Political reforme is an essential prerequisite to a flourishing economy
Oct 22nd 2016 – Economist
Just across the mighty Volga river from Sviyazhsk, an island fortress built by Ivan the Terrible in 1552 to help him conquer the Khanate of Kazan, stands a brand new city. It is the first to appear on Russia’s map since the fall of the Soviet Union. Innopolis, 820km (510 miles) due east of Moscow, was founded in 2012 as an IT park and a model for the sort of modernisation that Dmitry Medvedev, Russia’s prime minister and before that its president, had proclaimed a main priority. Now two years old, it is the smallest town in Russia, with the large ambition to launch the country into a high-tech era. Designed by Liu Thai Ker, the chief architect of Singapore, it has a university where 350 students are taught in English. Just half an hour’s drive away is Kazan, the capital of Tatarstan, an oil-rich republic that has recently adopted a new 15-year strategy to turn itself into a hub of creativity and growth. “We are competing not with Russian regions but with the world. Our new oil is human capital,” says Vladimir Gritskikh, a former physicist who co-ordinates the programme.
Innopolis has comfortable town houses, playgrounds with Wi-Fi and a large swimming pool. Igor Nosov, its manager, holds an American MBA. The city’s free economic zone is dominated by a circular office building for high-tech firms. There is just one thing in short supply: the firms themselves. So far the building has only about a dozen occupants. “Well, we’ve built a collective farm. Now we need the farmers,” quips one of the Tatar officials. Whether those farmers will come depends on a range of factors mostly outside Tatarstan’s control.
Technical modernisation has been one of Russia’s obsessions for centuries. At this year’s St Petersburg Economic Forum, Herman Gref, the chairman of Sberbank, Russia’s largest state bank, asked a short and simple question: “Can Russia compete?”
There was a difference between invention and innovation. Russian scientists and engineers invented the laser, electric light and hydraulic fracking, yet time and again the country failed to reap any economic benefit from its scientific brilliance. The reason, was not a lack of business talent but the adverse social, political and economic environment. Russia’s authorities build expensive innovation cities, but at the same time they prohibit demonstrations, suppress political opponents and independent businessmen, twist the legal system and create a regressive, authoritarian regime. They want the milk without the cow.
None of this was particularly new to Mr Gref. In 2000 the liberal economist, then aged 36, was picked by Mr Putin to draft a ten-year economic programme and lead reforms. “The centrepiece of the new social contract is the primacy of the citizen over the state,” Mr Gref wrote at the time. “The country has a unique chance provided by political stability, appetite for reform and rising oil prices to renew itself. Unless that chance is used, economic regression is inevitable, threatening not only social stability but the existence of Russia as a state.” Mr Putin signed off on Mr Gref’s plan and hired Andrei Illarionov, a determinedly libertarian economist, as his adviser.
During the first eight years of Mr Putin’s reign the economy grew by an impressive average of 7%, kickstarted by a 70% rouble devaluation in 1998. As state finances and economic rules became more stable, the market reforms of the 1990s began to have an impact. From the mid-2000s soaring oil prices stimulated further growth, mainly in the services and construction sectors, but also fuelled imports, and the economy started to overheat. When the financial crisis hit in 2008, the Russian economy crashed, contracting by 10% from the peak of 2008 to the trough of 2009.
The subsequent recovery was driven by higher government spending that propped up consumption. Between 2010 and 2014 the economy grew by only 3% a year, even though revenues from oil exports were 70% higher than during the oil boom of 2004-08. Russia used its abundance of natural resources to create a corporatist state that suppressed competition. Between 2005 and 2015 the share of the state in the economy doubled, from 35% to 70%.
Now the economy is in recession. Last year GDP shrank by 3.7% and real disposable income fell by 10%. Investment in fixed assets declined by 37% over the past four years, with the steepest fall coming after Russia’s attack on Ukraine in 2014.
The people running the economy are competent, well-educated technocrats (such as the head of the central bank, Elvira Nabiulina). But there are limits to what they can achieve. A depreciation of the rouble against the dollar of almost 50% since the start of 2014 has failed to rekindle economic growth, partly because Russian producers in the past preferred to import parts and materials rather than invest in domestic capacity. Those intermediate imports have now become unaffordable.
The slump in the oil price and Western sanctions have exacerbated the problems, but they did not cause them. Growth started to slow down in 2012 and 2013 when the oil price was still high and before the invasion of Ukraine. The root causes are that Russia’s market is not free, and the rules are opaque and enforced inconsistently. As an upper-middle-income country, it can develop only if its economy is integrated with the rest of the world. Its confrontations with the West and the activities of its security services make it an unenticing target for investment. “The investment climate matters in an open market economy. A state economy does not need an investment climate; it needs security services,” jokes Sergei Belyakov, a former deputy economics minister. Russian businessmen have stopped investing in their own country mainly because they see no future.
Property and power
When the Soviet Union collapsed, many people hoped that once liberated from communist ideology and enjoying a free market, Russia would be able to make good use of its immense natural and intellectual resources. But the market alone could not solve Russia’s fundamental problem: the close nexus between political power and property. A market by itself does not answer the key question of who is supposed to benefit from the results of economic production; it can serve different social structures. Everything depends on the distribution of property and political power. Yet although the 1991 revolution overturned the political and economic system and led to the sale of state assets, it did not sufficiently separate political power and property.
Part of the problem was the type of economy modern Russia had inherited from the Soviet days. Stalin’s crash industrialisation and urbanisation was designed to create a militarised autarky with a total disregard for cost, financial or human. Factories were built in cold and inaccessible places, using forced labour. The output of those factories was often worth less than the input in energy and materials. After Stalin’s death they were kept going by oil and gas money. The factory managers, known as “red directors”, travelled to Moscow to haggle with the relevant ministries for resources. They employed millions of people and had enormous lobbying power. When the Soviet Union collapsed, the only way to keep them quiet was to sell them their factories, which meant that much of industry remained in the hands of the old elite. This was a price worth paying to prevent civil conflict.
Yet many of these companies could survive only if their energy and transport costs were subsidised. For example, Yukos, once Russia’s largest oil firm, was forced to sell 70% of its oil in the domestic market, yet since its buyers could not afford to pay an open-market price, they accumulated huge debts that in the end had to be written off.
But whereas Gaidar’s government in 1992 had to act urgently to stop the country from falling apart, Mr Putin had no such excuse. When he first took over, oil prices were rising and there was broad political support for reforms. Mr Putin did not merely fail to dismantle the Soviet structure; he used Russia’s windfalls to reinforce it in order to preserve social stability and votes. It was always unrealistic to think that after the fall of the Soviet Union Russia would be able to build institutions overnight. Russia had been subjected to totalitarian rule for so long that it had no memory of life before it. In Russia, as in many other countries, access to valuable rights, economic activities and resources is determined by privilege enforced by the political and military elites. This system, called a “limited-access order”, relies on the ability of the elites to control rents, be it from land, raw materials or jobs for cronies. Its main objective is to preserve stability and prevent uncontrolled violence by giving those elites access to streams of rent. But that state monopoly on rent and violence collapsed with the Soviet Union.
In the mid-1990s control over natural-resource firms passed to the oligarchs, a powerful group of business tycoons who emerged from the rubble of the Soviet Union. Their power rested not so much on violence but on entrepreneurship, which allowed them to accumulate capital. But they also cultivated personal connections with the liberals in the government to gain privileged access to the most valuable assets.
In 1995 they struck an audacious deal, offering to lend money to the cash-strapped government and put their resources, including the media they controlled, behind an ailing Yeltsin. In return, they asked to manage the government’s shares in natural-resource firms. When Yeltsin was re-elected in 1996, they were allowed to auction off those shares to themselves. This “loans for shares” privatisation undermined the legitimacy of Russian capitalism and compromised the idea of property rights.
To protect their assets, the oligarchs had to ensure the continuity of the regime. In 1999, as Yeltsin prepared to step down, Boris Berezovsky, the ultimate oligarch, who had worked himself into the president’s family, proposed Mr Putin as Yeltsin’s successor. According to Berezovsky, Mr Putin had originally wanted to be chairman of Gazprom, Russia’s natural-gas behemoth, but instead he was offered the job of running Russia Inc.
Mr Putin was shaped mainly by two experiences. One was his service in the KGB, which made him a statist. The other was his time in St Petersburg, where he served as deputy mayor in the early 1990s, dabbling in business. That turned him into a capitalist, but of a particular kind. Capitalism to him meant not free competition but connections, special access and, above all, deals. As Fiona Hill and Clifford Gaddy wrote in their book, “Mr Putin: Operative in the Kremlin”, “Capitalism, in Putin’s understanding, is not production, management and marketing. It is wheeling and dealing. It is not about workers and customers. It is about personal connections with regulators. It is finding and using loopholes in the law, or creating loopholes.” Mr Putin did not destroy the oligarchy but merely changed the oligarchs, creating much closer links between property and political power. He wanted to control the market, transferring its benefits to the people he trusted—friends from St Petersburg and former KGB colleagues.
But whereas the oligarchs in the 1990s were ruthless self-made businessmen driven by profit, the men Mr Putin brought to power were specialists in suppression, violence and control, driven by revenge. The siloviki, people with roots in the KGB and other powerful ministries, had no special business skills, but quickly took over the commanding heights of the economy, capitalising on popular discontent with the oligarchs and using their licence to exert violence to amass property. In 2003 they jailed Mr Khodorkovsky, the most independent and politically ambitious of the oligarchs. A year later Yukos, his oil company, was dismembered and its assets taken over by Rosneft, a state oil firm chaired by Igor Sechin, one of Mr Putin’s most trusted lieutenants and an informal leader of the siloviki.
During the years when the oil-price boom fuelled domestic consumption, the new elite not only came to control the distribution of rent, it also limited access to the market in order to reduce competition, developing a system described as “soft legal constraints”. It involves writing the rules in such a way that to observe them is either prohibitively expensive or downright impossible, then handing out informal licences to break those rules.
Licence to offend
Just as in the Soviet era red directors haggled for resources, market participants now haggle for the right to break the rules, so the system gives the security services ultimate economic and political control. The licence can be withdrawn at any time if its holder steps out of line or gets too greedy, or if his assets start to look too attractive.
The story of Igor Pushkarev, a former mayor of Vladivostok, illustrates the point. In the early 2000s Mr Pushkarev, the owner of a large cement firm in Russia’s far east that got a lot of orders from the government, joined Mr Putin’s United Russia party, and in 2008 he was elected mayor of the city. Earlier this year he challenged Vladimir Miklushevsky, the regional governor, in the party primaries. Mr Miklushevsky went to see Mr Putin, and the next day Mr Pushkarev was arrested for “abuse of office”. The FSB started to expropriate his assets straight away.
Such lack of clear property rights creates distrust at all levels of Russian society, heightens the role of the security services and raises transaction costs. Every other Russian shop or restaurant employs security guards. While the economy was growing, there were plenty of profits to spread around and keep everyone happy, but now that it is shrinking, the rules have become even less clear and the fight for resources has turned more brutal. Property can be taken away regardless of political loyalty, turning owners into temporary holders.
Take Vladimir Yevtushenkov, the owner of Sistema, a holding company, who is perfectly loyal to the Kremlin. In 2009 Sistema bought a controlling stake in Bashneft, a medium-sized oil firm, from a local authority for $2.5 billion. It had been given explicit approval by Dmitry Medvedev, who was president at the time. But in September 2014 Mr Yevtushenkov was arrested and charged with buying stolen goods. His real crime was reportedly to refuse to sell Bashneft, which had become one of the world’s fastest-growing oil firms, to Rosneft, at a price below its market value. After three months under house arrest, Mr Yevtushenkov was released and cleared of all charges—but not before giving up Bashneft, a contolling stake in which has now been sold to Rosneft for $5.2 billion. The day after he was released, Mr Yevtushenkov (who still owns MTS, Russia’s largest mobile-phone company) went to a drinks party at the Kremlin and spoke to Mr Putin. “I thanked him for his wise decision…to release me,” Mr Yevtushenkov recently told Dozhd, an independent internet television channel. He continued: “If [you] like any of my other companies—[you are] welcome.”
Corruption Perception Index 2015 – Ranking out of 168, 1 = least corrupt
Denmark = 1
Britain = 10
United States = 16
Georgia = 48
China = 83
Azerbaijan, Russia = 119
Kazakhstan = 123
Ukraine = 130
Faced with prolonged economic stagnation, the Kremlin is now trying to stimulate growth by pouring money into the military-industrial sector and into infrastructure projects. Given the level of corruption, though, the cost of these projects could outweigh their benefits. And in the absence of a thriving private sector, those new roads and bridges may not do much good.
The main problem with Russian modernisation, says Mr Rogov, is that the new, competitive urban middle class that has emerged as the economy has developed has no place in the current authoritarian model, which is designed for those who depend on the state but cannot compete.
The prospects for change are not encouraging. Limited-access orders have been in operation for thousands of years: No forces inherent in the logic, social structure or historical dynamics of limited-access orders inevitably lead them to become open-access orders. Because natural states have internal forces built on exclusion and rent-creation, they are stable orders…extremely difficult to transform. Technology does not help because the elites can adopt it selectively, without having to face competition.
One of the biggest risks for Russia is not an implosion but a slow economic and intellectual degradation. As long a Russia’s elite sees modernisation as a matter of technology rather than of open access based on the rule of law, Innopolis is likely to remain the smallest town in Russia.