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Friday, December 08, 2006

Aslund Exposes Russia's Sham Economy

Writing in the Moscow Times Anders Aslund, senior fellow at the Peterson Institute for International Economics, exposes the fundamental hollowness and failure of the Putin economy.

In 1999, the McKinsey Global Institute published a report titled "Unlocking Economic Growth in Russia." Startlingly, the report suggested that the economy could grow by 8 percent per year for the foreseeable future without any changes to current economic policy. The report identified three factors underlying the growth projections. First of all, Russia had achieved a critical mass of market-based activity, private enterprise and financial stabilization. Second, physical and human capital were both abundant. Finally, moderated investment rates would be sufficient for high growth.

The institute was concerned, however, that too much production took place at obsolete plants, which it said had to be closed so that activity could be concentrated in the most modern factories. This report appeared long before anybody even imagined the current oil boom.

From this perspective, Russia's real average economic growth of 6.8 percent per year since 1999 does not look as impressive. Russia has also underperformed in relation to the other former Soviet republics, which have grown by an (unweighted) average of nearly 9 percent per year over the last three years. The stars have been the Baltic states, Armenia, Azerbaijan and Kazakhstan. All of these, with the exception of Azerbaijan, have undertaken more extensive structural reforms than Russia.

Many things have worked out well in the Russian economy since the financial crash of August 1998. In hindsight, the crash looks like the catharsis Russia needed to become a full-fledged market economy. It broke the protracted resistance from old-style managers and the Communists against reforms. It showed that only a full-fledged market economy made sense.

Ever since, Russia's macroeconomic performance has been stellar. Budget and current account surpluses have skyrocketed with world oil prices. The oligarchs have rationalized and revived old Soviet industries. For instance, they have concentrated steel production in the most efficient plants, just as the McKinsey report advised. Capital investment has grown at a reasonable clip of about 10 percent per year. Significant structural reforms were undertaken from 2000 to 2002, notably tax reforms and the adoption of the Civil Code.

The current economic growth erupted in 1999, before President Vladimir Putin came to power, and originated in the reforms carried out under President Boris Yeltsin in the 1990s. By 1999, they had reached a critical mass. Putin is not the creator but the beneficiary of the economic growth. The driver of the economic growth has been the private sector, but Putin is endangering that growth through his renationalization campaign. According to the European Bank for Reconstruction and Development, the private sector generated 70 percent of gross domestic product in 2004 but only 65 percent in 2005. And renationalization continues.

Putin is widely credited with the introduction of law and order in Russia, but where is it? Expenditures on law enforcement have increased significantly but have not produced significant results. According to official statistics, during Putin's first five years in power, Russia recorded an annual average of 32,200 homicides, compared to an average of 30,200 homicides during Yeltsin's last five years in the Kremlin. The public perception of social stability is merely the result of successful propaganda.

Initially, Putin's judicial reform appeared impressive, but it amounts to little more than a transfer of judicial power from regional executive bodies to the presidential administration. According to Transparency International, corruption in Russia declined at the beginning of the decade, as in most of the region, but has bucked the regional trend by increasing considerably since 2004.

Russia's oil surplus is so huge that it can hide many flaws in economic policy. Most striking, GDP in current dollars has increased almost five-fold over the past seven years, to some $960 billion this year from barely $200 billion in 1999. Russia is now the 10th-largest economy in the world, measured by GDP in current dollars, ranking just behind Spain. Barring a major disaster, Russia will become the world's fifth-biggest economy within the next two decades.

At present, the oil surplus is driving economic growth, which is being generated mainly by the consumer sector, retail trade and housing construction, while industrial output has increased by just 4 percent per year over the last two years. That these are the conditions underlying growth does not bode well.

Ironically, Russia's least dynamic sector is energy production. In 2003, oil production skyrocketed by 11 percent, thanks largely to private ownership and investment. But the confiscation of assets from Yukos led to the renationalization and disorganization of almost half the oil industry. The new state owners are less effective as managers and direct more of their efforts to purchasing further assets than developing those they already control. The remaining private oil companies are rightly afraid of investing or boosting production too much. As a consequence, oil production may rise by only 2 percent this year and stagnate in the future.

Some people do not handle luck well and end up succumbing to hubris, as is the case with Russia's current leaders. By and large structural reforms ended in 2003, even if continued restructuring of some enterprises is driving some isolated reform, as is the case in the electricity sector. Despite declining official enthusiasm, Russia is approaching WTO accession. Yet, beside what has been responsible macroeconomic policy, the overarching actual economic policy today is that of renationalization.

The evident cause of this economic policy is the oil bonanza. Former Prime Minister Yegor Gaidar and the economists Clifford Gaddy and Barry Ickes have all discussed Russian economic policy as a product of the oil curse. They compare current policy to that of Soviet times. The oil riches of the 1970s led to the Brezhnev petrification, and even contributed to the foolhardy war in Afghanistan, while economic growth was closely correlated with international oil prices. Economics was ignored to the point that investment in the vital oil and gas sector was badly neglected in just the same way that it is today. When the oil prices finally fell in the 1980s, the Soviet economy collapsed.

The situation is much better today. The leadership has learned the importance of macroeconomic stability and is focused on growth. Fortunately, private enterprise dominates, but wherever the public sector prevails problems amass -- in gas and oil production, banking, the aircraft and automotive industries and a large part of public transportation, health care, education and law enforcement. The longer oil prices remain high, the worse economic policy will become. The medium-term economic cost might not be high, but the long-term cost will be. Booms breed complacency and corruption.

Oil does not have to be such a curse. Kazakhstan's economy is even more dominated by oil but, unlike Russia, Kazakhstan steadily increases its oil production by developing new fields. It does so successfully because a multitude of foreign and private oil companies operate there. Kazakhstan is ahead of Russia in banking, labor market, pension and government reform, as well as scholarships abroad. And its growth rate has been at almost 10 percent per year for the last seven years.

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