putin’s increasingly repressive political system works against more progress as people and companies remain vulnerable to the whims of the state.

As Ian Bremmer, the founder of the Eurasia Group, argued in his book The J curve, in the early stages of a country’s transformation the stability an authoritarian government brings allows for more rapid economic development as the president can simply order things to happen. However, despite the chaotic confusion and debate of democracies, the freedoms that comes with it allows for greater innovation and risk taking that ultimate leads to a higher level of prosperity that autocracies can’t achieve. What remains to be seen is where Russia lies on this curve.