17 August 2003 00:17
Back from the brink
When Russia defaulted on its government debt and the rouble started declining in August 1998, Vladimir Karnayukhov,
general director of Sedmoi Kontinent, an upmarket supermarket chain in Moscow, felt the pain. He lost money as he held
prices at their previous levels for the first few days; and he lost clients in the subsequent weeks as the city's
fledgling middle class was crushed by wage cuts and job losses. "It was a cataclysm that could have been
avoided," he recalls.
Five years later, his company is one of many that still survive. The original six city-centre stores will have
expanded to 50 throughout the Moscow region by the end of this year with a tenfold increase in annual sales to more than
$1bn (GBP624m). And in a striking example of the successful transformation of the Russian food industry, the proportion
of domestic goods on Sedmoi's shelves has risen from a tenth to more than two-thirds.
Russia has experienced unprecedented growth since 1998, confounding forecasts of economic collapse. Fuelled by
exports of oil, gas and minerals, gross domestic product will, by the year-end, have expanded by more than 30 per cent
since 1998, including a forecast 6 per cent increase for 2003 - the fastest growth since before the first world war. A
near-bankrupt country has been transformed into one with international reserves exceeding $60bn.
While western leaders are struggling with the global slowdown, president Vladimir Putin holds his head high on the
world economic stage. Meanwhile, Russia's richest businessmen have made headlines, donating money to Oxford
University and the Guggenheim Museum and buying everything from villas on the French Riviera to Chelsea football
club.
"Russia is on course in the international landscape," says Alexei Kudrin, finance minister, who predicts
that the country should join both the Organisation of Economic Co-operation and Development and the World Trade
Organisation by 2006, when it is due to host the G8 summit for the first time.
But behind the huge economic achievements of the past five years lie difficulties of equal size. Despite more than a
decade of post-Communist reform, Russia's bureaucracy retains great power. Corruption is widespread, as is fear of
the arbitrary acts of state officials.
There is a startling disparity between big-spending central Moscow and scores of impoverished provincial cities and
towns, including many in Siberia's frozen wastes. A dozen rich businessmen control about half the economy, mainly
through their stakes in oil, gas and metals companies. Alongside these influential "oligarchs", most of whom
made their fortunes grabbing control of former state assets, are 40m poor, many of them racked by alcohol abuse, drugs
and disease.
Despite a recent increase in the birth rate, inspired perhaps by economic confidence, the 145m-strong population is
falling by 600,000 a year. Even with the boost of the past five years, GDP is only 70 per cent of the levels of Soviet
times.
The fundamental questions facing Russia are whether the gains since 1998 can survive a sustained decline in
hydrocarbon prices and whether the profits from the extraction of natural resources can be spread more evenly through
society.
The answers depend very much on Mr Putin's ability to promote further market-oriented reforms to encourage
entrepreneurship outside the extractive industries, while at the same time curbing the influence of both the state
bureaucracy and the oligarchs. It is a big challenge, as straightforward liberalisation may simply create more
opportunities for those who are already very rich. But without some sort of liberalisation, the economic growth could be
stifled. Willem Buiter, chief economist at the European Bank for Reconstruction and Development, says: "Without
serious changes, growth will peter out. In fact, I'm surprised it isn't happening already."
At least Russia has won time to deal with its problems. The atmosphere is very different from the crisis of August
1998, when the government defaulted on its domestic bonds, the rouble went into free fall, Russian banks went bankrupt
and financial markets trembled around the world. The International Monetary Fund feared for the future of its largest
borrower.
Today, Russia has sharply cut its debts to the IMF, paying back faster than scheduled. And the big losers of the 1998
crisis turned out to be the foreign fund managers that had been playing the Moscow markets, and millions of ordinary
Russians who saw their savings disappear as their banks collapsed. The oligarchs were also weakened, but they ruthlessly
removed capital from the banks they owned, and were able to shift their attention to crisis-proof assets - principally
oil and gas exporters.
The role of oil and gas in Russia has grown rapidly, with a strong increase in output and a huge rise in prices -
from an average of below $15 a barrel in 1998-99 to more than $27 in the following years. Last year the hydrocarbon
industry accounted for 15 per cent of GDP, 55 per cent of exports and nearly half of government revenues.
Unlike some other oil-exporting states which have wasted this windfall, Russia has made good use of the extra
revenues. Under Mr Putin, who took over in 2000 from Boris Yeltsin, his unpredictable predecessor, capital flight has
fallen. And oil and gas export revenues have gone to bolstering foreign exchange reserves, cutting foreign debt,
supporting annual surpluses on the federal budget and investment in modernising the hydrocarbons industry.
The four-fold devaluation of the rouble in 1998 spurred growth beyond the energy sector by stimulating local
production of everything from food to cars. A host of companies has sprung up, such as Wimm Bill Dann, the juice and
dairy processor, as well as small shops, restaurants and construction companies.
With the economy running in his favour, Mr Putin has been able to create an atmosphere of predictability. Political
opponents have been marginalised, including the once-strong Communist party. Moreover, Mr Putin is widely expected to be
re-elected next year and his supporters are expected to do well in the Duma elections this December.
The Kremlin remains a place for in-fighting and intrigue among its factions, including a group of ex-KGB men promoted
by Mr Putin, himself a former officer. Their influence may be behind the recent investigation of executives of the giant
Yukos oil group over offences linked to privatisations of the early 1990s. It represents a continuation of the arbitrary
decision-making reminiscent of the Yeltsin era.
Meanwhile, Mr Putin has pushed ahead with reforms designed to stabilise both the government finances and the economy,
notably a 13 per cent flat income tax rate, simplified corporate taxes, efforts to cut red tape, and new
business-friendly customs, labour and land codes. Also, he has tried to exert authority over wayward local governors in
an effort to re-assert the Kremlin's authority and make official decision-making more consistent.
The corporate sector has matched the president in pursuing reform, by paying more taxes, hiring outside advisers and
experts, appointing independent directors, and improving transparency through audited financial statements presented in
accordance with international accounting standards. Ironically, Yukos - just three years ago seen as a pariah by
investors for its roughshod treatment of minority shareholders - was in the forefront of such evolutions. "We
started to be inspired by the effect that the changes had in the valuation of Yukos," says a rival businessman.
In a very significant shift, the outflow of private capital which reached $30bn a year in Mr Yeltsin's day, has
declined rapidly and may have turned to a small inflow in the second quarter of this year. The effects are visible in
soaring prices in the Moscow property and stock markets, though the recent investigations into Yukos have alarmed some
investors.
Western bankers and international investors are also once again looking at Russia. And BP, the oil major, this year
announced a $6.75bn investment in a joint venture with TNK, in part owned by the diversified Russian industrial group
that also controls Alfa Bank.
But much remains to be done if Russia is fully to modernise its economy, create well-balanced, sustainable growth and
satisfy Mr Putin's hopes of doubling national income by 2010. The clearest sign of weakness is in consistently low
investment figures. After a surge in 2000-01, gross fixed capital investment in Russia last year fell to just 2.6 per
cent and will struggle to exceed 5 per cent this year, according to economic forecasts.
Foreign investment remains very low despite multi-billion-dollar projects. According to the EBRD, last year's
net total was zero. The average for 1989-2002 was just $50 a person, or 5 per cent of Poland's.
The biggest contribution to economic growth is coming from consumption, including, in Moscow and other wealthy
cities, conspicuous spending on imported luxuries such as German cars, Italian fashions and French wines. But along with
this has come inflation, driven by big wage increases, especially in the energy and minerals industries. Russians on
holiday in Europe are no longer necessarily just the owners of businesses, but also their employees and their
families.
Excessive wage growth means lower productivity and lower profitability. Economists calculate that the productivity
gains caused by the 1998 devaluation have now largely been eaten up through domestic price increases, meaning that local
Russian producers may soon face tougher competition from overseas. "There is macro-economic stability, the
investment climate and corporate governance is improving, and capital is coming back," Sergei Guriev, vice-rector
at the New Economic School in Moscow, says. "The big challenge is what happens when the oil price comes
down."
For liberal economists, the answer lies in more market-oriented reform. The list starts with banking, where one big
state-controlled institution, Sberbank, dominates the market but does little to fulfil the basic economic need of
supplying credit to smaller enterprises.
Utilities liberalisation comes next. UES, the electricity giant, is lumbering towards reform, including a significant
break-up of capacity. But Gazprom, the gas monopoly, remains under close state control as do the railways and many
defence industry plants.
At the EBRD, Mr Buiter argues that Russia also requires significant improvements in the rule of law to create a level
playing field for business, cut arbitrary state interference, reduce corruption and promote genuine competition. Without
such changes, there is little chance for new companies to compete with established groups, especially those with secure
backing from influential politicians and bureaucrats.
Mr Putin has toyed with such reforms, notably utilities liberalisation. But he seems to have pulled back for fear of
antagonising powerful vested interests, including politicians, civil servants and oligarchs. "The government
undertook the easier reforms, like tax, for which it was easy to find consensus. Now they are running into those where
they face much more opposition," says Christof Ruehl, chief economist with the World Bank's Moscow office.
Mr Putin may be biding his time until after the parliamentary and presidential elections. But, as a former KGB man
with little experience of running the economy, he may not appreciate how much economic dynamism depends on economic
freedom.
Also, he faces a serious dilemma. Leaving power in the hands of the bureaucracy would be dangerous for the economy.
Yevgeny Yasin, a former economy minister and liberal reformer, says: "The Russian economy is constrained by
bureaucratic shackles. If the economy is to grow, these chains must be dropped. If we can overcome this feudal system of
using power, we will create a stimulus for strong and sustainable economic growth and improve the standards of
living."
But liberalisation risks giving even more space to the already powerful oligarchs. The most modern companies in
today's Russia are largely those run by the oligarchs, who have been the biggest beneficiaries of the stability Mr
Putin has fostered. Peter Aven, a former trade minister who now runs Alfa Bank, estimates that 12 big groups control 60
per cent of the economy - probably more in absolute and proportionate terms than they did in 1998, and certainly in a
wider range of sectors.
That figure is likely to grow as reform proceeds. For example, the future break-up of UES, approved this year by the
Kremlin and parliament, will probably involve the sale of generating and distribution companies to big business
groups.
Similarly in banking, if the market were liberalised, the only domestic groups with sufficient capital to operate
nationally would probably be the oligarch-controlled conglomerates. It is little surprise that the bureaucrats
responsible for the industry - and perhaps Mr Putin himself - are so reluctant to move.
Poland and other central European states have often opted for foreign capital in big privatisations. But such ideas
have limited appeal in Russia. Ordinary Russians are proud of their traditional self-reliance. And oligarchs have
exploited such sentiments to limit foreign participation in assets sales - and are likely to do the same in future.
If Mr Putin decides against giving more economic opportunities to the oligarchs, he will have strong public support.
The recent Yukos investigation has proved popular with Russian voters, according to opinion polls. Most Russians believe
all big money in Russia has been gained through criminal means and favour prosecutions. They are convinced that the
privatisations in which the oligarchs made their fortunes represent a theft of property that once belonged to every
Russian. Mr Putin, however, insists he has no plans for a generalised assault on the oligarchs or privatisation.
In any case, such an approach would not change the country's economic structure or the dominance of a handful of
oil and gas companies. Prosecutions might change the identity of a few owners, but not the overall concentration of
economic power. Around the world, oil industry economics has favoured the emergence and survival of integrated giants.
Russia is unlikely to be different.
Mr Putin's nature is to tread carefully between the competing forces of oligarchs and bureaucrats, who are
themselves divided into factions. If he fails to broaden access to economic opportunity, he will risk stifling economic
growth and eventually provoke a social backlash.
Mikhail Khodorkovsky, the Yukos chief, and other leading oligarchs have realised the danger and are voluntarily
giving tens of millions of dollars to charity, including education, health care and the arts. Some business leaders have
also backed Mr Putin's calls for tax increases for poverty alleviation. But this is unlikely to amount to a serious
surrender of economic power.
The Russian economy is likely to remain dominated by tensions between the Kremlin and the oligarchs for the
foreseeable future. While oil and gas prices are high and the economy is doing well, they will probably be contained.
But in a future recession, they could burst into the open. Perhaps a cash-starved government will resort to punitive
taxation. Or populist politicians may demand asset seizures. Perhaps a belligerent oligarch will threaten to withhold
tax.
Today, none of these is likely. Five years after the 1998 crisis, Russia has confounded its critics in pulling away
from the brink of disaster faster than western experts forecast. But its economic future is still insecure.
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