Source: Carnegie
The Russian economy has at long last make a decisive turn upwards. After a decade of decline, gross domestic product increased by 3.2 percent last year, and it is rose by an annualized 8 percent in the last quarter last year and first quarter this year. The numbers are clear enough, but everybody has become so pessimistic about Russia that nobody faces up to the positive facts any longer.
The conventional wisdom is that the Russian industrial growth is only an effect of high oil prices and import substitution, facilitated by a great devaluation. But this makes little sense. Growth is not declining but gaining momentum, and a dynamism on this scale just not stop with anything less than a major shock.
Oil and gas have not led the recovery. On the contrary, oil production is stagnant. Major industries with 16-22 percent growth were chemicals, light manufacturing, pulp and paper and machine building, that is, intermediary goods and simple manufacturing, exactly the kind of industries we would like to see expanding at this stage. Within each industry, the best enterprises dash ahead, as should be the case when real restructuring is taking place.
Another worn-out argument is that the growth is superficial and not generated by investment. However, recovery in transition economies is usually export led, as was the case in Russia last year. Investments tend to follow recovery, as there is so much underutilized capital around. Russia surprises, as its investment in fixed assets rose by a stunning 13 percent during the first four months this year over the same period last year. It is swiftly gaining momentum.
For unclear reasons, everybody seems to worry about Russia's abundant tax collection. The issue has rather been excessive expenditures, but last the government put its finances in order by cutting wasteful and corrupt expenditures, such as enterprise subsidies, and the total government budget deficit stopped at 1.7 percent of GDP. So far this year, the budget has been in surplus.
A more significant concern was that the state revenues stopped with the regional governments, while the foreign debt service was held by the federal government. However, total federal revenues have risen from 11 percent of GDP in 1998 to over 18 percent of GDP so far this year. This also shows that central state power in Russia is alive and much stronger than most have believed.
Therefore, the foreign balance is no longer worrisome. Russia had staggering trade surplus of $33 billion this year and it is likely to surge over $40 billion this year. Consequently, Russia's international reserves have grown sharply by $1.5-2 billion a month during the last few months.
Last fall, the world was treated with a bizarre campaign of poor journalism around the Bank of New York, involving alleged money laundering of $7 billion. In the end, the only problem was that a few people had organized bank transfers privately without having bank license. The actual problem is that Russia as many emerging market economies has a poor bank system and tax system, but fortunately Russia has such a liberal currency regulation that Russian enterprises and individuals can keep their money in good international banks instead.
Last year, Russia had an accumulation of 25 percent of GDP, while the investment ratio was only 16 percent of GDP. The balance amounts to capital flight and foreign debt service. If half of the balance stayed in Russia, the country would have enough capital fro a growth rate of 8 percent a year.
Russia's new-found growth is spreading to other countries in the region. The long stagnant Ukraine and Kazakhstan recorded similar high growth rates during the first quarter this year. The previous vicious circle of decline in the former Soviet Union might actually be turning to a virtuous circle of growth.
No, something fundamental has changed in Russia. Whatever you talk about, Russians draw a clear line in time - before or after August 1998. It was a horrendous shock, imposing great social costs, but it changed the whole mentality, not only the exchange rate. A time comes when all disasters have occurred and all stupidities have been done. For Russia, August 1998 marked that line. It is reflected in changed behavior in the economy, changed economic interests and a new politics.
The financial crash was caused by several factors. The fundamental problem was a large budget deficit and large public expenditures. A group of World Bank economists have estimated total enterprise subsidies in Russia to no less than 16 percent of GDP in 1998, of which two thirds were extracted through barter and arrears. That was the reason why barter and arrears had grown for years in spite of stabilization.
After the crisis, the government had little choice but to cut the fiscal deficit, because there was no financing available any longer. At long last, the government and enterprises were forced to face up to a reasonably hard budget constraints. People and enterprises no longer dared to indulged in uncertain schemes to extract subsidies of which much less was available, so they fled to the safety of cash. Since August 1998, all kinds of arrears have fallen by three-quarters in real terms and barter almost by half, which has prompted a rapid monetization.
In 1997, Russia obtained no less than $46 billion in foreign portfolio investment. Most of it went into government bonds to finance the budget deficit. Because of Russia's default, all kinds of international credits have dried up, which has helped reinforce the credibility of the hard budget constraint.
One reflection of the hardening budget constraint was that almost 10,000 loss-making Russian enterprises were put into bankruptcy in 1999. Russian enterprises and they realized that they had to make money and started selling off assets that they did not use. Today, we see all the structural changes that we had hoped for much earlier, and Russia seems finally to get some return from the very substantial structural reforms it has actually undertaken.
Another fortunate consequence of the financial crash is that several of the most parasitical oligarchs have lost out, and their names are already forgotten. Also those who have survived have changed their policies. Until the crash, Lukoil and Yukos were against product-sharing agreements, because they did not think they needed the help of foreign investors to develop Russian oil fields. Since August 1998, they favor PSA because they realize their limitations. The financial crash seems to have been the beginning of the end of the oligarchic era.
Instead, a new group of Russian businessmen, who are mainly manufacturers, are coming to the fore. They produce for the market. Their increasing strength is a reflection of the economic growth, which promotes production for the market rather than sheer redistribution of resources, implying a new sort of politics. Russia is moving from the politics of rent-seeking redistribution to the politics of growth.
Last October, McKinsey Global Institute published a major empirical report of Russian industry. Its conclusion was that Russia had the real and human capital with a potential of a growth rate of 8 percent a year, and that its problem was primarily a distortional tax system, a poorly functioning government, involving large subsidies to inefficient companies, and the absence of a land market. However, neither the bank system nor the legal system were actually impediments at this stage of development.
These new businessmen are loudly demanding exactly these three reforms. Mr. Putin is no great thinker or reformer, but he is an astute and genuinely popular politician. As only the second politician in Russia after Boris Yeltsin, he has won a popular majority of 53 percent in a reasonably free and fair national election. In particular, he won in 84 out of 89 regions in Russia, proving that he is sensitive to Russian public opinion. Admittedly, the war in Chechnya was one of the levers with which he won his victory, but the greater confidence in the Russian economy was another factor behind his success. He is likely to surf on the current wave of economic growth and undertake the most needed reforms.
There is a broad consensus about the need for government reform, to clean up the state administration, and a liberal tax reform. The reform center led by Herman Gref shall be seen in this context. In a first stage, anybody was invited to participate to catch the consensus, but the discussions lacked focus. When it came down to writing a concrete reform program, Putin and Gref turned to a score of Moscow's experienced, but still young, liberal economists. In the course of two months, they have elaborated the most substantial reform program Russia has seen.
This program differs in many ways from previous programs. The first feature is that no program since the 500-day program of 1990 has caused such a popular stir. There is a sense that this is a program that can actually change something. One obvious reason is that the Gref Program appears to be the program of the new president, though Putin is ambiguous about the program's actual status. Gref has just been appointed Minister of Economic Development, and another leading Petersburg liberal, Alexei Kudrin, has become Deputy Prime Minister and Minister of Finance. Several members of the Gref group are being appointed deputy ministries in these two ministries.
Another reason for the excitement around this program is that it comes at a time of new economic growth, breeding hope for a better future. It also represents a new economic thinking of radical common sense. For the last few years, many of the Russian liberal economists have been more interested in secondary technicalities of the tax system and financial markets than in fundamental problems, such as elementary deregulation. Now, they have caught up with reality and focus on the basic flaws of the Russian market economy, over-extended, intrusive government and an arbitrary tax system.
At the same time, the left has abandoned its most unrealistic ideas. Today, the communists only insist on some more state enterprises and more state financing. In the fall of 1999, the Russian communists finally abandoned their ideas of a planned economy and opted for a regulated market economy in an almost social democratic vein. They do accept liberal tax reforms and far-reaching social reforms, though not private ownership of land. The Gref group presented their program to the communist faction in the Duma and won approval. Both the right and the left have come to their senses and settled for a normal market economy.
While the early Russian reform programs were avantgarde, the Gref program is elaborating a reform consensus. Its different proposals are discussed with the relevant government agency and the Prime Minister and are approved after some compromises. In parallel, the Gref group presents and seeks approval for its proposals from the chairmen of the relevant Duma committees. In this process, many leading politicians have already committed themselves to far-reaching reforms. This is the reason why the program has not been officially published as yet.
The two parts of the Gref program that seems to interest President Putin the most are government reform and reform of the courts of justice. His proposal for reigning in corrupt regional governors has already been presented to the Duma and gone through a first reading. The details will surely be altered, but the essence is to impose federal law on the land.
The government itself is undergoing a major reorganization. In particular, some of the most Soviet-like ministries, the Ministry for External Economic Relations and the Ministry for Relations with CIS countries, have been folded into Gref's new reform ministry. One immediate consequence is a change and coordination of Russia's foreign trade policy. The long-neglected goal of joining the WTO has risen on the political agenda.
The government has proposed a radical reinforcement of the courts of justice. The salaries of the judges will be doubled in a year, and the whole court system will double in five years.
For years, Russia has had a progressive personal income tax of maximum 35 percent, which has collected just over one percent of GDP, while Estonia has a flat income tax of 26 percent which collects 8 percent of GDP. This progressive income tax has never made sense, but now all of a sudden everybody seems to agree that a flat tax of 13 percent makes perfect sense. The government has already put such a proposal to the Duma, and it is likely to go through. The payroll tax will also be reduced by four percentage units to 35 percent, though that is still far too high. A couple of cumbersome turnover taxes will be abolished. With its current high tax revenues, Russia needs to undertake a swift tax reform.
Both the power utility UES and the Railway Ministry have proposed radical market reforms to created real markets, and their cash collection has risen sharply. The odd man out is the natural gas monopoly Gazprom which continues as the last Soviet enterprise. Curiously, much of its sales to CIS countries go to a company called Itera, which is obviously controlled by Gazprom management but it is utterly non-transparent. In effect, the Gazprom managers are exporting gas to themselves. When Itera does not pay Gazprom, they blame the importing country, and press for debt-equity-swaps for what Itera has not paid them. This might be the biggest remaining corporate governance scandal in Russia.
The Gref group has made standard proposals for bank reform, but Viktor Gerashchenko, the Soviet Chairman of the Central Bank of Russia has condemned them. Without the sale of the five foreign banks owned by the Central Bank and an audit of Sberbank, the IMF will not conclude a new agreement with Russia, but Gerashchenko is dead against these measures for unclear reasons. Today Gerashchenko sees the only serious impediment to a new IMF program, but as long as he is in office no agreement is likely.
Logically, this should be enough to lead to his ouster. Without an IMF agreement, Russia cannot get a Paris Club agreement and it cannot issue new Eurobonds. Recently, a public dispute has erupted between Gerashchenko and Prime Minister Kasyanov over the exchange rate. Kasyanov, as well as Putin, wants a reasonably low real exchange rate to keep Russian exports competitive, while Gerashchenko wants a higher rate. This might be a more serious threat to Gerashchenko, who looks ever more anachronistic and aggressive, but he is a supreme survivor.
Another weak point in the Gref program is land reform, which is still not accepted by the communists and many others in the Duma, and a swift resolution of these conflicts appear unlikely.
In view of all these splendid indicators of economic progress and reform, the appointment of President Putin's first government came as a cold shower. Three groups dominated in the struggle over the government. The first was a group of self-interested businessmen, headed by the oil trader and Sibneft owner Roman Abramovich, Yeltsin's old chief of staff Alexander Voloshin and Putin's new Prime Minister Mikhail Kasyanov. The shock was that this group seemed to dictate the appointment of the government, putting their people on posts controlling the most money, apart from the Ministry of Finance. The second group was KGB colleagues of Putin from St. Petersburg and the third was reformers from St. Petersburg. Both fared very badly because they got caught in vicious fighting, apparently allowing the Abramovich-Voloshin-Kasyanov group a free grab.
The immediate question is whether the Gref program can be implemented, when members of the group are so poorly represented in the government. Kasyanov has publicly dismissed the program as irrelevant, but in real life he is highly cooperative in the process. His public statements seem rather meant to denigrate the members of the group than their policies. As the program has been elaborated, it has already advanced beyond the group. Both Voloshin and Kasyanov clearly favor market competition and they are highly competent, though they do not necessarily like full transparency. While the Russian government is not being cleansed from corrupt practices, they are likely to be reigned in and less harmful to economic growth in the future.
Tycoon Boris Berezovsky's recent criticism of Putin's new policies is a reassuring sign that Berezovsky, whose approach to government is truly parasitical, is losing out. In the past, Berezovsky preferred compromises with the communists, when they still wanted to regulate everything.
It is clearly disappointing that Putin has not stood up more for good governance in the formation of his government, but Putin's intentions are not clear as yet, and he is a tight-lipped general. Yet, it is inconceivable that such an ambitious and strong politician would allow himself to be perceived as subordinate to the Abramovich-Voloshin-Kasyanov group. The natural conclusion is that Putin did not feel ready to take them on as yet, but that he will do so with one or several of them in the not-too-distant future.
The other great worry of Moscow liberals is that the situation is simply too good for serious reforms. The lesson they have learned is that reforms are only possible in a crisis and they fear that the crisis of August 1998 has already been forgotten. It is possible but I doubt it. August 1998 really brought a severe shock. We have seen many other countries that have found themselves suddenly and unexpectedly after a serious crisis. For instance, Poland saw a financial melt-down both in 1981 and 1989, but it was only in 1989 when the country was ready to move. Russia appears to be in a similar situation.
From this perspective, the currently highly oil prices are not a blessing but a danger. There is a risk that Russia will face an excessive inflow of foreign portfolio investment again, as in 1997. A big capital inflow would drive up the real exchange rate prematurely. Fortunately, the bond markets are dead, and it might take a year to revive them. Their absence makes it difficult to invest too large amounts of money in Russian securities.
World Link, July/August 2000, pp. 49, 51, 53-54.